The Problem of Transaction Costs

Mechanism design provides a general paradigm for deriving legal rules and institutions that implement social objectives as equilibrium outcomes of interactions among strategic individuals with private information and endogenous transaction costs. This paper designs mechanisms that generalize Ronald Coase’s farmer-rancher example of nuisance law from his seminal article, “The Problem of Social Costs,” and Judge Learned Hand’s negligence liability tests from his classic opinions in T. J. HOOPER (1932) and CARROLL TOWING (1947). Mechanism design encompasses the Pigouviansocial-planner and Coasean-transaction-cost paradigms as special cases, while accommodating alternative societal objectives, various equilibrium concepts, endogenous transaction costs, strategic agents, private information, truthful revelation of private costs and benefits, incentive compatibility, voluntary participation, and budgetary feasibility. These features extend previous paradigms and test their robustness in more sophisticated economic environments. The mechanism design paradigm provides modern theoretical foundations for economic analysis of law. Keywords: Mechanism design, Coasean transaction costs, Hand test, bilateral externalities, social costs, nuisance, negligence. JEL Codes: K0, D82, D23, K11, K13, C7 ∗ Department of Economics, Purnell Hall, University of Delaware, 42 Amstel Avenue, Newark, DE 19716, USA; e-­‐mail: [email protected]; voice: 302-­‐831-­‐1913; fax: 302-­‐831-­‐6968. http://ssrn.com/abstract=2605994. 1.0 Introduction This paper designs two new liability mechanisms that implement efficient legal outcomes in nuisance and negligence law, to illustrate a general mechanism design approach to the economic analysis of law. These mechanisms incentivize strategic parties to truthfully report their private information about the benefits and costs of their activities to a court or other authority. The court uses liability rules to align the parties’ mutual best responses or dominant strategies with socially optimal outcomes in equilibrium. The incompatible activities mechanism for nuisance law causes the parties to truthfully report their private net benefits and costs of alternative activity levels. It designs liability schedules so that the parties choose their joint surplus maximizing activity levels as their dominant strategies. The (benighted Hand) negligence mechanism, enables an uninformed authority to apply liability rules that cause the parties to report their private costs of care and choose bilateral care levels that minimize their joint expenditures on precaution and expected accident costs when their care levels have different effectiveness in preventing joint losses. While these mechanisms are novel and significant in their own right, the main point of this paper is to elaborate a general mechanism design paradigm for economic analysis of law. The mechanism design framework treats transaction costs as endogenous costs of credibly conveying the parties’ private information about preferences, costs and benefits, and other characteristics, when they behave strategically subject to incentive constraints and budgetary feasibility. The framework specifies the initial distribution and subsequent exchange of information that is necessary to determine efficient outcomes. Legal rules and institutions arise endogenously to govern legal interactions and coordinate decentralized private decision-making so that the parties achieve socially desirable outcomes in game-theoretic equilibrium. Endogenously designed rules and institutions cause the equilibrium outcomes to coincide with precisely stated social objectives, such as joint surplus maximization or cost minimization. Ronald Coase’s seminal paper, “The Problem of Social Cost” (1960), developed the Coasean transaction cost paradigm that underlies much of the existing economic analysis of law, especially in property, torts, and contracts. The Coasean approach allocates property rights to mitigate the effects of transaction costs on private negotiations and facilitate the transfer of rights to the party who values them most. It incorporates Judge Learned Hand’s (1932, 1947) mathematical formulation of negligence and product liability law that sets the standard of care for activities that 1 Mechanisms can achieve other social goals, such as fairness or Rawlsian justice.