Coase Theorem The initial allocation of legal rights and liabilities will not get in the way of the efficient allocation of resources Where parties to.

Coase TheoremCoase Theorem

The initial allocation of legal rights and liabilities The initial allocation of legal rights and liabilities will not get in the way of the efficient allocation will not get in the way of the efficient allocation

of resourcesof resources

• Where parties to a transaction are fully informed about the consequences of alternatives

• Where parties to a transaction can bargain freely and costlessly AND

• Where parties to a transaction can monitor and enforce compliance with contracts costlessly

That Means:That Means:

• It doesn’t matter who owns what, the person who can use ITIT best (measured in terms of willingness and ability to pay) will end up with ITIT

• It doesn’t matter who is responsible for the design, manufacture, or sale of a product, its attributes will be efficient

It Doesn’t Mean:It Doesn’t Mean:

That the distribution of income or wealth will be the same regardless of the prior distribution of rights and liabilities

(The distribution of income or wealth after a transaction depends on the distribution of wealth (assets or rights assets or rights minus liabilities or liabilities or

obligationsobligations) prior to the transaction)

SolutionSolution

Annualized Cost of Spark arrester = $3000 Annualized Cost of Spark arrester = $3000

Annualized Cost of Fire Damage = $4500Annualized Cost of Fire Damage = $4500

Annualized Cost of Spark arrester = $3000 Annualized Cost of Spark arrester = $3000

Annualized Cost of Fire Damage = $1500Annualized Cost of Fire Damage = $1500

Does it Matter who is Liable for Does it Matter who is Liable for damages?damages?

NONO

What Happens if Railroad is Liable?What Happens if Railroad is Liable?

• If fire damage If fire damage = $4500, = $4500, Railroad Co. Railroad Co. buys spark buys spark arresterarrester

• If fire damage If fire damage = $1500, = $1500, Railroad Co. Railroad Co. pays damages pays damages to farmersto farmers

What Happens if Farmer is What Happens if Farmer is Liable?Liable?

• If fire damage If fire damage = $4500, = $4500, farmer buys farmer buys spark arrester spark arrester for Railroad for Railroad Co. Co.

• If fire damage If fire damage = $1500, = $1500, farmer stands farmer stands ready to put ready to put out fires caused out fires caused by trainby train

Moral HazardMoral Hazard(term comes from insurance industry)(term comes from insurance industry)

The WASTEFUL behavior induced when people The WASTEFUL behavior induced when people do not bear the full consequences of their actionsdo not bear the full consequences of their actions

IN THE TRAIN/FARMER EXAMPLE, WHICH IN THE TRAIN/FARMER EXAMPLE, WHICH ASSIGNMENT OF LIABILITY WAS MORE ASSIGNMENT OF LIABILITY WAS MORE LIKELY TO CREATE A MORAL HAZARD?LIKELY TO CREATE A MORAL HAZARD?

Farmer or Railroad Co.?Farmer or Railroad Co.?

Asymmetric Information CostsAsymmetric Information Costs• Search cost -- the cost of obtaining full Search cost -- the cost of obtaining full

knowledge of the THING being transacted knowledge of the THING being transacted including the consequences of its use and its including the consequences of its use and its alternativesalternatives

• Bargaining cost -- the cost of reaching a Bargaining cost -- the cost of reaching a mutually satisfactory contractmutually satisfactory contract

• Monitoring and enforcement costs -- the cost of Monitoring and enforcement costs -- the cost of insuring compliance with contractual termsinsuring compliance with contractual terms

In the information asymmetries, market incentives together with either public provision of information or — in the case of information asymmetries — reassignment of liability, public certification, or enforced disclosure will often produce more efficient outcomes than will a regulatory program that restricts the range of goods and services made available, enforces maintenance standards, or establishes maximum levels of exposure to health and safety hazards.

Where participants in private market transactions err only because information is absent, public provision of information will be more efficient than regulation. This follows from the observation that public provision of information can meet economic objectives without removing alternatives from the market that some consumers or workers would prefer.

Kinds of Product LiabilityKinds of Product Liability(all theories of product liability require the injury to be (all theories of product liability require the injury to be related to product use -- reflect changing reality about related to product use -- reflect changing reality about

who is best located to make knowlegeable choices about who is best located to make knowlegeable choices about net benefits)net benefits)

• Caveat EmptorCaveat Emptor

• NegligenceNegligence

• Strict LiabilityStrict Liability– Voluntary and knowing assumption of the risk

(known and avoidable danger)– Contributory negligence (not just misuse)– Disclaimers

• Absolute LiabilityAbsolute Liability

DamagesDamages(no right without a remedy)(no right without a remedy)

• Economic Losses (replacement cost, out Economic Losses (replacement cost, out of pocket expenses)of pocket expenses)

• Compensation for Pain and SufferingCompensation for Pain and Suffering

• Punitive DamagesPunitive Damages

Regulatory OptimumRegulatory Optimum