ENFORCING PROPERTY RIGHTS; PROPERTY RULES VS. LIABILITY RULES

Example (Friedman’s example from Ch. 5): There is a railroad with trains that emit sparks. There are 100 farmers’ fields around the railroad. The farmers can either grow wheat, which burns, or clover, which does not. Growing wheat is more profitable than growing clover. The railroad can install a spark arrester on its trains, but that is costly.

Several different legal rules are possible. We will look at the following two rules:

- Property right by the farmers protected by a property rule (Rule 2 in the text)

- Property right by farmers protected by a liability rule (Rule 3 in the text)

The possible actions of the railroad and the farmers, and the resulting outcomes can be summarized in the following table:

Railroad / Farmers / Outcome
Outcome A / Sparks / Wheat / Fires
Outcome B / Sparks / Clover / No Fires
Outcome C / Spark Arrester / Wheat / No Fires
Outcome D / Spark Arrester / Clover / No Fires

The relative efficiency of the outcomes will depend on the relative costs of growing wheat vs. clover and of installing spark arrester. We’ll consider three possible sets of costs, each of which has a different socially efficient outcome:

Cost of / (1) / (2) / (3)
Outcome A (Fires) / 400 / 800 / 800
Outcome B (Clover) / 800 / 400 / 400
Outcome C (Spark Arrester) / 1000 / 1000 / 200

The farmers have the right not to have their fields being burned down. Suppose first the costs of outcomes are given by column (1).

What is the socially efficient outcome? A: Outcome A

How much is the railroad willing to pay for the permission to throw sparks?

A: Up to 1000

How much would the farmers be willing to accept to issue such permission?

A: Anything above 400

If the transaction costs of negotiations are 0, what will happen?

A: The railroad will pay the farmers between 400 and 1000

How would the answers to the questions above change if the relevant costs are given by column (2)? Column (3)? A: Do it yourself

Holdout Problem

The farmers have the right to be compensated for the damages if their fields are burned (“liability rule”).

Again, assume first that the relevant costs are described by column (1).

What will happen if transaction costs of negotiations are 0?

A: The railroad will pay the farmers between 400 and 1000

What if negotiations are costly, but there is no disagreement about the size of damages?

A: The railroad will run the trains emitting sparks and pay damages

How would the answers change if column (2) is the relevant cost schedule? (Consider the following situations (i) the transaction costs of negotiations are 0; A: The railroad will run the trains and emit sparks. The farmers will switch to clover. If the court is well informed, the damages will be set at 400. If neither the court nor the railroad know about the farmers’ option of switching to clover, the damage payment will be between 400 and 800. (ii) negotiations are costly and the court is well informed, i.e., the court knows the information in column (2); A: The court will set the damages at 400, because it will know that the farmers can switch to clover. (iii) negotiations are costly and the court is not well-informed. A: If negotiations are very costly, the railroad will run the trains, emit sparks, and pay damages of 800. Farmers won’t switch to clover. How high would the transaction costs of negotiations have to be in order to affect the outcome in (iii)? A: If the transactions costs of negotiations are less than 400, it would pay the railroad and the farmers to negotiate and have the railroad cover the transaction costs plus pay the farmers between 400 and (800-trasnsaction costs).)

What would happen if the costs are as in column (3)? A: Do it yourself

CONCLUSION: PROPERTY RULES WORK MORE EFFICIENTLY WHEN THE COSTS OF ALLOCATING PROPERTY RIGHTS BY MARKET TRANSACTIONS (NEGOTIATONS) ARE LOW. LIABILITY RULES WORK BETTER WHEN THE COSTS OF USING THE MARKET TO ALLOCATE RIGHTS ARE HIGH.

Accidents vs. continuing nuisances

Damage payments to victims vs. fines