From property rights to individual incentives

A number of issues related to the distributional effects induced by a Coasean negotiation have been raised in the economic and legal literature. Economists tend to appraise the issue in terms of final distribution of resources derived from initially different allocations.

The debate on the uniformity of the final allocations of resources serves as a logical premise to the issue of distributional effects. Microeconomic theory teaches us that different points along a contract (or conflict) curve correspond to different distributions of goods among the various players. In other words, notwithstanding the Pareto optimality of every agreement that falls along a contract curve, any change in the initial endowments necessarily generates a different final distribution of resources. Following this logic, Regan and Nutter elucidate the strict tie between uniformity of allocations and distribu­tional effects.⁶⁵ To affirm that the efficiency of the final allocation does not imply identical allocative outcomes at the equilibrium point, means to admit that the change of legal rules, although corrected by the Coasean negotiation on the level of efficiency, will always cause shifts of wealth between the various parties.

The observations that follow endeavour to account for the debate on the allocational uniformity and the distributional effects of the Coase theorem.

Property rights and social costs

The debate on this point was also initiated by Calabresi⁶⁶ and Wellisz,⁶⁷ who considered the issue of allocational uniformity as intrinsically related to that of distributional effects.⁶⁸ In order to evaluate the significance of their analy­ses, let us consider again Coase’s scenario with a farm and a ranch coexisting in the same environment.

In his 1988 notes on the problem of social cost, Coase argues against the soundness of this logic: ‘I consider this argument to be wrong, since a change in the liability rule will not lead to any alteration in the distribution of

wealth’.⁷⁰ Coase’s argument is that, if the right is assigned to the farmer, then the cost of the rancher’s liability will be discounted from the price necessary to acquire or rent the ranching business. The land destined for the activity of the rancher, subsequent to the shift of liability will be less valuable. Anal­ogously, the farming land, protected by the liability rule, will yield a greater revenue and will consequently demand a higher price on the market. The change in the relative costs of the two businesses will, thus, offset the patrimonial effects of the modified legal rule.

With these observations, Coase responds to the various criticisms on the distributional effects of his model by affirming that, as soon as the assign­ment of rights between the two industries is known, it will be reflected in the relative prices of their products. The wealth of prospective farmers, ranchers and land-owners will remain unaltered since the changes in the prices of their entitlements promptly will balance the momentary disequilibrium caused by the changed system of rights.⁷¹

Coase’s analysis, however, seems to presuppose a static system of legal rules in which, regardless of what may be the initial allocation of rights, a final equilibrium will be reached on a system of prices that fully offsets the distributional effects of the legal rule.

Coase does not overlook the possibility of a similar objection, and tries to reconcile the conflict through contractual devices. He believes that the distri­butional effects can be avoided even in the case of dynamic changes in the legal system through a different mechanism, which remains faithful to the nature of his model. According to Coase, in fact, the parties can agree to tie the price paid for the acquisition of any given property right to possible changes in the law.⁷³ By means of such contractual provisions, the parties would be able to obtain an effective shield against involuntary transfers of wealth due to exogenous changes in the assignment of rights and liability.⁷⁴

Allocational effects and the problem of extortion

According to the Coase theorem, in the absence of transaction costs, the voluntary exchange of property rights would lead to an efficient allocation of resources between alternative uses. According to Calabresi⁷⁵ and Wellisz,⁷⁶ however, the use of strategic behaviour in the process of contract formation risks altering such a result.⁷⁷ Elaborating on this variation on the general theme of distributional effects, Callabresi and Wellisz observe that the change in the rule of law creates the conditions for possible extortion on the part of the rights holders against the other individuals who are bound by the rule.

In order to clarify the point, consider a situation in which the optimal size for the rancher’s herd is 1000 head. In such a scenario, imagine that, in order to reduce the damage to his/her own crops, the farmer would be willing to compensate the rancher for a reduction of his/her herd to 800 head. Accord­ing to Coase, this agreement generates an optimal allocation of resources between the two activities. The criticism claims that, by introducing the possibility of strategic behaviour in the negotiation, the result may differ from such an ideal equilibrium. If the rancher threatens - for strategic rea­sons - to increase the size of his/her herd to 1500 head, the final agreement is likely to diverge substantially from the efficient allocation of resources boasted by Coase. The rancher will, in fact, seek to maximize the profit from the conceded reduction on the first 500 head (which, however, would have con­stituted an inefficient oversize for his/her firm), and the agreement will likely be reached on different terms from those predicted by the theorem. As a consequence of such strategic bargaining, there would still be too many cattle and too much damage to the crops.

In his 1988 notes on the problem of social cost, Coase did not elaborate on the theme of extortion. His silence on this point perhaps implies a tacit reference to the work of Demsetz, which in 1972 had supplied a convincing answer to this criticism.⁸⁰ According to Demsetz, the possibility of strategic behaviour in the negotiations does not alter the efficiency in the final alloca­tion of resources between the two activities.⁸¹ Despite possible uses of strategic bargaining, the number of cattle in our example will always be reduced to the point at which the sum of the values of the two activities is maximized.

Strategic stalls in Coasean bargaining

The residual problem of the allocative effects, often used to cast doubt on Coase’s model, merits one further word of clarification.⁸³ The credibility of the threat made in the course of strategic bargaining finds its limits in the market structure in which the Coasean negotiation takes place. A rancher who threatens to raise the number of his/her cattle beyond the maximum capacity of his/her industrial structure, or to a size that exceeds the absorp­tion of the beef market, for example, would make use of a non-credible threat, one incapable of playing any role in the negotiations.⁸⁴ In general, the competitive structure of the market eliminates much of the advantage that can be obtained through strategic behaviour in the negotiation process. Inasmuch as the market of resources is competitive (in our example, as long as there are alternative locations for the farming or ranching activity), strategic bargain­ing is not capable of bringing about any abnormal return.⁸⁵ If the farmer demands a level of compensation that exceeds the market price for that right (in addition to the cost necessary to move the herd to another locality), the rancher will opt for more economical alternatives, relocating elsewhere.

Thus the non-competitive structure of the market and the credibility of the threat become the only situations which seem to justify the concerns for the use of contractual strategies in Coase’s model. Beyond these marginal hy­potheses, the existence of a competitive market will exclude the possibility of any contractual mark-up that goes beyond the normal returns of a profit­maximizing firm.

The appropriate economic label for this problem is nothing more nor less than monopoly. It takes on the cast of such legal classifications as extortion only because the context seems to be one where the monopoly return is received by threatening to produce something that is not wanted - excessively large herds. The conventional monopoly problem involves a reduction or a threat to reduce the output of a desired good. In the unconventional monopoly problem presented here there is a threat to increase herd size beyond desirable levels. But this difference is superficial. The conventional monopoly problem can be viewed as one in which the monopolist produces more scarcity than is desired, and the unconventional monopoly problem discussed here can be considered one in which the monopolist threatens to produce too small a reduction in crop damage. Any additional sum that the rancher succeeds in transferring to himself from the farmer is correctly identified as a monopoly return.⁸⁷

According to Demsetz, the concerns for possible monopolistic structures in the market of rights considered by Coase must not, however, be used, to raise again the already resolved problem of the initial allocation of rights:

The temptation to resolve this monopoly problem merely by reversing the rule of liability must be resisted. Should the liability rule be reversed and the owner of ranchland now be held liable for damage done by his cattle to surrounding crops, the specific monopoly problem that we have been discussing would be resolved. But if the farmer enjoys a local monopoly such that the rancher has nowhere else to locate, the shoe will now be on the other foot. The farmer can threaten to increase the number of bushels of corn planted, and hence the damage for which the rancher will be liable, unless the rancher pays the farmer a sum greater than would be required under competitive conditions. The potential for monopoly and the wealth redistribu­tion implied by monopoly is present in principle whether or not the owner of ranchland is held liable for damages. Both the symmetry of the problem and its disappearance under competitive conditions refute the allegation that Coase’s analy­sis implicitly endorses the use of resources in undesirable activities.⁸⁸

Having freed the discussion from concerns on the potential use of contrac­tual strategies in a Coasean bargaining situation, we can now move to the examination of the controversial assumption of no transaction cost contract­ing, by many identified as the true weakness of Coase’s model.