. Hi, everybody. Welcome back.

In this lecture, we'll talk about transactions costs and The Coase Theorem and Posner's Corollary in the context of a real case, a case that was decided by the Supreme Court of the United States in the year 1914. The litigants in this case were a fiber company, the LeRoy Fibre Company and a railroad, the Chicago Minneapolis and St. Paul Railway. And the nature of the dispute was this. Leroy was a flax company. That is to say, they grew flax or they purchased flax that had been grown by local farmers and they collected the flax and sold the flax at wholesale. Leroy had a yard, a large yard, which was adjacent to a railroad track that was owned by the railway, the Chicago, Minneapolis and St. Paul Railway. Leroy used the yard to stack its flax and as the pictures that I'm showing here suggest this flax was stacked in huge rolls and stacked with the rolls one on top of the other. So, we can imagine that the LeRoy Fibre Company's lot was filled with stacks and stacks of flammable flax over the entire yard. But next to the yard, as I've said, was a railroad track and on the railroad track, there went trains operated by the Chicago, Minneapolis and St. Paul Railway. This was in the year 1910 or 1912 when trains were not yet diesel, but looked like the steam locomotive in the picture. And as you can see on the picture, this steam locomotive is spewing black smoke out from, from its smoke stack and this is the source of the problem between LeRoy and the railway. Here's a picture of LeRoy's lot, as if were, and those circles are meant to represent the stacks of flax that Leroy has stored on, on its lot. We'll assume that LeRoy is using its lot in what is for LeRoy, the profit maximizing way. That is, absent the train, the owner of the property has decided that his quiver of property rights on the lot is maximized in value if he uses the lot to store flax, as I've drawn it on the picture. But as you can see, the, the flax lot is

adjacent to a railroad track. And on the railroad track we'll assume there is a train. I'm not an artist, but you'll get the idea. There is a locomotive, and it's chugging down the track. And, of course, as the locomotive chugs down the track, as we saw in the earlier picture, it spews smoke. And in the smoke are embers. That is to say, the locomotive runs when somebody shovels coal into the engine. The coal burns. The burning produces steam. The steam turns the wheels. And then the spent fuel is pushed out of the smoke stack and as the smoke leaves the smoke stack, burning embers of coal leave the smoke stack as well. And, as it turns out, as the trains goes faster and faster, the smoke is churned out with more and more energy, and the embers go further and further away from the train. So, if the train is operated slowly, it will come down the track as it were and it will toss sparks a little bit of the way into LeRoy's yard. But if the train is going faster than then that, then it will throw the same smoke and the same embers further afield, further away from the tracks and therefore further into LeRoy's lot. So, we have a situation where if the railroad operates its trains, it will toss sparks into LeRoy's lot. And the sparks have the potential of setting the flax on fire and burning down the entirety of the property that is stored on the lot. So there's a dispute and the dispute arises as follows. One day, the railroad was operating a train along this track. And all sides agree that the train was being operated carelessly, negligently to use the legal term. What this almost certainly means is that the train was going too fast. And we can imagine what is was that made the engineer of the train drive it too fast. He was, after all, riding from Chicago to St. Paul, a distance of about 400 miles. In those days, there wasn't much between Chicago and Minneapolis except open territory and the occasional LeRoy Fibre Company and perhaps, the engineer had a

bit too much to drink, and he ran the train a bit too fast. And when he did, and passed the LeRoy lot, sparks flew a considerable distance from the train. They landed in LeRoy's lot and LeRoy's flax burned, costing LeRoy an enormous amount of money. And so LeRoy sued the railroad in federal court in Minneapolis, hoping to get the railroad judged liable for paying for the damages to LeRoy's lot. All sides agreed, or the jury determined, that the railroad was operating its train negligently. The lower court found for the railroad on the theory that LeRoy bore some responsibility for the burning of the flax, because it had placed its stacks of flax, as you can see, close to the railroad tracks. And it therefore created a hazard with the sparks. Because the railroad was there first, the lower court said, LeRoy knew that there was a danger that sparks might come from the engine, and burn down the flax. And therefore the lower court said, despite the fact that the train was being operated negligently, LeRoy was also negligent or careless because it had placed its flax too close to the tracks and created the hazard that the train would, in fact, toss its sparks into the lot and burn it all to a crisp. The Supreme Court of the United States reversed the lower court's decision, and decided for LeRoy. And its argument was, that the crucial fact was, that the railroad had been operating its train negligently. And the court held, since the railroad had operated its trains negligently, LeRoy had no obligation, no duty, to account for the negligent operation of the train; and therefore it had no duty not to store its flax close to the track, because, said only the negligently operated train had caused the fire. So, for the Supreme Court, the fact of LeRoy's carelessness was not at issue because LeRoy, in the view of the court, could not have its use of its own property limited by the negligent operation of the railroad's train. What's really of interest to us is not the majority decision or the lower court decision, but a very brief concurring opinion in the case by Oliver Wendell Holmes, a very famous judge.

Holmes agreed with much of the majority's decision in ruling on the, the case. But he was moved by the notion of the lower court that LeRoy might have born some responsibility for the damages that were done to its flax because it had acted carelessly in placing its, its flax too close to the track. And so for Holmes, there was a question for a jury to decide which had not happened in the original trial. And so Holmes would've returned the case back to a trial court in order to have a jury determine a crucial fact, which Holmes did not know, and indeed nobody knew because no one had been asked to determine this fact. Here, I've drawn a picture of the lot, and now I've drawn a line separating those two rows of flax. Okay? Let's call the area closer to the railroad track the near area, and call the area that is further away from the railroad track, the area of LeRoy's yard, the far area. Holmes asked a jury to determine the location of the line that separated the near and the far areas of LeRoy's lot and the significance of the line was as follows. The near line was placed at the farthest point away from the track that sparks would fly from a carefully operated train. That is, if the train were being operated lawfully, if it were going at the appropriate speed and were not being driven too fast or being driven carelessly by the engineer, then that carefully operated train, in the nature of things, would throw sparks no further than the near area. Only a negligently or carelessly operated train, one that was going too fast, would be able to get sparks from the track all the way down into the far area. And so Holmes's idea was this. The jury should identify on the basis of the facts of the case, the location of the line separating the near area from the far area. And for Holmes, once that line's location had been determined, LeRoy would pay for the damages caused by fires in the near area and the railroad would pay for damages caused by fires in the far area. That is, LeRoy would be required to anticipate that carefully operated trains would regularly come by its yard and throw sparks in the near area.

Since the railroad was there first for Holmes, it had the ability, it had the right, let's call it, to throw those sparks in the near area if its trains were being operated carefully. The only time that the railroad should be responsible for damages caused by the fire, Holmes argued, was when the railroad was acting negligently and if it was negligently, excuse me, it would toss its sparks all the way to the far area of the, of the, of the yard. So, the question then becomes, who should have the property right to throw sparks In the near area of LeRoy's yard. Notice that Holmes's resolution of the case would define a new property right, associated with the object of LeRoy's lot. And this new property right would be the property right to throw sparks from a carefully operated train onto LeRoy's yard in the near area. So for Holmes, he would decide the case first by having the jury decide where the near area and far area were and the Holmes would go back. Back into the chambers, bringing back an arrow with a tag that said, the bearer of this arrow has the right to throw sparks into the near area of LeRoy's yard. And Holmes would give this right to the railroad without having the railroad purchase it from the LeRoy Fibre Company or, heaven forbid, purchase it from the, from the court. Obviously that would be bribery and, as we've said earlier, we'll assume that doesn't happen. Leroy, of course, believes, perhaps as Jefferson did, LeRoy believes that this is their yard, and that the railroad should not have any right to throw sparks in any part of LeRoy's yard without LeRoy's permission. So, here in this case, at least under Holmes' theory of the case, the issue in dispute is who will have the property right, who will be granted by the court the property right, to throw sparks from the negligent, from a carefully operated train onto the near area of LeRoy's lot. Suppose that the right is worth $5000 to the railroad, which makes it a higher valuing owner, and only $1000 to LeRoy. What might this mean? If this railroad has the right, then in fact it can toss those sparks in LeRoy's yard and not worry about paying for any fires. But if it doesn't have the right, then it

must either buy the right from LeRoy and then throw the sparks in the near area of the yard. Or if LeRoy chooses not to sell, then the railroad must adapt either by not running trains past LeRoy's yard at all, or by building a spur on the track that moves the engine away from LeRoy's lot and therefore presents no danger of tossing the sparks from the now moved tracks onto LeRoy's lot. Suppose it costs the railroad $5,000 to build that spur or to stop operations. That is to say, if the railroad does not have the right, then it will bear a $5,000 cost in altering its operations to account for the liability that it will bear, if sparks are tossed on to LeRoy's lot. On the other hand, the property right in question we'll assume, is worth only $1000 to LeRoy. I suggested earlier that before the dispute, LeRoy was almost certainly using the lot in profit maximizing way. That is, that the owner of the lot had decided that he could maximize the value of all of the property rights in the lot, by storing flax close to the those tracks. If he is no longer in a position to do that, because the property right has been awarded to the railroad. Then the property owner will have to, the LeRoy will have to adjust to the operation of the railroad. If the railroad has the right, then the owner knows that if he puts his flax in the near area and a fire is caused, the railroad will not be charged and the owner will have to bear the cost of the fire himself. So, we'll assume he'll have to move the flax away from near area, and this will reduce the profitability of his business. If it didn't, he'd have done this to begin with. So, we can assume that by moving that use of the land from the best use, storing flax, to the next best use for LeRoy, which is leaving it open so that nothing catches fire, we'll assume that LeRoy's profits are reduced by $1000, and so the value of the property right to LeRoy is $1000. If the property right is in LeRoy, it will sell it for something more than $1,000, if it's in the railroad, LeRoy will only pay up to $1,000 in order to purchase the right. We see by these numbers that the railroad is the higher value in owner and the Coase

Theorem would apply if transactions costs are low, as they might well be in a case where there's a single railroad in a single LeRoy Fibre Company. And if transactions costs are low, the right will end up with the higher valuing owner no matter how the court decides. And if so, as we've seen, then the court's decision has a purely distributional effect. That is, the Coase Theorem suggests that no matter how the court decides the case, the property right will ultimately wind up in the hands of the highest valuing owner and efficient allocation of property rights will be achieved but the values that are, are realized by the railroad and LeRoy will obviously depend on who it is that wins the case, who it is that gets the property right to toss those sparks initially. If the Coase Theorem applies because bargaining costs are low, then the effect of the decision is purely distributional. The court decides who is more deserving of the windfall that is represented by the arrow, and gives the arrow to that individual. .