Property Rules and Liability Rules: Theory

Coase’s article demonstrates that legal rules are immaterial in private litigation so long as bargaining after a judgment is both permitted and costless. Were there no transaction costs, all factors of production would be put to their highest and best uses. Private parties would bargain around court judgments that inefficiently entitled A to grow crops or B to raise cattle.

But as Coase acknowledges, transaction costs are omnipresent and often immense in the real world. It costs resources in order to strike a deal. And yet, deals can indeed be struck. How should courts impose legal obligations now that we wish to take into account not just what should happen in the end but the much more complex question of what role courts should play knowing that their judgments will be only part of the social forces that determine what does happen.

Property Rules and Liability Rules

It is to this question that Guido Calabresi and A. Douglas Melamed attempted a partial answer in their famous article, Property Rules, Liability Rules, and Inalienability: One View of the Cathedral, 85 Harv. L. Rev. 1089 (1972). Calabresi and Melamed’s central insight was that judicial resolution involved a two-fold decision: whom to entitle and how to protect the entitlement. Either A or B will be adjudged the “winner,” in the sense that they are granted the disputed entitlement (the right to pollute or the right to clean air, for example), but there is more to decide. How is the entitlement they have been granted protected by a court? Calabresi and Melamed:

An entitlement is protected by a property rule to the extent that someone who wishes to remove the entitlement from its holder must buy it from him in a voluntary transaction in which the value of the entitlement is

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agreed upon by the seller. It is the form of entitlement which gives rise to the least amount of state intervention: once the original entitlement is decided upon, the state does not try to decide its value. It lets each of the parties say how much the entitlement is worth to him, and gives the seller a veto if the buyer does not offer enough. Property rules involve a collective decision as to who is to be given an initial entitlement but not as to the value of the entitlement.

Whenever someone may destroy the initial entitlement if he is willing to pay an objectively determined value for it, an entitlement is protected by a liability rule. This value may be what it is thought the original holder of the entitlement would have sold it for. But the holder’s complaint that he would have demanded more will not avail him once the objectively determined value is set. Obviously, liability rules involve an additional stage of state intervention: not only are entitlements protected, but their transfer or destruction is allowed on the basis of a value determined by some organ of the state rather than by the parties themselves.

An entitlement is inalienable to the extent that its transfer is not permitted between a willing buyer and a willing seller… . .

When a court awards damages, it is applying a liability rule, since the court, rather than the winner of the lawsuit, determines the value of what was lost to the winner. When a court awards an

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injunction, it gives to the winner an absolute right to refuse the loser’s request that he or she part with the subject of the injunction. If the loser wants it, he or she must meet the price that the winner sets to take the entitlement, even if that price is sky high.

Note, too, that what we call our property is protected in different ways in different situations. A home may be protected by a property rule against those who would trespass and take it. A court will order the trespassers thrown out and give to the record owner the right to insist on a price of his or her choosing to sell the house. But that same house may be protected only by a liability rule against the city in which it is located. The city, using its power of eminent domain, may take the house from the owner so long as it pays what a court determines is fair market value, irrespective of the price the owner would want to charge.

We have now enlarged the apparent set of options a court has in resolving a dispute. It may award the disputed entitlement (the right to pollute or to be free from pollution, the right to enter property or the right to refuse entry, etc.) to A or to B, and it may protect the entitlement it awards with a property, liability rule, or inalienability rule.

Choosing a Rule

How and why might a court choose a winner of the entitlement and choose whether to protect the entitlement with a property or liability rule? (Let’s exclude, for the moment, the inalienability rule.) Assume we have a plaintiff (P) suing a defendant (D) over an alleged nuisance. D wants to continue the nuisance, and P wants to stop it. The options confronting a court can be placed in a two by two chart, leading to four possible rules.

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Property Rule Protection Liability Rule

Protection P

Wins

1: D must get P’s consent to continue

2: D must pay damages to continue

D

Wins 3: D must consent to stop

4: P can force D to stop by paying damages How is a judge to choose among these rules? Calabresi and Melamed explain that courts base these decisions on various grounds: economic efficiency (attempting to ensure that the entitlement is awarded so that it winds up, perhaps after market transactions, so that no further transactions could be had without making someone worse off to a greater degree than others are made better off),1 _{distributional goals (the preferences a society has} for the distribution of wealth and specific goods, like food and health care), and, perhaps, other justice goals.

Restricting our attention to economic efficiency, we might at first wish to apply what we learned from Coase and assume that we should always use property rules and that it does not matter whether P or D wins the lawsuit. If we choose wrongly, for example if we decide P wins even though the entitlement to pollute is worth more to D than the entitlement to be free of pollution is worth to P, the parties can always transact after the fact to correct our mistake. That was the essence of (the second part of) the so- called Coase Theorem. But, as Coase himself indicated, this does not work if transaction costs are large. If the parties cannot easily correct our mistakes through post-judgment bargaining, then it matters very much where we place the entitlement.

1 _{There are various criteria for economic efficiency. The one here implied is called}

Kaldor-Hicks efficiency. The details do not concern us for the moment, beyond an understanding that this notion of efficiency applies to changes in the social order that provide more total gains to the winners than losses to the losers. At least in theory, the winners in such a situation could fully compensate the losers and still come out ahead.

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For example, transactions will be difficult if there are many individuals on one side, as in the case of a polluting factory and a town. For example, members of the town may act selfishly and refuse to pay their share (believing others will pick up the slack) in the event the entitlement was wrongly awarded to the factory. This is called free riding. If we erred the other way, wrongly awarding the entitlement to the town when in fact the factory values production more than the town values clean air, then some town members may selfishly demand too much to permit the factory to pollute. In other words, they may be hold-outs. If 10,000 people each have an individual right to stop a factory, so that the factory must strike a deal with each person in order to go into production, then it should be obvious that the factory faces a very expensive contracting problem and is subject to hold-outs.

Liability rules solve such problems. Replacing 10,000 individual negotiations with a court-determined damages award solves the problem of hold-outs and free riders. A court could, for example, following Rule 2 from the boxes above, allow the factory pollute, on the condition that it pay damages to the town members.

But the very thing that makes the liability rule so attractive, that it eliminates potentially expensive, individualized negotiation with a court’s determination of fair market values, also makes it potentially unattractive from an efficiency standpoint. It relies on the court’s ability to estimate the true values of the entitlement to the parties. The court may not be good at this. The very foundation of free markets is the belief that, in general, individuals know better than others how much things are worth to them. In setting damages, courts may not arrive at amounts that reflect what parties would pay or accept in the absence of transaction costs. That error represents an economic inefficiency and may lead to a shuttered factory that would in fact be efficient or a polluting factory that is inefficient.

Acting in realm of uncertainty, perhaps courts should do as best they can to put liability on (the opposite of grant the entitlement to) the party best positioned both to determine whether what that party wants is worth the damages award or negotiation. The court

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should also consider whether placing liability on one party or the other makes transactions more likely. And, finally, if bargaining looks particularly expensive and the court is reasonably well positioned to determine the value of the entitlement to each side, then the court should consider a liability rule. Calabresi and Melamed summarize the efficiency concerns thusly:

(1) that economic efficiency standing alone would dictate that set of entitlements which favors knowledgeable choices between social benefits and the social costs of obtaining them, and between social costs and the social costs of avoiding them; (2) that this implies, in the absence of certainty as to whether a benefit is worth its costs to society, that the cost should be put on the party or activity best located to make such a cost-benefit analysis; (3) that in particular contexts like accidents or pollution this suggests putting costs on the party or activity which can most cheaply avoid them; (4) that in the absence of certainty as to who that party or activity is, the costs should be put on the party or activity which can with the lowest transaction costs act in the market to correct an error in entitlements by inducing the party who can avoid social costs most cheaply to do so; and (5) that since we are in an area where by hypothesis markets do not work perfectly – there are transaction costs – a decision will often have to be made on whether market transactions [property rule protection] or collective fiat [liability rule protection] is most likely to bring

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us closer to the [efficient] result the “perfect” market would reach.

Nuisance Law

Suppose a plaintiff, P, sues a defendant, D, for committing what P believes is a nuisance. How should a court decide whether P should prevail and whether it should enjoin D’s conduct or permit D’s conduct with the payment of damages to P? Consider the example of the plaintiff Fontainebleau Hotel (building the shadow-casting addition) and the defendant Eden Roc Hotel (whose pool would cast in shade by the addition). The court must decide among the four options in our grid.

Property Rule Protection

Liability Rule Protection

P

Wins 1: Nuisance enjoined

2: Damages for nuisance but D can continue

D

Wins 3: No nuisance

4: P can force D to stop by paying damages

Which of the parties is the cheapest cost avoider, the one best able to calculate the total social costs and benefits from the proposed addition? Arguably, it would be Fountainebleau, which probably has better information about the costs of the addition and the revenue benefits it would bring. Although, Eden Roc might be better positioned to understand how the shadowed pool area would impact its business, that is the sort of damage that might not be difficult to calculate for anyone in the hotel business in the area. So perhaps we would be justified placing liability on the defendant, Fountainebleau.

Should we protect Eden Roc’s entitlement with a property or liability rule? There are only two parties, and so we do not have much concern about free riders or hold-outs. Are we concerned about strategic bargaining, the possibility that in negotiating Eden Roc would attempt to garner too much of the surplus for itself,

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mistaken about Fountainebleau’s willingness to pay – the kind of negotiating difficulty that could derail a deal that would be better for both sides if reached? Perhaps, and perhaps there’s some animosity on both sides – not to mention the fact that Eden Roc, as a competitor might have an unusual incentive to reduce the profitability of Fountainebleau. While property rule protection is ordinarily justified when there are a small number of commercial parties, liability rule protection does not seem like a bad option here. The damage caused to Eden Roc by the shadowing of its property seems like the sort of discrete harm that could be estimated reasonably through manageable expert testimony. Moreover, sentimental attachment or other idiosyncratic valuation that might not be captured by fair market value estimates is not relevant here, in the case of a commercial property.

Thus, resort to Rule 1, as the court in fact chose on purely formalistic grounds, or Rule 2 appear to be reasonable choices. The next two cases are ones in which the courts chose liability rules. As you read them, ask yourself why they did.

1.3.6. Property Rules and Liability Rules: Practice