Tutorial 2

Note that "Marginal Cost/Benefit" typically refers to Private Marginal Cost/Benefit as decision-making often only considers the private perspective. 

You can imagine that the farmer has a smaller plot of land, so building their fence is only $100. The rancher's larger fence costs $200 to build. 

In the absence of transaction costs, society would be indifferent between (a) and (b). Under the invariant version of the Coase Theorem, the economic outcome is the same, the cheaper fence costing $100.00 is built around the farmer’s field.

This about the total costs/benefits. In (a), the net surplus is -$100 from the fence. In (b), the net surplus is still -$100 from the fence. The amount transferred between the rancher and the farmer will cancel out to be a net $0.

The contract emerges under (b), the property law that imposes a rule that the rancher must compensate the farmer for damage to crops, so there is now an incentive (liability) for the rancher to reduce the costs from their animals trampling crops of others.

The contract would include terms allowing the rancher on to the farm to build the fence, or having the rancher reimburse the farmer if the farmer builds the fence. There would be a further term for the additional savings of $100.00 being divided, possibly but not necessarily 50/50 between the parties.

(Part-a, no liability) Farmer still builds own fence ($100). The farmer will build a fence costing $100.00 around their farm, thereby saving $200.00 in damages not incurred from wandering cattle ($300 less damages − $100 fence). The saving of $200.00 by the farmer is also a saving of $200.00 for society. 

(Part-b, strict liability) Rancher builds their own fence ($200). We know that since legal fees exceed $100, no contract will be formed. Instead, the rancher would build their own fence costing $200.00 around their ranch, thereby saving $100.00 in damages not incurred from wandering cattle ($300 less damages − $200 fence). The saving of $100.00 by the rancher is a saving of $100.00 for society.

Comparing (a) and (b), the rancher will save $200 in no liability rule as opposed to only $100 in strict liability rule if legal fees were too high.

Let's think back to the Farmer and the Rancher...

When there are no costs to making deals or negotiations, the farmer ends up putting up the fence around the cornfield instead of the rancher fencing in the cattle, no matter what the law says about who is responsible.

In this situation, the land for both cattle and corn is used in the same way regardless of who legally owns which rights. This idea is known as the “invariance” version of the Coase Theorem (more discussed in Q9), because the final use of resources doesn’t change based on who starts with the property rights.

This version of the Coase Theorem applies when there are no income effects and no endowment effects. Under those conditions, the efficient (socially best) outcome ends up being the same no matter how legal rights are assigned.

Now, on to the ranking of the six transactions: