Hi everybody, welcome back. Last time, we articulated the Coase theorem when bargaining costs are low.

An efficient allocation of property rights will be realized regardless of the initial placement of those property rights, although the distribution of the maximized value of the property rights will differ depending on that initial placement. For some years after the initial publication of Coase's argument in 1960, lawyers and economists debated It's meaning. Some people said that it was a profound result, although it was difficult to say exactly what was profound about it. Other people argued that it was, in fact, nothing new at all. It was very old wine in not even very new bottles. Because indeed, for decades, economists had known of the existence of something called the fundamental theorem of welfare economics. Which says essentially the same thing that the Coase theorem says, which is, under certain assumptions which mean that bargaining costs are low. Property rights will always gravitate towards their higher valuing owners, their highest valuing owners through free exchange in markets. So in this sense the Coase result is nothing new. It simply restates the argument that under conditions close to perfection property rights will always move through free exchange from lower valuing to higher valuing owners. But the exact terms of the allocation that results from all of this exchange will depend on the initial endowments; that is, the initial property rights that individuals hold. About ten years after the publication of Coase's article, a great deal of progress was made in understanding it through the efforts of the young, at that time, Richard Posner. One of the most remarkable intellectual figures in social science in the 20th century in the United States. Posner was, in the late 60s, a young law professor at that University of Chicago and he was quite taken with the economic approach to law. That is, he worked with Gary Becker in the Department of Economics at the University of Chicago and with Ronald Coase in the

law school to develop the implications. Of economic thinking for the development of legal systems and for the structure of economic excuse me, for the structure of legal rules. Posner has been a remarkable prolific scholar ever since the late 1960s and for the past quarter century or so. He's been a senior judge, a judge on the United States Court of Appeals for the seventh circuit in Chicago, a very prestigious judgeship. From which he has continued to write an enormous number of very, very influential legal opinions. Posner's idea was to, as it were challenge the assumption behind the Coase theorem. The assumption that transactions costs or bargaining costs were low. And Posner asked the question what would happen to the Coase theorem if transactions costs were high. So let's go back to the original example with which we began, in which Jefferson's value of the right to test sirens is $500. And Hamilton's value of the right to test sirens is $200. So that Jefferson is the higher valuing owner, and the Coase Theorem would say that if there are no bargaining costs, Jefferson will wind up with the property right, irrespective of whether he or Hamilton has been initially granted. The property right by the court. So let's in fact relax the assumption of low bargaining cost by in fact considering high bargaining costs. I suggested last time that there are a number of different sources or origins of transactions cost. But for now let's simplify all of those into a single source of transactions cost which we'll hypothesis as a sales tax. And the terms of the sales tax are, in the town where Hamilton and Jefferson live, every time a property right is transferred from a seller to a buyer. Then a sales tax of $700 must be paid to the town by the buyer of the property right. What this means is, that there is a $700 transactions cost associated with every transfer of property rights from one individual to the other. The outcome of the Coase theorem in the existence given the existence of these transactions costs will, in fact, not be the same as it was in our earlier example. If Jefferson wins then the court has given him the arrow initially and Jefferson, as

we saw, is the highest valuing owner of the right. And therefore, Hamilton will not be able to offer Jefferson enough to pry the right from Jefferson's hands into Hamilton's. And enable Hamilton to stop the silent testing. So if Jefferson wins, because the property right is already in the hands of the highest valuing owner. No transaction need take place at all to move. The property rights of the higher valuing owner. The sirens are in fact tested, and the total value of the two properties, just as it was in our earlier example, is $2500. But if Hamilton wins, Jefferson now has to buy the right. We saw that he was the higher valuing owner. Hamilton only values the right at $200 and is still willing to sell the right for some value above $200. Jefferson still values the right at $500 and is willing to pay up to $500 in order to get it. But now the transaction's cost will make it uneconomic for Jefferson to purchase the right from Hamilton. Since if he doesn't already have the right Jefferson will first have to pay Hamilton at least $200 to get the right from Hamilton and then on top of that pay him an additional $700 in sales tax. There is no price that Hamilton will accept that Jefferson will be able to pay if he has to pay the sales tax in addition. Hence, even if Hamilton were willing to sell for as little as $201, then Jefferson would have to pay $201 to Hamilton, $700 to the town, a total of $901. Which is substantially more than the $500, than the $500 that the property right is worth to Jefferson in the first place. So the existence of the sales tax. That is the existence of the high cost of transacting means that the property right once given to Hamilton, the lower valuing owner, the property right will stay with Hamilton. The lower valuing owner. The total value of the two properties will be only $2200. Because the property right has stayed with Hamilton, who exercises it negatively, and Jefferson will not be able to test the sirens and produce their $500 value. So in the presence of these high

transactions cost, the Coase theorem fails. It obviously does make a difference how the court initially allocates the property right in question with a high transactions cost. Transactions that would move the property right from the lower to the higher valuing owner have been blocked. Hence, what I'll call, Posner's corollary to, to Coase, to Coase's theorem. And that corollary is this, when bargaining costs are high an efficient allocation of property rights will occur only if the law initially allocates those property rights to their highest valuing owner. And thus obviates the need for any transaction in order to have property rights allocated efficiently. So again, when bargaining costs are high, property rights will only wind up in the hands of the highest-valued owner. Maximizing the total value of property rights if the judge is wise enough or smart enough to put that property right in the hands of the highest-valuing owner originally. And thus obviate the need for transaction to realize the efficient allocation of the property rights. This is a very interesting result, and Posner himself has developed this idea. That is the failure of the, of the Coase theorem in the presence of high transactions costs into a remarkably interesting theory of the judicial function itself. Posner asks what it is that judges should in fact be doing. Most of us, when we're asked what judges are in the world to do, would answer generally by saying that judges are in place to enforce the law. And by enforcing the law to do substantial justice between the parties who are before them, litigating the case. In our case, Hamilton versus Jefferson, we might ask what the just result in that case is. Is it fairer for Hamilton to have the property right, and thus be able to extract some income from Jefferson before he suffers the costs of the siren testing? Or does justice demand that Jefferson be allowed to use Rachael's alcove to, to perform an otherwise legal activity for his own benefit. Much of our answers to these questions turns, I think, and Posner agrees, on how

we feel about the parties. That is, we'd need to know a little bit more about Hamilton. And we need to know a little bit more about Jefferson in order for us to come to a decision in our own minds as to where the equities lie in the case. Who is the more deserving recipient of the arrow associated with the testing of sirens in Rachel's Alcove. Most of us think that this is what judges are there to do. But Posner's corollary suggests an alternative vision of what it is that judges are there to do, and that is by allocating property rights initially to their highest valuing owners, in cases where transactions costs are likely to be high, judges can achieve allocated efficiency. Even, as we'll see in an example, at the cost of what we might think of as justice or equity in the particular case. Posner's view on what judges should do, whether they should try to do justice between the parties or try to allocate rights efficiently, is one that is an extremely controversial response. Posner's argument is that justice, the idea of justice, is a subjective thing. There is no science of justice. There is no objective theory of justice, that all reasonable people are bound to accept, in the sense that all reasonable people are bound to accept the proposition that the Earth is round and not flat. Different people have different views of justice. Different people have different views of fairness and we have not yet succeeded in finding a language to express proposition about justice or fairness that are purely logical and that every reasonable person is required to accept. The result is that justice means something different to different people, and that includes judges as well. Posner's argument is that the subjectivity, the personal nature of feelings about judges, about justice, means that if judges actually try to do justice in the deciding of cases. They'll reach unacceptable results for a variety of reasons, all having to do with what we might call the rule of law. The rule of law is, broadly speaking, the proposition that like cases should be decided in the same way. And that cases should not turn on the personal qualities of the litigants but

should instead turn on general abstract rules that can be applied in every case objectively without consultation to the identity of the parties. If the rule of law is to be followed, then like cases must be decided in the same way. But if judges are trying to do justice, Posner argues, they often cannot do this, for several reasons. The same judge may frequently decide similar cases differently because the judge has a particular view of the equities of the case that changes with the circumstances. So, for example, we might find a judge who decides two siren testing cases in the same afternoon. In one case, he finds the Jefferson character to be more deserving, and allocates the property right to Jefferson. In the second case, he finds the Hamilton character to be more deserving, that the equities lie on Hamilton's side. And in the second case, the judge awards the property right to Hamilton, and feels that justice has been done in both cases. But of course, what the judge has also done is to create a completely unpredictable law about siren testing. It will depend on whether the judge likes you. Whether you get the right to test the sirens. Or whether you have to deal with somebody else being given the right to test sirens. In the same way, different judges, because of their different senses of equity or justice, will decide the same case differently. So if we take the same case of Hamilton versus Jefferson and put it before two judges, each of whom has a different vision of whether Hamilton or Jefferson is more deserving. Each judge, attempting to do justice, will in fact decide the case differently. Again, producing unpredictability, or arbitrariness in the, in the operation of the courts. So, for Posner, the attempt by judges to do justice is unacceptably arbitrary. But efficiency, as we've defined it, is for Posner, an objective standard. We may disagree over whether Hamilton or Jefferson is a better person, or whether they are, which of them is the, the, the more deserving holder of the property right in question. But if Hamilton values the property right

at $200 and Jefferson values the property right at $500 then everyone can agree that Jefferson is the higher valuing owner and that an efficient allocation of the property rights will move the propery right to Jefferson. And so, for Posner, efficiency has a quality of objectivity. That reasonable people must agree on what the efficient outcome is when in fact, they may not agree on what the just or fair outcome of a particular case is. Doing justice for Posner involves politics and therefore judges who are not politicians and are typically not elected. Judges should not do politics. For Posner, the proper province of politics are legislatures and executives, those branches of government that are elected by the people. This is, as I've said, a controversial view. Here's a contrary view held by many people, and the subject of a debate, as it were years ago when Posner was first developing his own ideas. The contrary view suggests first that Posner's corollary will be difficult to, to manifest, or difficult to operationalize, because it will frequently be very difficult for judges to determine in real cases who the higher valuing owner of a property right is. Posner's corollary suggests first the judges should try to do efficiency rather than doing justice. And if they try to do efficiency the Coase theorem tells them that when transaction costs are high the only way that efficiency can be achieved in the allocation property rights is for the judge to identify the higher valuing owner. And to initially give the property right to that higher valuing owner. But without negotiations to establish who the higher valuing owner is, it is frequently very difficult for a court to determine who that higher valuing owner is. Moreover say Posner's critics, in light of the distributional concerns that we've seen attached to the Coase theorem to first to the dependence of the result on the initial distribution of income. And then that qualification that we added that people have to have enough money to manifest all of their preferences. In light of these distributional questions the critics argue, efficiency is also an

arbitrary standard. Since different initial distributions of income will produce different economic values, and therefore different e-, effiecient allocations. Then what constitutes an efficient allocation depends directly on how income is distributed before exchange. And that is in the critics view just as arbitrary as standard as the justice standards that individual judges may try to apply. Posner's critics argue that it's best to confront the inevitable politics of these situations explicitly in the courtroom, rather than to try to hide these political concerns through the false objectivity of the efficiency rationale that Posner develops. There's a potential middle ground, which we'll see again a little bit later in the course. In this middle ground, judges decide only what might be called "easy cases", those which are amenable to the kind of clear, abstract rules, that are independent of the parties' identities, that are at the core of the value represented by the rule of law. That is, judges should be given cases only where the rule of law can easily be obeyed and where the same case can turn out the same result time after time. All the other cases are politics. All the other cases turn on subjective feelings of justice or equity. They turn on distributional concerns and they turn on issues that reasonable people can differ on. They are quintessentially political, and these questions this middle ground argues, should be decided in the popular branches. Next time, indeed in the next two lectures, we'll develop some of these qualifications of the Coase theorem using two cases to illustrate. See you then.