Chapter 2: cutting deals (the Coase

∗
Theorem)

Oren Sussman
c

September 9, 2017

1 Introduction
Chapter 1's study of the decision-making process was only an introduc-

tion to the main business of economic analysis: a study of human in-

teraction in a changing environment. Perhaps the simplest conceivable

social interaction is between two players exchanging one good against

another. The goods may be physical commodities, but they can also be

non-material commodities such as favors or legal rights. Consider the

following ctitious example: Frankie and Johnny decide to end an un-

1
happy marriage. There is no love or sympathy left between them, their

only objective at this point is to walk away from a bad relationship and

get along with their lives. The couple owns, jointly, some assets. Hence,

the deal that they are trying to execute is an exemption from their mu-

tual commitments against a certain allocation of the assets. As noted,

players interact within a certain environment. The relevant environment

here is divorce law. Consider, rst, a law that would enforce any mutu-

ally agreed split of the assets. In the absence of an agreement, an equal

split of the assets will be enforced, after deduction of legal costs. Legal

costs are massive: 50% of the estate. The purpose of this chapter is to

develop a theory that would be able to predict what deal, if any, is likely

∗
I would like to thank Luca Enriques for extremely helpful comments on an earlier
draft.
1 The example of divorce is chosen for its similarity with the main application of
this chapter: corporate insolvency. Both deal with the same problem: the possible
winding up of an association that no longer generates value to its members.

1
to be agreed upon within this environment, what deals are likely under

dierent environments and, most importantly, a normative evaluation of

the possible environments.

Simple as it is, the example captures the essence of many social in-

teractions. On the one hand, the two players face an intense conict of

interest. Each would like to increase his/her share of the pie at the ex-

pense of the other, and each may feel, strongly, that s/he deserves more

than 50%, either because s/he behaved better within the relationship,

made a greater contribution to the accumulation, or brought more into

the common pool, initially. On the other hand, they have a common

interest: to reach an agreement so as to avoid the legal expenses that

would aect both of them. Since conicts of interests are a fact of life,

the basic question of any social theory is whether the intensity of the

conict is bound to undermine the parties ability to pursue their com-

mon interests or, alternatively, that they can separate between the two,

bargain eectively for their share and at the same time avoid outcomes

that are mutually harmful.

Some useful terminology is provided with the aid of Figure 1. The

payos for players 1 and 2 are plotted against the horizontal and verti-

cal axes, respectively. Clearly, players cannot receive, jointly, more then

a 100% of the estate, which means that all points within the straight-

isosceles, shaded, triangle (including the edges) make the set of feasible

outcomes. As noted, half the estate will be lost to legal expenses if they

fail to reach an agreement. Then, the court will split the rest equally be-

tween them, which makes (0.25, 0.25) the disagreement point, also called
the status-quo, outside option, or threat point. Since the joint interest of

the players is to avoid legal expenses, the hypotenuse of the triangle de-

serves special attention; we call it the Pareto-ecient set. Since no player

would accept a deal that gives him less than his outside option, we call

the intersection of the Pareto-ecient set and the positive quadrant of

the status-quo point the bargaining set.

2 Economic eciency
Can one make normative statements on the basis of technical economic

analysis alone, without involving his own value judgments about right or

2
 Figure 1: the bargaining problem

P 2 ’s p a y o ff

b a rg a in in g se t
fe a sib le se t

0 .2 5
P a re to -e ffic ie n t se t

P 1 ’s p a y o ff
0 .2 5
d isa g re e m e n t p o in t
o r: th re a t p o in t, sta tu s-q u o p o in t,
O u tsid e o p tio n

wrong, good or evil, fair or foul? The answer is yes, to some extent. When

a certain action makes everyone worse-o (by their own subjectively-

dened motives and sentiments) we can say that the outcome is econom-

ically inecient. Presumably, such outcomes can be deemed undesirable

under any set of moral values. The denitions below operationalize this

simple idea into the notion of Pareto eciency, which is the most common

criterion of eciency in economics.

Denition 1. An outcome is said to be Pareto dominated if there exist

another feasible outcome such that at least one player is better o and

the others are not worse o.

and

Denition 2. An outcome is said to be Pareto ecient if there is no

other outcome that Pareto dominates it.

In Figure 1, all points on the hypotenuse are Pareto ecient, while

points inside the shaded triangle are not. Points above the hypotenuse

are not feasible. Clearly, there is an innite number of Pareto-ecient

outcomes, all of which satisfy the denition of economic eciency to

the same extent. Some readers may feel that points towards the center

3
of the hypotenuse are fair while points towards the corners are not.

Economic theory has little to say about about such or any other notion

of fairness. (As it happens, philosophers and social thinkers are bitterly

divided about the meaning of fairness and, even more so, about the

role of public policy in promoting it.) Yet, economic theory draws a

sharp distinction between eciency and fairness, which enables us to put

aside philosophical disagreements, provide an eciency analysis, thereby

informing public policy decision independently of moral values or political

ideology.

To illustrate the point, suppose that a social reformer suggests to

move from an ecient but (in his view) unfair outcome (on the hy-

potenuse towards the corner) to an inecient but a fair one (inside the

shaded triangle towards the center). An eciency analysis should point

out that the suggested outcome is Pareto dominated. Hence, there exist

other outcomes that could benet some (perhaps all) players, probably

satisfying the social reformer's notion of fairness. It follows that there is

little substance in the popular view that there is a fundamental conict

between eciency and fairness: the more of the former, the less of the

later. Rather, whatever is the equitable (or other) objective that society
2
decides to pursue, technical eciency considerations so as to minimize

the (opportunity) cost required in order to achieve that goal are still

relevant.

Another pisperception is that eciency considerations should be used

in order to maximize the size of the pie while fairness considerations

should be used in order to determine how to cut up the pie and dis-

tribute it among the players. Consider the case where fair outcomes

(towards the center) generate an aggregate payo that is smaller than

the aggregate payo of the unfair outcomes (towards the corners); see
34
Figure 2. In this case, Pareto eciency does not require that overall

2 These considerations are technical in the sense that the analysis need not deploy
the moral considerations that were used in order to dene the objective.
3 One (of many) possible stories that can justify the shape plotted in Figure 2 is
that there is a single productive resource, a plot of land for example, which would be
more productive if cultivated by a single player rather rather than by many (or that
giving it to one player and taxing him so as to support the other would decrease the
former's incentive to put eort into cultivating the eld).
4 For a diagrammatic representation of the aggregate payo draw a straight lines
with −450 slope via the relevant outcome and read the quantity on the intersection
of that line and the horizontal axis.

4
 Figure 2: eciency and fairness

P2’s payoff

P1’s payoff

output is maximized. Rather, it deems outcomes like point A (in Figure

2) as economically inecient. Loosely speaking, the reason is that there

are points that generate the same level of fairness with higher payos

for both players. While more fairness implies a lower average standard

of living, it does not imply sacricing economic eciency. Eciency con-

sideration cannot help society dene what notion of fairness (if any) is

desirable, but eciency consideration could rule out policies if there are

others that achieve the same objective at a lower cost.

3 Rubinstein's alternating oers bargaining

game
In order to analyze the Frankie-and-Johnny bargaining problem we need

to describe, in greater (albeit more abstract) detail, the environment

in which the two players interact. Such a description is called a game.

It describes the players, the possible actions that they can take and

the payos associated with each outcome. A player's payos depends

on all the actions that he has take and on all the actions taken by his

opponent. We describe the game with the aid of Figure 3, which is called

5
the extensive form of the game. In spite of the graphic similarity, this

tree diers from a decision tree, as here, a dierent player takes action

at each node.

• There is an estate to be distributed between P1 and P 2.

• The bargaining has T rounds, each round is indexed by t = 1, 2..., T .

• There are two players, P1 and P 2. The players are selsh, mate-

rialistic, rational and impatient, so that they subjectively discount

next-round deliveries using βP 1 and βP 2 factors. No other objec-

tives, say, building a reputation for, say, toughness aects their

5
behavior.

• In the rst, t = 1, P 1, gives an oer (x1 , 1 − x1 ), x1 being

round,

his own share of the estate, 0 ≤ x1 ≤ 1. If P 2 accepts the oer

it is implemented right away. If P 2 rejects the oer, he will get

the right to make the next round oer (x2 , 1 − x2 ), x2 being P 1's

share (as oered at t = 2 by P 2). If the oer is accepted it is

implemented; if it is rejected, it would be P 1's turn to make an

oer at the next round, and so on: oers are echanged until agree-

ment is reached at which point the agrreed upon distribution and

bargainind terminates.

• If the players fail to reach an agreement in the last, t=T round, the

status-quo point is implemented. For simplicity of the exposition,

we analyze the game with a (0, 0) status-quo point, but comment

on the extension of the result to non-zero status-quo points.

• Each player knows and understands all the rules of the game: his

own subjective valuations, his feasible moves and payos and those

of his opponent. Moreover, each player knows that his opponent

knows that he knows and understand the rules of the game. For

example, P 1 knows that P 2 is rational, but also that P 2 understand

that he, P 1, is rational as well.

5 As a rule, we use sub-scripts to denote the time index and superscripts to denote
the players' index.

6
 Figure 3: the alternating oers bargaing game

t= 1 t= 2

P 1 m a k e s a n o ffe r (x 1 ,1 – x 1 )

R
P2 P 2 m a k e s a n o ffe r ...

A
(x 1 ,1 – x 1 )
im p le m e n te d
A : accept
R : re je c ts

3.1 Building-up intuition: a simpler game

Consider the slightly simpler game with only one round, T = 1, and

two feasible oers only: a fair one (0.5, 0.5), and an insulting one

(0.95, 0.05), see Figure 4. Since P2 cannot respond with a counter-oer,

this is sometimes called a game with a take-it-leave-it oer.

Given the assumptions that we made so far, particularly the assump-

tion that each player is rational and aware of the other's rationality, it

is hard to avoid the conclusion that this game will end with P1 making

an insulting oer and P2 accepting. The argument is as follows: P1 is

rational and thus forward looking. He should therefore ask: what will

be P 2's reaction to each one of his own oers? Knowing that P2 cares

only about his payo, he can predict his reaction: accept the insulting

oer. By a similar argument, though less surprisingly, P1 can predict

that P2 would also accept a fair oer. It follows that P 1's own payo of

the two oers are 0.95 and 0.5, respectively. The former dominates. We

can thus conclude that the only plausible equilibrium path (namely,

the sequence of moves to be taken) in this game is an insulting oer by

P 1, which would be accepted by P 2.

Notice that the method for nding the equilibrium path is by back-

7
 Figure 4: a one-round bargaining game with two feasible oers

A
(0 .5 ,0 .5 )

fa ir P2
R
(0 ,0 )
P1 A
(0 .9 5 ,0 .0 5 )
in su lt P2
R
(0 ,0 )

ward induction, as shown in Chapter 1.

3.2 Non-credible threats

In this equilibrium, P1 takes advantage of P 2's rationality. Knowing

that P2 cares only about his material benet, it is rational for him to

accept the insulting oer. Could P2 avoid this grim outcome by telling

P1 up front: I will accept only the fair oer; if you give me an insulting

oer I will teach you a lesson and reject it, to my own (and your)

disadvantage. If P 1 believes the threat, he would deliver the fair oer

that pays him 0.5 rather than the insulting oer that would be rejected

and thus pay him zero. If that happens, P 2 will not have to exercise the

threat of rejecting the insulting oer and can benet from a payo of 0.5

resulting from the fair oer. Clearly, it is in P 2's best interest to do his

best to convince P 1 that he will reject the insulting oer.

But can P 1 be convinced? Not if he knows for sure that P 2 val-

ues only the material payo from the game and plays rationally. For

by the time that P2 gets the insulting oer he already knows that the

threat failed to achieve the desired outcome. At this point, there is no

cost in reneging on his threat, and there is small gain to be made from

8
accepting it. P1 can thus discard P 2's non-credible threat and deliver

the insulting oer. It might seem unrealistic to suppose that P2 does

not care about making a fool of himself and losing the reputation of a

tough guy that he tried to build up. Indeed, real-world individuals

care about such things, perhaps because because they are worried about

future consequences of being known to be wimps. But such considera-

tions were ruled out by assuming that this is two-period game and that

the world ends afterwords. Hence, a valid conclusion of this discussion

might be that the above assumptions fail to capture important aspects

of real-world situations. It should not undermine the conclusion that for

the circumstances described above, realistic or not, the sequence (insult,

accept) is a good prediction of the outcome of the interaction.

A more general and fundamental conclusion from the discussion is

that equilibrium path is a very partial description of what is going on

in any game. For the actions that the players take in equilibrium are

supported by a rich and complicated set of considerations about how

their opponents would react to other actions o the equilibrium path.

To capture these considerations we use the notion of a strategy, one of

the basic concepts of Game Theory:

Denition 3. A strategy is a complete action plan that describes how

a player would respond to each move by his opponent.

Example 1. Reject an insulting oer and accept a fair oer is a strategy.

4 Equilibrium in the alternating-oers game

We nd the equilibrium by analyzing, rst, a one-period game, T = 1,
then extending the game to T = 2, and ultimately to T → ∞.

4.1 Equilibrium for the T =1 game

This game diers only slightly from the one in Section 3.2. Though

now there is an innite number of feasible oers, the decision for P1

is as simple. x1 = 0.95 dominates x1 = 0.5, x1 = 0.96 dominates
For

x1 = 0.95, x1 = 0.97 dominates x1 = 0.96 and so on, all the way up to

x1 = 1. Notice that when x1 = 1, P 2 is indierent between accepting and

9
rejecting. So we can rene the argument and say that the oer should

be just below x1 = 1, so that P2 gains a clear (though small) benet

from accepting the oer. Hence, from this point onwards, we adopt the

practice of denoting x1 = 1 as the the equilibrium, without repeating the

modication just below x1 = 1 by a very small amount so as to leave

P2 with a small yet a positive payo.

This outcome is Pareto ecient: neither time nor any fraction of the

estate is wasted. To see more clearly why this is an interesting state-

ment, consider the case of a non-zero status-quo point, say (0.25, 0.25).
Following the same steps as above, it is easy to see that the equilibrium

path would be an oer of just below x1 = 0.75, which would be accepted.

Hence, P1 will be ruthless in pursuing his own interests, but also careful

not to push his opponent to the point of rejection by giving him an oer

of, say, xt = 0.8. Clearly, being careful in that way is in P 1's best inter-

est, for a rejection by P2 would destroy value for both. The important

lesson is that the pursuit of self interest may not destroy the incentive

to preserve joint interests. Even without altruism or a sense of social

cohesion, parties will, at least in some cases, preserve joint interest even

when they compete one with the other on their own share of with the

common good.

4.2 Equilibrium for the T =2 game

The equilibrium path in the T2 case is a t = 1 oer, x1 = 1 − β P 2 ,

that will be accepted by P2 and would thus terminate the bargaining

without a second round. The argument is, again, by backward induction,

assisted by Figure 5. Notice that the decision nodes of the responding

player (namelyP 2 in t = 1 and P 1 in t = 2) are placed on a straight

segment, with 0 and 1 at the ends, to express the fact that an oer

can be any number between 0 and 1. If there is a second round, P 2

will fully utilize the situation to his own advantage and give an oer of

x2 = 0. P 1 will have no choice but to accept. So P1 should give a t=1

oer that would tempt P2 to avoid another round of bargaining, but

nothing better than the minimum required for that purpose. For P 2, the
P2
subjective discounted value of 1 − x2 = 1 is β . So he would be tempted

by an oer of 1 − x1 = β P 2 .

10
 Figure 5: alternating-oers bargaining with T =2

t= 1 t= 2

P1
x1 0
R
P2 P2
x2 0
1 R
A P1 (0 ,0 )
(x 1 ,1 -x 1 )
1 A
(ß P 1 x 2 , ß P 2 (1 -x 2 ))

Two points are worth making. First, the two-period problem adds an-

other dimension to the discussion of the eciency property of the equilib-

rium. For now, economic ineciency may arise either because the parties

fail to reach an agreement (and, hence, fall back on the status-quo point)

or because they fail to reach an early agreement. Due to impatience,

a delay in reaching an agreement would postpone the delivery of each

player's share of the estate, and thus decrease the subjective value of the

payos.

Second, Impatience is a disadvantage in bargaining: P 1's share of the

P2
estate is decreasing in β , namely P 2's patience. The more patient P 2

is, the higher he values future delivery and, thus, the more P 1 has to pay

him so as to tempt him into an early agreement.

4.3 Equilibrium for the T →∞ game

Adding a second round to the T =1 problem has diminished P 1's rst-

mover advantage, but has not removed it completely. It is plausible that

adding another period, which will give P 1 the last word will restore
some of the advantage that he had in the T = 1 game, but will not com-

pletely. It is likely that the more periods there are namely, the further

11
into the future the last-period eect is being pushed, the more symmet-

ric the outcome of the game would be. But how many periods should

we add? Since this question has neither a theoretical nor an empirical

answer, perhaps we should adopt the solution that is most convenient

analytically, which is to take the number of bargaining rounds to inn-

ity. The analytical convenience of the T → ∞ game results from the

following property: when the nal period is innitely remote into the

future, forward looking players will see in front of them exactly the same

game, regardless of the rounds in which the take a decision. (This is a

similar argument to the one presented in the calculation of an innite,

converging, geometric series in the Appendix to Chapter 1.)

By the same backward-induction argument used in the derivation of

the equilibrium of the T = 2 game, it is clear bargaining would terminate

t = 1: in T − 1, it is in the best interest of the player who makes the

oer to tempt his opponent to accepting an oer, which eectively makes

T − 1, the last period of the game for the player who makes an oer in
T −2; and so on. Then, x1 depends on what P 2 could get had he rejected
the oer and went on bargaining into t = 2. But what he would get then

depends what P 1 would get had he carried the bargaining into t = 3.

Now use the basic property of an innite game: that the end point is

equally distant from t=1 and t = 3. Hence, P 1 payo at t = 3 must be

x1 . So in order to terminate the bargaining at t = 2, P 2 would have to

oer him

x2 = β P 1 x1 .

Now, in order to terminate the bargaining at t = 1, P 1 will have to oer

P2
1 − x1 = β P 2 (1 − x2 ) .

Now solve:

Proposition 1. With T → ∞, the alternating oers bargaining game

would end after one round with P 1's oer of

1 − βP 2
x1 =
1 − β P 1β P 2

being accepted by P 2.

12
 Notice also that with an equal amount impatience, β1 = β2 = β,

1 − β2 1−β 1
x1 = 1 2
= = .
1−β β (1 − β) (1 + β) 1+β

Moreover, if the time lapsing between one oer and the next is very short,

the loss of subjective value from one round to the next is close to nil,

so that the subjective discount factor is extremely close to 1, which we

denote as β → 1. Hence,

Proposition 2. With the same subjective time preferences and a very

short time to wait from one round of bargaining to the next,

1
x1 = x2 = .
2

5 Taking a shortcut: Nash bargaining

There are many economic problems where bargaining is important, albeit

it is not the main focus of the analysis. In such problems, describing,

again, the entire setting of the Rubinstein model, let alone repeating the

entire argument behind Proposition 1, would make the analysis needlessly

long, as well as distract attention away from its main focus. In such cases

it is common to take a shortcut, and use a reduced form formula that

captures the main insights of the Rubinstein analysis: the parties would

split the pie, in its entirety (namely, without wasting a bit) so that each

player gets a slice, φi ≥ 0, φP 1 + φP 2 = 1, that reects his bargaining

i
power. It is understood that φ is aected by the player's patience relative

to his opponent's, by the number of bargaining rounds as well as the

player's rst-mover or second-mover position, so that the analysis can

take into consideration the eect of changes in φi , with only an informal

reference to these factors. This shortcut is called Nash bargaining.

In case of a non-zero status-quo point, bP 1 , bP 2 , the eective pie

that the players are bargaining on is just that part which is beyond the

status-quo point, namely 1 − bP 1 − b P 2 . Hence, each player would get his

outside option, plus a fraction of the eective pie,

xi = bi + φi 1 − bP 1 − bP 2


.

13
Another way of thinking about this formula is that if P 1 could give a
P1

P2
take-it-or-leave it oer, his share would be x = 1 − b . If P 2 could
give a take-it-or-leave it oer, that oer, which would be accepted, would

be x P 1 = bP 1 . Now take the interim point between these two extreme

cases, such that this point is closer to the former case the higher is P 1's
bargaining position. Namely:

xP 1 = φP 1 1 − bP 2 + 1 − φP 1 bP 1

(and symmetrically for P 2).

6 The Coase Theorem

Consider, again, the divorce example in the introduction. The legal en-

vironment guarantees the players certain legal rights: 50% of the estate,

net of legal expenses. But since these expenses were very signicant, and

since the litigation oered no material benet to the players, the litigious

course of action was economically inecient. So could the parties avoid

it? According to our analysis so far, the answer is yes. Moreover, even

if the law favored any one of the parties (on ground of, say, prenup-

tial agreement or property), deviating from the (50, 50) rule, the answer

would be the same: the parties would avoid litigation, though the out-

come is likely to shift in the direction of the party who is advantaged by

the law. But how general is this conclusion? Should we expect this con-

clusion to hold under any conceivable environment, regardless of the legal

rights that it allocates to the parties? Ronald Coase, winner of the 1991

Nobel Prize in Economics, articulated in his famous theorem to answer

to this question. The Theorem is somewhat vague so that dierent for-

6
mulations can be found in the literature. The following formulation is

my own:

Proposition 3. (Coase Theorem) In absence of imperfections in the

7
negotiation process, and whatever legal rights the players have, provided

6 See Coase (1960).

7 The common formulation in the literature is in the absence of transaction costs.
We deviate from this common formulations to indicate that the factors that might
prevent the Theorem from holding are broader than just a direct cost of transacting;
see the next section.

14
that these rights are well dened, the players will bargain out a deal that

will be economically ecient.

The great weakness of the Coase Theorem is that the two conditions

necessary to achieve economic eciency, absence of imperfections and

clearly-dened property rights, are only vaguely dened. Indeed, without

a clear denition of what these conditions the proposition is meaningless.

Moreover, lacking a clear denition it is not clear how to identify the

conditions empirically, which implies that the theorem is not falsiable

and, therefore, of no scientic value.

6.1 Imperfect negotiations

Consider a slightly dierent environment in which the couple seeks a

divorce. The parties can settle out of court (play S, see Table in Figure

1) and split the estate each getting one half. They can also litigate (play

L) which will cost them a xed amount equal to 25% of the estate. Unlike

in the previous example where the court had a xed rule about splitting

the estate, we now assume that the court is allowed discretion. We make

an additional (strong) assumption that the rst party to le has a greater
8
chance to getting judgment in his/her favor. Hence, if P1 plays L and

P2 plays S, P 1 will surely gain the rst-mover advantage and will beat

his/her opponent. In such circumstances P1 will bear legal expanses

of 0.25 but will be able to grab the entire estate. If both players play

L they have an equal chance to be rst, so their payos drop to 50%

of the estate, net of legal expenses. The Table in Figure 1 shows the

payos for each of the four combinations of the L and S strategies. In

brackets, the rst number is P 1's payo and the second is P 2's payo.

Notice that in this scenario the players move simultaneously, while in the

alternating-oers game they moved sequentially.

To nd an equilibrium in such a normal form game we look for a

combination of strategies, one for P1 and the other for P 2, such that

each player's strategy is a best response to the play of his opponent.

8 In recent years there has been a growing incidence of forum shopping for the
jurisdiction that would best serve that party that les for divorce: some jurisdictions
favor a party on the basis of gender, some accept pre-nuptial agreements and some
exclude pre-marriage assets from the estate. In such an environment, coosing the
jurisdiction gives the rst party to le a considerable advantage.

15
 Table 1: the litigation game

P2

L S

L (0.25,0.25) (0.75,0)
P1
S (0,0.75) (0.5,0.5)

Suppose that P1 P 2 plays L. His best response is to play L

thinks that

as well, which would pay him 0.25, better than zero, which is the payo

for playing S . At the same time, if P 2 thinks that P 1 will play L, his

best response is also L. Hence, (L, L) is a Nash Equilibrium, formulated

by John Nash, winner of the 1994 Nobel Prize in Economics. Actually,

in this case, since L is a best response to both L and S , (L, L) is the only
Nash Equilibrium in this game.

6.2 Pre commitment and the missing deal problem

Clearly, we got an economic-inecient outcome: (S, S) Pareto-dominates

the equilibrium outcome (L, L). Why? Suppose that the players recog-

nize the problem. They meet up and strike a deal to avoid litigation,

namely play S. Could each trust the other to stick to the agreement?

The answer is no. To see why, suppose, by way of contradiction, that P1

believes that P2 would stick to the agreement. Given that he is selsh

and rational, he would notice immediately that breaching the agreement

would increase his payo from 0.5 to 0.75. Moreover, he should realize

that if P2 is selsh and rational he would breach the agreement too.

Hence, sticking to the agreement would decrease P 1's payo from 0.25
to zero. Clearly, the rational thing to do is to breach the agreement.

But what is the imperfection that fails the Coase theorem? The

potential deal that would avoid the ineciency is that each player should

16
play S in return for his opponent also playing S. But the object to be

exchanged in such a deal is not a physical good that can be delivered

upon the completion of the deal. Rather, it is a promise, that has value

only if the parties can commit to deliver, or if there is some enforcement

mechanism behind it. In the absence of a commitment mechanism, the

deal has failed to materialize.

As we shall see below, whenever an equilibrium delivers an inecient

outcome, the core reason is that a deal that could potentially benet

all parties has failed to materialize. There are several reasons for the

failure: absence of communication lines between the parties to the po-

tential deal (particularly in cases when there are many players, some of

which are not present), legal or institutional barriers, shortage of liquid-

ity or, sometimes, the physical properties of the object to be exchanged.

We shall discuss these reasons in great detail below, and particularly in

Chapter 6. But ultimately, all these factors boil down to a missing deal,

also called an externality, a missing market or a market failure.

7 A note on equilibria in games

It might seem that the equilibrium in the game described in Figure 4

is of a completely dierent nature than the Nash Equilibrium dened

above. This is not the case, for the equilibrium where P1 delivers an

insulting oer that P2 accepts is also a Nash Equilibrium. To see that

more clearly, one may present the game there in a normal form (namely

as a matrix) and notice that the combination of an insulting oer by P1

and the AA for P2 is one where each player is best-responding to the

strategy of his opponent. However, the combination of a fair oer by P1

and the AR for P2 (namely, accept a fair oer and reject an insulting

one) is also a Nash Equilibrium. Reinhardt Selten, winner of the 1994

Nobel Prize in Economics, was the one who pointed out that the threat

of rejecting an insulting oer is non credible, and thus, the notion of a

Nash Equilibrium should be narrowed down so as to eliminate equilibria

that are supported by a non-credible threat. Naturally, this renement,

called a sub-game perfect equilibrium, is relevant to dynamic games only.

17
 Figure 6: nancial distress

(D– 1,y – D)
repay
lend
L B

no default
(–1 ,y)
(0,0)

time

ex ante ex post

8 Important distinction: ex-ante and ex-post

eciency
A crucial distinction for the understanding of many problems in nancial

economics is the one between ex-ante and ex-post eciency. We illustrate

it with the aid of the lending example in Figure 6. A lender, L, can lend

¿1 to a borrower, B , to fund a project that would yield an amount y > 1

(assume, for simplicity, that the interest rate is zero). It is agreed that

upon maturity, B D, 1 < D < y . B may

would pay back an amount

perform on the agreement by delivering the amount D , or he may default

and pay nothing; there is no penalty, legal or other, for default. Clearly,

both options are ex-post ecient as they imply dierent partitions of

the pie, y, none of which Pareto dominates the other. It is also clear

that the only equilibrium in this game is one where L does not lend,

anticipating a default if he lends. Clearly that equilibrium is ex-ante

inecient, for (0, 0) is Pareto dominated by (D − 1, y − D)

So why does the Coase Theorem fails in this case? Because the deal,

 B would repay the loan in exchange for L lending the money has failed

to materialize due to a missing commitment mechanism. The substan-

tial question here is whether the parties can build up an enforcement

18
mechanism that would allow them to execute the deal. Alternatively,

whether a third party can provide it for them, which takes us back to

the spontaneous-order question.

9 Application: insolvency law 9

Insolvency law, similar to divorce law, provides stakeholders an envi-

ronment where they can unwind a relationship that lost its value, and

distribute the left-overs among themselves. Most real-world insolvency

laws can be described as a point between two extreme ends. The rst

extreme approach is freedom of contracting, where the role of the law is

limited to a strict enforcement of the contractual rights of all the parties

involved. Ex ante, when the contracts are negotiated, the allocation of

rights is agreed by mutual consent. Particularly, the contracting parties

may adopt an egalitarian approach where all stakeholders have similar

rights, or they may choose to allocate more rights to certain stakeholders,

particularly the secured creditors (see Appendix for more legal and insti-

tutional detail). Ex post, when stakeholders try to exercise their rights,

the only question relevant to the court is whether the rights were lawfully

acquired. The court would avoid the question whether the allocation of

rights is ecient or fair or. Rather, it would assume that the contract-

ing parties have taken all such factors into consideration, ex ante. The

second approach to insolvency is judicial activism, where the creditors'

rights are placed under judicial review. Particularly, the courts are em-

powered to block the liquidation rights of the secured creditors in cases

where these are deemed to be inconsistent with the common good. 19th

century England was close to the rst model, while 1980s US was close to

the second, with judges sometimes acting as if any company, regardless

of how poorly it performed, was worthy of protection from creditors

10
trying to enforce their liquidation rights. The public-policy question

is which point between these two extremes would best serve the public

interest. It is worth noting that the freedom of contracting approach is

9 In England, the word insolvency applies, exclusively, to companies, while the word
bankruptcy is reserved to natural persons. In the US, the word bankruptcy applies
to both.
10 See, for example, Weiss and Wruck (1998).

19
 Figure 7: the lending problem

y=50
I=10

b=70 C F

0
L=20

an instance of deference to spontaneous order.

9.1 Financial and economic distress

Denition 4. A company is said to be in economic distress if its going-

concern value falls short of its liquidation value. A debtor is said to be

nancially distressed if its going-concern value falls short of the value of

its debt.

Consider a sole-ownership, equity-nanced company with an asset

that yields ¿5 per annum, in perpetuity. The risk-free interest rate is

10% and the liquidation value is 100. Since the company has no debt,

by denition it cannot be nancially distressed. Its owner is safe of any

forced liquidation simply because no one has the right to force such an

action on him. Yet the company is economically distressed, since its

going-concern value is 5/0.1 = 50 while its liquidation value is 100. It is

in the owner's best interest to liquidate the asset, as doing so and putting

the money in the bank would generate an annual income of ¿10, more

than the asset currently yields. An economically distressed company is

one were the most protable option is disinvestment.

Consider, next, a company with secured, senior debt of 70. For sim-

20
plicity, assume that the interest rate is zero. The debt is in default, so

that the secured creditor, C, has the right to repossess the asset and

sell it. The market price of the liquidated assets is 20. If C does not

exercise the liquidation right, and if the company owner, F, can fund an

investment of 10 in working capital, it can generate an income of 50; see

Figure 7. The assumptions here is that F has some exclusive know-how

in managing the asset, which explains why the value of the assets once

separated from F is only 20. Lastly, suppose that C has no will or, per-

haps, is unable to fund the working capital himself. Without the funding

for working capital, the company has a zero value. Clearly, the company

is not economically distressed, for its going concern value, 50 − 10, is

greater than its liquidation value, 20. Yet, it is nancially distressed as

the income generated by carrying-on operation will not be sucient to

pay back the debt.

9.2 Debt overhang

Could an economically-viable company be liquidated prematurely due to

nancial distress? According to the debt-overhang scenario, the answer

is yes. Consider a potential creditor who is approached by F for the

working-capital funding. Should he lend, he will be junior to C. Hence,

when the income, 50, is generated, he would be second in line, to be paid

only after C is satised. Since C has a claim to any income up to 70,

nothing would be left to the junior creditor. He should refuse lending. C

should foresee this line of events and liquidate the assets up-front, and

save 20 out of his unfortunate investment.

9.3 Debt forgiveness

Is debt overhang a violation of the Coase Theorem? Not according to

the description of the facts so far. For it is in the best interest of C

and F to agree a debt forgiveness of between 30 and 50, that would
decrease the value of the debt from 70 to between 40 and 20, depending

on bargaining power. That would allow the junior creditor to provide

funding for working capital, and for F to operate the company, still

leaving the senior creditor with a payo between 40 and 20, better (or

equal) to what he would get in liquidation. Notice that such a deal does

21
not even require any communication between C and F, for the former

can simply cancel 30 units of debt, unilaterally. Clearly, there is no need

for any external intervention to convince C to show mercy towards F,

for that leniency is entirely in C 's best interest.

The case for leniency is more dramatic if we interpret the same story

somewhat dierently. Suppose that I, instead of being an investment in

working capital, is the opportunity cost of F : he can simply walk away

from his failed business and nd a job that would pay him 10. It is still

in the best interest of C to forgive the debt down, so as to leave F with a

payo of 10, which might explain how come so many managers of failed

businesses still manage to get a relatively good deal, to the rage of the

public and other stakeholders.

9.3.1 Debt-for-equity swaps

An institutionally dierent but economically equivalent way of forgiving

debt is for C to write o all his debt in return for the company's equity,

previously held by F. Such a swap would place C at the end of the line,

and would turn the provider of the working capital to a senior (unsecured)

creditor, allowing him to collect his debt of 10. That can be the case if F
has a zero outside option, so that he has a (weak) incentive to stay with

the company and manage the asset. In case he has an outside option of

10, C could swap all his debt for up to 80% of the company, leaving the

latter with 0.2 · 50, just enough to compensate him for not exercising the

option of walking away.

10 The limits of freedom of contracting

According to the analysis so far, a freedom of contracting regime provides

a valid solution to the problem of nancial distress. In such an environ-

ment the Coase Theorem applies, so that economically-viable companies

would never be liquidated because debtors and creditors would negotiate

Pareto-ecient outcomes that maximize their joint value, and the free-

dom of contracting the approach to insolvency works. In other words, it

is better to treat nancial distress as a commercial aair that needs to

be sorted out through negotiations between business people rather than

22
a legalistic aair that needs to sorted out in a court of law. The role

of the courts is to provide strict enforcement of the contract in case the

negotiations break down, which is a very unlikely event according to the

analysis so far.

That, in turn, leads us to the next question: do the assumptions

above capture the reality of distress, or is it an abstraction that fails to

capture some of the most important aspects of the situation, particularly

the imperfections in the negotiation process? These imperfections are

hard to characterize in a general manner, but the following examples

may provide an idea.

10.1 Third parties

It is sometimes argued that a company may be liquidated because the

debtor and the creditor fail to take into consideration the loss of value

to third parties. To see how that might work, consider a modication of

the example above where the continuation value of the company, 50, is

made of 20 cash while 30 is the value of the rm to its workers. More

specically, suppose that wages, W, are senior to any debt (by law). F 's
cash income, 20, is thus some gross amount minus W. While working

for F, the workers have acquired some specic know-how that cannot be

used on other jobs. So if the company is liquidated and the workers seek

other employment their wages would be W − 30. In technical jargon,

the workers have rm-specic, non transferable human capital. We

interpret I as F 's outside option. So after allowing F to collect an

amount of 10 so as to keep him on board, the company's cash surplus

is only 10, less than its liquidation value. It seems that liquidation is in

C 's best interest.

However, the following deal, which preserves the company as a going

concern, is in the best interest of both C and the workers, as it splits the

continuation value, 20, equally between them. The workers would spend

an amount of 20 buying 60 units of the senior debt plus all the liquidation
11
rights and write them o. That would allow the workers to keep their

jobs, which are worth to them 30, leaving them with a surplus of 10. As

11 The liquidation rights may be bought via a contract that commits C not to
liquidate. Such a contract may be necessary because as C is left with only10 units
of debt, the liquidation option has a higher value, 20.

23
for C, he gets 20 from selling the debt and the liquidation rights, plus

10 from collecting the remaining debt, which is 10 above the liquidation

option. F would get just enough so as not to walk away.

Hence, by itself, the existence of third parties makes no material

change to the Coase Theorem. Once third parties have a seat at the

negotiating table they are no longer third parties; they become, simply,

parties to the deal. Then, they can trade like the other parties and make

sure that good deals don't slip through.

The concern about third parties is that there may be circumstances

where they will not be able to join at the negotiating table, thus creating

a missing-deal problem. Perhaps there are too many of them, they are

not organized enough to send a delegation, or perhaps they are short

of the liquidity that they need in order to complete the deal that is

described above. As we shall see, particularly in Chapter 6, there exist

no precise and sharp answer to the question: what might prevent third

parties from joining in a deal? At the same time, it is important to

recognize that the root problem that prevents an economic system from

achieving eciency, here and in all the examples below, is always the

same: some imperfection that prevent the parties from transacting a

deal that would be to the advantage of all of them.

10.2 Private benets

Another argument that is often raised against the freedom of contracting

regime is that liquidation destroys value, which comes in the form of

emotional stress, loss of dignity or a crisis in family life, private benets

as they are sometimes called. Assume, for simplicity that I =0 while

the private benets equal to 40. Like before, there is more value in

continuation than in liquidation, but since the 40 is non-cash value, it

cannot be used in order to buy C out of his liquidation rights. Again,

a missing-deal problem fails the Coase Theorem. Perhaps, some would

argue, a humane society should activate its judges to intervene in such

cases, even at the cost of breaching a contractual right.

An alternative way to tell the story is that the 40 payo is cash that

cannot be pledged. By that we mean that F 's cash payments are not

observable, neither by C nor by the court. Hence, although that amount

24
 Figure 8: ex-ante uncertainty

cash=80+80
L=40
solvency

insolvency
cash=0
L=20

time

ex ante ex post

will materialize, in cash, eventually, there is no way that F can commit

to pay it back. Once C foresees that situation, he would liquidate the

company up front. Again, a case in favor of judicial activism might be

attractive. Notice that, like in the other cases discussed in this section,

it is not the physical nature of the output the fails the Coase Theorem

but, rather, the Physical nature of the output explains why the mutually

benecial deal cannot be transacted: F lacks the currency to pay for the

goods that C can deliver.

And yet, before we reach the nal conclusion that Coase Theorem,

indeed, failed, we should ask ourselves: for what purpose did F issue

a debt of 70, backed by a liquidation right? The answer must be that

at the point of contracting both the debtor and the creditor expected

that other circumstances might materialize, in which case both the debt

and the liquidation rights would serve some purpose. For example, it is

possible that the parties conceived two possible realizations ax ante, one

of insolvency as described above and the other of solvency with cash ow

of 80 + 80 and a liquidation value of 40; see Figure 8. But the parties

also conceived that collecting debt may be dicult or costly: perhaps,

the debtor could hide the cash or claim that he never got it. The detail

of the interaction is described in Figure 9. F can pay the debt and end

25
 Figure 9: the solvent scenario

(70,90)
repay

F has cash of 80 F

default
renegotiate
C (80,80)

liquidate

(40,80)

with a value of 90 (10 left after paying the rst-stage debt and 80 from

carrying on with his business). Alternatively he can default, in which

case C may liquidate for 40 (leaving F with the 80 cash that he hides)

or he may start bargaining with F, in which case we assume that he has

all the bargaining power. He would thus give F a take-it-or-leave-it oer:

pay your debt or I liquidate. F would accept. Now going back to the

original Figure-9 node, F must realize that it is not in his best interest

to play games with C ; better pay the debt up-front. Hence, in case

of solvency the liquidation right, which stays o the equilibrium path,

plays an important economic role: it facilitates the enforcement of debt

contracts.

In this case, judicial activism can be harmful, as it can undermine

creditors' willingness to lend. Notice, again, that from an ex-post point

of view, the liquidation right contributes nothing to economic eciency.

So in that sense, the courts can't be too lenient. Yet, from an ex-ante

point of view, too much leniency can bring the credit market to a halt.

The freedom of contracting approach would be to assume that the debtor

and the creditor considered the possibility of involving the courts by

including a clause in the contract: in case F claims that he cannot pay,

a judge (or some other arbitrator) will investigate and decide whether

26
the debt should be written o, without any liquidation. If such a clause

does not exist in the contract, it is probably because the parties have

realized that it will be non-manageable or too costly. Since the parties

are best informed about the detail of the transaction, and since they have

the incentive to structure the contract so as to extract as much value as

possible from the deal, their design of the deal, as expressed in the debt

contract should prevail.

10.3 Uncoordinated creditors: a creditors run

Another concern about freedom of contracting is that a missing-deal

problem might arise if there is a multiplicity of creditors, who are so

poorly coordinated that they cannot agree among themselves a deal that

is actually in their best interest. As each tries to pursue his own interests,

they might create a creditor's run that will destroy value for everyone.

To capture this situation, consider a company, F , with secured debt of

70 held in equal amount by two bond-holders. The debt is not prioritized,

so that whoever gets to the assets rst, is fully paid. The liquidation value

is 40. The company has a cash reserve of only 60, and a continuation

value (non pledgeable) of 80. In order to continue, it has to get its

creditor's mutual consent to write down a modest amount of 10. The

game is described in Table 2. If both accept (A) the oer they will get

30 each. If both run on the assets (R) the rst will be fully paid at
35 and the second will get the left-over, 5 ; since each has a chance of
50% to be rst, the expected payo of 20 each. If one plays R and the
other plays A, the write-o will not go through. But the R player will

be the only one who makes a claim against the assets and thus paid in

full. Clearly, (A, A) is the economically-ecient outcome but (R, R) is

the unique Nash equilibrium.

So might the creditors run justify judicial activism? Again, from the

point of view of freedom of contracting the question is why did the debtor

structure its debt in a manner that any restructuring is so dicult? A

possible answer is that the debtor tried to pre-commit not to renegotiate

the debt; such hard commitment would be to his advantage. Suppose

that there is another realization similar to the one that is described in

Figure 8, only that bargaining power is symmetric. In this case, the debt

27
 Table 2: creditors run

c re d ito r 2

R A

R (2 0 ,2 0 ) (3 5 ,5 )
c re d ito r 1
A (5 ,3 5 ) (3 0 ,3 0 )

renegotiation would end up at a repayment of 60 = (40 + 80) /2. As a

result, and unlike in the case of Figure 8, debt renegotiation will be in the

debtor's best interest. But having debt dispersed across many creditors

is a way of pre-committing not to engage in such renegotiations.

11 Concluding remark: spontaneous order

The discussion above provides a vivid example of how market partici-

pants can create, bottom up, a spontaneous order: by writing contracts

that secure debt (or not), by dispersing debt or concentrating it, by call-

ing for arbitration in certain cases or asking for strict enforcement of

the contracts that they have written. Once the order has been created,

players would no-longer be free to do whatever they wish: they would

have to operate within the rights that they acquired ex ante and be re-

stricted by the rights that they have pledged to others. Having developed

a normative concept to evaluate any order, we have concluded that ab-

sent the missing-deal problem, the spontaneous approach will generate

a satisfactory outcome. But once some deal opportunities are missing,

things become more complicated. For while a top-down intervention

could improve things on one dimension, it could worsen things on other

28
dimensions. These ideas will be developed to greater sophistication and

precision in subsequent chapters.

12 Appendix
12.1 Seniority and security interests

A stakeholder is a party that has a lawful and enforceable right against

a company. The main stakeholders are typically shareholders, creditors,

workers, suppliers, buyers and the tax authorities. Typically, and apart

from shareholders, stakeholders have a debt claim against the company:

xed in value, with little or no conditionalities. The shareholders (own-

ers) of the company, who control and run it, typically have an equity

claim in the company, which gives them the right to collect all income

left after the debt has been paid. If a stakeholder's rights have been

breached he make seek remedy from the courts. In practice, most rights

are satised out of court.

By seniority we mean that ex post, when the investment matures and

yields income, all stakeholders are ordered in an imaginary queue, from

the most senior to the most junior. They are then paid out according to

their rights and in order of their seniority. A junior party will get nothing

until the more senior parties are fully satised. In case there are several

individuals with the same seniority, they will be dened as a seniority

class and be paid pro rata, according to the size of their stake.

By security right we mean that a certain stakeholder has the right to

repossess some specically-dened assets in case his rights are breached.

In many cases the senior creditors are also the secured creditors, in which

case there is an overlap between the benets obtained from seniority and

those that are obtained from security interests.

Typically, the order of seniority is banks, tax authorities, bondholders,

trade credits, workers and owners, but that can be changed by contract

and by country-specic legislation.

29
References
[1] R. H. Coase (1960), The Problem of Social Cost. Journal of Law

and Economics, Vol. 3 (October), pp. 1-44.

[2] Weiss, Lawrence A. and Karen H. Wruck (1998). Information prob-

lems, conicts of interest, and asset stripping: Chapter 11's failure

in the case of Eastern Airlines, Journal of Financial Economics, 48,

pp. 55-97.

30