Law and Economics, 6th edition


1 Be rkele aw y L ory rkele hol ars hi p R eposit aw Sc Be y L aw Boo ks Berkeley L 7-2016 a w a nd E conomic L ion s, 6th edit R e r t C o ot e ob r Ber keley L aw Thom a s Ule n Follow thi s and additional works at: http://s ks Part of the Economic s , and the Law Common s s Common nded Citation Recomme as, "Law and Economic Ber dition" (2016). s, 6th e aw Bo len, Thom Cooter, Robert and U oks. Book 2. keley L http://s ks/2 eposit ks rkeley L en accepted for inclusion in Be ory. It has be aw Boo aw Scholarship R n access by Berkeley L ree and ope k is brought to you for f This Boo eposit rkeley L ory. For mor e infor mation, p lease contact [email protected] . strator of Be ized admini by an author aw Scholarship R

2 Authors’ Note LAW AND ECONOMICS ( pdf 6th edition) Robert Cooter and Thomas Ulen by This is a pdf version of the latest version (6th edition) of Law and Economics by C ooter and U len. The ownership of this book has reverted from the publisher to its authors, so we are posting it onl ine for everyone freely to read or use as a After more than thirty years as the field’s leading textbook, it continues to textbook. cover the latest developments in the economic analysis of property, , contracts, torts Each new edition refines the analytical core, incorporates legal process, and crimes. new applications, and expands previous discussions of empirical legal studies and conom ics. We hope that you enjoy reading this book as much as behavioral law and e we e njoyed wr iting it. Looking forwa rd to next year, this duet will become an internet symphony ishing. that ge of the internet revolut ion in publ s full advanta Improvements take will be po sted to th e internet continuously in small amounts (7.1, 7.2, 7.3, etc.), until a new edition appears w ith lar ge c hanges ( 8.0) . Not just a textbook , the 7th edition will have supporting materials, including translation s. For updates, join the email lis t fou nd by googling “Cooter and Ulen Berkeley Law Repository” . Perhaps you will have something to contribute to the website. For the best feast, the host supplies the main course each guest contributes a dish.


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8 S E DITION IXTH Law & Economics ROBERT COOTER University of California, Berkeley THOMAS ULEN University of Illinois, Urbana-Champaign Addison-Wesley Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montréal Toronto Delhi Mexico City S ̃ ao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

9 Senior Prepress Supervisor: Caroline Fell Sally Yagan Editorial Director: Senior Manufacturing Buyer: Carol Melville Donna Battista Editor in Chief: Bruce Kenselaar Cover Designer: Noel Kamm Seibert Acquisitions Editor: Fo t o l i a / © S e r h i y Ko b y a k o v Cover Image: Melissa Pellerano Editorial Project Manager: PreMediaGlobal Full-Service Project Management: Nancy Freihofer Senior Production Project Manager: Composition: PreMediaGlobal Alison Eusden Supplements Coordinator: Courier Westford, Inc. Printer/Binder: Angela Lee Senior Media Producer: Cover Printer: Lehigh Phoenix Director of Marketing: Patrice Jones Text Font: Times Ian Gold Marketing Assistant: Credits and acknowledgments borrowed from other sources and reproduced with permission, in this textbook appear on the appropriate page within text. Copyright © 2012, 2008, 2004, 2000 Pearson Education, Inc. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617 671-3447, or e-mail at Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. Library of Congress Cataloging-in-Publication Data Cooter, Robert. Law and economics / Robert Cooter, Thomas Ulen.—6th ed. p. cm. Rev. ed. of: Law & economics / Robert Cooter, Thomas Ulen. Includes index. ISBN 978-0-13-254065-0 1. Law and economics. I. Ulen, Thomas. II. Cooter, Robert. Law & economics. III. Title. K487.E3C665 2011 340’.11—dc22 2010049060 10 9 8 7 6 5 4 3 2 1 ISBN-10: 0-13-254065-7 ISBN-13: 978-0-13-254065-0

10 Contents Preface x An Introduction to Law and Economics 1 1. 3 I. What Is the Economic Analysis of Law? Some Examples 4 II. III. The Primacy of Efficiency Over Distribution in Analyzing Private Law 7 IV. Why Should Lawyers Study Economics? Why Should Economists Study Law? 9 The Plan of This Book V. 10 2. 11 A Brief Review of Microeconomic Theory Overview: The Structure of Microeconomic Theory I. 11 II. Some Fundamental Concepts: Maximization, Equilibrium, 12 and Efficiency Mathematical Tools 14 III. IV. The Theory of Consumer Choice and Demand 18 V. The Theory of Supply 26 VI. Market Equilibrium 28 Game Theory VII. 33 VIII. The Theory of Asset Pricing 37 General Equilibrium and Welfare Economics IX. 37 X. Decision Making Under Uncertainty: Risk and Insurance 43 XI. Profits and Growth 49 XII. Behavioral Economics 50 3. 55 A Brief Introduction to Law and Legal Institutions I. The Civil Law and the Common Law Traditions 56 II. The Institutions of the Federal and the State Court Systems in the United States 59 III. The Nature of a Legal Dispute 62 IV. How Legal Rules Evolve 64 vii

11 Contents viii 70 4. An Economic Theory of Property 73 I. The Legal Concept of Property II. 74 Bargaining Theory The Origins of the Institution of Property: A Thought III. 76 Experiment An Economic Theory of Property 81 IV. How are Property Rights Protected? 94 V. What Can be Privately Owned?—Public and Private Goods 102 VI. 105 VII. What May Owners Do with Their Property? VIII. On Distribution 106 Appendix: The Philosophical Concept of Property 109 Topics in the Economics of Property Law 5. 112 112 What can be Privately Owned? I. II. How are Property Rights Established and Verified? 143 III. What May Owners Do with Their Property? 156 166 IV. What are the Remedies for the Violation of Property Rights? 187 An Economic Theory of Tort Law 6. 189 Defining Tort Law I. II. 199 An Economic Theory of Tort Liability Appendix: Liability and Symmetry 228 Topics in the Economics of Tort Liability 7. 230 I. Extending the Economic Model 230 253 Computing Damages II. 261 III. An Empirical Assessment of the U.S. Tort Liability System 276 An Economic Theory of Contract Law 8. 277 I. Bargain Theory: An Introduction to Contracts An Economic Theory of Contract Enforcement 283 II. 287 III. An Economic Theory of Contract Remedies 291 Economic Interpretation of Contracts IV. V. Relational Contracts: The Economics of the Long-Run 299

12 ix Contents 307 9. Topics in the Economics of Contract Law 307 I. Remedies as Incentives II. 341 Formation Defenses and Performance Excuses 373 Appendix: Mathematical Appendix 382 10. An Economic Theory of the Legal Process The Goal of the Legal Process: Minimizing Social Costs 384 I. Why Sue? 386 II. Exchange of Information 391 III. IV. Settlement Bargaining 399 Trial V. 403 VI. 410 Appeals 419 11. Topics in the Economics of the Legal Process I. Complaints, Lawyers, Nuisances, and Other Issues in the Legal Process 419 442 II. An Empirical Assessment of the Legal Process 454 12. An Economic Theory of Crime and Punishment 455 I. The Traditional Theory of Criminal Law 460 II. An Economic Theory of Crime and Punishment 13. Topics in the Economics of Crime and Punishment 485 485 Crime and Punishment in the United States I. II. Does Punishment Deter Crime? 491 III. Efficient Punishment 501 510 IV. The Death Penalty 518 The Economics of Addictive Drugs and Crime V. 522 VI. The Economics of Handgun Control Explaining the Decline in Crime in the United States 526 VII. Case Index 533 535 Name Index Subject Index 539

13 Preface Law and Economics arrives as the field celebrates its his sixth edition of th (roughly) 30 birthday. What began as a scholarly niche has grown into one of the most widely used tools of legal analysis. The subject has spread from the T United States to many other countries. As scholarship deepens, the concepts in the core of law and economics become clearer and more stable, and new applications develop from the core like biological species evolving through specialization. With each new edition, we continue to refine the explanation of the analytical core and to incorporate new applications selectively as space permits. This edition expands previous discus- sions of empirical legal studies and behavioral law and economics. As we incorporate new material and respond to the suggestions that so many people have sent us, the book feels more like a symphony and less like a duet. We hope that you enjoy reading this book as much as we enjoyed writing it. The book continues to cover the economic analysis of the law of property, torts, contracts, the legal process and crimes. Instructors and students who have used previ- ous editions will notice that we have reversed the order in which we treat torts and con- tracts, and we have divided the material on legal process into two chapters—one on theory and one on topics—in parallel with our treatment of all the other substantive ar- eas of the law. Below we describe what is new in this edition, followed by an account of the book’s website. New to This Edition The Sixth Edition has been revised and updated to reflect the latest developments in law and economics. Major changes to the text are as follows: • Tables and graphs have been updated. • New boxes and suggested readings have been added throughout the text. • Web Notes have been updated and added. • Chapter 6 contains additional information on liability and customs in trade. •Chapter 8improves the explanation of contractual commitments through a better representation of the principal-agent problem. x

14 xi Preface • Chapter 9 now includes new material on lapses, vicarious liability, incomprehensi- ble harms, punitive damages, mass torts, medical malpractice, and some behav- ioral aspects of contract remedies. •Chapter 10contains a new treatment of decision making by potential litigants and their lawyers, and new figures and decision trees. • Chapter 11, a new chapter, combines new material on the legal process and an updated empirical assessment of various aspects of legal disputes. •Chapter 12now contains the theoretical material on crime and punishment, updated and clarified. • Chapter 13 applies the theoretical insights of the previous chapter to wide-ranging policy issues in criminal justice and updates data and information from previous editions. Online Resources The Companion Website presents a wealth of supplementary materials to help in teaching and learning law and economics. “Web Notes” throughout the book indi- cate the points at which there is additional material on the Companion Website at www.pear These notes extend the text presentations, provide guides and links to new articles and books, and contain excerpts from cases. We also include some examples of examinations and problem sets. reflective of changes to the new edition, will be An updated Instructor’s Manual, is available for download available for instructors’ reference. The Instructor’s Manual on the Instructor's Resource center at Acknowledgments We c o n t i n u e t o b e ex t r e m e l y g r a t e f u l t o o u r c o l l e a g u e s a t B o a l t H a l l o f t h e University of California, Berkeley, and at the University of Illinois College of Law for the superb scholarly environments in which we work. Our colleagues have been extremely generous with their time in helping us to understand the law better. And in one of the great, ongoing miracles of the academic enterprise, we continue to learn much from the students whom we have the pleasure to teach at Berkeley, Illinois, and elsewhere. We s h o u l d a l s o t h a n k t h e m a ny c o l l e a g u e s a n d s t u d e n t s a t o t h e r u n ive r s i t i e s w h o have used our book in their classes and sent us many helpful suggestions about how to improve the book. We particularly thank Joe Kennedy of Georgetown, who has given us remarkably thorough and singularly helpful comments on improvements in the text. We ’d l i ke t o t h a n k t h e f o l l ow i n g r ev i ew e r s f o r t h e i r t h o u g h t f u l c o m m e n t a r y o n t h e fi f t h edition: Howard Bodenhorn, J. Lon Carlson, Joseph M. Jadlow, and Mark E. McBride. We wo u l d a l s o l i ke t o t h a n k t h o s e w h o h ave p r ov i d e d r e s e a r c h a s s i s t a n c e f o r t h i s sixth edition: Theodore Ulen, Timothy Ulen, and Brian Doxey. And, also, for their long-time support and help: Jan Crouter, Dhammika Dharmapala, Lee Ann Fennell,

15 Preface xii Nuno Garoupa, John Lopatka, Richard McAdams, Andy Morriss, Tom Nonnenmacher, Noel Netusil, Dan Vander Ploeg, and David Wishart. Finally, we owe particular thanks to our assistants, Ida Ng at Boalt Hall and Sally Cook at the University of Illinois College of Law. They do many big things to help us get our work done, as well as many little things without which much of our work would be impossible to do. Thanks so much. ROBERT D. COOTER Berkeley, CA THOMAS S. ULEN Champaign, IL November, 2010

16 An Introduction to Law and Economics 1 Fo r t h e r a t i o n a l s t u d y o f t h e l a w t h e b l a c k - l e t t e r m a n m a y b e t h e m a n o f t h e p re s e n t , but the man of the future is the man of statistics and the master of economics. . . . We learn that for everything we have to give up something else, and we are taught to set the advantage we gain against the other advantage we lose, and to know what we are doing when we elect. Oliver Wendell Holmes. 1 T ARV HE EV . 457, 469, 474 (1897) ,10 H L ATH OF THE AW P . L. R To m e t h e m o s t i n t e re s t i n g a s p e c t o f t h e l a w a n d e c o n o m i c s m o v e m e n t h a s b e e n i t s a s - piration to place the study of law on a scientific basis, with coherent theory, precise hypotheses deduced from the theory, and empirical tests of the hypotheses. Law is a social institution of enormous antiquity and importance, and I can see no reason why it should not be amenable to scientific study. Economics is the most advanced of the social sciences, and the legal system contains many parallels to and overlaps with the systems that economists have studied successfully. AURE F ICHAEL Judge Richard A. Posner, in M & R B ERGH , EDS ., E SSAYS IN L AW AND E CONOMICS (1989) OGER V AN DEN LAW NTIL RECENTLY , confined the use of economics to antitrust law, regulated in- dustries, tax, and some special topics like determining monetary damages. In U these areas, law needed economics to answer such questions as “What is the de- fendant’s share of the market?”; “Will price controls on automobile insurance reduce its availability?”; “Who really bears the burden of the capital gains tax?”; and “How much future income did the children lose because of their mother’s death?” Beginning in the early 1960s, this limited interaction changed dramatically when the economic analysis of law expanded into the more traditional areas of the law, such 2 as property, contracts, torts, criminal law and procedure, and constitutional law. This 1 Our citation style is a variant of the legal citation style most commonly used in the United States. Here is what the citation means: the author of the article from which the quotation was taken is Oliver Wendell Holmes; the title of the article is “The Path of the Law”; and the article may be found in volume 10 of the Harvard Law Review , which was published in 1897, beginning on page 457. The quoted material comes from pages 469 and 474 of that article. 2 The modern field is said to have begun with the publication of two landmark articles—Ronald H. Coase, The Problem of Social Cost, 3 J. L. & E CON . 1 (1960) and Guido Calabresi, Some Thoughts on Risk L.J. 499 (1961). ALE 70 Y Distribution and the Law of Torts, 1

17 2 CHAPTER 1 Introduction to Law and Economics An new use of economics in the law asked such questions as, “Will private ownership of the electromagnetic spectrum encourage its efficient use?”; “What remedy for breach of contract will cause efficient reliance on promises?”; “Do businesses take too much or too little precaution when the law holds them strictly liable for injuries to con- sumers?”; and “Will harsher punishments deter violent crime?” Economics has changed the nature of legal scholarship, the common understanding of legal rules and institutions, and even the practice of law. As proof, consider these in- dicators of the impact of economics on law. By 1990 at least one economist was on the faculty of each of the top law schools in North America and some in Western Europe. Joint degree programs (a Ph.D. in economics and a J.D. in law) exist at many prominent universities. Law reviews publish many articles using the economic approach, and there 3 are several journals devoted exclusively to the field. An exhaustive study found that ar- ticles using the economic approach are cited in the major American law journals more 4 Many law school courses in America now in- than articles using any other approach. clude at least a brief summary of the economic analysis of law in question. Many sub- stantive law areas, such as corporation law, are often taught from a law-and-economics 5 By the late 1990s, there were professional organizations in law and eco- perspective. nomics in Asia, Europe, Canada, the United States, Latin America, Australia, and else- where. The field received the highest level of recognition in 1991 and 1992 when 6 were awarded to economists who helped to consecutive Nobel Prizes in Economics found the economic analysis of law—Ronald Coase and Gary Becker. Summing this up, Professor Bruce Ackerman of the Yale Law School described the economic approach to law as “the most important development in legal scholarship of the twentieth century.” The new field’s impact extends beyond the universities to the practice of law and the implementation of public policy. Economics provided the intellectual foundations for the deregulation movement in the 1970s, which resulted in such dramatic changes in America as the dissolution of regulatory bodies that set prices and routes for airlines, trucks, and railroads. Economics also served as the intellectual force behind the revolu- tion in antitrust law in the United States in the 1970s and 1980s. In another policy area, a commission created by Congress in 1984 to reform criminal sentencing in the federal courts explicitly used the findings of law and economics to reach some of its results. Furthermore, several prominent law-and-economics scholars have become federal judges and use economic analysis in their opinions—Associate Justice Stephen Breyer of the U.S. Supreme Court; Judge Richard A. Posner and Judge Frank Easterbrook of the U.S. Court of Appeals for the Seventh Circuit; Judge Guido Calabresi of the U.S. 3 For example, the Journal of Law and Economics began in 1958; the Journal of Legal Studies in 1972; , the Research in Law and Economics , and the Journal of Law, International Review of Law and Economics Economics, and Organization in the 1980s; and the Journal of Empirical Legal Studies in 2004. 4 William M. Landes & Richard A. Posner, The Influence of Economics on Law: A Quantitative Study, 36 J. L. & E . 385 (1993). CON 5 See, e.g., S TEPHEN M. B AINBRIDGE , C ORPORATION L AW A N D E CONOMICS (2002). 6 The full name of the Nobel Prize in Economics is the Bank of Sweden Prize in the Economic Sciences in Memory of Alfred Nobel. See our book’s website for a full list of those who have won the Nobel Prize and brief descriptions of their work.

18 I. What Is the Economic Analysis of Law? 3 Court of Appeals for the Second Circuit; Judge Douglas Ginsburg, and former Judge Robert Bork of the U.S. Court of Appeals for the D.C. Circuit; and Judge Alex Kozinski of the U.S. Court of Appeals for the Ninth Circuit. I. What Is the Economic Analysis of Law? Why has the economic analysis of law succeeded so spectacularly, especially in 7 the United States but increasingly also in other countries? Like the rabbit in Australia, economics found a vacant niche in the “intellectual ecology” of the law and rapidly filled it. To explain the niche, consider this classical definition of some kinds of laws: “A law is an obligation backed by a state sanction.” Lawmakers often ask, “How will a sanction affect behavior?” For example, if punitive damages are imposed upon the maker of a defective product, what will happen to the safety and price of the product in the future? Or will the amount of crime de- crease if third-time offenders are automatically imprisoned? Lawyers answered such questions in 1960 in much the same way as they had 2000 years earlier—by consulting intuition and any available facts. Economics provided a scientific theory to predict the effects of legal sanctions on behavior. To economists, sanctions look like prices, and presumably, people respond to these sanctions much as they respond to prices. People respond to higher prices by consuming less of the more expensive good; presumably, people also respond to more severe legal sanctions by doing less of the sanctioned activity. Economics has mathe- matically precise theories (price theory and game theory) and empirically sound methods (statistics and econometrics) for analyzing the effects of the implicit prices that laws attach to behavior. Consider a legal example. Suppose that a manufacturer knows that his product will sometimes injure consumers. How safe will he make the product? For a profit- maximizing firm, the answer depends upon three costs: First, the cost of making the product safer, which depends on its design and manufacture; second, the manufac- turer’s legal liability for injuries to consumers; and third, the extent to which injuries discourage consumers from buying the product. The profit-maximizing firm will adjust safety until the cost of additional safety equals the benefit from reduced liability and higher consumer demand for the good. Economics generally provides a behavioral theory to predict how people respond to laws. This theory surpasses intuition just as science surpasses common sense. The re- sponse of people is always relevant to making, revising, repealing, and interpreting laws. A famous essay in law and economics describes the law as a cathedral—a large, ancient, 8 complex, beautiful, mysterious, and sacred building. Behavioral science resembles the mortar between the cathedral’s stones, which support the structure everywhere. 7 See Nuno Garoupa & Thomas S. Ulen, The Market for Legal Innovation: Law and Economics in Europe LA . L. R EV . 1555 (2008). , 59 A and the United States 8 Guido Calabresi & A. Douglas Melamed, Property Rules, Liability Rules, and Inalienability: One View of the Cathedral, 85 H ARV . L. R EV . 1089 (1972).

19 4 CHAPTER 1 Introduction to Law and Economics An A prediction can be neutral or loaded with respect to social values. A study finds that higher fines for speeding on the highway will presumably cause less of it. Is this good or bad on balance? The finding does not suggest an answer. In contrast, suppose that a study proves that the additional cost of collecting higher fines exceeds the result- ing benefit from fewer accidents, so a higher fine is “inefficient.” This finding suggests that a higher fine would be bad. Efficiency is always relevant to policymaking, because public officials never advocate wasting money. As this example shows, besides neutral predictions, economics makes loaded predictions. Judges and other officials need a method for evaluating laws’ effects on important social values. Economics provides such a method for efficiency. Besides efficiency, economics predicts the effects of laws on another important value: the distribution of income. Among the earliest applications of economics to public policy was its use to predict who really bears the burden of alternative taxes. More than other so- cial scientists, economists understand how laws affect the distribution of income across classes and groups. While almost all economists favor changes that increase efficiency, some economists take sides in disputes about distribution and others do not take sides. Instead of efficiency or distribution, people in business mostly talk about profits. Much of the work of lawyers aims to increase the profits of businesses, especially by helping businesses to make deals, avoid litigation, and obey regulations. These three ac- tivities correspond to three areas of legal practice in large law firms: transactions, litiga- tion, and regulation. Efficiency and profitability are so closely related that lawyers can use the efficiency principles in this book to help businesses make more money. Economic efficiency is a comprehensive measure of public benefits that include the profits of firms, the well-being of consumers, and the wages of workers. The logic of maximizing the comprehensive measure (efficiency) is very similar to the logic of maximizing one of its components (profits). A good legal system keeps the profitability of business and the wel- fare of people aligned, so that the pursuit of profits also benefits the public. II. Some Examples To give you a better idea of what law and economics is about, we turn to some ex- amples based upon classics in the subject. First, we try to identify the implicit price that the legal rule attaches to behavior in each example. Second, we predict the conse- quences of variations in that implicit price. Finally, we evaluate the effects in terms of efficiency and, where possible, distribution. Example 1: A commission on reforming criminal law has identified cer- tain white-collar crimes (such as embezzling money from one’s employer) that are typically committed after rational consideration of the potential gain and the risk of getting caught and punished. After taking extensive testimony, much of it from economists, the commission decides that a monetary fine is the appropriate pun- ishment for these offenses, not imprisonment. The commission wants to know, “How high should the fine be?” The economists who testified before the commission have a framework for an- swering this question. The commission focused on rational crimes that seldom occur unless the expected gain to the criminal exceeds the expected cost. The expected cost

20 II. Some Examples 5 depends upon two factors: the probability of being caught and convicted and the sever- ity of the punishment. For our purposes, define the expected cost of crime to the crimi- nal as the product of the probability of a fine times its magnitude. creases by 5 percent and the magni- Suppose that the probability of punishment de tude of the fine in creases by 5 percent. In that case, the expected cost of crime to the criminal roughly remains the same. Because of this, the criminal will presumably re- spond by committing the same amount of crime. (In Chapter 12 we shall explain the exact conditions for this conclusion to be true.) This is a prediction about how illegal behavior responds to its implicit price. Now we evaluate this effect with respect to economic efficiency. When a decrease in the probability of a fine offsets an increase in its magnitude, the expected cost of crime remains roughly the same for criminals, but the costs of crime to the criminal justice sys- tem may change. The costs to the criminal justice system of increasing a fine’s probabil- ity include expenditures on apprehending and prosecuting criminals—for example, on the number and quality of auditors, tax and bank examiners, police, prosecuting attor- neys, and the like. While the cost of increasing the probability of catching and convicting white-collar criminals is relatively high, administering fines is relatively cheap. These facts imply a prescription for holding white-collar crime down to any specified level at least cost to the state: Invest little in apprehending and prosecuting offenders, and fine se- verely those who are apprehended. Thus, the commission might recommend very high monetary fines in its schedule of punishments for white-collar offenses. Professor Gary Becker derived this result in a famous paper cited by the Nobel Prize Committee in its award to him. Chapters 12 and 13 discuss these findings in detail. Example 2: An oil company contracts to deliver oil from the Middle East to a European manufacturer. Before the oil is delivered, war breaks out and the oil company cannot perform as promised. The lack of oil causes the European manu- facturer to lose money. The manufacturer brings an action (that is, files a lawsuit) against the oil company for breach of contract. The manufacturer asks the court to award damages equal to the money that it lost. The contract is silent about the risk of war, so that the court cannot simply read the contract and resolve the dispute on the contract’s own terms. The oil company contends that it should be excused from performance because it could do nothing about the war and neither of the con- tracting parties foresaw it. In resolving the suit, the court must decide whether to excuse the oil company from performance on the ground that the war made the performance “impossible,” or to find the oil company in breach of contract and to 9 require the oil company to compensate the manufacturer for lost profits. War is a risk of doing business in the Middle East that one of the parties to the con- tract must bear, and the court must decide which one it is. What are the consequences of different court rulings? The court’s decision simultaneously accomplishes two things. First, it resolves the dispute between the litigants—“dispute resolution.” Second, it guides future parties who are in similar circumstances about how courts might resolve their dispute—“rule creation.” Law and economics is helpful in resolving 9 For a full discussion of the cases on which this example is based, see Richard A. Posner & Andrew . 88 (1977). Impossibility and Related Doctrines in Contract Law, 6 J. L EGAL S TUD Rosenfield,

21 6 CHAPTER 1 Introduction to Law and Economics An disputes, but it particularly shines in creating rules. Indeed, a central question in this book is, “How will the rule articulated by the lawmaker to resolve a particular dispute affect the behavior of similarly situated parties in the future?” And, “Is the predicted behavior desirable?” The oil company and the manufacturer can take precautions against war in the Middle East, although neither of them can prevent it. The oil company can sign backup contracts for delivery of Venezuelan oil, and the manufacturer can store oil for emer- gency use. Efficiency requires the party to take precaution who can do so at least cost. Is the oil company or the manufacturer better situated to take precautions against war? Since the oil company works in the Middle East, it is probably better situated than a European manufacturer to assess the risk of war in that region and to take precautions against it. For the sake of efficiency, the court might hold the oil company liable and cite the principle that courts will allocate risks uncovered in a contract to the party who 10 which is can bear them at least cost. This is the principle of the least-cost risk-bearer, consistent with some decisions in cases that arose from the Middle Eastern war of 1967. Chapters 8 and 9 consider this principle’s foundation. Eddie’s Electric Company emits smoke that dirties the wash Example 3: hanging at Lucille’s Laundry. Eddie’s can completely abate the pollution by in- Lucille’s stalling scrubbers on its stacks, and can completely exclude the smoke by installing filters on its ventilation system. Installing filters is cheaper than installing scrubbers. No one else is affected by this pollution because Eddie’s and Lucille’s Lucille’s are near to each other and far from anyone else. initiates court proceed- ings to have Eddie’s declared to be a “nuisance.” If the action succeeds, the court will order Eddie’s to abate its pollution. Otherwise, the court will not intervene in the dispute. What is the appropriate resolution of this dispute? Efficiency requires Lucille’s to install filters, which is cheaper than Eddie’s in- stalling scrubbers. How can the court produce this result? The answer depends on whether or not and Lucille’s can cooperate. First, assume that Eddie’s and Eddie’s cannot bargain together or cooperate. If wins the action and the court Lucille’s Lucille’s Eddie’s to abate the pollution, Eddie’s orders will have to install scrubbers, which is ef- ficient. However, if Lucille’s loses the action, then Lucille’s will have to install filters, which is inefficient. Consequently, it is efficient for Lucille’s to lose the action. Now, consider how the analysis changes if Eddie’s Lucille’s can bargain together and and cooperate. Their joint profits (the sum of the profits of and Lucille’s ) will be Eddie’s higher if they choose the cheaper means of eliminating the harm from pollution. When their joint profits are higher, they can divide the gain between them in order to make both of them better off. The cheaper means is also the efficient means. Efficiency is achieved bargain together and cooperate, regardless of Lucille’s and Eddie’s in this example when the rule of law. Ronald Coase derived this result in a famous paper cited by the Nobel Prize Committee when he received the award. Chapter 4 elaborates on this famous result. 10 The principle assumes that the entire loss from nonperformance must be allocated by the court to one of the parties. Alternatively, the court might divide the loss between the parties.

22 III. The Primacy of Efficiency Over Distribution in Analyzing Private Law 7 III. The Primacy of Efficiency Over Distribution in Analyzing Private Law We explained that economists are experts on two policy values—efficiency and distribution. The stakes in most legal disputes have monetary value. Deciding a legal dispute almost always involves allocating the stakes between the parties. The decision about how much of the stakes each party gets creates incentives for future behavior, not just for the parties to this dispute but also for everyone who is similarly situated. In this book we use these incentive effects to make predictions about the consequences of le- gal decisions, policies, rules, and institutions. In evaluating these consequences, we will focus on efficiency rather than distribution. Why? By making a rule, the division of the stakes in a legal dispute affects all similarly situated people. If a plaintiff in a case is a consumer of a particular good, an investor in a particular stock, or the driver of a car, then a decision for the plaintiff may benefit everyone who consumes this good, invests in this stock, or drives a car. Most propo- nents of income redistribution, however, have something else in mind. Instead of con- templating distribution to consumers, investors, or drivers, advocates of income redistribution usually target social groups, such as the poor, women, or minorities. Some people passionately advocate government redistribution of income by class, gen- der, or race for the sake of social justice. A possible way to pursue redistribution is through private law—the law of property, contracts, and torts. According to this philos- ophy, courts should interpret or make private laws to redistribute income to deserving groups of people. For example, if consumers are poorer on average than investors, then courts should interpret liability rules to favor consumers and disfavor corporations. This book rejects the redistributive approach to private law. Pursuing redistributive goals is an exceptional use of private law that special circumstances may justify but that ought not be the usual use of private law. Here is why. Like the rest of the population, economists disagree among themselves about redistributive ends. However, economists generally agree about redistributive . By avoiding waste, efficient redistribution means benefits everyone relative to inefficient redistribution. By avoiding waste, efficient re- distribution also builds support for redistribution. For example, people are more likely to donate to a charitable organization that efficiently redistributes income than to one that spends most of its revenue on administration. A piquant example will help you to appreciate the advantages of efficient redistri- bution. Assume that a desert contains two oases, one of which has ice cream and the other has none. The advocates of social justice who favor redistribution obtain control over the state and declare that the first oasis should share its ice cream with the second oasis. In response, the first oasis fills a large bowl with ice cream and sends a youth running across the desert carrying the bowl to the second oasis. The hot sun melts some of the ice cream, so the first oasis gives up more ice cream than the second oasis re- ceives. The melted ice cream represents the cost of redistribution. People who disagree vehemently about how much ice cream the first oasis should give to the second oasis may agree that a fast runner should transport it. Also they might agree to choose an honest runner who will not eat the ice cream along the route.

23 8 CHAPTER 1 Introduction to Law and Economics An Many economists believe that progressive taxation and social welfare programs— the “tax-and-transfer system,” as it is usually called—can accomplish redistributive goals in modern states more efficiently than can be done through modifying or reshuf- fling private legal rights. There are several reasons why reshuffling private legal rights resembles giving the ice cream to a slow runner. First, the income tax precisely targets inequality, whereas redistribution by private legal rights relies on crude averages. To illustrate, assume that courts interpret a law to 11 favor consumers over corporations in order to redistribute income from rich to poor. “Consumers” and “investors” imperfectly correspond to “poor” and “rich.” Consumers of Ferrari automobiles, skiing vacations, and the opera tend to be relatively rich. Many small businesses are organized as corporations. Furthermore, the members of unions with good pension plans own the stocks of large companies. By taxing income progres- sively, law distinguishes more precisely between rich and poor than by taking the indi- rect approach of targeting “consumers” and “investors.” Second, the distributive effects of reshuffling private rights are hard to predict. To illustrate, the courts cannot be confident that holding a corporation liable to its con- sumers will reduce the wealth of its stockholders. Perhaps the corporation will pass on its higher costs to consumers in the form of higher prices, in which case the court’s holding will redistribute costs from some consumers to other consumers. Third, the transaction costs of redistribution through private legal rights are typi- cally high. To illustrate, a plaintiff’s attorney working on a contingency fee in the United States routinely charges one-third of the judgment. If the defendant’s attorney collects a similar amount in hourly fees, then attorneys for the two sides will absorb two-thirds of the stakes in dispute. The tax-and-transfer system is more efficient. Besides these three reasons, there is a fourth: Redistribution by private law distorts the economy more than progressive taxation does. In general, relying on broad-based taxes, rather than narrowly focused laws, reduces the distorting effects of redistributive policies. For example, assume that a law to benefit consumers of tomatoes causes a de- cline in the return enjoyed by investors in tomato farms. Investors will respond by with- drawing funds from tomato farms and investing in other businesses. Consequently, the supply of tomatoes will be too small and consumers will pay too high a price for them. This law distorts the market for tomatoes. For these reasons and more, economists who favor redistribution and economists who oppose it can agree that private legal rights are usually the wrong way to pursue distributive justice. Unfortunately, lawyers without training in economics seldom ap- preciate these facts. We h ave p r e s e n t e d s eve r a l r e a s o n s a g a i n s t b a s i n g p r iva t e l aw o n r e d i s t r i bu t ive g o a l s . Specifically, we discussed imprecise targeting, unpredictable consequences, high transac- tion costs, and distortions in incentives. For these reasons, the general principles of private law cannot rest on income redistribution. (In special circumstances, however, a private law can redistribute relatively efficiently, such as a well-designed law giving crippled people the right to sue employers for not providing wheelchair access to the workplace.) 11 Courts might always find in favor of the individual consumer when he or she sues a corporation regarding liability for harms arising in the use of the corporation’s products.

24 IV. Why Should Lawyers Study Economics? Why Should Economists Study Law? 9 Web Note 1.1 Besides efficiency, what other policy values should matter to making law and Fa i r n e s s Ve rs u s We l f a re (2002), Louis Kaplow and Steven applying it? In Shavell of the Harvard Law School say “None.” Others disagree. See Chris Deconstructing the New Efficiency Rationale, 86 C ORNELL L. R EV . Sanchirico, What (If Anything) Can Economics Say About 1005 (2001), and Daniel Farber, 101 M ICH . L. R Equity?, . 1791 (2003). EV There is a more complete discussion of this literature under Chapter 1 at the website for this book and links to additional sites of interest. IV. Why Should Lawyers Study Economics? Why Should Economists Study Law? The economic analysis of law unites two great fields and facilitates understanding each of them. You probably think of laws as promoting justice; indeed, many people can think in no other way. Economics conceives of laws as incentives for changing behavior (implicit prices) and as instruments for policy objectives (efficiency and distribution). However, economic analysis often takes for granted such legal institutions as property and contract, which dramatically affect the economy. Thus, differences in laws cause capital markets to be organized differently in Japan, Germany, and the United States. Failures in financial laws and contracting contributed to the banking collapse of 2008 in the United States and the subsequent recession, which was less severe in Japan and Germany. Also, the absence of secure property and reliable contracts paralyzes the economies of some poor nations. Improving the effectiveness of law in poor countries is important to their economic development. Law needs economics to understand its be- havioral consequences, and economics needs law to understand the underpinnings of markets. Economists and lawyers can also learn techniques from each other. From econo- mists, lawyers can learn quantitative reasoning for making theories and doing empiri- cal research. From lawyers, economists can learn to persuade ordinary people—an art Stern Warning for Students If you are like most students who read this book—scholars of the highest moral caliber—you need not upset yourself by reading the rest of this paragraph. If you are one of those wicked students—we get a few every year—here is a stern warning for you. According to traditional Chinese beliefs, sinners are tried and punished in ten courts of hell after they die. The sixth court tries the sin of “abusing books,” punishable by being sawn in half from head to toe. The eighth court tries the sin of “cheating on exams,” punishable by being cut open and having your intes- tines ripped out. So don’t you dare abuse this book or cheat on the exams!

25 10 CHAPTER 1 Introduction to Law and Economics An that lawyers continually practice and refine. Lawyers can describe facts and give them names with moral resonance, whereas economists are obtuse to language too often. If economists will listen to what the law has to teach them, they will find their models be- ing drawn closer to what people really care about. V. The Plan of This Book To b e n e fi t f r o m e a c h o t h e r, l aw y e r s m u s t l e a r n s o m e e c o n o m i c s a n d e c o n o m i s t s must learn some law. Readers can do so in the next two chapters. Chapter 2 briefly re- views microeconomic theory. If you are familiar with that theory, then you can read the material quickly as a review or skim the headings for unfamiliar topics. As a check, you might try the problems at the end of Chapter 2. Chapter 3 is an introduction to the law and the legal process, which is essential reading for those without legal training. We explain how the legal system works, how the U.S. legal system differs from the rest of the world, and what counts as “law.” Chapter 4 begins the substantive treatment of the law from an economic viewpoint. The chapters on substantive legal issues are arranged in pairs. Chapters 4 and 5 focus on property law; Chapters 6 and 7, on tort law; Chapters 8 and 9, on contract law; Chapters 10 and 11, on resolving legal disputes; and 12 and 13, on criminal law. The first chapter of each pair explains the basic economic analysis of that area of law, and the second chap- ter applies the core economic theory to a series of topics. So, Chapter 6 develops an eco- nomic theory of tort liability, and Chapter 7 applies it to automobile accidents, medical practice, and defective products. Chapters 4 through 11 deal with laws where the typical plaintiff in a suit is a private person (“private law”), and Chapters 12 and 13 deal with criminal law where the plaintiff is the public prosecutor (“public law”). Suggested Readings At the end of every chapter we shall list some of the most important writings on the subject. Please check the website for this book ( ) for additional resources. OUCKAERT , B OUDEWIJN , & G ERRIT CONOMICS E G EEST , EDS ., E NCYCLOPEDIA OF L AW A N D E D B (rev. ed., 2011). , -S CHMIDT , K EN , & T HOMAS S. U LEN AU EDS ., A L AW A N D E CONOMICS A NTHOLOGY (1997). D (2d ed. 2008). ICELI , T HOMAS J, T HE E CONOMIC A PPROACH TO L AW M L , P ETER , ED ., T HE N EW P ALGRAVE D ICTIONARY OF E CONOMICS AND EWMAN AW (3 vols., 1998). N NTRODUCTION TO , A. M ITCHELL , A N I OLINSKY L AW A N D E CONOMICS (3rd, 2003). P , vs. 1 OLINSKY , A. M ITCHELL , & S TEVEN S HAVELL , EDS ., H ANDBOOK OF L AW A N D E CONOMICS P 2 (2007). AND Posner, Richard A., The Decline of Law as an Autonomous Discipline, 1962–1987, ARV . L. R EV . 761 (1987). 100 H (7th ed., 2007). OSNER , R ICHARD A., E CONOMIC A NALYSIS OF L AW P (2003). HAVELL , S TEVEN , F OUNDATIONS OF THE AW CONOMIC A NALYSIS OF L E S

26 A Brief Review of Microeconomic Theory 2 Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. . . . It is ideas, not vested interests, which are dangerous for good or evil. OHN EYNES , J M K AY N A R D T ONEY MPLOYMENT , I NTEREST , AND M E (1936) G ENERAL T HE HEORY OF In this state of imbecility, I had, for amusement, turned my attention to political economy. , EQUINCEY T HOMAS D C O E ATER (1821) PIUM ONFESSIONS OF AN NGLISH E Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses. HARLES R OBBINS , L ORD R OBBINS , IONEL L C A N ATURE AND S IGNIFICANCE OF E CONOMIC S CIENCE (1932) E N SSAY ON THE HE ECONOMIC ANALYSIS of law draws upon the principles of microeconomic the- ory, which we review in this chapter. For those who have not studied this branch of economics, reading this chapter will prove challenging but useful for under- T standing the remainder of the book. For those who have already mastered microeco- nomic theory, reading this chapter is unnecessary. For those readers who are somewhere in between these extremes, we suggest that you begin reading this chapter, skimming what is familiar and studying carefully what is unfamiliar. If you’re not sure where you lie on this spectrum of knowledge, turn to the questions at the end of the chapter. If you have difficulty answering them, you will benefit from studying this chapter carefully. I. Overview: The Structure of Microeconomic Theory Microeconomics concerns decision making by individuals and small groups, such as families, clubs, firms, and governmental agencies. As the famous quote from Lord Robbins at the beginning of the chapter says, microeconomics is the study of how 11

27 12 CHAPTER 2 ief Review of Microeconomic Theory A Br scarce resources are allocated among competing ends. Should you buy that digital au- diotape player you’d like, or should you buy a dapper suit for your job interview? Should you take a trip with some friends this weekend or study at home? Because you have limited income and time and cannot, therefore, buy or do everything that you might want to buy or do, you have to make choices. Microeconomic theory offers a general theory about how people make such decisions. We divide our study of microeconomics into five sections. The first is the theory of consumer choice and demand. This theory describes how the typical consumer, con- strained by a limited income, chooses among the many goods and services offered for sale. The second section deals with the choices made by business organizations or firms. We shall develop a model of the firm that helps us to see how the firm decides what goods and services to produce, how much to produce, and at what price to sell its out- put. In the third section, we shall consider how consumers and firms interact. By com- bining the theory of the consumer and the firm, we shall explain how the decisions of consumers and firms are coordinated through movements in market price. Eventually, the decisions of consumers and firms must be made consistent in the sense that some- how the two sides agree about the quantity and price of the good or service that will be produced and consumed. When these consumption and production decisions are con- sistent in this sense, we say that the market is in equilibrium. We shall see that power- ful forces propel markets toward equilibrium, so that attempts to divert the market from its path are frequently ineffectual or harmful. The fourth section of microeconomic theory describes the supply and demand for inputs into the productive process. These inputs include labor, capital, land, and mana- gerial talent; more generally, inputs are all the things that firms must acquire in order to produce the goods and services that consumers or other firms wish to purchase. The final section of microeconomics deals with the area known as welfare economics. There we shall discuss the organization of markets and how they achieve efficiency. These topics constitute the core of our review of microeconomic theory. There are four additional topics that do not fit neatly into the sections noted above but that we think you should know about them in order to understand the economic analysis of legal rules and institutions. These are game theory, the economic theory of decision making under uncertainty, growth theory, and behavioral economics. We shall cover these four topics in the final sections of this chapter. II. Some Fundamental Concepts: Maximization, Equilibrium, and Efficiency Economists usually assume that each economic actor maximizes something: Consumers maximize utility (that is, happiness or satisfaction), firms maximize profits, politicians maximize votes, bureaucracies maximize revenues, charities maximize social welfare, and so forth. Economists often say that models assuming maximizing behavior work because most people are rational, and rationality requires maximization.

28 II. Some Fundamental Concepts: Maximization, Equilibrium, and Efficiency 13 One conception of rationality holds that a rational actor can rank alternatives according to the extent that they give her what she wants. In practice, the alternatives available to the actor are constrained. For example, a rational consumer can rank alternative bun- dles of consumer goods, and the consumer’s budget constrains her choice among them. A rational consumer should choose the best alternative that the constraints allow. Another common way of understanding this conception of rational behavior is to rec- ognize that consumers choose alternatives that are well suited to achieving their ends. Choosing the best alternative that the constraints allow can be described mathe- maximizing . To see why, consider that the real numbers can be ranked matically as from small to large, just as the rational consumer ranks alternatives according to the extent that they give her what she wants. Consequently, better alternatives can be asso- ciated with larger numbers. Economists call this association a “utility function,” about which we shall say more in the following sections. Furthermore, the constraint on choice can usually be expressed mathematically as a “feasibility constraint.” Choosing the best alternative that the constraints allow corresponds to maximizing the utility function subject to the feasibility constraint. So, the consumer who goes shopping is said to maximize utility subject to her budget constraint. Turning to the second fundamental concept, there is no habit of thought so deeply ingrained among economists as the urge to characterize each social phenomenon as an equilibrium in the interaction of maximizing actors. An equilibrium is a pattern of in- teraction that persists unless disturbed by outside forces. Economists usually assume that interactions tend toward an equilibrium, regardless of whether they occur in mar- kets, elections, clubs, games, teams, corporations, or marriages. There is a vital connection between maximization and equilibrium in microeco- nomic theory. We characterize the behavior of every individual or group as maximizing something. Maximizing behavior tends to push these individuals and groups toward a point of rest, an equilibrium. They certainly do not intend for an equilibrium to result; instead, they simply try to maximize whatever it is that interests them. Nonetheless, the interaction of maximizing agents usually results in an equilibrium. stable A equilibrium is one that will not change unless outside forces intervene. To illustrate, the snowpack in a mountain valley is in stable equilibrium, whereas the snowpack on the mountain’s peak may be in unstable equilibrium. An interaction headed toward a stable equilibrium actually reaches this destination unless outside forces divert it. In social life, outside forces often intervene before an interaction reaches equilibrium. Nevertheless, equilibrium analysis makes sense. Advanced micro- economic theories of growth, cycles, and disequilibria exist, but we shall not need them in this book. The comparison of equilibria, called comparative statics, will be our basic approach. Turning to the third fundamental concept, economists have several distinct defini- tions of efficiency . A production process is said to be productively efficient if either of two conditions holds: 1. It is not possible to produce the same amount of output using a lower-cost combination of inputs, or 2. It is not possible to produce more output using the same combination of inputs.

29 14 CHAPTER 2 ief Review of Microeconomic Theory A Br Consider a firm that uses labor and machinery to produce a consumer good called a “widget.” Suppose that the firm currently produces 100 widgets per week using 10 workers and 15 machines. The firm is productively efficient if 1. it is not possible to produce 100 widgets per week by using 10 workers and fewer than 15 machines, or by using 15 machines and fewer than 10 work- ers, or 2. it is not possible to produce more than 100 widgets per week from the com- bination of 10 workers and 15 machines. 1 Pa re t o e ffi c i e n c y after its inventor or sometimes The other kind of efficiency, called allocative efficiency , concerns the satisfaction of individual preferences. A referred to as particular situation is said to be Pa re t o allocatively efficient if it is impossible to or change it so as to make at least one person better off (in his own estimation) without making another person worse off (again, in his own estimation). For simplicity’s sake, assume that there are only two consumers, Smith and Jones, and two goods, umbrellas and bread. Initially, the goods are distributed between them. Is the allocation Pareto effi- cient? Yes, if it is impossible to reallocate the bread and umbrellas so as to make either 2 Smith or Jones better off without making the other person worse off. These three basic concepts—maximization, equilibrium, and efficiency—are fun- damental to explaining economic behavior, especially in decentralized institutions like markets that involve the coordinated interaction of many different people. III. Mathematical Tools Yo u m a y h a v e b e e n a n x i o u s a b o u t t h e a m o u n t o f m a t h e m a t i c s t h a t y o u w i l l f i n d i n this book. There is not much. We use simple algebra and graphs. A. Functions Economics is rife with functions: production functions, utility functions, cost func- tions, social welfare functions, and others. A is a relationship between two sets function of numbers such that for each number in one set, there corresponds exactly one number in the other set. To illustrate, the columns below correspond to a functional relationship between the numbers in the left-hand column and those in the right-hand column. Thus, the number 4 in the -column below corresponds to the number 10 in the y -column. x In fact, notice that each number in the x -column corresponds to exactly one number in the y -column. Thus, we can say that the variable y is a function of the variable x , or in the most common form of notation. ). = f ( x y 1 Vilfredo Pareto was an Italian-Swiss political scientist, lawyer, and economist who wrote around 1900. 2 There is another efficiency concept—a potential Pareto improvement or Kaldor-Hicks efficiency—that we describe in section IX.C that follows.

30 III. Mathematical Tools 15 x of f equals some y ” or “ x is a function of y This is read as “ .” column y -column x- 2 3 0 3 4 10 10 6 12 9 12 7 -column that corresponds to x Note that the number 4 is not the only number in the the number 10 in the y -column; the number 6 also corresponds to the number 10. In this x table, for a given value of y , but for some values of y , , there corresponds one value of x x determines an exact value of y , . A value of there corresponds more than one value of y does not determine an exact value of x . Thus, in is f(x), y = y whereas a value of x , and x , because it depends on the value of is called the dependent variable called the x , but independent variable . Because y is a function of y in this table, x depends upon because x does not (to our knowledge) depend for its values on y, x . y is not a function of , that also depends z Now suppose that there is another dependent variable, named x . The function relating : g might be named x to z upon g(x). z = ) and f ( x ), with different dependent variables, z When there are two functions, g ( x , remembering which function goes with which variable can be hard. To avoid y and this difficulty, the same name is often given to a function and the variable determined by it. Following this strategy, the preceding functions would be renamed as follows: y y f(x) = y(x), = Q z = g(x) Q z = z(x). Sometimes an abstract function will be discussed without ever specifying the exact y numbers that belong to it. For example, the reader might be told that is a function of . The x , and never be told exactly which values of y correspond to which values of x but in an as point then is simply to make the general statement that y depends upon x yet unspecified way. If exact numbers are given, they may be listed in a table, as we have seen. Another way of showing the relationship between a dependent and an inde- z(x) z pendent variable is to give an exact equation. For example, a function might = be given the exact form x z > 2, = z(x) = 5 + z with values of x matches values of equal to five plus which states that the function z one-half of whatever value associated z takes. The table below gives the values of x x with several different values of :

31 16 CHAPTER 2 ief Review of Microeconomic Theory A Br z- column x- column 6.5 3 12.5 15 6 8.0 2 6.0 9.5 9 A function can relate a dependent variable (there is always just one of them to a y we are function) to more than one independent variable. If we write h(x, z), = to every saying that the function h matches one value of the dependent variable y pair of values of the independent variables . This function might have the x and z specific form z, + 3x =- h(x, z) = y y increases according to which y decreases by 3 units when x increases by 1 unit, and z increases by 1 unit. by 1 unit when B. Graphs We c a n i m p r ove t h e i n t u i t ive u n d e r s t a n d i n g o f a f u n c t i o n a l r e l a t i o n s h i p b y v i s u a l - izing it in a graph. In a graph, values of the independent variable are usually read off the horizontal axis, and values of the dependent variable are usually read off the verti- cal axis. Each point in the grid of lines corresponds to a pair of values for the variables. For an example, see Figure 2.1. The upward-sloping line on the graph represents all of the pairs of values that satisfy the function > 2. You can check this by find- y = 5 + x ing a couple of points that ought to be on the line that corresponds to that function. For What value should y = 0, y then a little arithmetic have? If x example, what if = 0? will reveal that x should equal (0, is a point on the line de- 10. - 10) - Thus, the pair What value will fined by the function. What if x y have? In that case, the second = 0? y FIGURE 2.1 Graphs of the linear relationships 15 2 y = 5 + x (with a positive slope) and 2 > x + 5 = y ! 2 > x (with a negative slope). y = 5 - 10 5 x x – – 15 – 10 5 10 15 – 5 0 – 5 x y = 5 – 2 ! 10 – y –

32 III. Mathematical Tools 17 term in the right-hand side of the equation disappears, so that Thus, the pair of y = 5. values (5, 0) is a point on the line defined by the function. y The graph of reveals some things about the relationship between y 2 + x 5 = > x and that we otherwise might not so easily discover. For example, notice that the line positive representing the equation slopes upward, or from southwest to northeast. The direct is a slope one. Thus, y and x , as it is called, reveals that the relationship between x decreases, as decreases. Put more generally, when the x increases, so does y . And as y independent and dependent variables move in the same direction, the slope of the graph of their relationship will be positive. The graph also reveals the strength of this direct relationship by showing whether increases by 2 small changes in lead to small or large changes in y . Notice that if x x units, y increases by 1 unit. Another way of putting this is to say that in order to get a 3 . x , there must be a 20-unit increase in y 10-unit increase in The opposite of a direct relationship is an inverse relationship. In that sort of rela- tionship, the dependent and independent variables move in opposite directions. Thus, if are inversely related, an increase in x (the independent variable) will lead to a x and y will lead to an . An example of an in- decrease in y . Also, a decrease in x increase in y verse relationship between an independent and a dependent variable is y = 2. > x - 5 The graph of this line is also shown in Figure 2.1. Note that the line is downward- sloping; that is, the line runs from northwest to southeast. 2.1: UESTION Q 5 + x. y = Show in a Suppose that the equation were graph like the one in Figure 2.1 what the graph of that equation would look y like. Is the relationship between x direct or inverse? Is the slope of the and new equation greater or less than the slope shown in Figure 2.1? Now suppose that the equation were Show in a graph like the x. - 5 = y one in Figure 2.1 what the graph of that equation would look like. Is the rela- direct or inverse? Is the slope of the new equation tionship between x and y positive or negative? Would the slope of the equation be steeper 2 > x - 5 = y 5 = y - x? or shallower than that of the one in x + 5 y 2 = > The graph of in Figure 2.1 also reveals that the relationship between the variables is linear . This means that when we graph the values of the independent and dependent variables, the resulting relationship is a straight line. One of the impli- cations of linearity is that changes in the independent variable cause a constant rate of change in the dependent variable. In terms of Figure 2.1, if we would like to know the , it doesn’t matter whether we investigate that x of doubling the amount of y effect on y equals 2 or 3147. The effect on x effect when is proportion- x of doubling the value of . x ally the same, regardless of the value of The alternative to a linear relationship is, of course, a nonlinear relationship. In general, nonlinear relationships are trickier to deal with than are linear relationships. 1 3 , in the The slope of the equation we have been dealing with in Figure 2.1 is which is the coefficient of x 2 equation. In fact, in any linear relationship the coefficient of the independent variable gives the slope of the equation.

33 18 CHAPTER 2 ief Review of Microeconomic Theory A Br y FIGURE 2.2 The graph of a nonlinear relationship, 2 x = y given by the equation . 2 x = y x – x 0 y FIGURE 2.3 The graph of a nonlinear relationship, xy. = A xy = A 0 x They frequently, although not always, are characterized by the independent variable be- 1 2 2 = ing raised to a power by an exponent. Examples are and . y = 5 > x Figure 2.2 x y 2 shows a graph of Another common nonlinear relationship in economics is . x y = is a constant. A graph of that function is given = given by the example where A A xy, in Figure 2.3. IV. The Theory of Consumer Choice and Demand The economist’s general theory of how people make choices is referred to as the theory of rational choice. In this section we show how that theory explains the con- sumer’s choice of what goods and services to purchase and in what amounts. A. Consumer Preference Orderings The construction of the economic model of consumer choice begins with an ac- count of the preferences of consumers. Consumers are assumed to know the things they like and dislike and to be able to rank the available alternative combinations of goods and services according to their ability to satisfy the consumer’s preferences. This in- volves no more than ranking the alternatives as better than, worse than, or equally as good as one another. Indeed, some economists believe that the conditions they impose on the ordering or ranking of consumer preferences constitute what an economist rational means by the term . What are those conditions? They are that a consumer’s . For an ordering to , and complete, transitive preference ordering or ranking be reflexive be simply means that the consumer be able to tell us how she ranks all the complete

34 IV. The Theory of Consumer Choice and Demand 19 A represents a bundle of possible combinations of goods and services. Suppose that represents another bundle of the same goods and serv- certain goods and services and B ices but in different amounts. Completeness requires that the consumer be able to tell to B , or that she prefers B to A , or that A us that she prefers B are equally good A and A and having B ). The consumer (that is, that the consumer is indifferent between having is not allowed to say, “I can’t compare them.” is an arcane condition on consumer preferences. It means that any bun- Reflexivity A dle of goods, , is at least as good as itself. That condition is so trivially true that it is difficult to give a justification for its inclusion. Transitivity means that the preference ordering obeys the following condition: is preferred to bundle B and bundle If bundle is preferred to bundle C , then it A B A must be the case that C . This also applies to indifference: If the is preferred to consumer is indifferent between A and B and between B and C , then she is also in- different between A and C . Transitivity precludes the circularity of individual pref- erences. That is, transitivity means that it is impossible for A B , to be preferred to to be preferred to , and C to be preferred to A . Most of us would probably feel B C that someone who had circular preferences was extremely young or childish or crazy. UESTION 2.2: Q Suppose that you have asked James whether he would like a hamburger or a hot dog for lunch, and he said that he wanted a hot dog. Five hours later you ask him what he would like for dinner, a hamburger or a hot dog. James answers, “A hamburger.” Do James’s preferences for hot dogs ver- sus hamburgers obey the conditions above? Why or why not? It is important to remember that the preferences of the consumer are subjective . Different people have different tastes, and these will be reflected in the fact that they may have very different preference orderings over the same goods and services. Economists leave to other disciplines, such as psychology and sociology, the study of the source of these preferences. We take consumer tastes or preferences as given, or, as economists say, as exogenous , which means that they are determined outside the eco- 4 nomic system. An important consequence of the subjectivity of individual preferences is that economists have no accepted method for comparing the strength of people’s prefer- A to bundle B , and Jill tells us ences. Suppose that Stan tells us that he prefers bundle A to B . Is there any way to tell who would that she feels the same way: She also prefers prefer having A more? In the abstract, the answer is, “No, there is not.” All we have from each consumer is the of preference, not the strength of those preferences. order Indeed, there is no metric by which to measure the strength of preferences, although economists sometimes jokingly refer to the “utils” of satisfaction that a consumer is enjoying. The inability to make interpersonal comparisons of well-being has some 4 Many people new to the study of microeconomics will find this assumption of the exogeneity of preferences to be highly unrealistic. And there is some controversy about this assumption even within economics, some economists contending that preferences are endogenous—that is, determined within the economic system by such things as advertising. We cannot elaborate on this controversy here but are well aware of it.

35 20 CHAPTER 2 A Br ief Review of Microeconomic Theory important implications for the design and implementation of public policy, as we shall see in the section on welfare economics. B. Utility Functions and Indifference Curves Once a consumer describes what his or her preference ordering is, we may derive for that consumer. The utility function identifies higher preferences a utility function y , with larger numbers. Suppose that there are only two commodities or services, x and stand for the consumer’s utility, then the func- u available to a given consumer. If we let u(x, y) tion = u describes the utility that the consumer gets from different combina- x tions of and y . A very helpful way of visualizing the consumer’s utility function is by means of a graph called an . An example is shown in Figure 2.4. There we indifference map indifference curves have drawn several . Each curve represents all the combinations that give the consumer the same amount of utility or well-being. Alternatively, of x and y we might say that the consumer’s tastes are such that he is indifferent among all the y x and combinations of that lie along a given curve—hence, the name indifference . Thus, all those combinations of lying along the indifference curve y and x curve marked give the consumer the same utility. Those combinations lying on the U 0 give this consumer similar utility, but this level higher indifference curve marked U 1 y lying along indiffer- of utility is higher than that of all those combinations of x and ence curve . U 0 UESTION 2.3: Begin at point Now decrease x from to How Q x ). . x y ( x , 0 0 1 0 increase to offset the decrease in and keep the consumer much must y x indifferent? The problem of consumer choice arises from the collision of the consumer’s pref- erences with obstacles to his or her satisfaction. The obstacles are the constraints that force decision makers to choose among alternatives. There are many constraints, including time, energy, knowledge, and one’s culture, but foremost among these is y FIGURE 2.4 The consumer’s indifference map. x ) ( , y y 0 0 0 U 3 U 2 U 1 U 0 0 x x x 0 1

36 IV. The Theory of Consumer Choice and Demand 21 y FIGURE 2.5 The consumer’s income constraint or budget line. I p = y p + x x y 0 x limited income. We can represent the consumer’s income constraint or budget line by the line in Figure 2.5. The area below the line and the line itself represent all the com- 5 y x I . and that are affordable, given the consumer’s income, binations of Presumably, the consumer intends to spend all of her income on purchases of these two goods and services, so that the combinations upon which we shall focus are those that are on the budget line itself. UESTION 2.4: In a figure like the one in Figure 2.5 and beginning with a Q budget line like the one in Figure 2.5, show how you would draw the new in- come constraint to reflect the following changes? 1. An increase in the consumer’s income, prices held constant. 2. A decrease in the consumer’s income, prices held constant. 3. A decrease in the price of , income and the price of y held constant. x , income and the price of x held constant. 4. An increase in the price of y C. The Consumer’s Optimum We m a y n ow c o m b i n e t h e i n f o r m a t i o n a b o u t t h e c o n s u m e r ’s t a s t e s g ive n b y t h e indifference map and the information about the income constraint given by the budget line in order to show what combination of and y maximizes the consumer’s x utility, subject to the constraint imposed by her income. See Figure 2.6. There the * x . * y consumer’s optimum bundle is shown as point M , which contains and Of all y and x the feasible combinations of , that combination gives this consumer the great- 6 est utility. 5 where is the price per unit of x and is the price p + x p = I p y, The equation for the budget line is p x y y x per unit of y . As an exercise, you might try to rearrange this equation, with as the dependent variable, in y order to show that the slope of the line is negative. When you do so, you will find that the coefficient of the x p -term is equal to relative price . - Economists refer to this ratio as . p > x y 6 Because we have assumed that the normal indifference curves are convex to the origin, there is a unique bundle of x and y that maximizes the consumer’s utility. For other shapes of the indifference curves it is possible that there is more than one bundle that maximizes utility.

37 22 A Br ief Review of Microeconomic Theory CHAPTER 2 y FIGURE 2.6 The consumer’s optimum. M * y U = xy 0 x x * D. A Generalization: The Economic Optimum Marginal Benefit as Marginal Cost ! Because of the central importance of constrained maximization in microeconomic theory, let us take a moment to examine a more general way of characterizing such a maximum: A constrained maximum, or any other economic optimum, can be described as a point where marginal cost equals marginal benefit. 7 Let’s see how this rule characterizes maximizing decisions. Begin by assuming that the decision maker chooses some initial level of whatever it is he is interested in maximizing. He then attempts to determine whether that initial level is his maximum; is that level as good as he can do, given his constraints? He can answer the question by changes away from that initial marginal, making very small, what an economist calls level. Suppose that the decision maker proposes to increase slightly above his initial level whatever it is he is doing. There will be a cost associated with this small increase . But there will also be a benefit of having or doing more of what- marginal cost called ever it is that he is attempting to maximize. The benefit of this small increase is called . The decision maker will perceive himself as doing better at this new marginal benefit marginal benefit of the small in- level, by comparison to his initial level, so long as the crease is greater than the marginal cost of the change. He will continue to make these small, or marginal, adjustments so long as the marginal benefit exceeds the marginal cost, and he will stop making changes when the marginal cost of the last change made equals (or is greater than) the marginal benefit. That level is the decision maker’s maximum. Suppose that, instead of increasing his level above the ini- Q UESTION 2.5: tial choice, the decision maker first tries decreasing the amount of whatever it is he is attempting to maximize. Explain how the comparison of marginal cost 7 minimize This rule could describe equally well an economic optimum where the goal of the decision maker is to = but the demonstration of something. In that case, the optimum would still be the point at which MB, MC the stylized decision making that got one to that point would be different from that given in the text.

38 IV. The Theory of Consumer Choice and Demand 23 and marginal benefit for these decreases is made and leads the decision maker to the optimum. (Assume that the initial level is greater than what will ulti- mately prove to be the optimum.) in Figure We c a n c h a r a c t e r i z e t h e c o n s u m e r ’s i n c o m e - c o n s t r a i n e d m a x i m u m , M 2.6, in terms of the equality of marginal cost and benefit. Small changes in either di- rection along the budget line, I , represent a situation in which the consumer spends a dollar less on one good and a dollar more on the other. To illustrate, assume the consumer decides to spend a dollar less on x . Purchasing a y and a dollar more on y causes a loss in utility that we may call the marginal cost of the dollar less of budget reallocation. But the dollar previously spent on can now be spent on x . y More units of mean greater utility, so that we may call this increase the marginal x benefit of the budget reallocation. Should the consumer spend a dollar less on good and a dollar more on x ? Only if y the marginal cost (the decrease in utility from one dollar less of ) is less than the mar- y ginal benefit (the increase in utility from having one dollar more of x ). The rational consumer will continue to reallocate dollars away from the purchase of y and toward the purchase of x until the marginal benefit of the last change made equals the marginal M cost. This occurs at the point in Figure 2.6. Figure 2.7 applies constrained maximization to reduce the amount of pollution. Along the vertical axis are dollar amounts. Along the horizontal axis are units of pollu- tion reduction. At the origin there is no effort to reduce pollution. At the vertical line labeled “100%,” pollution has been completely eliminated. MB The curve labeled shows the marginal benefit to society of reducing pollution. We a s s u m e t h a t t h i s h a s b e e n c o r r e c t l y m e a s u r e d t o t a ke i n t o a c c o u n t h e a l t h , s c e n i c , and all other benefits that accrue to members of society from reducing pollution at var- ious levels. This line starts off high and then declines. This downward slope captures the fact that the very first efforts at pollution reduction confer large benefits on society. The next effort at reducing pollution also confers a social benefit, but not quite as great as the initial efforts. Finally, as we approach the vertical line labeled “100%” and all vestiges of pollution are being eliminated, the benefit to society of achieving those last steps is positive, but not nearly as great as the benefit of the early stages of pollution reduction. FIGURE 2.7 $ The socially optimal amount of Marginal cost of pollution-reduction effort. pollution reduction MC Marginal benefit MB MC = of pollution reduction MB Reduction 0 in pollution * P 100%

39 24 CHAPTER 2 ief Review of Microeconomic Theory A Br MC The curve labeled represents the “social” as opposed to “private” marginal cost of achieving given levels of pollution reduction. The individuals and firms that pol- lute must incur costs to reduce pollution: They may have to adopt cleaner and safer pro- duction processes that are also more expensive; they may have to install monitoring devices that check the levels of pollution they generate; and they may have to defend themselves in court when they are accused of violating the pollution-reduction guide- lines. We have drawn the curve to be upward-sloping to indicate that the marginal MC costs of achieving any given level of pollution-reduction increase. This means that the cost of reducing the very worst pollution may not be very high, but that successive levels of reduction will be ever more expensive. Given declining marginal benefit and rising marginal cost, the question then arises, “What is the optimal amount of pollution-reduction effort for society?” An examina- tion of Figure 2.7 shows that is the socially optimal amount of pollution-reduction P * effort. Any more effort will cost more than it is worth. Any less would cause a reduc- tion in benefits that would be greater than the savings in costs. Note that, according to this particular graph, it would not be optimal for society to try to eliminate pollution entirely. Here it is socially optimal to tolerate some pollution. the remaining pollution equals P Specifically, when pollution reduction equals * , , which is the “optimal amount of pollution.” Few goods are free. Much of - P * 100% the wisdom of economics comes from the recognition of this fact and of the derivation of techniques for computing the costs and benefits. Suppose that we were to characterize society’s decision 2.6: UESTION Q making with regard to pollution-reduction efforts as an attempt to maximize the net benefit of pollution-reduction efforts. Let us define net benefit as the difference between marginal benefit and marginal cost. What level of pollution- reduction effort corresponds to this goal? Q UESTION 2.7: Using a graph like Figure 2.7, show the effect on the deter- mination of the socially optimal amount of pollution-reduction effort of the following: 1. Some technological change that lowers the marginal cost of achieving every level of pollution reduction. 2. A discovery that there are greater health risks associated with every given level of pollution than were previously thought to be the case. the optimum for nearly all decisions occurs If you understand that for economists, , then you have gone a long at the point at which marginal benefit equals marginal cost way toward mastering the microeconomic tools necessary to answer most questions that we will raise in this book. E. Individual Demand We m a y u s e t h e m o d e l o f c o n s u m e r c h o i c e o f t h e p r ev i o u s s e c t i o n s t o d e r ive a r e - lationship between the price of a good and the amount of that good in a consumer’s op- represents this relationship. timum bundle. The demand curve

40 IV. The Theory of Consumer Choice and Demand 25 FIGURE 2.8 P x An individual’s demand curve, showing the inverse relationship between price P 0 and quantity demanded. P 1 D 0 x x x 0 1 in Figure 2.6, note that when the price of Starting from point x is that given by M x x the budget line, the optimal amount of x will * . But what amount of to consume is this consumer want to purchase so as to maximize utility when the price of x is lower than that given by the budget line in Figure 2.6? We can answer that question by hold- and ing x I constant, letting P fall, and writing down the amount of P in the succeed- x y ing optimal bundles. Not surprisingly, the result of this exercise will be that the price of and the amount of x in the optimum bundles are inversely related. That is, when the x goes up, x , “all other things equal,” and I held constant (or ceteris paribus price of P y x that the consumer will purchase goes down, and as economists say), the amount of . law of demand vice versa. This result is the famous demanded to x a n d t h e q u a n t i t y o f We m a y g r a p h t h i s r e l a t i o n s h i p b e t w e e n P x get the individual demand curve, D , shown in Figure 2.8. The demand curve we have drawn in Figure 2.8 could have had a different slope than that shown; it might have been either flatter or steeper. The steepness of the demand curve is related to an important concept called the price elasticity of demand , or simply elasticity of 8 demand . This is an extremely useful concept: It measures how responsive consumer de- mand is to changes in price. And there are some standard attributes of goods that in- fluence how responsive demand is likely to be. For instance, if two goods are similar in their use, then an increase in the price of the first good with no change in the price of the second good causes consumers to buy significantly less of the first good. Generalizing, the most important determinant of the price elasticity of demand for a 8 The measure is frequently denoted by the letter inelastic e , and the ranges of elasticity are called (e 6 1), (e elastic and unitary elastic = 1). (e 7 1), By convention, e , the price elasticity of demand, is a positive (or absolute) number, even though the calculation we suggested will lead to a negative number. For an in- elastically demanded good, the percentage change in price exceeds the percentage change in quantity 0.5 demanded. Thus, a good that has e is one for which a 50 percent decline in price will cause a 25 per cent = increase in the quantity demanded, or for which a 15 percent increase in price will cause a 7.5 percent de- cline in quantity demanded. For an elastically demanded good, the percentage change in price is less than the percentage change in quantity demanded. As a result, a good that has e = 1.5 is one for which a 50 per- cent decline in price will cause a 75 percent increase in quantity demanded, or for which a 20 percent in- crease in price will cause a 30 percent decline in quantity demanded.

41 26 CHAPTER 2 ief Review of Microeconomic Theory A Br good is the availability of substitutes. The more substitutes for the good, the greater the elasticity of demand; the fewer the substitutes, the lower the elasticity. Substitution is easier for narrowly defined goods and harder for broad categories. If the price of cucumbers goes up, switching to peas or carrots is easy; if the price of vegetables goes up, switching to meat is possible; but if the price of food goes up, eating less is hard to do. So, we expect that demand is more elastic for cucumbers than vegetables and more elastic for vegetables than food. Also, demand is more elastic in the long run than the short run. To illustrate, if electricity prices rise rela- tive to natural gas, consumers will increasingly switch to burning gas as they gradu- ally replace furnaces and appliances. Economists often measure and remeasure the price elasticities of demand for numerous goods and services to predict responses to price changes. V. T h e T h e o r y o f S u p p l y We n ow t u r n t o a r ev i ew o f t h e o t h e r s i d e o f t h e m a r ke t : t h e s u p p l y s i d e . T h e key institution in supplying goods and services for sale to consumers is the business firm. In this section we shall see what goal the firm seeks and how it decides what to supply. In the following section, we merge our models of supply and demand to see how the inde- pendent maximizing activities of consumers and firms achieve a market equilibrium. A. The Profit-Maximizing Firm The firm is the institution in which output (products and services) is fabricated from inputs (capital, labor, land, and so on). Just as we assume that consumers ration- ally maximize utility subject to their income constraint, we assume that firms maximize profits subject to the constraints imposed on them by consumer demand and the tech- nology of production . profits total revenue and In microeconomics, are defined as the difference between the of production. Total revenue for the firm equals the number of units of total costs output sold multiplied by the price of each unit. Total costs equal the costs of each of the inputs times the number of units of input used, summed over all inputs. The profit- maximizing firm produces that amount of output that leads to the greatest positive dif- ference between the firm’s revenue and its costs. Microeconomic theory demonstrates that the firm will maximize its profits if it produces that amount of output whose mar- ginal cost equals its marginal revenue . (In fact, this is simply an application of the gen- eral rule we discussed in section IV.D earlier: To achieve an optimum, equate marginal cost and marginal benefit.) These considerations suggest that when marginal revenue exceeds marginal cost, the firm should expand production, and that when marginal cost exceeds marginal rev- enue, it should reduce production. It follows that profits will be maximized for that out- put for which marginal cost and marginal revenue are equal. Note the economy of this rule: To maximize profits, the firm need not concern itself with its total costs or total revenues; instead, it can simply experiment on production unit by unit in order to dis- cover the output level that maximizes its profits.

42 V. The Theory of Supply 27 Price FIGURE 2.9 The profit-maximizing output for a firm. MC AC p MR = p AC ' 0 q q * In Figure 2.9 the profit-maximizing output of the firm is shown at the point at MC which the marginal cost curve, labeled , and marginal revenue curve of the firm are q equal. The profit-maximizing output level is denoted . Total profits at this level of * production, denoted by the shaded area in the figure, equal the difference between the p times ) and the total costs of the firm (the average cost * q total revenues of the firm ( * ). * q of producing q times There are several things you should note about the curves in the graph. We have drawn the marginal revenue curve as horizontal and equal to the prevailing price. This implies that the firm can sell as much as it likes at that prevailing price. Doubling its sales will have no effect on the market price of the good or service. This sort of behav- price-taking behavior. It characterizes industries in which there are ior is referred to as so many firms, most of them small, that the actions of no single firm can affect the mar- ket price of the good or service. An example might be farming. There are so many sup- pliers of wheat that the decision of one farmer to double or triple output or cut it in half will have no impact on its market price. (Of course, if all farms decide to double out- put, there will be a substantial impact on market price.) Such an industry is said to be “perfectly competitive.” B. The Short Run and the Long Run In microeconomics the firm is said to operate in two different time frames: the short run and the long run. These time periods do not correspond to calendar time. Instead they are defined in terms of the firm’s inputs. In the short run at least one input is fixed (all others being variable), and the usual factor of production that is fixed is capital (the firm’s buildings, machines, and other durable inputs). Because capital is fixed costs . In the fixed in the short run, all the costs associated with capital are called short run the firm can, in essence, ignore those costs: They will be incurred regardless of whether the firm produces nothing at all or 10 million units of output. (The only costs that change in the short run are “variable costs,” which rise or fall depending on how much output the firm produces.) The long run is distinguished by the fact that all factors of production become variable. There are no longer any fixed costs. Established firms may expand their productive capacity or leave the industry entirely, and new firms may enter the business.

43 28 CHAPTER 2 ief Review of Microeconomic Theory A Br Another important distinction between the long and the short run has to do with the equilibrium level of profits for each firm. At any point in time there is an average rate of return earned by capital in the economy as a whole. When profits being earned in a particular industry exceed the average profit rate for comparable investments, firms will enter the industry, assuming there are no barriers to entry. As entry occurs, the to- tal industry output increases, and the price of the industry output goes down, causing each firm’s revenue to decrease. Also, the increased competition for the factors of pro- duction causes input prices to rise, pushing up each firm’s costs. The combination of these two forces causes each firm’s profits to decline. Entry ceases when profits fall to the average rate. Economists have a special way of describing these facts. The average return on capital is treated as part of the costs that are subtracted from revenues to get “economic profits.” Thus, when the rate of return on invested capital in this industry equals the 9 average for the economy as a whole, it is said that “economic profits are zero.” This leads to the conclusion that economic profits are zero in an industry that is in long-run equilibrium. Because this condition can occur only at the minimum point of the firm’s average cost curve, where the average costs of production are as low as they can possibly be, inputs will be most efficiently used in long-run equilibrium. Thus, the condition of zero economic profits, far from being a nightmare, is really a desirable state. VI. Market Equilibrium Having described the behavior of utility-maximizing consumers and profit- maximizing producers, our next task is to bring them together to explain how they interact. We shall first demonstrate how a unique price and quantity are determined by the interaction of supply and demand in a perfectly competitive market and then show what happens to price and quantity when the market structure changes to one of monopoly. We conclude this section with an example of equilibrium analysis of an important public policy issue. A. Equilibrium in a Perfectly Competitive Industry An industry in which there are so many firms that no one of them can influence the market price by its individual decisions and in which there are so many consumers that the individual utility-maximizing decisions of no one consumer can affect the market price is called a perfectly competitive industry . For such an industry the aggregate de- mand for and the aggregate supply of output can be represented by the downward-sloping demand curve, and the upward-sloping supply curve, shown s = s(p), d = d(p), 9 When profits in a given industry are less than the average in the economy as a whole, economic profits are said to be negative. When that is the case, firms exit this industry for other industries where the profits are at least equal to the average for the economy. As an exercise, see if you can demonstrate the process by which profits go to zero when negative economic profits in an industry cause exit to take place.

44 VI. Market Equilibrium 29 Price FIGURE 2.10 Market equilibrium in a perfectly ) p s = s ( competitive market. excess supply P 1 P c d d ( = p ) 0 Quantity q q q c s1 d1 market-clearing price and quantity occur at the point equilibrium or in Figure 2.10. The of intersection of the aggregate supply and demand curves. At that combination of price and quantity, the decisions of consumers and suppliers are consistent. ,q in Figure 2.10 is an equilibrium is to P One way to see why the combination c c see what would happen if a different price-quantity combination were obtained. At that price, producers would maximize Suppose that the initial market price was . P 1 of output, and utility-maximizing consumers would be their profits by supplying q s1 q prepared to purchase units of output. These supply and demand decisions are in- d1 , the amount that suppliers would like to sell exceeds the amount that P consistent: At 1 consumers would like to buy. How will the market deal with this excess supply? Clearly, the market price must fall. As the price falls, consumers will demand more and producers will supply less, so the gap between supply and demand will diminish. . Eventually the price may reach And at that price, as we have seen, the amount that P c suppliers wish to sell and the amount that consumers wish to purchase are equal. B. Equilibrium in a Monopolistic Market Monopoly is at the other extreme of market structure. In a monopoly there is only one supplier; so, that firm and the industry are identical. A monopoly can arise and per- sist only where there are barriers to entry that make it impossible for competing firms to appear. In general, such barriers can arise from two sources: first, from statutory and other legal restrictions on entry; and second, from technological conditions of produc- tion known as . An example of a statutory restriction on entry was economies of scale the Civil Aeronautics Board’s refusal from the 1930s until the mid-1970s to permit entry of new airlines into the market for passenger traffic on such major routes as Los Angeles–New York and Chicago–Miami. The second barrier to entry is technological. Economies of scale are a condition of production in which the greater the level of output, the lower the average cost of pro- duction. Where such conditions exist, one firm can produce any level of output at less cost than multiple firms. A monopolist that owes its existence to economies of scale is sometimes called a natural monopoly . Public utilities, such as local water, telecommu- nications, cable, and power companies, are often natural monopolies. The technological advantages of a natural monopoly would be partially lost if the single firm is allowed

45 30 CHAPTER 2 A Br ief Review of Microeconomic Theory Opportunity Cost and Comparative Advantage We have been implicitly using one of the most fundamental concepts in microeconomics: . This term refers to the economic cost of an alternative that has been fore- opportunity cost gone. When you decided to attend a college, graduate school, or law school, you gave up certain other valuable alternatives, such as taking a job, training for the Olympics, or traveling around the world on a tramp steamer. In reckoning the cost of going to college, graduate school, or law school, the true economic cost was that of the next best alternative. This point is true of the decisions of all economic actors: When maximizing utility, the consumer must consider the opportunities given up by choosing one bundle of consumer goods rather than another; when maximizing profits, the firm must consider the opportunities foregone by com- mitting its resources to the production of widgets rather than to something else. In general, the economic notion of opportunity cost is more expansive than the more 10 common notion of accounting cost. An example will make this point. Suppose that a rich relative gives you a car whose market value is $15,000. She says that if you sell the car, you may keep the proceeds, but that if you use the car yourself, she’ll pay for the gas, oil, mainte- nance, repairs, and insurance. In short she says, “The use of the car is FREE!” But is it? Suppose that the $15,000 for which the car could be sold would earn 12 percent interest per year in a savings account, giving $1800 per year in interest income. If you use the car for 1 year, its resale value will fall to $11,000—a cost to you of $4000. Therefore, the opportunity cost to you of using the car for 1 year is $4000 plus the foregone interest of $1800—a total of $5800. This is far from being free. The accounting cost of using the car is zero, but the op- portunity cost is positive. is another useful economic concept related to the notion of op- Comparative advantage portunity cost. The law of comparative advantage asserts that people should engage in those pursuits where their opportunity costs are lower than others. For example, someone who is 7feet tall has a comparative advantage in pursuing a career in professional basketball. But what about someone whose skills are such that she can do many things well? Suppose, for example, that a skilled attorney is also an extremely skilled typist. Should she do her own typing or hire someone else to do it while she specializes in the practice of law? The notion of comparative advantage argues for specialization: The attorney can make so much more money by specializing in the practice of law than by trying to do both jobs that she could easily afford to hire someone else who is less efficient at typing to do her typing for her. to restrict its output and to charge a monopoly price. For that reason, natural monopo- lies are typically regulated by the government. The monopolist, like the competitive firm, maximizes profit by producing that out- put for which marginal cost equals marginal revenue. Marginal cost of the monopolist, as for the competitive firm, is the cost of producing one more unit of output. This cost curve is represented in Figure 2.11 by the curve labeled . But marginal revenue for MC the monopolist is different from what it was for the competitive firm. Recall that mar- ginal revenue describes the change in a firm’s total revenues for a small, or marginal, 10 G OY R UFFIN & P AUL The example is taken from R REGORY , P RINCIPLES OF M ICROECONOMICS 156 (2d ed. 1986).

46 VI. Market Equilibrium 31 Price FIGURE 2.11 Profit-maximizing output and price for MC a monopolist. P m P c MR ) d = d ( p 0 Quantity q q m c change in the number of units of output sold. For the competitive firm marginal rev- enue is equal to the price of output. Because the competitive firm can sell as much as it likes at the prevailing price, each additional unit of output sold adds exactly the sale price to the firm’s total revenues. But for the monopolist, marginal revenue declines as the number of units sold increases. This is indicated in Figure 2.11 by the downward- sloping curve labeled MR MR curve lies below the demand curve. This . Notice that the indicates that the marginal revenue from any unit sold by a monopolist is always less MR ; than the price. is positive but declining for units of output between 0 and q thus, c the sale of each of those units increases the firm’s total revenues but at a decreasing and for unit actually adds nothing to the firm’s total revenues rate. The q 0), = (MR 0 each unit of output beyond MR is less than zero, which means that each of those , q c units actually reduces the monopolist’s total revenues. The reason for this complex relationship between marginal revenue and units sold by the monopolist is the downward-sloping demand curve. The downward-sloping de- mand curve implies that the monopolist must lower the price to sell more units; but in order to sell an additional unit of output he or she must lower the price not just on the 11 last or marginal unit but on all the units sold. From this fact it can be shown, using calculus, that the addition to total revenues from an additional unit of output sold will always be less than the price charged for that unit. Thus, because MR is always less than the price for all units of output and because price declines along the demand curve, the MR curve must also be downward sloping and lie below the demand curve. The monopolist maximizes his profit by choosing that output level for which mar- q , is shown in Figure ginal revenue and marginal cost are equal. This output level, m 2.11. The demand curve indicates that consumers are willing to pay P for that amount m of output. Notice that if this industry were competitive instead of monopolized, the profit-maximizing actions of the firms would have resulted in an equilibrium price and , and the industry demand quantity at the intersection of the aggregate supply curve, S , P is lower than the monopolistic price, and the . The competitive price, D curve, c 11 This assumes that the monopolist cannot price-discriminate (that is, charge different prices to different consumers for the same product).

47 32 CHAPTER 2 A Br ief Review of Microeconomic Theory quantity of output produced and consumed under competition, q , is greater than under c monopoly. Economists distinguish additional market structures that are intermediate between the extremes of perfect competition and monopoly. The most important among these . An oligopolistic market is one containing a imperfect competition and oligopoly are few firms that recognize that their individual profit-maximizing decisions are interde- depends not only on its marginal pendent. That means that what is optimal for firm A D have decided to , and C , costs and the demand for its output but also on what firms B produce and the prices they are charging. The economic analysis of this interdepen- dence requires a knowledge of game theory, which we discuss below. An imperfectly competitive market is one that shares most of the characteristics of a perfectly competitive market—for example, free entry and exit of firms and the pres- ence of many firms—but has one important monopolistic element: Firms produce differentiable output rather than the homogeneous output produced by perfectly com- petitive firms. Thus, imperfectly competitive firms distinguish their output by brand names, colors, sizes, quality, durability, and so on. C. An Example of Equilibrium Analysis It is useful to have an example applying this theory to a real problem. Let us imag- ine a market for rental housing like the one shown in Figure 2.12. The demand for , and the supply of rental housing is given by the D rental housing is given by the curve upward-sloping supply curve . Assuming that the rental housing market is competi- S tive, then the independent actions of consumers and of profit-maximizing housing own- units of rental housing being ers will lead to a rental rate of being charged and of r h 1 1 supplied and demanded. Note that this is an equilibrium in the sense we discussed above: The decisions of those demanding the product and of those supplying it are con- r . Unless something causes the demand curve or the supply curve to sistent at the price 1 shift, this price and output combination will remain in force. r But now suppose that the city government feels that is too high and passes an 1 , considerably below ordinance that specifies a maximum rental rate for housing of r m Rental FIGURE 2.12 rate The consequences of a rent-control ordinance that prescribes rents below S the market-clearing rental rate. r 2 r 1 r m D 0 Housing h h h s d 1 excess demand

48 VII. Game Theory 33 the equilibrium market rate. The hope of the government is that at least the same amount of housing will be consumed by renters but at a lower rental rate. A look at , consumers demand Figure 2.12, however, leads one to doubt that result. At r units h d m . r But at of rental housing, an increase over the quantity demanded at the higher rate, 1 units of rental housing. h this lower rate suppliers are only prepared to supply s Apparently it does not pay them to devote as much of their housing units to renters at r is all one can get from renting housing units, suppliers that lower rate; perhaps if m prefer to switch some of their units to other uses, such as occupancy by the owner’s family or their sale as condominiums. The result of the rate ceiling imposed by the gov- ). (h ernment is a shortage of, or excess demand for, rental units equal to h - d s If the rate ceiling is strictly enforced, the shortage will persist. Some non-price methods of determining who gets the units of rental housing must be found, such as h s queuing. Eventually, the shortage may be eased if either the demand curve shifts inward or the supply curve shifts outward. It is also possible that landlords will let their prop- erty deteriorate by withholding routine maintenance and repairs, so that the quality of provides a competitive rate of return to them. their property falls to such an extent that r m strictly enforced, then consumers and suppliers not If, however, the rate ceiling is will find a way to erase the shortage. For example, renters could offer free services or secret payments (sometimes called side payments ) to landlords in order to get the ef- r fective rental rate above and induce the landlord to rent to them rather than to those m Those services and side payments could amount to - . r willing to pay only (r ) r m m 2 per housing unit. VII. Game Theory The law frequently confronts situations in which there are few decision makers and in which the optimal action for one person to take depends on what another actor chooses. These situations are like games in that people must decide upon a strategy. A strategy is a Game theory deals with any situa- plan for acting that responds to the reactions of others. tion in which strategy is important. Game theory will, consequently, enhance our under- standing of some legal rules and institutions. For those who would like to pursue this 12 topic in more detail, there are now several excellent introductory books on game theory. To characterize a game, we must specify three things: players, 1. strategies 2. of each player, and payoffs 3. to each player for each strategy. 12 For those who would like to pursue game theory in more detail, there are now several excellent introduc- tory texts: E RIC R ASMUSEN , G AMES AND I NFORMATION : A N I NTRODUCTION TO G AME T HEORY (3d ed. 2001); D AV I D REPS , G AME T HEORY AND E CONOMIC M K (1990); and A VINASH D IXIT & B ARRY N ALEBUFF , ODELING (1991). HINKING S TRATEGICALLY : T HE C OMPETITIVE E DGE IN B USINESS , P OLITICS , AND E VERYDAY L IFE T More advanced treatments may be found in R M YERSON , G OGER T HEORY (1991) and D REW AME F UDENBERG & J EAN T IROLE , G AME T HEORY (1991). With special reference to law, see D OUGLAS B AIRD , ICKER R G ERTNER , & R ANDAL P OBERT , G AME T HEORY AND THE L AW (1995).

49 34 CHAPTER 2 ief Review of Microeconomic Theory A Br Suspect 1 Let’s consider a famous example—the prisoner’s dilemma. Two people, , conspire to commit a crime. They are apprehended by the police outside and Suspect 2 the place where the crime was committed, taken to the police station, and placed in sep- arate rooms so that they cannot communicate. The authorities question them individu- ally and try to play one suspect against the other. The evidence against them is circumstantial—they were simply in the wrong place at the wrong time. If the prosecu- tor must go to trial with only this evidence, then the suspects will have to be charged with a minor offense and given a relatively light punishment—say, 1 year in prison. The prosecutor would very much prefer that one or both of the suspects confesses to the more serious crime that they are thought to have committed. Specifically, if either suspect confesses (and thereby implicates the other) and the other does not, the non-confessor will receive 7 years in prison, and as a reward for assisting the state, the confessor will only receive six months in jail. If both suspects can be induced to confess, each will spend 5 years in prison. What should each suspect do—confess or keep quiet? The strategies available to the suspects can be shown in a payoff matrix like that in Figure 2.13. Each suspect has two strategies: confess or keep quiet. The payoffs to each player from following a given strategy are shown by the entries in the four cells of the Suspect 2 given in the lower left-hand corner of each cell and box, with the payoff to Suspect 1 given in the upper right-hand corner of the cell. the payoff to Suspect 1 confesses and Here is how to read the entries in the payoff matrix. If Suspect 2 also confesses, each will receive 5 years in prison. If Suspect 1 confesses and Suspect 2 keeps quiet, Suspect 1 will spend six months in jail, and Suspect 2 will spend 7 years in prison. If Suspect 1 Suspect 2 confesses, then Suspect 2 will keeps quiet and Suspect 1 spend six months in jail, and will spend 7 years in prison. Finally, if both sus- pects keep quiet, each will spend 1 year in prison. Suspect 1 ’s options. The payoff matrix is sometimes There is another way to look at referred to as the of the game. An alternative is the extensive form . This strategic form puts one player’s options in the form of a decision tree, which is shown in Figure 2.14. We n ow w i s h t o ex p l o r e w h a t t h e o p t i m a l s t r a t eg y — c o n f e s s o r ke e p q u i e t — i s f o r each player, given the options in the payoff matrix and given some choice made by the other player. Let’s consider how will select her optimal strategy. Remember Suspect 1 Suspect 1 FIGURE 2.13 The strategic form of a game, also Confess Keep quiet known as a payoff matrix. –7 –5 Confess –5 –0.5 Suspect 2 –1 –0.5 Keep quiet –1 –7

50 VII. Game Theory 35 Suspect 1’s payoff FIGURE 2.14 –5 The extensive form of the prisoner’s dilemma. confesses Suspect 2 confesses – 0.5 keeps quiet Suspect 1 –7 confesses Suspect 2 keeps quiet keeps quiet –1 that the players are being kept in separate rooms and cannot communicate with one another. (Because the game is symmetrical, this is exactly the same way in which Suspect 2 will select his optimal strategy.) do if confesses? If she keeps quiet when Suspect 1 First, what should Suspect 2 confesses, she will spend 7 years in prison. If she confesses when Suspect 2 Suspect 2 Suspect 2 confesses, she will spend 5 years. So, if confesses, clearly the best thing for Suspect 1 to do is to confess. adopts the alternative strategy of keeping quiet? What is the Suspect 2 But what if to do then? If best thing for Suspect 1 Suspect 1 confesses, Suspect 2 keeps quiet and keeps quiet, she will spend only half a year in prison. If she keeps quiet when Suspect 2 to do if the other Suspect 1 she will spend 1 year in prison. Again, the best thing for suspect keeps quiet is to confess. will always confess. Regardless of what the other player does, Suspect 1 Thus, confessing will always mean less time in prison for her. In the jargon of game theory —the optimal move for a player to this means that confessing is a dominant strategy make is the same, regardless of what the other player does. Because the other suspect will go through precisely the same calculations, he will also confess. Confessing is the dominant strategy for each player. The result is that the suspects are both going to confess, and, therefore, each will spend 5 years in prison. The solution to this game, that both suspects confess, is an equilibrium: There is no reason for either player to change his or her strategy. There is a famous concept in game theory that characterizes this equilibrium—a Nash equilibrium . In such an equi- librium, no individual player can do any better by changing his or her behavior so long as the other players do not change theirs. (Notice that the competitive equilibrium that we discussed in previous sections is an example of a Nash equilibrium when there are many players in the game.) The notion of a Nash equilibrium is fundamental in game theory, but it has short- comings. For instance, some games have no Nash equilibrium. Some games have sev- eral Nash equilibria. And finally, there is not necessarily a correspondence between the

51 36 CHAPTER 2 ief Review of Microeconomic Theory A Br Nash equilibrium and Pareto efficiency, the criterion that economists use to evaluate many equilibria. To see why, return to the prisoner’s dilemma above. We have seen that it is a Nash equilibrium for both suspects to confess. But you should note that this is a Pareto-efficient solution to the game from the viewpoint of the accused. When not both suspects confess, they will each spend 5 years in prison. It is possible for both players to be better off. That would happen if they would both keep quiet. Thus, cell 4 (where each receives a year in prison) is a Pareto-efficient outcome. Clearly, that solu- tion is impossible because the suspects cannot make binding commitments not to con- 13 fess. We may use the prisoner’s dilemma to discuss another important fundamental con- repeated games . Suppose that the prisoner’s dilemma were to be cept of game theory— played not just once but a number of times by the same players. Would that change our analysis of the game? If the same players play the same game according to the same rules repeatedly, then it is possible that cooperation can arise and that players have an incentive to establish a reputation—in this case, for trustworthiness. An important thing to know about a repeated game is whether the game will be re- peated a number of times or an indefinite number. To see the difference, suppose fixed that the prisoner’s dilemma above is to be repeated exactly ten times. Each player’s op- timal strategy must now be considered across games, not just for one game at a time. Suspect 2 thinking through, before the first game is played, what strategy he Imagine ought to follow for each game. He might imagine that he and his partner, if caught after Suspect each crime, will learn (or agree) to keep quiet rather than to confess. But then thinks forward to the final game, the tenth. Even if the players had learned (or agreed) 2 to keep quiet through Game 9, things will be different in Game 10. Because this is the last time the game is to be played, Suspect 1 has a strong incentive to confess. If she confesses on the last game and Suspect 2 sticks to the agreement not to confess, he will spend 7 years in prison to her half year. Knowing that she has this incentive to cheat on an agreement not to confess in the last game, the best strategy for is also to Suspect 2 confess in the final game. But now Game 9 becomes, in a sense, the final game. And in deciding on the optimal strategy for that game, exactly the same logic applies as it did Suspect 1 can work all this out, for Game 10—both players will confess in Game 9, too. too, and she will realize that the best thing to do is to confess in Game 8, and so on. In unravels the terminology of game theory, the game so that confession takes place by each player every time the game is played, if it is to be played a fixed number of times . Things may be different if the game is to be repeated an indefinite number of times. In those circumstances there may be an inducement to cooperation. Robert Axelrod has shown that in a game like the prisoner’s dilemma repeated an indefinite number of times, the optimal strategy is tit-for-tat —if the other player cooperated on the last play, you cooperate on this play; if she didn’t cooperate on the last play, you 14 don’t on this play. 13 Can you think of a workable way in which the suspects might have agreed never to confess before they perpetrated the crime? Put in the language of game theory, can a participant in a game like the prisoner’s dilemma make a credible commitment not to confess if she and her partner are caught? 14 (1984). OBERT A XELROD , T HE E VOLUTION OF C OOPERATION See R

52 IX. General Equilibrium and Welfare Economics 37 These considerations of a fixed versus an indefinite number of plays of a game may seem removed from the concerns of the law, but they really are not. Consider, for example, the relations between a creditor and a debtor. When the debtor’s affairs are going well, the credit relations between the creditor and the debtor may be analogized to a game played an indefinite number of times. But if the debtor is likely to become insolvent soon, the relations between debtor and creditor become much more like a game to be played a fixed (and, perhaps, few) number of times. As a result, trust and cooperation between the parties may break down, with the debtor trying to hide his as- sets and the creditor trying to grab them for resale to recoup his losses. We s h a l l s e e t h a t t h e s e c o n c e p t s f r o m g a m e t h e o r y w i l l p l a y a n i m p o r t a n t r o l e i n our understanding of legal rules and institutions. VIII. The Theory of Asset Pricing The area of microeconomic theory that deals with capital and labor markets is be- yond the scope of the material in this book. There is, however, one tool from this area that we shall use: the theory of asset pricing. Assets are resources that generate a stream of income. For instance, an apartment building can generate a stream of rental payments; a patent can generate a stream of royalty payments; an annuity can generate a fixed amount of income per year. There is a technique for converting these various streams of future income (or future expenses or, still more generally, net receipts) into a lump sum today. The general question that is being asked is, “How much would you be prepared to pay today for an asset that gen- erated a given future flow of net receipts in the future?” We c a n a n s w e r t h a t q u e s t i o n b y c o m p u t i n g w h a t i s c a l l e d t h e present discounted value of the future flow of net receipts. Suppose that ownership of a particular asset will generate in net receipts at the end of the first year; in net receipts at the end F F 1 2 F of the second year; in net receipts at the end of the third year; and at the end of F 3 n n th year. The present discounted value of that asset, supposing that the prevailing the , is equal to: r rate of interest is F F F F n 2 3 1 ### + + PDV = + + . n 2 3 ) ) (1 r r (1 + + + r ) (1 + r ) (1 This result has many applications to law. For instance, suppose that a court is seek- ing to compensate someone whose property was destroyed. One method of valuing the loss is to compute the present discounted value of the future flow of net receipts to which the owner was entitled. IX. General Equilibrium and Welfare Economics The microeconomic theory we have been reviewing to this point has focused on the fundamental concepts of maximization, equilibrium, and efficiency in describing the decisions of consumers and firms. The part of microeconomic theory called welfare economics explores how the decisions of many individuals and firms interact to affect

53 38 CHAPTER 2 ief Review of Microeconomic Theory A Br the well-being of individuals as a group. Welfare economics is much more philosophi- cal than other topics in microeconomic theory. Here the great policy issues are raised. For example, is there an inherent conflict between efficiency and fairness? To what ex- tent can unregulated markets maximize individual well-being? When and how should the government intervene in the marketplace? Can economics identify a just distribu- tion of goods and services? In this brief introduction, we can only hint at how micro- economic theory approaches these questions. Nonetheless, this material is fundamental to the economic analysis of legal rules. A. General Equilibrium and Efficiency Theorems One of the great accomplishments of modern microeconomics is the specification of the conditions under which the independent decisions of utility-maximizing con- sumers and profit-maximizing firms will lead to the inevitable, spontaneous establish- ment of equilibrium in all markets simultaneously. Such a condition is known as general equilibrium . General equilibrium will be achieved only when competitive forces have led to the equality of marginal benefit and marginal cost in the market for every single commodity and service. As you can well imagine, this condition is un- likely to be realized in the real world. However, there are two practical reasons for knowing what conditions must hold for general equilibrium to obtain. First, while all real-world markets may not obey those conditions, many of them will. Second, the specification of the conditions that lead to general equilibrium provides a benchmark for evaluating various markets and making recommendations for public policy. Modern microeconomics has demonstrated that general equilibrium has character- istics that economists describe as socially optimal—that is, the general equilibrium is both productively and allocatively efficient. B. Market Failure General equilibrium is, in welfare terms, such a desirable outcome that it would be helpful to know the conditions under which it will hold. Stripped of detail, the essential condition is that all markets are perfectly competitive. We can characterize the things that can go wrong to prevent this essential condition from being attained in a market. In this section we shall describe the four sources of market failure, as it is called, and describe the public policies that can, in theory, correct those failures. 1. Monopoly and Market Power The first source of market failure is monop- oly in its various forms: monopoly in the output market, collusion among otherwise competitive firms or suppliers of inputs, and monopsony (only one buyer) in the input market. If the industry were competitive, marginal benefit and marginal cost would be equal. But as illustrated in Figure 2.11, the monopolist’s profit-maximizing output and price combination occurs at a point where the price exceeds the marginal cost of pro- duction. The price is too high, and the quantity supplied is too low from the viewpoint of efficiency. The public policies for correcting the shortcomings of monopoly are to replace monopoly with competition where possible, or to regulate the price charged by the

54 IX. General Equilibrium and Welfare Economics 39 monopolist. The first policy is the rationale for the antitrust laws. But sometimes it is not possible or even desirable to replace a monopoly. Natural monopolies, such as pub- lic utilities, are an example; those monopolies are allowed to continue in existence, but government regulates their prices. The second source of market failure is the presence of what econ- 2. Externalities omists call externalities . Exchange inside a market is voluntary and mutually benefi- cial. Typically, the parties to the exchange capture all the benefits and bear all the costs, thus having the best information about the desirability of the exchange. But sometimes the benefits of an exchange may spill over onto other parties than those explicitly en- gaged in the exchange. Moreover, the costs of the exchange may also spill over onto external benefit other parties. The first instance is an example of an ; the second, an external cost . An example of an external benefit is the pollination that a beekeeper pro- vides to his neighbor who runs an apple orchard. An example of an external cost is air or water pollution. externality ) Let’s explore the idea of an external cost (frequently called simply an to see how it can lead to market failure and what public policies can correct this failing. Suppose that a factory located upstream from a populous city dumps toxic materials into the river as a by-product of its production process. This action by the factory im- poses an unbargained-for cost on the townspeople downstream: They must incur some additional costs to clean up the water or to bring in safe water from elsewhere. In what way has the market failed in this example? The reason the market fails in the presence of external costs is that the generator of the externality does not have to pay for harm- ing others, and so exercises too little self-restraint. He or she acts as if the cost of dis- posing of waste is zero, when, in fact, there are real costs involved, as the people downstream can testify. In a technical sense, the externality generator produces too much output and too much harm because there is a difference between private marginal cost and social marginal cost. Private marginal cost, in our example, is the marginal cost of production for the factory. Social marginal cost is the sum of private marginal cost and the additional mar- ginal costs involuntarily imposed on third parties by each unit of production. The dif- ference is shown in Figure 2.15. Social marginal cost is greater than private marginal cost at every level of output. The vertical difference between the two curves equals the FIGURE 2.15 $ SMC The difference between private and social marginal cost. PMC t $ P c q q q p 0 s

55 40 A Br ief Review of Microeconomic Theory CHAPTER 2 amount of the external marginal cost at any level of output. Note that if production is zero, there is no externality, but that as production increases, the amount of external cost per unit of output increases. The profit-maximizing firm operates along its private marginal cost curve and maximizes profits by choosing that output level for which —namely, = P . q PMC p c But from society’s point of view, this output is too large. Society’s resources will be P q SMC . and most efficiently used if the firm chooses its output level by equating at s c At that level the firm has taken into account not only its own costs of production but also any costs it imposes on others involuntarily. What public policies will induce the externality generator to take external costs into account? That is one of the central questions that this book will seek to answer. The key to achieving the social optimum where there are externalities is to induce pri- vate profit-maximizers to restrict their output to the socially optimal, not privately opti- mal, point. This is done by policies that cause the firm to operate along the social marginal cost curve rather than along the private marginal cost curve. When this is ac- complished, the externality is said to have been in the sense that the pri- internalized vate firm now takes it into consideration. In Figure 2.15, if the firm is producing output, is there any 2.8: UESTION Q external cost being generated? If so, why is this output level called a social op- external cost? At what level of out- timum? Would it not be optimal to have no put would that occur? Does our earlier discussion that characterized any social optimum as the point at which (social) marginal cost equals (social) marginal benefit provide any guidance? Is the point at which social marginal cost and social marginal benefit are equal consistent with the existence of some exter- nal cost? Why or why not? 3. Public Goods The third source of market failure is the presence of a commod- public good ity called a . A public good is a commodity with two very closely related characteristics: 1. Nonrivalrous consumption: consumption of a public good by one person does not leave less for any other consumer. Nonexcludability: 2. the costs of excluding nonpaying beneficiaries who con- sume the good are so high that no private profit-maximizing firm is willing to supply the good. Consider national defense. Suppose, for the purposes of illustration, that national defense were provided by competing private companies. For an annual fee a company would sell protection to its customers against loss from foreign invasion by air, land, or sea. Only those customers who purchase some company’s services would be protected against foreign invasion. Perhaps these customers could be identified by special gar- painted on the roof of their homes. ments, and their property denoted by a large white X Who will purchase the services of these private national defense companies? Some will but many will not. Many of the nonpurchasers will reason that if their neighbor will purchase a protection policy from a private national defense company, then they, too,

56 IX. General Equilibrium and Welfare Economics 41 will be protected: It will prove virtually impossible for the private company to protect the property and person of the neighbor without also providing security to the nearby nonpurchaser. Thus, the consumption of national defense is nonrivalrous: Consumption by one person does not leave less for any other consumer. For that reason, there is a free strong inducement for consumers of the privately provided public good to try to be riders : They hope to benefit at no cost to themselves from the payment of others. The related problem for the private supplier of a public good is the difficulty of ex- cluding nonpaying beneficiaries. The attempt to distinguish those who have from those who have not subscribed to the private defense companies is almost certain to fail; for example, the identifying clothes and property markings can easily be counterfeited. As a result of the presence of free riders and the high cost of distinguishing non- paying from paying beneficiaries, it is not likely that the private company will be able to induce many people to purchase defense services. If private profit-maximizing firms are the only providers of national defense, too little of that good will be provided. How can public policy correct the market failure in the provision of public goods? There are two general correctives. First, the government may undertake to subsidize the private provision of the public good, either directly or indirectly through the tax sys- tem. An example might be research on basic science. Second, the government may un- dertake to provide the public good itself and to pay the costs of providing the service through the revenues raised by compulsory taxation. This is, in fact, how national de- fense is supplied. Web Note 2.1 Another kind of problem that markets have is coordinating people, especially when they act collectively. See our website for a discussion of coordination and collective action applied to legal issues. The fourth source of market failure 4. Severe Informational Asymmetries is an imbalance of information between parties to an exchange, one so severe that ex- change is impeded. To i l l u s t r a t e , i t i s o f t e n t h e c a s e t h a t s e l l e r s k n ow m o r e a b o u t t h e q u a l i t y o f g o o d s than do buyers. For example, a person who offers his car for sale knows far more about its quirks than does a potential buyer. Similarly, when a bank presents a depository agreement for the signature of a person opening a checking account, the bank knows far more than the customer about the legal consequences of the agreement. When sellers know more about a product than do buyers, or vice versa, informa- tion is said to be distributed asymmetrically in the market. Under some circumstances, these asymmetries can be corrected by the mechanism of voluntary exchange, for ex- ample, by the seller’s willingness to provide a warranty to guarantee the quality of a product. But severe asymmetries can disrupt markets so much that a social optimum cannot be achieved by voluntary exchange. When that happens, government interven- tion in the market can ideally correct for the informational asymmetries and induce more nearly optimal exchange. For example, the purchasers of a home are often at a

57 42 CHAPTER 2 ief Review of Microeconomic Theory A Br disadvantage vis-à-vis the current owners in learning of latent defects, such as the pres- ence of termites or a cracked foundation. As a result, the market for the sale of homes may not function efficiently; purchasers may be paying too much for homes or may in- efficiently refrain from purchases because of a fear of latent defects. Many states have responded by requiring sellers to disclose knowledge of any latent defects to prospec- tive purchasers of houses. If the sellers do not make this disclosure, then they may be responsible for correcting those defects. Web Note 2.2 One of the most important issues in welfare economics has been the deriva- tion of a social welfare function, which aggregates individual preferences into social preferences. The Arrow Impossibility Theorem, one of the most signifi- cant intellectual achievements of modern economics, argues that a social welfare function with minimally desirable properties cannot be constructed. We describe the theorem in more detail at our website. C. Potential Pareto Improvements or Kaldor-Hicks Efficiency Dissatisfied with the Pareto criterion, economists developed the notion of a (sometimes called Kaldor-Hicks efficiency ). This is an potential Pareto improvement attempt to surmount the restriction of the Pareto criterion that only those changes are recommended in which at least one person is made better off and no one is made worse off. That criterion requires that gainers explicitly compensate losers in any change. If there is not explicit payment, losers can veto any change. That is, every change must be by unanimous consent. This has clear disadvantages as a guide to public policy. By contrast, a potential Pareto improvement allows changes in which there are both gainers and losers but requires that the gainers gain more than the losers lose. If this con- dition is satisfied, the gainers can, in principle, compensate the losers and still have a surplus left for themselves. For a potential Pareto improvement, compensation does not actually have to be made, but it must be possible in principle. In essence, this is the tech- nique of cost-benefit analysis. In cost-benefit analysis, a project is undertaken when its benefits exceed its costs, which implies that the gainers could compensate the losers. Cost-benefit analysis tries to take into account both the private and social costs and ben- efits of the action being contemplated. There are both theoretical and empirical prob- lems with this standard, but it is indispensable to applied welfare economics. Consider how these two criteria—the Pareto criterion and the Kaldor-Hicks criterion—would help us to analyze the efficiency and distributive justice of a manu- facturing plant’s decision to relocate. Suppose that the plant announces that it is going to move from town A to town B . There will be gainers—those in town B who will be employed by the new plant, the retail merchants and home builders in B, the sharehold- ers of the corporation, and so on. But there will also be losers—those in town A who are now unemployed, the retail merchants in A, the customers of the plant who are now located further away from the plant, and so on. If we were to apply the Pareto criterion

58 X. Decision Making Under Uncertainty: Risk and Insurance 43 to this decision, the gainers would have to pay the losers whatever it would take for them to be indifferent between the plant’s staying in and moving to B . If we were to A apply the potential Pareto criterion to this decision, the gainers would have to gain more than the losers lose but no compensation would actually occur. Web Note 2.3 See our website for much more on cost-benefit analysis as a guide to public policy, including legal change. X. Decision Making Under Uncertainty: Risk and Insurance In nearly all of the economic models we have examined so far, we have implicitly assumed that uncertainty did not cloud the decision. This is clearly a simplifying as- sumption. It is time to expand our basic economic model by explicitly allowing for the presence of uncertainty. A. Expected Monetary Value Suppose that an entrepreneur is considering two possible projects in which to in- vest. The first, involves the production of an output whose market is familiar and D , 1 ; stable. There is no uncertainty about the outcome of project D the entrepreneur can 1 . D The second course of action, , be confident of earning a profit of $200 if he takes D 2 1 involves a novel product whose reception by the consuming public is uncertain. If con- sumers like the new product, the entrepreneur can earn profits of $300. However, if they do not like it, he stands to lose $30. How is the entrepreneur supposed to compare these two projects? One possibility expected value is to compare their expected monetary values. An is the sum of the probabilities of each possible outcome times the value of each of those outcomes. For through O example, suppose that there are four possible numerical outcomes, labeled 1 to a decision. Suppose also that there are four separate probability estimates, la- O , 4 associated with each of the four outcomes. If these are the only beled through p , p 1 4 possible outcomes, then these probabilities must sum to 1. The expected value ( EV ) of this decision is then: + . O O p + p O p EV = p + O 4 1 3 2 4 2 1 3 To r e t u r n t o o u r ex a m p l e , t h e e n t r e p r e n e u r c a n g e t $ 2 0 0 b y c h o o s i n g W h a t i s D 1. There are two possible outcomes, and in D the expected monetary value of decision ? 2 order to perform the calculation the entrepreneur needs to know the probabilities. Let p (1 - p) is the probabil- denote the probability of the new product’s succeeding. Thus, p is given D for any probability ity that it fails. Then, the expected monetary value of 2 by the expression: EMV(D - 30)(1 - ( + = ) p). 300p 2

59 44 A Br ief Review of Microeconomic Theory CHAPTER 2 1 the expected , Thus, if the probability of success for the new product equals 3 monetary value of the decision to introduce that new product equals $80. Where does the decision maker get information about the probabilities of the various outcomes? Perhaps the seasoned entrepreneur has some intuition about or p p. Still an- perhaps marketing surveys have provided a scientific basis for assessing that will make the expected other possibility might be that he calculates the level of p A strong reason for doing D equal to that of the certain event, D monetary value of . 1 2 is, it would be valu- p that would be that, although he might not know for sure what must be in order for it to give the same expected profits as p able to know how high for . D the safe course of action, For example, even if there was no way to know p 1 sure, suppose that one could calculate that in order for the uncertain course of action to have a higher expected value than the safe course of action, the probability of suc- cess of the new product would have to be 0.95, a near certainty. That would be valu- able information. It is a simple matter to calculate the level of p that equates the expected monetary that solves the following equation: value of and That is the p D . D 1 2 30(1 - p) - 200, = 300p which implies that The implication, of course, is that if the probability of the = .7. p new product’s success is .7 or greater, then has a higher expected monetary value D 2 and the entrepreneur will choose than does D . D 1 2 B. Maximization of Expected Utility: Attitudes Toward Risk Do people deal with uncertainty by maximizing expected monetary values? D have the same ex- , D Suppose that the two decisions of the previous section, and 1 2 pected monetary value. Would you be indifferent between the two courses of action? D is not. Upon reflection, many would hesitate to take is a sure thing. Probably not. D 1 2 unless the expected monetary value of D was greater than that of . D The reason D 2 1 2 D for this hesitation may lie in the fact that many of us are reluctant to gamble, and 2 certainly is a gamble. We are generally much more comfortable with a sure thing like . D Can we formalize our theory of decision making under uncertainty to take account 1 of this attitude? The formal explanation for this phenomenon of avoiding gambles was first offered in the eighteenth century by the Swiss mathematician and cleric Daniel Bernoulli. Bernoulli often noticed that people who make decisions under uncertainty do not at- tempt to maximize expected monetary values. Rather, they maximize expected utility. The introduction of utility allows us to introduce the notion of decision makers’ atti- tudes toward risk. Assume that utility is a function of, among other things, money 1. Risk Aversion income: U(I). = U

60 X. Decision Making Under Uncertainty: Risk and Insurance 45 Utility FIGURE 2.16 Risk aversion as diminishing marginal ) I U = U ( utility of income. 310 300 125 100 Income 0 $1,000 $1,000 Bernoulli suggested that a common relationship between money income and utility was that as income increased, utility also increased, but at a decreasing rate. Such a utility function exhibits diminishing marginal utility of income. For exam- ple, if one’s income level is $10,000, an additional $100 in income will add more to one’s total utility than will $100 added to that same person’s income of $40,000. A utility function like that shown in Figure 2.16 has this property. When this person’s income is increased by $1000 at a low level of income, her utility increases from 100 to 125 units, an increase of 25 units. But when her income is increased by $1000 at a higher level of income, her utility increases from 300 to 310 units, an in- crease of only 10 units. A person who has diminishing marginal utility from money income is said to be Here is a more formal definition of risk aversion: risk-averse. A person is said to be risk-averse if she considers the utility of a certain prospect of money income to be higher than the expected utility of an uncertain prospect of equal expected monetary value. For example, in the preceding entrepreneur’s project, a risk-averse decision maker might prefer to have $80 for certain rather than undertake a project whose EMV equals $80. 2. Risk Neutrality Economists presume that most people are averse toward risk, but some people are either neutral toward risk or, like gamblers, rock climbers, and race car drivers, prefer risk. Like aversion, these attitudes toward risk may also be defined in terms of the individual’s utility function in money income and the marginal utility of income. has a constant marginal utility of income and is, risk neutral Someone who is therefore, indifferent between a certain prospect of income and an uncertain prospect of equal expected monetary value. Figure 2.17 gives the utility function for a risk-neutral person. It is a straight line because the marginal utility of income to a risk-neutral person is constant. The figure compares the change in utility when the risk-neutral person’s income is increased by $1000 at two different levels of income. When this person’s income is

61 46 A Br ief Review of Microeconomic Theory CHAPTER 2 Utility FIGURE 2.17 Risk neutrality as constant marginal utility of income. I U = U ) ( 180 160 100 80 Income 0 $1,000 $1,000 increased by $1000 at a low level of income, his utility increases from 80 to 100 units, an increase of 20 units. And when his income is increased by $1000 at a high level of income, his utility increases by exactly the same amount, 20 units, from 160 to 180 units. Thus, for the risk-neutral person the marginal utility of income is constant. Economists and finance specialists very rarely attribute an attitude of risk-neutrality to individuals. However, they quite commonly assume that business organizations are risk-neutral. Someone who is 3. Risk-Seeking or Risk-Preferring or risk- risk-seeking has an increasing marginal utility of income and, therefore, prefers an un- preferring certain prospect of income to a certain prospect of equal expected monetary value. Figure 2.18 gives the utility function of a risk-preferring individual. The figure allows us to compare the change in utility when the risk-preferring person’s income is increased by $1000 at two different levels of income. When this person’s income is in- creased by $1000 at a low level of income, her utility increases from 80 to 85 units, an increase of 5 units. However, when her income is increased by $1000 at a high level of income, her utility increases from 200 to 230 units, an increase of 30 units. Thus, for the risk-preferring person the marginal utility of income increases. Web Note 2.4 One of the winners of the Nobel Prize in Economics in 2002 was Daniel Kahneman, Professor Emeritus of Psychology at Princeton University. Kahneman and his coauthor, the late Amos Tversky, did experiments to see the extent to which people’s attitudes toward risk fit those we have just stud- ied. The experiments suggested that most people have complex feelings about losses and gains that Kahneman and Tversky characterized as “loss aversion.” See section XII, on page 50 and our website for more on the experiments and their implications.

62 X. Decision Making Under Uncertainty: Risk and Insurance 47 Utility FIGURE 2.18 Risk preferring as increasing marginal ) I U = U ( utility of income. 230 200 85 80 Income 0 $1,000 $1,000 C. The Demand for Insurance One of the most important behavioral implications of risk aversion is that people will pay money to avoid having to face uncertain outcomes. That is, a risk-averse per- son might prefer a lower certain income to a higher uncertain income. There are three ways in which a risk-averse person may convert an uncertain into a certain outcome. First, he may purchase insurance from someone else. In ex- change for giving up a certain amount of income (the insurance premium), the in- surance company will bear the risk of the uncertain event. The risk-averse person considers himself better off with the lower certain income than facing the uncertain higher income. Second, he may self-insure. This may involve incurring expenses to minimize the probability of an uncertain event’s occurring or to minimize the mone- tary loss in the event of a particular contingency. An example is the installation of smoke detectors in a home. Another form of self-insurance is the setting aside of a sum of money to cover possible losses. Third, a risk-averse person who is consider- ing the purchase of some risky asset may reduce the price he is willing to pay for that asset. D. The Supply of Insurance for insurance by risk- demand The material of the previous section concerns the averse individuals. Let us now turn to a brief consideration of the supply of insurance by profit-maximizing insurance companies. Insurance companies are presumed to be profit-maximizing firms. They offer in- surance contracts not because they prefer gambles to certainties but because of a math- ematical theorem known as the law of large numbers. This law holds that unpredictable events for individuals become predictable among large groups of individuals. For ex- ample, none of us knows whether our house will burn down next year. But the occur- rence of fire in a city, state, or nation is regular enough so that an insurance company can easily determine the objective probabilities. By insuring a large number of people, an insurance company can predict the total amount of claims.

63 48 CHAPTER 2 ief Review of Microeconomic Theory A Br Moral hazard arises when the behavior of the insured person or 1. Moral Hazard entity changes after the purchase of insurance so that the probability of loss or the size of the loss increases. An extreme example is the insured’s incentive to burn his home when he has been allowed to insure it for more than its market value. A more realistic example comes from loss due to theft. Suppose that you have just purchased a new sound system for your car but that you do not have insurance to cover your loss from theft. Under these circumstances you are likely to lock your car whenever you leave it, to park it in well- lighted places at night, to patronize only well-patrolled parking garages, and so on. Now suppose that you purchase an insurance policy that will, unrealistically, com- pensate you for the full cost of any insured loss that you suffer. With the policy in force you now may be less assiduous about locking your car or parking in well-lighted places. In short, the very fact that your loss is insured may cause you to act so as to in- crease the probability of a loss. Insurance companies attempt to set their premiums so that, roughly, the premium modestly exceeds the expected monetary value of the loss. Therefore, a premium that has been set without regard for the increased probability of loss due to moral hazard will be too low and thus threaten the continued profitability of the firm. Every insurer is aware of this problem and has developed methods to minimize it. Among the most coinsurance and deductibles . Under coinsurance the insuree shoulders a common are fixed percentage of his loss, with the insurer picking up the remaining portion of the loss; under a deductible plan, the insuree shoulders a fixed dollar amount of the loss, with the insurance company paying for all losses above that amount. In addition, some insurance companies offer reductions in premiums for certain easily established acts that reduce claims. For example, life and health insurance premiums are less for non- smokers; auto insurance premiums are less for nondrinkers; and fire insurance rates are lower for those who install smoke detectors. 2. Adverse Selection The other major problem faced by insurance companies is called . This arises because of the high cost to insurers of accurately adverse selection distinguishing between high- and low-risk insurees. Although the law of large numbers helps the company in assessing probabilities, what it calculates from the large sample are average probabilities. The insurance premium must be set using this average proba- bility of a particular loss. For example, insurance companies have determined that un- married males between the ages of 16 and, say, 25, have a much higher likelihood of being in an automobile accident than do other identifiable groups of drivers. As a re- sult, the insurance premium charged to members of this group is higher than that charged to other groups whose likelihood of accident is much lower. But even though unmarried males between the ages of 16 and 25 are, on average, much more likely to be involved in an accident, there are some young men within that group who are even more reckless than average and some who are much less reckless than the group’s average. If it is difficult for the insurer to distinguish these groups from the larger group of unmarried males aged 16 to 25, then the premium that is set equal to the average likelihood of harm within the group will seem like a bargain to those who know they are reckless and too high to those who know that they are safer than their peers. Let us assume, as seems reasonable, that in many cases the individuals know bet- ter than the insurance company what their true risks are. For example, the insured alone

64 XI. Profits and Growth 49 may know that he drinks heavily and smokes in bed or that he is intending to murder his spouse, in whose insurance policy he has just been named principal beneficiary. If so, then this asymmetrical information may induce only high-risk people to purchase insurance and low-risk people to purchase none. As a result, the insurance company will find itself paying out more in claims than it had anticipated. It may, therefore, raise the premiums higher. This will drive out some more relatively safer customers, leaving an even-riskier clientele behind. The incidence and volume of claims may go up yet again, setting off a new round of premium increases, defections of less-risky customers, . and so on. This process is referred to as an insurance death spiral The same devices that insurance companies employ to minimize risks of moral haz- ards also may serve to minimize the adverse selection problem. Coinsurance and de- ductible provisions are much less attractive to high-risk than to low-risk insurees so that an insuree’s willingness to accept those provisions may indicate to the insurance com- pany to which risk class the applicant belongs. Exclusion of benefits for loss arising from preexisting conditions is another method of trying to distinguish high- and low-risk peo- ple. The insurer can also attempt, over a longer time horizon, to reduce the adverse selec- tion bias by developing better methods of discriminating among the insured, such as medical and psychological testing, so as to place insurees in more accurate risk classes. Finally, insurers frequently practice —the practice of adjusting the in- experience rating suree’s premium up or down according to his experience of insurable losses. If an insuree appears to be accident prone, then the insurer may raise his premium to reflect the greater probability or size of loss. In the limit, the insurer may refuse to cover the insuree. 15 XI. Profits and Growth Imagine a banker who asks to be paid by placing one penny on the first square of a chess board, two pennies on the second square, four on the third, and so on. Using only the white squares, the initial penny would double in value thirty-one times, leaving $21.5 million on the last white square. Growth compounds faster than the mind can grasp. In 1900 Argentina’s income per person resembled Canada’s, and today Canada’s is more than three times higher. After World War II, Korea and Nigeria had similar national income per person, and today Korea’s is nineteen times higher. Most people cannot imagine China with more economic in- fluence in the world than the United States, but, if current trends continue, China will surpass 16 the United States in national income in 2014. Lifting so many people out of poverty in East Asia in the late twentieth century is one of history’s remarkable accomplishments. In con- trast, one of history’s depressing economic failures in the late twentieth century is sub- Saharan Africa, where GDP per person declined since 1975 roughly by 25 percent. Why do some countries grow faster than others? Sustained growth requires innovation. An innovation occurs when someone discovers a better way to make something or some- thing better to make. Entrepreneurs make things in better ways by improving organizations 15 This section draws on Chapter 1 of R OBERT C OOTER & H ANS -B ERND S CHAEFER , L AW A N D T H E P OVERTY OF N AT I O N S (2011). 16 Because China’s population is 4 to 5 times greater than the United States’ population, China’s income per capita in 2014 will still be one-fourth to one-fifth that of the United States. This prediction was made by Carl J. Dahlman, Luce Professor of International Affairs and Information, Georgetown University.

65 50 CHAPTER 2 ief Review of Microeconomic Theory A Br and markets, and scientists invent better things to make. Growth will remain mysterious un- til economics has an adequate theory of innovation. The only contribution to growth theory so far that merited a Nobel Prize in Economics shows the consequences of innovation for 17 capital and labor but does not attempt to explain innovation. Law, we believe, is part of the mystery’s solution. When an innovator has a new idea, it must be developed in order for the economy to grow. Combining new ideas and capital runs into a fundamental obstacle illustrated by this example: An economist who worked at a Boston investment bank received a letter that read, “I know how your bank can make $10 million. If you give me $1 million, I will tell you.” The letter captures concisely the problem of financing innovation: The bank does not want to pay for in- formation without first determining its worth, and the innovator fears disclosing infor- mation to the bank without first getting paid. Law is central to solving this problem. Later chapters in this book mention “transactional lawyers,” who use law to overcome the mistrust that prevents people from cooperating in business. The most fundamental bodies of transaction law are property and contracts, which we cover in Chapters 4, 5, 8, and 9. Making these bodies of law efficient promotes economic growth by uniting innovative ideas and capital. Countries with efficient property and contract have estab- lished the legal foundation for innovation and growth. XII. Behavioral Economics In our review of microeconomic theory we have followed modern microecono- mists in assuming that decision makers are rationally self-interested. This theory of de- rational choice theory and has served the economics profession cision making is called well over the past 60 or more years in theorizing about how people make explicitly eco- nomic decisions. But rational choice theory has been under attack over the past 30 years or so. This attack has been principally empirical. That is, it has been premised on experimental findings that people do not behave in the ways predicted by rational choice theory. (We will give examples shortly.) Two p r i n c i p a l n a m e s i n t h e ex p e r i m e n t a l l i t e r a t u r e t h a t h ave b e e n c r i t i c a l o f r a t i o n a l choice theory are Daniel Kahneman and Amos Tversky. As we noted above, Kahneman won the Nobel Prize in Economics in 2002. The body of literature inspired by Kahneman and Tversky has as acquired the name behavioral economics and the legal 18 . analysis that takes account of these findings is called behavioral law and economics What are some examples of behavioral economics? Let us consider two (although there are many others) that have particular relevance to the law. The first is the result of experiments involving the ultimatum bargaining game . In that game there are two play- ers, neither of whom knows the identity of the other. They interact anonymously. Their task in the game is to divide a small sum of money—say, $20. One player is designated 17 In 1987 Robert Solow received the Nobel Prize in Economics for his contributions to economic growth theory. 18 For a summary of the field, see Russell B. Korobkin & Thomas S. Ulen, Law and Behavioral Science: Removing the Rationality Assumption from Law and Economics , 88 C AL . L. R EV . 1051 (2000).

66 XII. Behavioral Economics 51 Player 1; the other, Player 2. Player 1 makes some proposal to Player 2 about how the $20 should be divided; Player 2 can then either accept that proposal, in which case the experimenter actually gives the two players the amounts proposed by Player 1, or re- ject the proposal, in which case neither player gets any money. Rational choice theory predicts that Player 1 will take advantage of her position as the proposer to give herself a disproportionate share of the $20—say, $15, leaving $5 for Player 2. Player 1 might also reason that Player 2 will take $5 rather than nothing. And, in fact, Player 2 might think that Player 1 is selfish, but that, after all, $5 is better than nothing. This game has been played in experiments in over 140 countries and among groups with vastly different incomes, ages, education levels, religions, and the like, and in countries that are wealthy and countries that are poor. The modal (most common) out- come is a 50-50 split of the stakes—each player gets $10. Equally interesting is the fact that in many countries if Player 1 tries to take more than 70 percent of the stakes (more 19 than $14 in our $20 example), Player 2 rejects the offer and they each get nothing. We t a ke s o m e h e a r t f r o m t h e fa c t t h a t s t r a n g e r s s e l d o m t a ke a d va n t a g e o f o n e a n - other in the ultimatum bargaining game. Rather, the norm seems to be to treat the other party fairly; in fact, to treat him or her exactly as one treats oneself. Are there legal im- plications of this insight? We return to this point in Chapters 8 and 9 when we consider the concern of contract law with some forms of advantage-taking in bargaining. A second example of a behavioral economics finding is the . This hindsight bias refers to the fact that things that actually happen seem, in hindsight ( ex post ), to have been far more likely than they were in foresight ( ex ante ). So, if you asked people in spring 2010 the probability that Spain would win the 2010 World Cup in South Africa, they might have said, “10 percent.” But if you ask them after Spain actually won the cup, they will say it was much more likely—say, 40 percent. Is there a legal implication? Consider something that we will discuss in Chapter 6: How do we in- duce someone to take the right amount of precaution against harming another per- son? As we will see, one way to do that is to expose the possible injurer to liability for the injuries that a victim suffers if the injurer did not take a prudent amount of before an ac- precaution. Here’s the problem—what might seem prudent precaution cident occurs might appear, in hindsight, to have been imprudent. That is, if an acci- dent has occurred, the hindsight bias may tell us that the accident was more inevitable than we would have thought before. Rational choice theory cannot explain the observed behavior in the ultimatum bar- gaining game or hindsight bias. The central insight of behavioral economics is that hu- man beings make predictable errors in judgment, cognition, and decision making. They are, to quote the title of a book on this topic by Dan Ariely, “predictably irrational.” Economic analysis should use rational choice theory or behavioral theory, depending on which one predicts the law’s effects on the behavior more accurately. 19 The group that typically plays this game in line with the predictions of rational choice theory (in which Player 1 makes a proposal to take much more than half of the stakes and Player 2 accepts that) are gradu- ate students in economics. Did they select a graduate study in economics because they already find ra- tional choice theory attractive? Or did their graduate studies in economics convince them that rational choice was the appropriate way to behave?

67 52 CHAPTER 2 ief Review of Microeconomic Theory A Br Review Questions If you are not certain whether you need to refresh your understanding of microeco- nomic theory, try these questions. If you find them to be too hard, read this chapter and try them again. If only some of the questions are too hard, turn to the section of the chapter that covers that material and review that section. 2.1. Define the role of the mathematical concepts of maximization and equilibrium in microeconomic theory. and 2.2. Define and distinguish between productive efficiency allocative efficiency. 2.3. What are consumers assumed to maximize? What are some constraints under which this maximization takes place? Describe the individual consumer’s constrained maximum. Can you characterize this constrained maximum as a point where marginal cost and marginal benefit are equal? 2.4. A married couple with children is considering divorce. They are negotiating about two elements of the divorce: the level of child support that will be paid to the partner who keeps the children, and the amount of time that the children will spend with each partner. Whoever has the children would prefer more child support from the other partner and more time with the children. Furthermore, the partner who keeps the children believes that as the amount of child support increases, the value of more time with the children declines relative to the value of child support. a. Draw a typical indifference curve for the partner who keeps the children with the level of child support on the horizontal axis and the amount of time that the children spend with this partner on the vertical axis. Is this indifference curve convex to the origin? Why or why not? b. Suppose that the partner who keeps the children has this utility function cv, the weekly level of child support and the number = u = c = v where of days per week that the children spend with this partner. Suppose that initially the weekly support level is $100, and the number of days per week spent with this partner is 4. What is the utility to this partner from that arrangement? If the other partner wishes to reduce the weekly support to $80, how many more days with the children must the child-keeping partner have in order to maintain utility at the previous level? 2.5. Define and explain what ranges of value it may take. price elasticity of demand 2.6. Use the notion of opportunity cost to explain why “There’s no such thing as a free lunch.” : The cost of a week of vacation is simply the money cost of the 2.7. True Fa l s e or plane, food, and so forth. (Explain your answer.) hat are firms assumed to maximize? Under what constraints do firms 2.8. W perform this maximization? Describe how the individual firm determines the output level that achieves that maximum. Can you characterize the firm’s constrained maximum as one for which marginal cost equals marginal benefit? 2.9. Characterize these different market structures in which a firm may operate: perfect competition, monopoly, oligopoly, and imperfect competition.

68 Review Questions 53 Compare the industry output and price in a perfectly competitive industry with the output and price of a monopolist. 2.10. What conditions must hold for a monopoly to exist? 2.11. Suppose that the local government determines that the price of food is too high and imposes a ceiling on the market price of food that is below the equilibrium price in that locality. Predict some of the consequences of this ceiling. 2.12. The minimum wage is typically set above the market-clearing wage in the market for labor. Using a graph with an upward-sloping supply of labor, a downward-sloping demand for labor, with the quantity of labor measured on the horizontal axis and the wage rate measured on the vertical axis, show the effect on the labor market of a minimum wage set above the equilibrium wage rate. True 2.13. Fa l s e : In Japan, workers cannot be fired once they have been hired; or therefore, in Japan a minimum wage law (where the minimum would be set above the wage that would cause the market for labor to clear) would not cause unemployment. 2.14. In the United States in the late twentieth century, no-fault divorce laws became the norm in the states (divorce being a matter for states, not the federal government, to regulate). Ignoring for the sake of this problem all the other factors that influence the marriage decision and that have changed during the same time period, what does the move to no-fault divorce do to the implicit (legal) price of divorce? What would be your prediction about the effect of this change in the implicit price of divorce on the quality and quantity of marriages and divorces? If, in the next decade, the states were to repudiate the experiment in no-fault divorce and return to the old regime, would you predict a change in the quality and quantity of marriages and divorces? 2.15. The Truth-in-Lending Act (15 U.S.C. §§1601–1604 (1982)) requires the uniform disclosure of the interest rate to borrowers in a readily intelligible form. Assume that before the act, there was uncertainty among borrowers about the true level of the interest rate, but that after the act, that uncertainty is reduced. What effect on the amount of borrowing would you predict from passage of the act? Would there be disproportionate effects on the poor and the rich? Why? Does the act increase the marginal cost of lenders? Does it reduce the profits of lenders? 2.16. What is general equilibrium and under what conditions will it be achieved? What are the welfare consequences of general equilibrium? 2.17. What are the four sources of market failure? Explain how each of them causes individual profit- and utility-maximizers to make decisions that may be privately optimal but are socially suboptimal. What general policies might correct each of the instances of market failure? 2.18. Which of the following are private goods and might, therefore, be provided in socially optimal amounts by private profit-maximizers? Which are public goods and should, therefore, be provided by the public sector or by the private sector with public subsidies? a. A swimming pool large enough to accommodate hundreds of people. b. A fireworks display.

69 54 CHAPTER 2 ief Review of Microeconomic Theory A Br A heart transplant. c. d. Va c c i n a t i o n a g a i n s t a h i g h l y c o n t a g i o u s d i s e a s e . e. A wilderness area. f. Vocational education. g. On-the-job training. Secondary education. h. or Pa re t o o p t i m a l i t y ? What is the importance 2.19. What is meant by Pa re t o e ffi c i e n c y of the initial distribution of resources in determining what the distribution of resources will be after all Pareto improvements have been made? 2.20. A valuable resource in which we typically forbid voluntary exchange is votes. This may be inefficient in that, as we have seen, given any initial endowment of resources, voluntary exchange always makes both parties better off (absent any clear sources of market failure). Show that it would be a Pareto improvement if we were to allow a legal market for votes. Are there any clear sources of market failure in the market for votes? If so, what regulatory correctives would you apply to that market? Is it bothersome that there is a wide variance in income and wealth among the participants in this market, and if so, why is that variance more troubling in this market than in others, and what would you do about it in the market for votes? 2.21. Distinguish between the Pareto criterion for evaluating a social change in which there are gainers and losers and the Kaldor-Hicks (or potential Pareto) criterion. dominant strategy 2.22. What is a in a game? Where both players in a two-person game have a dominant strategy, is there an equilibrium solution for the game? What is a Nash equilibrium ? Is a dominant-strategy equilibrium a Nash equilibrium? What are the possible shortcomings of a Nash equilibrium in a game? Suggested Readings RIELY , D AN , P REDICTABLY I RRATIONAL , R EVISED AND E XPANDED E DITION A HE H IDDEN F ORCES : T T S HAPE O UR D ECISIONS (2010). HAT : AT W E L L OHN , M URRAY M ILGATE , & P ETER N EWMAN , EDS ., T ICTIONARY N EW P ALGRAVE , J A D HE E OF E , 4 vols. (1991). CONOMICS REPS , D AV I D (1990). OURSE IN M ICROECONOMIC T HEORY , A C K (1991). ANDSBURG , S TEPHEN , T HE A RMCHAIR E CONOMIST L EVITT TEVEN D., & S TEVEN J. D UBNER , F REAKONOMICS , S OGUE E CONOMIST E XPLAINS T HE : A R L IDDEN IDE OF H E VERYTHING (2005). S UPERFREAKONOMICS EVITT TEVEN D., & S AT R I OT I C J. D UBNER , S , S : G LOBAL W ARMING , P TEVEN L P ROSTITUTES , AND W HY S UICIDE B OMBERS S HOULD B UY L IFE I NSURANCE (2009). R INDYK OBERT , & D ANIEL , R UBINFELD , M ICROECONOMICS (6th ed. 2004). P , HALER , R ICHARD H., & C ASS R. S UNSTEIN , N UDGE : I MPROVING D ECISIONS A BOUT H EALTH T W EALTH , AND H APPINESS (2008). SSUES INTER , H AROLD , T RADE -O FFS A N I NTRODUCTION TO E CONOMIC R EASONING AND S OCIAL I W (2005).

70 A Brief Introduction to Law and Legal Institutions 3 “You are old,” said the youth, “and your jaws are too weak For anything tougher than suet. Yet you finished the goose, with the bones and the beak. Pray, how do you manage to do it?” “In my youth,” said his father, “I took to the law, And argued each case with my wife. And the muscular strength, which it gave to my jaw, Has lasted the rest of my life.” EWIS ARROLL , C From “Father William” in L A DVENTURES IN LICE ONDERLAND ’ S A W The life of the law has not been logic: it has been experience. The felt necessities of the time, the prevalent moral and political theories, institutions of public policy, avowed or unconscious, even the prejudices which judges share with their fellow-men, have had a good deal more to do than the syllogism in determining the rules by which men should be governed. ENDELL H OLMES O LIVER W , T L AW 1 (1881) C HE OMMON picks up a law journal will understand much more of it than NECONOMISTWHO a lawyer who picks up an economics journal. For this reason, it is not hard to A convince a lawyer that he does not know economics. (Convincing him that he should learn economics is harder!) On the other hand, economists are sometimes hard to convince that any aspect of social life is not, at its root, really economics. With re- spect to the law, economists sometimes wonder what lawyers really study: Is the law a branch of philosophy? Is it a list of famous cases? Is it a collection of rules? In any case, economists cannot contribute significantly to law without studying it. This chapter provides an introduction to the law for nonlawyers. We shall explain, first, differences and similarities between the two great legal traditions that spread from Europe to much of the world; second, the structure of the United States’ federal and state court systems; third, how a legal dispute gets raised and resolved in systems like that of the United States; and finally, how the legal rules made by judges evolve. 55

71 56 CHAPTER 3 ief Introduction to Law and Legal Institutions A Br I. The Civil Law and the Common Law Traditions Legislatures make laws by enacting bills, which judges must interpret and apply. If legislation is deliberately vague or inadvertently ambiguous, judges can choose among several different interpretations. Sometimes the choice of an interpretation overshad- ows the enactment of the bill, in which case the judge makes the law more than the leg- islature. Judges make law by interpreting legislation in all legal systems with independent courts. Judges make law in other ways as well. In medieval Europe, the king in most coun- tries could issue pronouncements that were law, and the king’s courts possessed similar powers. However, the king’s courts were not free to pronounce as law any command that they wished. According to one tradition in legal theory, the courts of the English king were to examine community life and “find” law as it already existed. The courts of the English king were to select among prevailing social norms and enforce some of them. These enforceable social norms were supposedly the “laws of nature,” which rea- son and necessity prescribed. precedent The finding of a rule of law by a court of the English king created a that 1 future courts were expected to follow. A precedent in common law resembles a gener- ally accepted interpretation in civil law. Precedent was followed flexibly, not slavishly, so the law changed gradually. Over many years, the king’s courts “found” many impor- tant laws, especially in the areas of crimes, property, contracts, and accidents (“torts”). These findings are called the “common law” because they are allegedly rooted in the common practices of people. Common law is still applied in the English-language countries, except where superseded by legislation. Legal history is different in France and the other countries of Europe: When France revolted at the end of the eighteenth century, the revolutionaries thought that the judges were as corrupt and worthless as the king, so they killed the king and extin- guished his laws, thus abolishing the common law of France. A comprehensive set of statutes was required to fill the void, so people would know what counts as property, how a valid contract is formed, and who is to bear the cost of accidents. Napoleon sup- plied them by commissioning legal scholars to draft the rules called the Code , which was promulgated in 1804. The scholars who drafted it took as their Napoléon model the Corpus Juris Civilis (“The Body of the Civil Law”), which was compiled . 528–534 at the behest of the Roman emperor Justinian. Thus, the A . D and edited in French revolutionaries looked to ancient sources and pure reason for law, rather than to the more immediate heritage derived from medieval times. Napoleon’s armies spread the Code Napoléon through much of Europe, where it remained long after his troops withdrew. Similarly, Europeans spread their law throughout the world, and this influence persisted long after the colonial empires col- lapsed. The “civil law tradition,” as it is called, predominates in most of Western 1 “Precedent” refers to the practice of resolving similar cases in a similar fashion. If it is known that a court is going to resolve a dispute by applying precedent, then the disputants have a good idea what the legal res- olution of their dispute might be. This can induce the disputants to settle the matter themselves against the background law that they know the court will use.

72 I. The Civil Law and the Common Law Traditions 57 Europe, Central and South America, the parts of Asia colonized by European coun- tries other than Britain, and even in pockets of the common law world, such as Louisiana, Québec, and Puerto Rico. The common law tradition, which originated in England, prevails not only in Great Britain, but also in Ireland, the United States, Canada, Australia, New Zealand, and the parts of Africa and Asia that Britain colonized, including India. Besides these two great traditions, the unique history of each country puts its own stamp on the law. For example, Japan, which was never colonized, voluntarily adopted a code that draws heavily on the German civil code while yet remaining distinctively Japanese. In much of the Middle East, Islamic law blended with, or displaced, the law of the European colonialists. In Eastern Europe, communism bent the civil law tradition to its own purposes, and now the post-Communist regimes are trying to straighten it. The common law and civil law traditions differ significantly with respect to how judge-made law is justified. Common law judges traditionally justify their findings of law by reference to precedent and social norms, or by broad requirements of rationality presupposed by public policy. Civil law judges traditionally justify their interpretation of a code directly by reference to its meaning, which scholars tease out in lengthy com- mentaries. Because common law judges rely relatively more on past court decisions and civil law judges rely relatively more on the words in statutes, the common law sys- tem is based more on precedent than the civil law system. The difference in the pattern of justification affects the training of lawyers. The common law method is taught by reading cases and arguing directly from them, whereas the civil law method is taught by reading the code and arguing from commentaries on it. All such generalizations about the difference between the two traditions, however, seem simplistic relative to the subtlety and complexity of reality. For example, although the United States is ostensibly a common law country, the American states have tried to obtain greater uniformity in commercial law by enacting the Uniform Commercial Code . Deciding disputes that fall under the in America has Uniform Commercial Code many similarities to deciding disputes that fall under the French Civil Code. Additionally, the American Law Institute, an organization founded in the 1920s, meets periodically to restate the law as it is emerging in the various states. These restate- ments, such as the and the Restatement (Second) of Restatement (Second) of Contracts To r t s , serve a similar function to the codes that are thought to be characteristic of the civil law countries. Comparative law scholars vigorously debate whether the differ- ences between civil and common law are more apparent than real. Besides the difference in history between common and civil law, the laws are ap- plied differently in the two traditions. In the common law countries, the arguments for the two sides in a dispute are made exclusively by their lawyers, and the judge is not supposed to direct a line of questioning or develop an argument. In this adversarial process , the judge acts more or less as a neutral referee who makes the lawyers follow the rules of procedure and evidence. The principle underlying the adversarial system is that the truth will emerge from a vigorous debate by the two sides. In contrast, the civil law judge takes an active role in directing questions and de- veloping arguments. In this inquisitorial process , the judge is supposed to ferret out the truth. The lawyers often have to respond to the judge, rather than develop the case

73 58 CHAPTER 3 ief Introduction to Law and Legal Institutions A Br themselves. The principle underlying the inquisitorial system is that the court has a di- rect interest in finding the truth regarding private disputes and crimes. Another difference between the two systems concerns the use of juries. Juries are more commonly used in common law systems. In America, either party to a dispute usually has the right to a jury trial, although both parties sometimes waive this right and allow the judge to decide the case. In England, the jury has been abolished in almost all 2 civil trials since 1966, but it is often used in criminal trials. (Notice the different use of 3 ) In France, however, the jury has been abolished for “civil” in the preceding sentence. all trials except the most serious crimes, like murder. In general, the abolition of juries is more advanced in continental Europe than in some common law countries. In a com- mon law trial before a jury, the judge is supposed to decide questions of law, whereas the jury is supposed to decide questions of fact. In every legal system, laws form a hierarchy. The constitution takes precedence over statutes, and statutes usually take precedence over rules issued by the executive or government agencies. In countries with common law, statutes take precedence over it. “Taking precedence” means that the higher law prevails in the event of conflict. The courts, as the main interpreters of law, must decide whether laws conflict. We have ex- plained that judges make law indirectly by interpreting statutes or codes. Another way that judges make law is by finding a conflict between laws and setting aside the lower- level law. Finally, judges make common law directly in those countries that maintain the common law system—a process we explain later in this chapter. Constitutions are necessarily general and vague, so their interpretation is espe- cially problematic. The power to review legislation for its constitutionality gives courts the power, in principle, to set aside laws enacted by the legislature. This power is potentially dangerous because it brings judges into conflict with the elected repre- sentatives of the nation. The extent to which this power is exercised varies greatly from one country to another. In the United States, the federal courts have few limits on their ability to strike down laws that, in the courts’ opinion, contradict the Constitution. Some of the most profound laws in America have been made by courts interpreting the Constitution, as in Brown v. Board of Education in 1954, which even- tually ended laws mandating racial segregation of schools. In other countries, such as Great Britain, the courts do not have the power to review statutes for their constitu- tionality, and the courts never strike down legislation as unconstitutional. The scope of constitutional review, which is fundamental to the power and prestige of courts, has no necessary connection with whether the country’s legal tradition is common or civil law. 2 Except in cases involving defamation. 3 “Civil law” has two meanings. It may refer to the system of law in most of continental Europe that rejects common law. In addition, “civil law” may refer to laws controlling disagreements between two private par- ties, which might arise, say, from a broken contract or an automobile accident. In this latter sense, the op- posite of “civil law” is criminal or penal law, in which actions are initiated by the state’s prosecutor against someone accused of violating a criminal statute, such as forgery or murder. Thus, the common law of, say, contracts can be described as “civil law,” meaning “private law” or “not criminal law.”

74 II. The Institutions of the Federal and the State Court Systems in the United States 59 II. The Institutions of the Federal and the State Court Systems in the United States In the United States, whether at the state or the federal level, the court systems are or- ganized in three tiers. These tiers constitute a hierarchical pyramid, with a very broad base of many courts, an intermediate level with a smaller number of courts, and a single court at the top of the pyramid. At the lowest level are the trial courts of general jurisdiction . These are the “entry-level” courts that first hear a wide array of civil and criminal disputes. The trial courts of general jurisdiction are “courts of record”; that is, the proceedings are writ- ten down and saved by the government. In the state systems these courts are usually organ- ized along county lines. For example, in the State of Illinois there are 102 counties, and each has a “Circuit Court” that serves as the trial court of general jurisdiction within the county. These trial courts have different names in different states: In California they are called “Superior Courts”; in New York State, “Supreme Courts.” The nearly universal prac- tice is for each civil and criminal case to be tried to a single judge and possibly to a jury. In the federal system the entire country is divided into 94 judicial districts, each of which contains a federal district court, which is the trial court of general jurisdiction for the federal judiciary. Every state in the Union has at least one federal district court, only one. The District of Columbia has its own district court. The and about half have larger states, where larger numbers of disputes involving federal questions arise, have up to four district courts, usually organized along geographical divisions of the state. New York has four districts: the Southern, the Northern, the Eastern, and the Western. Illinois has three federal districts: the Northern, the Central, and the Southern. As the volume of federal litigation has grown, Congress has responded not by creating more districts but by appointing more judges within each district. One of the busiest districts is the Southern District of New York, which contains most of New York City. As of 4 2010, there were 44 district judges in that district (and 15 magistrate judges). Another busy district, the Northern District of Illinois, has 32 district judges (and 14 magistrate 5 The usual procedure in the federal districts is for a single judge to hear each judges). case, but a three-judge panel sometimes hears a case. In addition, the federal court system includes several specialized tribunals. For ex- ample, there are special tax courts, and federal administrative agencies, such as the Federal Communications Commission, have administrative law judges who hear argu- ments about matters before those agencies. There is also, as we shall soon see, a special 6 appellate tribunal in the federal system for dealing with intellectual property cases. 4 In the last edition of this book, there were 25 district judges in that district. 5 In the last edition there were 12 district judges in the Northern District of Illinois. Magistrate judges are ap- pointed by district court judges in each federal district for renewable eight-year terms. Those magistrates pre- side over trials for federal misdemeanor crimes and hear preliminary motions in more serious federal crimes and pretrial motions for many civil cases. Magistrates may preside over federal civil trials if the parties consent. 6 As of August 2010, there were a total of 678 federal district court judges, 179 Court of Appeals judges, 9judges on the Court of International Trade, and 9 justices of the United States Supreme Court for a total of 875 federal judges. There are currently 98 vacancies in the federal judiciary. Because Article III of the U.S. Constitution provides for these judges, the 875 federal judges are called “Article III judges.”

75 60 CHAPTER 3 A Br ief Introduction to Law and Legal Institutions or appellate courts Above the trial courts in the state and federal systems are . In most state court systems, there is only one court of appeal. But courts of appeal about one-third of the states and the federal system have intermediate appellate courts that stand between the trial courts of general jurisdiction and the highest court (the court of last resort ). For example, in Illinois there are five intermediate appellate dis- tricts with a total of just over 50 justices. Where these courts exist, parties from the trial court may appeal “as of right,” which means that so long as they are willing to pay the costs involved, the parties may always seek appellate review of a lower court’s judg- ment. Appeal is also a right in the federal system, at least from the district courts to the intermediate courts of appeal. While there may be a right for either party to appeal the judgment of the trial courts of general jurisdiction, matters may be different if either party wishes to appeal the judg- ment of an intermediate appellate court. In both the state and the federal judiciary, the discretionary right of review. This means that the highest appellate court typically has a Supreme Court of Illinois, the Supreme Court of the United States, and all other courts of last resort may select which cases they will review, within certain limits. Some cases—for example, disputes between two states—come to the United States Supreme Court directly and without the discretion of the justices. And in many states the highest court is obligated to review death sentences. Thus, the United States Supreme Court and the highest courts in the states control most, but not all, of their docket. An intermediate court of appeal in the federal judiciary is called the “Court of Appeals for the ___ Circuit.” There are thirteen of these circuits, as Figure 3.1 indi- cates. Eleven of these courts of appeal are numbered; for example, the First Circuit is in New England; the Seventh Circuit covers Indiana, Illinois, and Wisconsin; and the Ninth Circuit covers the West Coast, some of the mountain states, and Alaska and Hawaii. The District of Columbia constitutes its own circuit and also has its own dis- trict court. All the other circuits include several states. An unsuccessful litigant from FIGURE 3.1 WA Puerto Rico United States Courts ME MI VT 1 MT ND 1 of Appeal and United OR NH MN NY States District Courts. MA ID SD WI 2 WY MI Virgin RI 9 8 PA CT Islands IA 3 NE NV 3 OH NJ IL UT IN DE 6 CO 7 MD WV 10 CA VA KS MO 4 D.C. DC KY Washington NC TN FEDERAL AZ OK AR SC Wa s h i n g t o n D . C . NM GA (intellectual property) AL MS 11 LA TX 5 FL HI AK 9 9 Northern Mariana Islands Guam

76 II. The Institutions of the Federal and the State Court Systems in the United States 61 the federal district court can take an appeal, as a matter of right, to the court of appeals. Those courts often sit in a panel of three judges. Sometimes, for a particularly signifi- cant case, all of the circuit judges will sit together to decide the case. In that case the or “in bank.” Where more than one judge hears a case, court is said to be sitting en banc the matter is decided by majority vote. There is also a special intermediate appellate court in the federal system just for hearing matters regarding intellectual property: the United States Court of Appeals for the Federal Circuit. Congress established that court in 1982. This is the only U.S. Court of Appeals defined by its subject matter jurisdiction rather than by geography. The U.S. Court of Appeals for the Federal Circuit assumed the jurisdiction of the U.S. Court of Customs and Patent Appeals and the appellate jurisdiction of the U.S. Court of Claims. There are 15 judges on the Federal Circuit. The Supreme Court of the United States is the highest court in the federal judici- ary. That court has nine members, consisting of the Chief Justice of the United States and eight Associate Justices. All of the justices, rather than a panel, decide each case. The Court begins its work on the first Monday in October and concludes its term some- time in June of the following year. The workload of the Supreme Court increased sig- nificantly until the 1980s; since then the number of opinions that the Supreme Court issues has declined significantly. Typically, the justices decide less than 10 percent of the cases submitted to them for review. There is lively dispute about whether this figure is too large or too small. In the recent past some commentators have urged Congress to establish a national court of appeals between the courts of appeals and the Supreme Court. The argument is that this National Court would handle the more routine appeals arising from the thirteen circuits (for example , those in which there is a split among the circuits, which means that some circuits say the law is one way and other circuits say the opposite). Proponents say this would free up the Supreme Court to devote more of its energies to truly important cases. Finally, there are rules that specify whether a dispute should be heard in the state 7 or the federal court system. This is often a matter of great strategic significance in an attorney’s handling of a case. The general rules for deciding jurisdiction are relatively straightforward. State courts have jurisdiction in disputes involving state statutes or in civil actions between residents of that state or in cases arising under federal law when Congress has not given exclusive jurisdiction to the federal courts. The jurisdiction of the federal courts is defined by Congress, through the powers assigned in the Constitution. That jurisdiction is limited to three principal areas: 1. Federal questions—that is, those matters arising under the United States 8 Constitution or federal laws or treaties. 2. Cases to which the United States is a party. Typically, these are criminal cases under federal statute law. 7 The rules for resolving whether a state or federal law should apply in a particular dispute are complex and themselves constitute a special course in law school called “Conflict of Laws.” 8 There used to be a minimum dollar amount in controversy ($10,000) before a case could be a federal case, even if it was a federal question. That minimum no longer applies to matters arising under federal law.

77 62 CHAPTER 3 ief Introduction to Law and Legal Institutions A Br 3. Diversity cases—any civil dispute, currently involving more than $75,000, between citizens of different states. In the late eighteenth century, Congress allowed these disputes to be removed from state to federal courts because it felt that state loyalties were so strong that the citizen of another state might lose in a state court, regardless of the merits of his or her case, sim- 9 ply because he or she was a “foreigner.” In the event that a federal district court hears a diversity dispute involving a not federal question, the Court will generally apply the law of the state in which it sits. Today diversity of citizenship is no longer as compelling a reason for the federal courts to assume jurisdiction as it was 200 years ago. Indeed, former Chief Justice Burger urged Congress to ease the caseload of the federal judiciary by entirely removing the 10 diversity cases from federal jurisdiction. As to the selection and tenure of judges, there are two broad practices. For the fed- eral bench, the rule is appointment by the president with the advice and consent of the Senate for life tenure with removal only by impeachment by the House of Representatives and conviction by the Senate. For state judges in a majority of the states, the rule is election to the bench and limited tenure. For the remainder of the states, the state judiciary is nominated by the executive branch and approved by the leg- islature for varying, but fixed, terms. III. The Nature of a Legal Dispute A legal dispute arises when someone claims to have been illegally harmed at the hands of another. It is possible that the victim and the injurer can resolve their dispute themselves, but sometimes they cannot. The person who feels injured may have a cause of action , that is, a valid legal claim, against another person or organization. To assert that action, he files a complaint plaintiff . The com- and is, therefore, referred to as the plaint must state what has happened, why the plaintiff feels that he has been injured, what area of law is involved, what statute or other law is relevant, and what relief he wishes the court to give him. The complaint and the management of the subsequent as- pects of the dispute are complicated matters; typically, private citizens retain the serv- ices of a lawyer, who usually has far more experience in these matters than does the 11 citizen, to help them in all this. The person who is alleged to have injured the victim or plaintiff is called the defendant and must answer the complaint. The answer does not go into detail about the 9 In 2007 Congress raised the minimum amount in controversy in diversity cases in order to alter the case- load of the federal courts. Clearly, the greater the amount in controversy required, the fewer the number of diversity cases that will be eligible for resolution by the federal courts. 10 But there is still an argument for maintaining federal jurisdiction in diversity cases where the benefits of a decision may accrue to the people in one state and the costs fall on the people of another state. 11 Private citizens may, of course, represent themselves in a legal dispute. That is referred to as someone ap- pearing pro se —that is, “for himself.” A common joke among lawyers is that a person who represents him- self has a fool for a client.

78 III. The Nature of a Legal Dispute 63 matters at hand; rather, it is a short statement of what the defendant intends to argue in detail if the matter goes to trial. Thus, the answer may say that the facts as alleged are true but that even so, the defendant is not legally responsible for the plaintiff’s misfor- tune. Figuratively, this form of answer says, “So what?” Or the answer may say that the facts as alleged in the complaint are incorrect and that when the true facts are known, the defendant will be seen to be innocent of any wrongdoing. The dispute may well stop at this point. For example, the parties may decide not to their dispute—that proceed to trial. They may drop the whole matter, or they may settle is, reach a mutually satisfactory agreement between themselves. If the case is not set- tled or dropped, a judge must make a determination based on the complaint and the an- swer whether there is sufficient reason to proceed to trial. The judge may determine that the plaintiff has failed to state a valid cause of action or that the defendant has made a complete and convincing answer to the complaint. If so, she might dismiss the summary judgment complaint or enter for the defendant. Usually, she will allow the parties to proceed to trial. Parties may appeal from a summary judgment or a dismissal. If the dispute proceeds to trial, a jury may be empaneled to determine the facts, or else the case will be tried to a judge without a jury; this latter situation is called a bench trial . Each side will develop evidence and testimony supporting its assertions, and then 12 the jury or judge will retire to determine who wins. The standard that the jury or judge will use to make this determination is by a preponderance of the evidence . That means that if the plaintiff’s arguments are more believable than the defendant’s, then the plain- tiff wins; if the defendant’s are more believable, the defendant wins. Some people say that the preponderance-of-the-evidence standard means that if the plaintiff’s story is 51 per- cent believable, she wins. Notice that this standard, which is the routine standard in cases involving private parties as litigants, is different from the one that is used in criminal pro- beyond ceedings. There, the prosecution must convince the jury that the defendant is guilty a much more exacting standard than is preponderance of the evidence. a reasonable doubt, The courts can and have established other standards for prevailing in private law clear and convinc- disputes. For example, some jurisdictions have created a standard of for some aspects of a civil case, such as the award of punitive damages. ing evidence No one can be certain exactly what that standard entails, but it is certainly more de- manding than the preponderance-of-the-evidence standard and less demanding than the beyond-a-reasonable-doubt standard of criminal law. The jury returns with a verdict, which says, simply, which party wins. But the ver- dict is not the end of the matter. The judge must It is the enter judgment on the verdict. judgment, not the verdict, that is the controlling action of the court. Most of the time the judge issues a judgment that follows exactly the jury verdict. But in a few rare cases the judge decides that the jury got the matter entirely wrong and enters a judgment non obstante verdicto or j.n.o.v. (judgment notwithstanding the verdict), holding the exact opposite of what the jury decided. 12 Even after the trial has begun but before the judge or jury returns with a verdict, the parties are free to set- tle the case. There are even examples—about which we have a question in Chapter 11—regarding situa- tions in which the plaintiff has secretly settled with one of multiple defendants but allows the trial to go forward to a conclusion.

79 64 CHAPTER 3 ief Introduction to Law and Legal Institutions A Br In a civil dispute, either party, winner or loser, may appeal the court’s decision. The winner may appeal because he feels that he has not received everything to which he is en- titled; the loser may appeal for the obvious reason that he thinks that he ought to have won. Interestingly, the ground for the appeal must be that the court below made a mistake about law, including the relevant general principles that the court applied and the the relevant procedures that were used in court, but not about the For instance, the appellant (the facts. party filing the appeal) may allege that the judge gave the jury improper instructions about what the relevant law was, or about what facts they could and could not consider, or that the judge improperly excluded some evidence or testimony from the jury’s consideration. At the appellate level there will be no new evidence or facts introduced. The appel- late court takes the facts as developed in the trial court as given. The only people to ap- pear before the appellate panel will be the attorneys for the appellant and appellee. The attorneys will submit written briefs to the appellate panel and then appear before the panel for oral argument, during which they may receive very close questioning on the matters at hand. There may be additional briefs submitted by parties who are called amici curiae (friends of the court); these parties are not directly involved in the legal dispute but feel that the legal issue involved touches their interests sufficiently that they would like the court to consider their arguments in addition to those of the appellant and appellee. The appellate panel retires to consider the matter and later issues its opinion. The judges may be in unanimous agreement and issue only one opinion. However, there may be a split in the panel, and that split may result in multiple opinions: a majority and a minority or dissenting opinions. The appellate panel may affirm the lower court’s judgment or remands the matter that judgment. In some instances, the panel reverse (that is, sends it back) to the lower court for specific corrective action, such as a recal- culation of the damages owed to the plaintiff. IV. How Legal Rules Evolve We n ow c o n s i d e r a s e q u e n c e o f c a s e s i n o r d e r t o a p p l y t h e p r e c e d i n g i d e a s a n d tort law, show how law evolves. The three cases come from England and concern which covers accidents. 13 BUTTERFIELD V. FORRESTER , 11 EAST 60 (K.B., 1809) 14 This was an action on the case for obstructing a highway, by means of which obstruc- tion the plaintiff, who was riding along the road, was thrown down with his horse, and 15 injured, etc. At the trial before Bayley, J., at Derby, it appeared that the defendant, for the purpose of making some repairs to his house, which was close by the roadside at 13 Our selection and discussion of these cases owes a great debt to the stimulating lectures given by Professor Robert Summers to the Fifth Legal Institute for Economists. 14 The phrase “action on the case” refers to an old legal category of dispute. Simply read it as “dispute.” 15 “J.” means “Judge” or “Justice” and, by tradition, opinions are headed by the last name of the judge or jus- tice who wrote the opinion.

80 IV. How Legal Rules Evolve 65 one end of the town, had put up a pole across part of the road, a free passage being left by another branch or street in the same direction. That the plaintiff left a public house [a tavern] not far distant from the place in question at 8 o’clock in the evening in August, when they were just beginning to light candles, but while there was light enough left to discern the obstruction at one hundred yards distance; and the witness who proved this, said that if the plaintiff had not been riding very hard, he might have observed and avoided it; the plaintiff, however, who was riding violently, did not ob- serve it, but rode against it, and fell with his horse and was much hurt in consequence of the accident; and there was no evidence of his being intoxicated at the time. On this evidence, Bayley, J., directed the jury, that if a person riding with reasonable and ordi- nary care could have seen and avoided the obstruction; and if they were satisfied that the plaintiff was riding along the street extremely hard, and without ordinary care, they should find a verdict for the defendant, which they accordingly did. QUESTION 3.1: Who is the plaintiff? What is he asking the court to do? a. b. Is there a statute involved in this dispute? Who won? c. d. Was the jury asked to determine fact or law? How was the law stated? When this case was tried, English law accepted the principle that a defendant whose negligence caused the plaintiff’s injury would be held liable. Consequently, the judge instructed the jury that the defendant should be held liable if he could have avoided the accident by taking “reasonable” care. This case presented a novel issue: but further suppose that the victim was also Suppose that the defendant was negligent, negligent. Should the defendant still be held liable for the victim’s losses? An excerpt from the opinion of the judge in this appeal follows. LORD ELLENBOROUGH, C.J. A party is not to cast himself upon an obstruction which had been made by the fault of another, and avail himself of it, if he does not himself use common and ordinary caution to be in the right. In case of persons riding upon what is considered to be the wrong side of the road, that would not authorize another purposely to ride up against them. One person being in fault will not dispense with another’s using ordinary care for himself. Two things must concur to support this action: an obstruction in the road by the fault of the defendant, and no want of ordinary care to avoid it on the part of the plaintiff. [C]ontributory negligence is a complete bar to recovery. QUESTION 3.2: a. Who appealed the judgment? b. Who won the appeal? c. What is the judge’s holding?

81 66 CHAPTER 3 ief Introduction to Law and Legal Institutions A Br When precedent does not provide a clear rule for resolving a dispute, the judges must Novel disputes are the occasion for altering the law made by create such a rule. judges. Lord Ellenborough created a new precedent in this case. How broad is the new precedent? Under a narrow interpretation, the judge held that riders of horses cannot recover money damages for their injuries from a negligent defendant if they do not ride with ordinary care, and this lack of care contributes to the accident. This narrow inter- pretation says that the rule applies only to accidents like this one. Indeed, Lord Ellenborough’s example of a horseman riding on the wrong side of the road into an- other horseman riding on the correct side would seem to support this narrow interpreta- tion. But a broader interpretation of the court’s holding is possible, and did, in fact, come to be the common interpretation. Under a broad interpretation of the holding, Lord Ellenborough held that no plaintiffs can recover when their own negligence con- tributes to their injury (even if the defendant was negligent). This was new law. About 30 years later, another novel case arose involving similar facts. 16 DAVIES V. MANN , 10 M.&W. 545 (EX., 1842) At the trial, before ERSKINE, J., it appeared that the plaintiff, having fettered the fore- feet of an ass belonging to him, turned it into a public highway, and at the same time in question the ass was grazing on the off side of a road about eight yards wide, when the defendant’s wagon, with a team of three horses, coming down a slight descent, at what the witness termed a smartish pace, ran against the ass, knocked it down, and the wheels passing over it, it died soon after. . . . The learned judge told the jury, that . . . if they thought that the accident might have been avoided by the exercise of ordinary 16 The traditional English court system that took shape in the late twelfth century and prevailed until the late nineteenth century consisted of three common law courts and a court of equity. The first of the common law courts was the Court of Common Pleas. The members of that court were called “Justices” and were presided over by the Chief Justice. The court originally concentrated on civil disputes concerning land but came to consider a wider range of civil disputes. The Court of King’s Bench, the second common law court, was originally a criminal court but over time became a court of review over the civil issues appealed from the Court of Common Pleas. The third common law court was the Court of Exchequer of Pleas or, more simply, the Court of Exchequer. The Exchequer was the King’s treasury. This court originally heard disputes arising from tax liability and other matters concerning the King’s revenues. By the late sixteenth century, the Court of Exchequer had extended its jurisdiction to cover nearly all civil disputes. Members of that court, in which the appeal in Davies v. Mann was heard, were called “Baron,” abbreviated “B.,” and were presided over by the Chief Baron, abbreviated “C.B.” The equity court was the Court of Chancery, so called because it was presided over by the Chancellor, the most important member of the King’s Council. England established this court by the late fifteenth cen- tury as a separate court specializing in the dispensing of a more flexible kind of justice than that available in the so-called “law” courts, especially with respect to remedies. There is, therefore, a great historical and sub- stantive difference between the courts of law and the court of equity. One of the most important of those dif- ferences has to do with the types of remedies available to a successful plaintiff. Roughly speaking, a court of law would award only compensatory money damages—an amount that would compensate the plaintiff for his injury. A court of equity would possibly do more than that if the plaintiff could demonstrate that his in- juries were such that a payment of money damages would inevitably undercompensate him. ( continued )

82 IV. How Legal Rules Evolve 67 care on the part of the driver, to find for the plaintiff. The jury found their verdict for the plaintiff. . . . Godson now moved for a new trial, on the ground of misdirection. [That is, the de- fendant’s lawyer appealed the judgment on the ground that the judge in the trial court had incorrectly instructed the jury on the law to be applied to the facts in this case.] The act of the plaintiff in turning the donkey into the public highway was an illegal one, and, as the injury arose principally from that act, the plaintiff was not entitled to compensation for that injury which, but for his own unlawful act would never have occurred. . . . The principle of law, as deducible from the cases is, that where an acci- dent is the result of faults on both sides neither party can maintain an action. Thus, in Butterfield v. Forrester , 11 East 60, it was held that one who is injured by an obstruc- tion on a highway, against which he fell, cannot maintain an action, if it appear that he was riding with great violence and want of ordinary care, without which he might have seen and avoided the obstruction. LORD ABINGER, C.B. [A]s the defendant might, by proper care, have avoided injur- ing the animal, and did not, he is liable for the consequences of his negligence, though the animal may have been improperly there. PARKE, B. [T]he negligence which is to preclude a plaintiff from recovering in an ac- tion of this nature, must be such as that he could, by ordinary care, have avoided the consequences of the defendant’s negligence. [A]lthough the ass may have been wrongfully there, still the defendant was bound to go along the road at such a pace as would be likely to prevent mischief. Were this not so, a man might justify the driv- ing over goods left on a public highway, or even over a man lying asleep there, or the purposely running against a carriage going on the wrong side of the road. . . . [New trial denied.] QUESTION 3.3: Who appealed the judgment? a. b. Who won the appeal? What is the judge’s holding? Actually, there are three opinions. Are they in accord? c. A plaintiff has suffered a loss: His donkey was killed, allegedly because the defen- dant was driving a wagon too quickly for the conditions on the road. However, the plaintiff himself was negligent for having left his donkey unattended, although fettered, beside a public road. Strictly following the rule in Butterfield, the plaintiff’s fault or negligence contributed to his losses and thus should bar his recovery. That is precisely what Mann’s lawyer argued in appealing the judgment for the plaintiff in the lower court. But at the trial, the court believed that the facts in Davies v. Mann were In the Judicature Act of 1873 and the Supreme Court of Judicature (Consolidation) Act of 1925, the British Parliament replaced all of these courts—and the distinction between law and equity—with a greatly simplified structure that drew no distinction between common law and equity. As we shall see in Chapter 4, these dusty historical matters are relevant to one of the most famous ex- amples of law and economics: the Calabresi and Melamed argument regarding the most efficient method of protecting a legal entitlement.

83 68 CHAPTER 3 ief Introduction to Law and Legal Institutions A Br distinguishable from those in earlier cases in which a contributorily negligent plaintiff was not allowed to recover from a negligent defendant. There appear to be two reasons for excusing the plaintiff’s negligence in Lord Abinger’s and Baron Parke’s opinions. First, there is the element of time. Although the plaintiff was negligent in leaving his donkey unattended on the public highway, the defendant’s negligence came afterward. And if the defendant had not been driving recklessly, he would have had time to avoid the donkey by stopping or swerving—even though the donkey ought not to have been unattended where he was. Apparently, the defendant’s negligence came afterward and controlled the outcome. This doctrine has come to be known as the “last clear chance” rule: If both parties to an accident are negligent, the party who had the last clear chance to avoid the accident will be held responsible for losses arising from the accident. The second argument for excusing the plaintiff’s negligence is to encourage pre- cautions in the future by people situated like the defendant. Again, Baron Parke puts the point nicely, “[A]lthough the ass may have been wrongfully there, still the defen- dant was bound to go along the road at such a pace as would be likely to prevent mis- chief. Were this not so, a man might justify the driving over goods left on a public highway, or even over a man lying asleep there, or the purposely running against a car- riage going on the wrong side of the road.” This interpretation of the law suggests that rules should create incentives for avoiding accidents. Davies v. Mann Notice that Butterfield v. changes the law handed down in Fo r re s t e r . The blanket rule from the earlier case—contributory negligence is a com- plete bar to recovery—was amended by judges who faced a new situation. We may say that after Davies v. Mann the legal rule became: Contributory negligence is a complete bar to recovery unless the defendant had the last clear chance to avoid the accident and did not take that chance. The “last clear chance” doctrine was quickly adopted throughout the common law 17 world. 17 But that is not the end of the story of contributory negligence and “last clear chance.” For a fascinating further episode, see . v. Loach, [1916] 1 A.C. 719. In brief, here is British Columbia Electric Rail Co., Ltd what was at dispute in that case: Benjamin Sands was driving a horse-drawn wagon and talking with a friend. Not paying attention to his surroundings, he pulled onto the train tracks and stopped. He looked up to see a train coming. The train’s engineer applied the brakes as soon as he saw Sands and his wagon on the tracks. Unfortunately, the brakes, unknown to the engineer, were defective and failed to stop the train before it ran into and killed Mr. Sands. Loach, the executor of Sands’s estate, sued the British Columbia Electric Rail Co. on a theory of negligence. The railroad claimed, following Butterfield, that it should not be held liable because Sands was contributorily negligent. Loach answered that the railroad had, following Davies, the last clear chance to avoid the injury and did not take that chance. The railroad claimed that it had not, in fact, had the last clear chance because its brakes were defective. (Everyone agreed that the train would have stopped in time had the brakes been in good working order and that the railroad should have checked the brakes before leaving the roundhouse that morning.) The holding was that the railroad should be held liable: To hold otherwise would, the court said, create an incentive not to maintain one’s train (or car or wagon or other device) in good working order.

84 Suggested Readings 69 Conclusion To s u m m a r i z e , w e c o m p a r e d t h e t wo g r e a t l eg a l t r a d i t i o n s — t h e c iv i l l aw a n d t h e common law. We examined the hierarchical structure of U.S. courts. We saw some of the general characteristics of a legal dispute: a plaintiff who alleges that he or she has been wronged by a defendant and seeks the courts’ help in getting relief. We learned some methods that judges use to resolve novel issues. Finally, we looked at the evolu- tion of the doctrine of contributory negligence as developed by courts. This chapter provides a brief, selective introduction to some of the basic facts about law, which we analyze using economics in the rest of the book. Suggested Readings , H AROLD J., & W ILLIAM R. G B , T HE N AT U R E A N D F UNCTIONS OF L AW ERMAN REINER (4th ed. 1980). ARDOZO , B ENJAMIN , T HE N AT U R E O F T HE J UDICIAL P ROCESS (1921). C E C , M A., T HE N ISENBERG ELVIN OMMON L AW (1989). AT U R E O F T H E MERICAN RANKLIN , M ARC A., T HE B IOGRAPHY OF A L EGAL D ISPUTE : A N I NTRODUCTION TO A F C P ROCEDURE (1968). IVIL NTRODUCTION TO EVI DWARD (1949). N I , E L EGAL R EASONING H., A L YSTEMS OF ERRYMAN , J OHN H., T HE C IVIL L AW T RADITION : A N I NTRODUCTION TO THE L EGAL S M W ESTERN E UROPE AND L AT I N A MERICA (2nd ed. 1985).

85 An Economic Theory of Property 4 There is nothing which so generally strikes the imagination and engages the affections of mankind, as the right of property; or that sole and despotic dominion which one man claims and exercises over the external things of the world, in total exclusion of the right of any other individual in the universe. , W ILLIAM LACKSTONE B C E P . 2 (1765–69) OMMENTARIES ON THE , BK. II, CH. 1, AWS OF NGLAND L In the African tribe called the Barotse, “property law defines not so much the rights of persons over things as the obligations owed between persons in respect of things.” , M AX G LUCKMAN I J URISPRUDENCE 171 (1965) AROTSE B DEAS IN [T]he theory of the Communists may be summed up in a single sentence: Abolition of private property. ARX & F RIEDRICH E K , ARL M NGELS T M ANIFESTO (1848) C HE OMMUNIST HE LAW OF property supplies the legal framework for allocating resources and distributing wealth. As the contrasting quotes above indicate, people and soci- T eties disagree sharply about how to allocate resources and distribute wealth. Blackstone viewed property as providing its owner with complete control over re- sources, and he regarded this freedom to control material things as “the guardian of every other right.” Gluckman found that property in an African tribe called the Barotse conveyed to its owner responsibility, not freedom. For example, the Barotse hold rich persons responsible for contributing to the prosperity of their kin. Finally, Marx and Engels regarded property as the institution by which the few enslaved the many. Classical philosophers try to resolve these deep disputes over social organization by explaining what property really is. The appendix to this chapter provides some examples of philosophical theories, such as the theory that property is an expectation (Bentham), xpression (Hegel), or the foun- the object of fair distribution (Aristotle), a means of self-e dation of liberty in community life (Burke). to explain what property Instead of trying really is, an economic theory tries to predict the effects of alternative forms of ownership, especially the effects on efficiency and distribution. We shall make such predictions about alternative property rules and institutions. 70

86 CHAPTER 4 An 71 Economic Theory of Property Here are some examples of problems addressed by property rules and institutions that we will analyze: “This morning in a remote meadow in Wyoming, a mule Example 1: 1 was born. To whom does that mule belong?” Does the mule belong to (1) the owner of the mule’s mother, (2) the lumber company that has leased the land on which the mule was grazing, or (3) the federal government because the property is a national forest? Orbitcom, Inc., spent $125 million designing, launching, Example 2: and maintaining a satellite for the transmission of business data between Europe and the United States. The satellite is positioned in a geosynchronous orbit 2 25 miles above the Atlantic Ocean. Recently a natural resource-monitoring satel- lite belonging to the Windsong Corporation has strayed so close to Orbitcom’s satellite that the company’s transmissions between Europe and the United States have become unreliable. As a result, Orbitcom has lost customers and has sued Windsong for trespassing on Orbitcom’s right to its geosynchronous satellite orbit. Example 3: Foster inspects a house under construction in a new subdivi- sion on the north side of town and decides to buy it. The day after she moves in, the wind shifts and begins to blow from the north. She smells a powerful stench. On inquiring, she learns that a large cattle feedlot is located north of the subdivi- sion, just over the ridge, and, to make matters worse, the owner of this old busi- ness plans to expand it. Foster joins other property owners in an action to shut down the feedlot. Example 4: Bloggs inherits the remnant of a farm from his father, most of which has already been sold for a housing development. The remaining acreage, which his father called “The Swamp,” is currently used for fishing and duck hunting, but Bloggs decides to drain and develop it as a residential area. However, scientists at the local community college have determined that Bloggs’s property is part of the wetlands that nourish local streams and the fish in the town’s river. The town council, hearing of Bloggs’s plans, passes an ordinance for- bidding the draining of wetlands. Bloggs sues for the right to develop his prop- erty, or, failing that, for an order compelling the town to buy the property from him at the price that would prevail if development were allowed. Example 5: A county ordinance requires houses to be set back 5 feet from the property line. Joe Potatoes buys some heavily wooded land in an unde- veloped area and builds a house on it. Ten years later Fred Parsley, who owns the adjoining lot, has his land surveyed and discovers that Potatoes’s house extends 2 feet over the property line onto Parsley’s property. Potatoes offers to compen- sate Parsley for the trespass, but Parsley rejects the offer and sues to have Potatoes relocate the house in conformity with the ordinance. 1 This remarkable question is how Professor John Cribbet, one of the leading scholars of property law, opened his first lecture on property to first-year law students at the University of Illinois College of Law. 2 A geosynchronous orbit means that the satellite is traveling around the Earth at exactly the same speed at which the Earth is turning so that the satellite appears to remain stationary above a point on the Earth’s surface.

87 72 CHAPTER 4 Economic Theory of Property An These five examples capture some of the most fundamental questions that any system of property law must answer. The first and second examples ask how property rights are initially assigned. Orbitcom apparently bases its ownership claim on having placed a satellite in the orbit in dispute before anyone else. This claim appeals to a legal principle called the rule of first possession , according to which the first party to use an unowned resource acquires a claim to it. (How might this rule apply to the mule born on the remote Wyoming meadow?) The general issue raised here is, “How does a person acquire ownership of something?” The second example also asks what kinds of things may be privately owned. Orbitcom asserts that a satellite orbit may be privately owned like land or a musical composition, whereas Windsong feels, perhaps, that orbits should be commonly owned by all and open to all on the same terms, like the high seas. Economics has a lot to say about the consequences of resources being privately owned, commonly owned, or unowned. The third example concerns a problem sometimes known as “incompatible uses.” May one property owner create a stench on his own property that offends his neigh- bors? In general, the law tries to prevent property owners from interfering with each other, but in this example, as in many other cases, there is a trade-off between compet- ing activities. Is the cattle feedlot interfering with the homeowner by creating the stench, or is the homeowner interfering with the feedlot by moving nearby and seeking to shut it down? The legal outcome turns in part on whether the stench constitutes a “nuisance” as defined by law. Economics has a lot to say about this determination. The fourth example, like the third, raises the question, “What may owners legiti- mately do with their property?” The difference is that Example 3 concerns a dispute between private owners and Example 4 concerns a dispute between a private owner and a government. The specific question in Example 4 is whether a property owner can develop his land according to his own wishes or must conform to restrictions on development imposed by a local government. The general question concerns the ex- tent to which government may constrain a private owner’s use of her property. We will show that economics has a lot to say about government’s regulating and taking private property. In the last example, one property owner has encroached on the land of another, but that encroachment has gone undetected and without apparent harm for many years. The question raised by this example concerns the remedy for trespass. Should the owner be denied a remedy because the trespass has persisted for so long? Alternatively, should the court award compensatory damages to the owner? Or should the court enjoin the trespasser and force him to move his house? As we shall see, economics predicts the effects of various remedies and thus provides a powerful tool for choosing the best one. We s h a l l a l s o s e e w h y c o u r t s p r e f e r t h e remedy of issuing an order called an “injunc tion” to stop trespassing or otherwise interfering with the property owner. The examples raise these four fundamental questions of property law: 1. How are ownership rights established? 2. What can be privately owned? 3. What may owners do with their property? 4. What are the remedies for the violation of property rights?

88 I. The Legal Concept of Property 73 In the next two chapters we shall be using economics to answer these questions. Traditional legal scholarship on property law is notoriously weak in its use of the- 3 ory, at least in comparison to contracts and torts. This fact contributes to the feel- ing of many students that the common law of property is diffuse and unorganized. Through economics it is possible to give the subject more coherence and order. In this chapter we concentrate on developing fundamental tools for the economic analysis of property: bargaining theory, public goods theory, and the theory of externalities. In the next chapter we apply these tools to a large number of property laws and institutions. I. The Legal Concept of Property bundle of rights . These rights describe what From a legal viewpoint, property is a people may and may not do with the resources they own: the extent to which they may possess, use, develop, improve, transform, consume, deplete, destroy, sell, donate, be- queath, transfer, mortgage, lease, loan, or exclude others from their property. These rights are not immutable; they may, for example, change from one generation to an- other. But at any point in time, they constitute the detailed answer of the law to the four fundamental questions of property law listed above. Three facts about the bundle of legal rights constituting ownership are fundamen- tal to our later understanding of property. First, these rights are impersonal in the sense that they attach to property, not persons. Any person who owns the property has the rights. In this respect, property rights are different from contract rights. Contract rights personal are in the sense that one person owes something to another person. Second, the owner is free to exercise the rights over his or her property, by which we mean that no law forbids or requires the owner to exercise those rights. In our example at the beginning of the chapter, Parsley can farm his land or leave it fallow, and the law is indifferent as to which he chooses to do. Third, others are forbidden to interfere with the owner’s exercise of his rights. If others interfere, the court will enjoin them to stop—the court will issue an order that they must stop interfering on pain of punish- ment for contempt of court. Thus, if Parsley decides to farm his land, Potatoes can- not put stones in the way of the plow. This protection is needed against two types of interlopers—private persons and the government. The legal conception of property is, then, that of a bundle of rights over resources that the owner is free to exercise and whose exercise is protected from interference by others. Thus, property creates a zone of privacy in which owners can exercise their will over things without being answerable to others, as stressed in the preceding quote from 3 In contracts and torts there was a classical theory that dominated American law at the beginning of the twentieth century. The introductory chapters on contracts and torts describe these classical theories. There was, however, no classical theory of property of comparable coherence, detail, or stature. Instead there is a long philosophical tradition of analyzing the institution of property at a very abstract level. Some of these philosophical theories of property are described in the appendix to this chapter.

89 74 CHAPTER 4 Economic Theory of Property An Blackstone. These facts are sometimes summarized by saying that property gives owners liberty over things. This general definition of property is compatible with many different theories of what particular rights are to be included in the protected bundle and of how to protect those rights. It is also consistent with different accounts of the responsibili- ties that a person assumes by becoming an owner. The law has tended to look be- yond itself to philosophy for help in deciding which rights to include in the bundle of property rights. In the approach taken in this chapter, we focus on how alternative bundles of rights create incentives to use resources efficiently. An efficient use of resources maximizes the wealth of a nation. We begin by showing how the right to exchange property con- tributes to the nation’s wealth. 4 II. Bargaining Theory To d eve l o p a n e c o n o m i c t h e o r y o f p r o p e r t y, w e m u s t fi r s t d eve l o p t h e e c o - nomic theory of bargaining games. At first you may not see the relevance of this theory to property law, but later you will recognize that it is the very foundation of the economic theory of property. The elements of bargaining theory can be devel- oped through an example of a familiar exchange—selling a used car. Consider these facts: Adam, who lives in a small town, has a 1957 Chevy convertible in good repair. The pleasure of owning and driving the car is worth $3000 to Adam. Blair, who has been coveting the car for years, inherits $5000 and decides to try to buy the car from Adam. After inspecting the car, Blair decides that the pleasure of owning and driving it is worth $4000 to her. According to these facts, an agreement to sell will enable the car to pass from Adam, who values it at $3000, to Blair, who values it at $4000. The potential seller values the car less than the potential buyer, so there is scope for a bargain. Assuming that exchanges are voluntary, Adam will not accept less than $3000 for the car, and Blair will not pay more than $4000, so the sale price will have to be somewhere in between. A reasonable sale price would be $3500, which splits the difference. The logic of the situation can be clarified by restating the facts in the language of game theory. The parties to the kind of game represented by this example can both benefit from cooperating with each other. To be specific, they can move a resource (the car) from someone who values it less (Adam) to someone who values it more (Blair). Moving the resource in this case from Adam, who values it at $3000, to Blair, 4 Bargaining theory is a form of game theory. See the section on game theory in Chapter 2 for some useful background information.

90 II. Bargaining Theory 75 cooperative surplus is the who values it at $4000, will create $1000 in value. The name for the value created by moving the resource to a more valuable use. Of course, the share of this surplus that each party receives depends on the price at which the car is sold. If the price is set at $3500, each will enjoy an equal share of the value created by the exchange, or $500. If the price is set at $3800, the value will be divided un- equally, with Adam enjoying 4/5 or $800, and Blair enjoying 1/5 or $200. Or if the price is set at $3200, Adam will enjoy $200 or 1/5 of the value created, whereas Blair will enjoy $800 or 4/5. The parties typically bargain with each other over the price. In the course of nego- tiating, the parties may assert facts (“The motor is mechanically perfect. . . .”), appeal to norms (“$3700 is an unfair price. . . .”), threaten (“I won’t take less than $3500. . . .”), and so forth. These are the tools used in the art of bargaining. The fact that the parties can negotiate is an advantage of bargaining or cooperative games relative to other games (called games), such as the famous Prisoner’s Dilemma, which noncooperative we examined in Chapter 2. Even when negotiation is possible, however, there is no guarantee that it will succeed. If the negotiations break down and the parties fail to co- operate, their attempt to shift resources to a more valuable use will fail, and they will not create value. Thus, the obstacle to creating value in a bargaining game is that the parties must agree on how to divide it. Value will be divided between them at a rate determined by the price at which the car is sold. Agreement about the car’s price marks successful negotiations, whereas disagreement marks a failure in the bargain- ing process. To a p p l y g a m e t h e o r y t o t h i s ex a m p l e , l e t u s c h a r a c t e r i z e t h e p o s s i b l e o u t c o m e s as a cooperative solution and a noncooperative solution. The cooperative solution is the one in which Adam and Blair reach agreement over a price and succeed in ex- changing the car for money. The noncooperative solution is the one in which they fail to agree on a price and fail to exchange the car for money. To analyze the logic of bargaining, we must first consider the consequences of noncooperation. If the parties fail to cooperate, they will each achieve some level of well-being on their own. Adam will keep the car and use it, which is worth $3000 to him. Blair will keep her money—$5000—or spend it on something other than the car. For simplicity, assume that the value she places on this use of her money is its face value, specifically, $5000. Thus, the payoffs to the parties in the noncooperative solution, called their threat values , are $3000 for Adam (the value to him of keeping the car) and $5000 to Blair (the amount of her cash). The total value of the noncooperative solution is + $3000 = $8000. $5000 In contrast, the cooperative solution is for Adam to sell the car to Blair. Through cooperation, Blair will own the car, which is worth $4000 to her, and in addition, the two parties will each end up with a share of Blair’s $5000. For example, Adam might accept $3500 in exchange for the convertible. Blair then has the car, worth $4000 to her, and $1500 of her $5000. Thus, the value of the cooperative solution is $4000 + $1500 (the amount that Blair retains of her original (the value of the car to Blair) $5000) + $3500 (the amount received by Adam for the car) = $9000. The surplus from cooperation is the difference in value between cooperation and noncooperation: $9000 - $8000 = $1000.

91 76 CHAPTER 4 Economic Theory of Property An In any voluntary agreement, each player must receive at least the threat value or there is no advantage to cooperating. A reasonable solution to the bargaining prob- lem is for each player to receive the threat value plus an equal share of the cooperative 5 surplus: specifically, $3500 for Adam and $5500 for Blair. To a c c o m p l i s h t h e d iv i s i o n , Blair should pay Adam $3500 for the car. This leaves Adam with $3500 in cash and no car, and leaves Blair with a car worth $4000 to her and $1500 in cash. UESTION 4.1: Suppose Adam receives a bid of $3200 from a third party Q named Clair. How does Clair’s bid change the threat values, the surplus from cooperation, and the reasonable solution? We h ave ex p l a i n e d t h a t t h e p r o c e s s o f b a rg a i n i n g c a n b e d iv i d e d i n t o t h r e e s t e p s : establishing the threat values, determining the cooperative surplus, and agreeing on terms for distributing the surplus from cooperation. These steps will be used in the next section to understand the origins of the institution of property. Before proceeding, however, we must warn you about a common problem in the economic analysis of law. In general, economic analysis sometimes uses morally or legally insensitive language to describe useful concepts. “Threat value” is an example. “Threat” connotes “coercion” and coercion often voids a contract or constitutes a tort or crime. If you are speaking to a judge or juror, do not say “threat” unless you intend to connote illegality. This is one example where you will need to substitute other terms for economic language. Refusing to cooperate with the other party and going alone is usually legal. Instead of “threat value” you might try the phrase “ fallback position ” or “ go-it-alone value. ” III. The Origins of the Institution of Property: A Thought Experiment The bargaining model shows how cooperation can create a surplus that benefits everyone. This type of reasoning can be used to perform a thought experiment that is helpful in understanding the origins of property. 5 Economists have long struggled with the fact that self-interested rationality alone does not seem sufficient to determine the distribution of the cooperative surplus. That is why we use the term reasonable solution, which invokes social norms, rather than rational solution . To see the difference, consider this rational ac- count of the division of the cooperative surplus. Suppose that somehow Adam knows that the cooperative surplus resulting from an agreement between Blair and him is $1000. Being perfectly rational, he says to Blair that he will sell the car to her for $3995. And, further, he explains to her why she should accept that price, even though it gives Adam $995 of the cooperative surplus and Blair, $5: “If you do not accept that price, I will not do business with you, in which case you will realize $0 worth of cooperative surplus. At the $3995 price, you get $5 of the cooperative surplus and that surely is better than nothing.” Leaving aside all the strategic reasons that Blair might balk at this (Will Adam really walk away if she refuses?), this division of the cooperative surplus is perfectly rational, but it may not be reasonable. In fact, carefully controlled experiments have demonstrated that most people would not accept Adam’s offer, rational though it be.

92 III. The Origins of the Institution of Property: A Thought Experiment 77 A Civil Dispute as a Bargaining Game Because trials are costly, both parties can usually gain by settling out of court. That is why so few disputes ever come to trial. As we will see in Chapter 10, the best current estimate is that approximately 5 percent of all disputes that reach the stage of filing a legal complaint in the United States actually result in litigation. Here is a problem in which you must apply bargain- ing theory to a civil dispute: F ACTS : Arthur alleges that Betty borrowed a valuable kettle and broke it, so he sues to recover its value, which is $300. The facts are very confusing. Betty con- tends that she did not borrow a kettle from Arthur; even if it is proved that she bor- rowed a kettle from Arthur, she contends it is not broken; even if it is proved that she borrowed a kettle from Arthur and that it is broken, she contends that she did not break it. Assume that because the facts in the case are so unclear, Arthur and Betty in- dependently believe that the chances of either side’s winning in court are an even 50 percent. Further assume that litigation in small claims court will cost each party $50 and that the costs of settling out of court are nil. So, cooperation in this case is a matter of settling out of court and saving the cost of a trial. Noncooperation in this case means trying the dispute. QUESTIONS: a. What is Arthur’s threat value? b. What is Betty’s threat value? c. If Arthur and Betty cooperate together in settling their disagreement, what is the net cost of resolving the dispute? d. What is the cooperative surplus? e. A reasonable settlement would be for Betty to pay Arthur _____. f. Suppose that instead of both sides believing that there is an even chance of win- ning, both sides are optimistic. Specifically, Arthur thinks that he will win with prob- ability 2/3, and Betty thinks that she will win with probability 2/3. 1. What is Arthur’s putative threat value (what he believes he can secure on his own without Betty’s cooperation)? 2. What is Betty’s putative threat value (what she believes she can secure on her own without Arthur’s cooperation)? 3. The putative cooperative surplus equals _____. 4. Describe the obstacle to settlement in a few words. Let us imagine a simplified world in which there are people, land, farm tools, and weapons but no courts and no police. In this imaginary world, government does not vindicate and protect the rights to property asserted by the people who live on the land. Individuals, families, or alliances of families enforce property rights to the extent that they defend their land holdings. People must decide how many resources to devote to defending their property claims. Rational people allocate their limited resources so that,

93 78 CHAPTER 4 Economic Theory of Property An as we saw in Chapter 2, the marginal cost of defending land is just equal to the mar- ginal benefit. This means that at the margin, the value of the resources used for military ends (the marginal benefit) equals their value when used for productive ends, such as raising crops and livestock (marginal [opportunity] cost). For example, the occupants are rational if allocating a little more time to patrolling the perimeter of the property preserves as much additional wealth for the defenders as they would enjoy by allocat- ing a little more time to raising crops. The same statement could be made about allo- cating land between crops and fortifications, or about beating metal into swords or plowshares. These facts describe a world in which farming and fighting are individually rational. But are they socially efficient? In Chapter 2 we offered the following defini- tion of inefficient production: The same (or fewer) inputs could be used to produce a greater (or the same) total output. Can some mechanism be found that uses fewer resources to achieve the same level of protection for property claims? One possible mechanism is law. Suppose that the costs of operating this system of property rights are less than the sum of all individual costs of private defense. Such a mechanism would allow the transfer of resources from fighting to farming. For example, the landowners might create a government to protect their property rights at lower cost in individual taxes than each individual spends on fighting. The savings might come from economies of scale in having one large army in the society to defend everyone, 6 In other words, there may be a rather than many small, privately financed armies. natural monopoly on force. We c o u l d i m a g i n e t h e p a r t i e s b a rg a i n i n g t o g e t h e r ove r t h e t e r m s f o r e s t a b l i s h i n g a government to recognize and enforce their property rights. They are motivated by the realization that there are economies of scale in protecting property. By reaching an agreement to have one government backed by one army, everyone can enjoy greater wealth and security. The bargain eventually reached by such negotiations is called the 7 social contract by philosophers because it establishes the basic terms for social life. It would be rational for the parties negotiating the social contract to take account of other rights of owners besides the right to exclude. Many of the rights that are currently in the bundle called property could be considered, such as the right to use, transfer, and transform. Indeed, many rights other than property rights could be a part of the social contract, such as freedom of speech and freedom of religion, but they do not concern us in this chapter. 6 Recall that economies of scale occur when the cost per unit (or average cost of production) declines as the total amount of output increases. A production technology for which the unit costs are falling at every level natural monopoly because one producer can sell at a lower of production, even very large levels, is called a price than many smaller producers. 7 The social contract has usually been thought of as a logical construct, but some theorists have used it to explain history. For example, it has been argued that feudalism in the Middle Ages corresponds roughly to the conditions of our imaginary world. The economic factors that caused this system to be replaced in some parts of Western Europe by a system of private property rights enforced by a central government are discussed in D (1973). C. N ORTH & R OBERT P AUL T HOMAS , THE R ISE OF THE W ESTERN W ORLD OUGLASS

94 III. The Origins of the Institution of Property: A Thought Experiment 79 The same bargaining model used to explain the sale of a secondhand car can be applied to this thought experiment, in which a primitive society develops a system of property rights. First, a description is given of what people would do in the absence of civil government, when military strength alone established ownership claims. That state of nature situation—called the —corresponds to the threat values of the noncooper- ative solution, which prevails if the parties cannot agree. Second, a description is given of the advantages of creating a government to recognize and enforce property rights. Civil society, in which such a government exists, corresponds to the game’s cooperative solution, which prevails if the parties can agree. The social surplus, defined as the differ- ence between the total amount spent defending land in the state of nature and the total cost of operating a property-rights system in civil society, corresponds to the coopera- tive surplus in the game. Third, an agreement describes the methods for distributing the advantages from cooperation. In the car example, this agreement arises from the price that the buyer offers and the seller accepts. In the thought experiment, this agreement arises from the social contract that includes the fundamental laws of property. To s e e t h e p a r a l l e l m o r e c l e a r l y, i m a g i n e t h a t o u r wo r l d c o n s i s t s o f o n l y t wo A people, B . In a state of nature, each one grows some corn, steals corn from and the other party, and defends against theft. Each of the parties has different levels of skill at farming, stealing, and defending. Their payoffs in a state of nature are sum- A and B produce 200 units of corn, but it gets marized in Table 4.1. Taken together, A steals 40 units of corn from B and loses 10 reallocated by theft. For example, units of corn to B through theft. Notice that A ultimately enjoys 80 units of corn, and B enjoys 120 units, after taking into account the gains and losses from theft. and B may decide to enter into a co- Instead of persisting in a state of nature, A operative agreement, recognize each other’s property rights, and adopt an enforce- ment mechanism that puts an end to theft. Let us assume that cooperation will enable them to devote more resources to farming and fewer resources to fighting, so that total production will rise from 200 units to 300 units. One hundred units thus constitutes the social or cooperative surplus. In civil society there will be a mecha- nism for distributing the surplus from cooperation, such as government taxes and subsidies. The parties must decide through bargaining how this is to be done. A rea- sonable division of that surplus gives each party an equal share. So, in civil society, each party receives half the cooperative surplus plus the individual net consumption TABLE 4.1 The State of Nature Corn Corn Gained Corn Lost Net Corn by Theft Grown Through Theft Farmer Consumption A5040 80 210 B15010 240 120 Totals 200 50 250 200

95 80 CHAPTER 4 Economic Theory of Property An TABLE 4.2 Civil Society Net Corn Consumption Farmer Share of Surplus Threat Value A 130 50 80 120 170 B 50 Totals 300 100 200 in the state of nature, which is each party’s threat value. These facts are summarized in Table 4.2. What is the meaning of this “thought experiment” concerning the origins of prop- erty? Read literally, you might conclude that individuals or tribes acquire government by meeting together and agreeing to create a system of law, including property rights. This literal reading is bad history and bad anthropology. Instead of a contract, a system of property law can begin with a military conquest, a rebellion against feudalism, or the disintegration of communism. Instead of history, the thought experiment is really about processes that go on all the time. In a changing society, new forms of property arise continually. To illustrate, prop- erty law for underground gas and the electromagnetic spectrum (radio and television broadcasting) developed in the United States during the last century; and property law for computer software, music, video, and other material on the Internet, and genetically engineered forms of life developed in the last several decades. The need for a new form of property law arises in situations corresponding to our thought experiment. For ex- ample, like corn, digital music can be stolen. Without effective property law, people in- vest a lot of resources in stealing that music or trying to prevent its theft. These efforts redistribute music, rather than invent or manufacture it. Now the United States has property law that prevents the stealing of digital music. The imposition of these laws may have greatly stimulated the production of music. So, our thought experiment is re- ally a parable about the incentive structure that motivates societies to continually create property. The first question that we posed about property law is, “How are property rights established?” This is a question about how an owner acquires the legal right to prop- erty. Our thought experiment answers the question, “Why are ownership rights estab- lished?” This is a question about why a society creates property as a legal right. The two questions are closely connected. Societies create property as a legal right to en- courage production, discourage theft, and reduce the costs of protecting goods. Law prescribes various ways that someone can acquire a property right, such as by finding and purchasing land with natural gas beneath it, inventing a computer program, or dis- covering sunken treasure. We now turn to the elaboration of how bargaining theory can help the law pre- scribe ways for the acquisition of property that also encourage production, or discour- age theft, and reduce the costs of protecting goods.

96 IV. An Economic Theory of Property 81 UESTION 4.2: Q ? Can the resulting inequality in civil society a. Is the cooperative solution fair be justified? To answer these questions, draw on your intuitive ideas of fair- ness or, better still, a concept of fairness developed by a major philosopher such as Hobbes, Locke, Rawls, or Aristotle. b. Suppose that the bargaining process did not allow destructive threats, such as the threat to steal. How might this restriction affect the distribution of the surplus? c. What is the difference between the principle, “To each according to his threat value,” and this principle, “To each according to his productivity”? IV. An Economic Theory of Property The fact that the same theory of bargaining can be applied to selling a used car or creating a civil society is proof of that theory’s generality and power. Indeed, bargaining theory is so powerful that, as this section will show, it serves as the basis for an economic theory of property and of property law. Let us briefly summarize where we are going. By bargaining together, people frequently agree on the terms for interacting and cooperating. But sometimes the terms for interacting and cooperating are imposed on people from the outside—for example, by law. The terms are often more efficient when people agree on them than when a lawmaker or conqueror imposes them. It follows that law is unnecessary and undesirable where bargaining succeeds, and that law is neces- sary and desirable where bargaining fails. These propositions apply to the four questions about property that we asked above. In certain circumstances we do not need property law to answer the four questions that we posed at the beginning of this chapter. Rather, in those special circumstances, pri- vate bargaining will establish what things are property, who has claims to that property, what things an owner may and may not do with the property, and who may interfere with an owner’s property. The special circumstances that define the limits of law are specified in a remarkable proposition called the Coase Theorem . This theorem, to which we now turn, helped to found the economic analysis of law and won its inventor the Nobel Prize in economics. 8 A. The Coase Theorem Different commentators formulate the Coase Theorem differently. We will ex- pound a simple version of the theorem and then acquaint you with some of the commentary. 8 The theorem is discussed in Professor Ronald H. Coase’s The Problem of Social Cost , 3 J. L AW & E CON . 1 ERRING (1960). The article has been reprinted in numerous legal and economic anthologies, notably R. B (1984) (a compendium of the 22 “greatest” articles published in the ., G REAT A MERICAN L AW R EVIEWS ED United States’ law reviews before 1965).

97 82 CHAPTER 4 Economic Theory of Property An FIGURE 4.1 Ranch tilled Farm Consider the example of the rancher and the farmer as depicted in Figure 4.1. A cattle rancher lives beside a farmer. The farmer grows corn on some of his land and leaves some of it uncultivated. The rancher runs cattle over all of her land. The boundary between the ranch and the farm is clear, but there is no fence. Thus, from time to time the cattle wander onto the farmer’s property and damage the corn. The damage could be reduced by building a fence, continually supervising the cattle, keeping fewer cattle, or growing less corn—each of which is costly. The rancher and the farmer could bargain with each other to decide who should bear the cost of the damage. Alternatively, the law could intervene and assign liability for the damages. There are two specific rules the law could adopt: 1. The farmer is responsible for keeping the cattle off his property, and he must pay for the damages when they get in (a regime we could call “ranch- ers’ rights” or “open range”), or 2. The rancher is responsible for keeping the cattle on her property, and she must pay for the damage when they get out (“farmers’ rights” or “closed range”). Under the first rule, the farmer would have no legal recourse against the dam- age done by his neighbor’s cattle. To reduce the damage, the farmer would have to grow less corn or fence his cornfields. Under the second rule, the rancher must build a fence to keep the cattle on her property. If the cattle escape, the law could ascer- tain the facts, determine the monetary value of the damage, and make the rancher pay the farmer. Which law is better? Perhaps you think that fairness requires injurers to pay for the damage they cause. If so, you will approach the question as traditional lawyers do, by thinking about causes and fairness. The rancher’s cows harm the farmer’s crops, but the farmer’s crops do not harm the rancher’s cows. The cause of the harm runs from rancher to farmer, and many people believe that fairness requires the party who causes harm to pay for it. Professor Coase, however, answered in terms of efficiency . All other things equal, we would like the legal rule to encourage efficiency in both ranching and farming.

98 IV. An Economic Theory of Property 83 This approach yielded a counterintuitive conclusion, which can be explained using some numbers. Suppose that, without any fence, the invasion by the cattle costs the farmer $100 per year in lost profits from growing corn. The cost of installing and main- taining a fence around the farmer’s cornfields is $50 per year, and the cost of installing a fence around the ranch is $75 per year. Thus, we are assuming that damage of $100 can be avoided at an annual cost of $50 by the farmer or $75 by the rancher. Obviously, efficiency requires the farmer to build a fence around his cornfields, rather than the rancher to build a fence around her ranch. Now, consider what will happen under either legal rule. Under the first legal rule (ranchers’ rights), the farmer will bear damage of $100 each year from the wandering cattle. He can eliminate this damage at a cost of $50 per year, for a net savings of $50 per year. Therefore, the first rule will cause the farmer to build a fence around his corn- fields. Under the second rule (farmers’ rights), the rancher can escape liability for $100 at a cost of $75. Consequently, the second rule will cause the rancher to build a fence around her ranch, thus saving $25. Apparently, the first rule, which saves $50, is more efficient than the second rule, which saves $25. But this efficiency is only apparent; it is not real. We m a y b eg i n o u r u n d e r s t a n d i n g o f t h i s a p p a r e n t p u z z l e b y fi r s t i m a g i n i n g h ow the rancher and the farmer could have resolved their problem by cooperative bargain- ing and then comparing that outcome with the apparent outcomes under the different legal rules. Suppose that the farmer and the rancher had fallen in love, married, and combined their business interests. They would then maximize the combined profits from farming and ranching, and these joint profits will be highest when they build a fence around the cornfields, not around the ranch. Consequently, the married couple will build a fence around the cornfields, regardless of whether the law is the first rule or the second rule. In other words, they will cooperate to maximize their joint profits, regardless of the rule of law. We h ave s e e n t h a t t h e fi r s t r u l e i s m o r e e ffi c i e n t t h a n t h e s e c o n d i f t h e fa r m e r a n d the rancher follow the law without cooperating, but that the law makes no difference to efficiency when they cooperate. The farmer and the rancher do not need to get married in order to cooperate. Rational businesspeople can often bargain together and agree on terms of cooperation. By bargaining to an agreement, rather than following the law noncooperatively, the rancher and the farmer can save $25. That is, if the parties can bargain successfully with each other, the efficient outcome will be achieved, regardless of the rule of law. Recall that the most efficient outcome is for the farmer to build a fence around his cornfields, and that when the parties simply follow the law without cooperating, the second rule (farmers’ rights) leads to the apparent inefficiency of the build- rancher’s ing a fence around her ranch. But consider how bargaining might proceed under the second rule: R ANCHER : “The law makes me responsible for any damage that my cattle do to your crops. There would be no damage if there was a fence. I can fence my ranch for $75 per year, whereas you can fence your cornfields for $50 per year. Let’s make a deal. I’ll pay you $50 per year to fence your cornfield.”

99 84 CHAPTER 4 An Economic Theory of Property : ARMER F “If I agree, and you pay me $50 per year to fence my cornfields, I won’t be any better off than if I did nothing and you had to fence your ranch. However, you’ll save $25. You shouldn’t receive all of the gains from cooperation. You should give me a share of the gains by paying me more than $50 per year for fencing my cornfields.” R : “OK. Let’s split the savings from cooperation. I’ll pay you $62.50 per ANCHER year, and you build the fence. That way we’ll each receive half of the $25 gained by cooperating.” F : “Agreed.” ARMER Note the important implication: Cooperation leads to the fence’s being built around the farmer’s cornfields, despite the fact that the second legal rule (farmers’ rights) was con- trolling. The greater efficiency of the first legal rule is apparent, not real. Note, also, the parallel between bargaining over the right of ownership of a used car from earlier in the chapter and the rights of ownership of land. Adam owns the car, and Blair values it more than Adam. By bargaining to an agreement, they can create a surplus and divide it between them. Similarly, the second legal rule imposes an obligation on the rancher to constrain her cattle, but the farmer can constrain them at less cost than the rancher. By bargaining to an 9 agreement, both parties can save costs and divide the savings between them. Let’s generalize what we have learned from this exercise. When one activity inter- feres with another, the law must decide whether one party has the right to interfere or whether the other party has the right to be free from interference. Fairness apparently re- quires the party who causes harm to pay for it. In contrast, efficiency requires allocating the right to the party who values it the most. When the parties follow the law noncooper- atively, the legal allocation of rights matters to efficiency. When the parties bargain suc- cessfully, the legal allocation of rights does not matter to efficiency. Given successful bargaining, the use of resources (the placement of a fence, the number of cattle run, the extent of land planted in cornfields, and so forth) is efficient, regardless of the legal rule. We have discussed “successful bargaining,” but we have not discussed why bar- gains sometimes succeed and sometimes fail. Bargaining occurs through communica- tion between the parties. Communication has v arious costs, such as renting a conference room, hiring a stenographer, and spending time in discussion. Coase used the term “transaction costs” to refer to the costs of communicating, as well as to a variety of 9 The bargaining situation is quite different if the law adopts the first rule (ranchers’ rights), rather than the second rule (farmers’ rights). Under the first rule, the farmer is responsible for building a fence to keep the cattle out of his cornfields. In these circumstances, cooperation between the farmer and the rancher does not save costs relative to following the law noncooperatively. Consequently, under the first rule, the farmer will go ahead and build the fence, without any bargaining. The first rule has an analogy in the used-car ex- ample. Recall that Blair values the car more than Adam does, which is why a surplus can be created by Adam’s selling the car to Blair. If Blair initially owns the car, there is nothing to be gained by bargaining with Adam or cooperating with him. Thus, Blair’s owning the car is analogous to ranchers’ rights. In the car example, there is no scope for a bargain because the party who values the car the most already owns it; in the cattle-corn example, there is no scope for a bargain because the party who can fence the cattle at least cost already has the duty to build the fence.

100 IV. An Economic Theory of Property 85 other costs that we will discuss later. In fact, he used “transaction costs” to encompass all of the impediments to bargaining. Given this definition, bargaining necessarily suc- ceeds when transaction costs are zero. We can summarize this result by stating this ver- sion of the Coase Theorem: When transaction costs are zero, an efficient use of resources results from private bar- gaining, regardless of the legal assignment of property rights. Now we must relate the Coase Theorem to our larger project of developing an eco- nomic theory of property. The theorem states abstractly what our example showed con- cretely: If transaction costs are zero, then we do not need to worry about specifying legal rules regarding property in order to achieve efficiency. Private bargaining will take care of such issues as which things may be owned, what owners may and may not do with their property, and so on. By specifying the circumstances under which property law is unimportant to effi- is impor- cient resource use, the Coase Theorem specifies implicitly when property law tant. The assignment of property rights might be crucial to the efficient use of resources zero. not when transaction costs are To make the point more explicit, we posit this corollary to the Coase Theorem: When transaction costs are high enough to prevent bargaining, the efficient use of resources will depend on how property rights are assigned. Figure 4.2 represents the corollary graphically. Transaction costs lie on a spectrum from zero to infinity. In any particular situation, a threshold level of transaction costs di- vides the spectrum into a region in which bargaining succeeds and one in which it fails. To a p p r e c i a t e t h e c o r o l l a r y, l e t u s r e t u r n t o t h e r a n c h e r a n d t h e fa r m e r. B a rg a i n i n g to an agreement requires communication. Assume that communication is costly. Specifically, assume that the transaction costs of bargaining are $35. Transaction costs must be subtracted from the surplus in order to compute the net value of cooperating. Suppose that the second legal rule (farmers’ rights) prevails, so that a surplus of $25 can be achieved by an agreement that the rancher will pay the farmer to fence the cornfields. The net value of the bargain is the cooperative surplus minus the transaction costs— $35 - = - $10. Recognizing that the net value of the bargain is negative, the parties $25 will not bargain. If the parties do not bargain, they will follow the law noncooperatively. Specifically, the farmer will assert his right to be free from invasions of cattle, and the rancher will fence the ranch, which is inefficient. In order to avoid this inefficiency, the law would have to adopt the first rule (ranchers’ rights), in which case the parties will not bargain, and they will achieve efficiency by following the law noncooperatively. threshold FIGURE 4.2 A threshold level of transaction costs bargaining fails; bargaining succeeds; that distinguishes the areas in which legal rights matter legal rights do not matter to efficiency to efficiency the Coase Theorem applies and does not apply. low Transaction Costs high

101 86 CHAPTER 4 Economic Theory of Property An Sometimes the threshold’s location is obvious to everyone. For example, when a mi- nor road crosses a main road, the law should prescribe that drivers in the minor road must yield to drivers on the main road. Motorists do not have time to bargain with each other and arrive at this result on their own. Sometimes the threshold’s location is not obvious and people sharply disagree over policy. Motorists cannot buy insurance against their own pain and suffering from an accident. Legal scholars disagree sharply over whether such insurance is unavailable because transaction costs are prohibitively high or because mo- torists do not value compensation for pain and suffering enough to pay for it. UESTION 4.3: Suppose that a railroad runs beside a field in which com- Q mercial crops are grown. The railroad is powered by a steam locomotive that spews hot cinders out of its smokestack. From time to time those cinders land on the crops nearest to the track and burn them to the ground. Assume that each year, the farmer whose crops are burned loses $3000 in profits, and that the annual cost to the railroad of installing and maintaining a spark-arrester that would prevent any damage to the crops is $1750. Does it matter to the ef- ficient use of the farmer’s land or to the efficient operation of the railroad whether the law protects the farmer from invasion by sparks or allows the rail- road to emit sparks without liability? Why or why not? The Coase Theorem is so remarkable that many people have questioned it. Although we cannot discuss this rich literature here, we have embodied some of the most important points in the following questions: Q UESTION 4.4: The long run. Some commentators thought that the Coase Theorem might be true in the short run but not in the long run. In the example of the farmer and the rancher, changing the use of fields takes time. For example, to convert a field from grazing land to farmland, the farmer must fence and plough the land. The efficiency of the Coase Theorem in the long run depends on the ability of private bargaining to accommodate any additional costs of altering re- source use over long time periods as relative prices and opportunity costs change. Discuss some ways that a contract for long-run cooperation between the rancher and the farmer would differ from a contract for short-run cooperation. Q 4.5: Invariance. With zero transaction costs, the farmer fences the UESTION cornfield rather than the rancher fencing the ranch—regardless of the rule of law. Notice that in this example, the use of the fields for cattle-ranching and corn- growing is the same, regardless of the initial assignment of property rights. This version of the Coase Theorem is called the version (because the use invariance of resources is invariant to the assignment of property rights). This version turns out to be a special case. The more general case is one in which the resource allo- cation will be efficient (but not necessarily identical), regardless of the assign- ment of property rights. There will be a Pareto-efficient allocation of goods and services, but it may be different from the Pareto-efficient allocation that would have resulted from assigning that same entitlement to someone else. To illustrate, assume that farmers like to eat more corn and less beef, whereas ranchers like to eat more beef and less corn. Assume that farmers and

102 IV. An Economic Theory of Property 87 ranchers own their own land, that transaction costs are zero, and that fence is costly relative to their incomes. The change from “ranchers’ rights” to “farm- ers’ rights” will increase the income of farmers and decrease the income of ranchers. Consequently, the demand for corn will increase, and the demand for beef will decrease. Greater demand for corn requires the planting and fencing of more cornfields. Thus, the change in law causes the building of more fences. Remember the distinction between “price effects” and “income effects” in 10 demand theory? Can you use these concepts to explain this example? 4.6: Endowment effects. Q UESTION Surveys and experiments reveal that people sometimes demand much more to give up something that they have than they would be willing to pay to acquire it. To illustrate, contrast a situa- tion in which people have an opportunity to “sell” the clean air that they cur- rently enjoy to a polluter to the situation in which people currently not enjoying clean air have an opportunity to “buy” clean air from a polluter. Evidence suggests that people may demand a higher price to “sell” a right to endowment clean air than they would pay to “buy” the same right. An is an initial assignment of ownership rights. The divergence between buying and endowment effect selling price is called an because the price varies depending on the initial assignment of ownership. Why might farmers place a different value on the right to be free from straying cattle depending on whether they were selling or buying that right? Is it rational to place different values on those rights? How do these flip-flops in the relative valuation complicate an efficiency analysis of the assignment of property rights? Q 4.7: Social norms. Social norms often evolve to cope with ex- UESTION ternal costs, without bargaining or law. For example, a social norm in a county in northern California requires that ranchers assume responsibility for control- ling their cattle, even though parts of the county are “open range” (that is, areas in which legal responsibility rests with farmers). Furthermore, the ranchers and farmers in this county apparently do not engage in the kind of bargaining envisioned by the Coase Theorem. How damaging are these facts to Coase’s analysis? Why would you expect neighbors in long-run relationships to adopt 11 efficient norms to control externalities? 10 In the long run, ranchland will be more valuable if the rancher does not have to install fences, and farm- land will be more valuable if the farmer does not have to install fences. If ranchers and farmers rent their land, the rule that determines the cost of fencing may affect the rental value of the land, not the profitabil- OBERT D. C OOTER , ity of the activity that occurs on it. On the various versions of the Coase Theorem, see R The Coase Theorem , in T HE N EW P ALGRAVE : A D ICTIONARY OF E CONOMICS (1987). On the special assump- tions underlying the invariance version of the Coase Theorem, see the graphical treatment in T S. HOMAS U LEN , Flogging a Dead Pig: Professor Posin on the Coase Theorem , 38 W AYNE L. R EV . 91 (1991). 11 See Robert Ellickson, Of Coase and Cattle: Dispute Resolution Among Neighbors in Shasta County , 38 S TA N . L. R EV . 623 (1986).

103 88 CHAPTER 4 Economic Theory of Property An Web Note 4.1 There is more on the Coase Theorem at our website, where we pose additional questions and describe some experimental studies designed to test the Coase Theorem. B. The Elements of Transaction Costs What are transaction costs? Are they ever really negligible? We cannot use the Coase Theorem to understand law without answering these questions. Transaction costs are the costs of exchange. An exchange has three steps. First, an exchange partner has to be located. This involves finding someone who wants to buy what you are sell- ing or sell what you are buying. Second, a bargain must be struck between the ex- change partners. A bargain is reached by successful negotiation, which may include the drafting of an agreement. Third, after a bargain has been reached, it must be enforced. Enforcement involves monitoring performance of the parties and punishing violations of the agreement. We may call the three forms of transaction costs corresponding to these three steps of an exchange: (1) search costs, (2) bargaining costs, and (3) enforce- ment costs. Q UESTION 4.8: Classify each of the following examples as a cost of search- ing, bargaining, or enforcing an agreement to purchase a 1957 Chevrolet: a. Haggling over the price. b. Collecting the monthly payments for the purchase of the car. c. Taking time off from work for the buyer and seller to meet. d. Purchasing an advertisement in the “classified” section of the newspaper. e. Purchasing a newspaper to obtain the “classified” section. f. The buyer asking the seller questions about the car’s ignition system. When are transaction costs high, and when are they low? Consider this question by looking at the three elements of the costs of exchange. Search costs tend to be high for unique goods or services, and low for standardized goods or services. To illustrate, finding someone who is selling a 1957 Chevrolet is harder than finding someone who is selling a soft drink. Turning from search costs to bargaining costs, note that our examples of bargaining assumed that both parties know each other’s threat values and the cooperative solution. Game theorists say that information is “public” in negotiations when each party knows these values. (Game theorists refer to these negotiations as “common knowledge” situa- tions.) Conversely, information is “private” when one party knows some of these values and the other does not. If the parties know the threat values and the cooperative solution, they can compute reasonable terms for cooperation. In general, public information facil- itates agreement by enabling the parties to compute reasonable terms for cooperation. Consequently, negotiations tend to be simple and easy when information about the threat values and the cooperative solution is public. To illustrate, negotiations for the sale of a watermelon are simple because there is not much to know about it.

104 IV. An Economic Theory of Property 89 Negotiations tend to be complicated and difficult when information about threat values and the cooperative solution is private. Private information impedes bargain- ing because much of it must be converted into public information before computing reasonable terms for cooperation. In general, bargaining is costly when it requires converting a lot of private information into public information. To illustrate, negotia- tions for the sale of a house involve many issues of finance, timing, quality, and price. The seller of a house knows a lot more about its hidden defects than the buyer knows, and the buyer knows a lot more about his or her ability to obtain financing than the seller knows. Each attempts to extract these facts from the other over the course of negotiations. To a degree, the parties may want to divulge some information. But they may be reluctant to divulge all. Each party’s share of the cooperative surplus de- pends, in part, on keeping some information private. But concluding the bargain re- quires making some information public. Balancing these conflicting pulls is difficult and potentially costly. There is an extensive literature on bargaining games, including a large number of 12 carefully constructed experiments testing the Coase Theorem. One of the most robust conclusions of these experiments is that bargainers are more likely to cooperate when their rights are clear and less likely to agree when their rights are ambiguous. Put in more formal terms, bargaining games are easier to solve when the threat values are public knowledge. The rights of the parties define their threat values in legal disputes. One implication of this finding is that property law ought to favor criteria for determin- ing ownership that are clear and simple. The most immediate prescription for efficient property law is to make rights clear and simple. For example, a system for the public registration of ownership claims to land avoids many disputes and makes settlement easier for those that arise. Similarly, the fact that someone possesses or uses an item of property is easy to confirm. In view of this fact, the law gives weight to possession and use when determining ownership. Conversely, unclear ownership rights are a major ob- stacle to cooperation and a major cause of wasted resources. Thus, squatters who oc- cupy land owned by others in developing countries fail to improve their dwellings because it is not clear that they would own the improvements. Most of our bargaining examples concern two parties. Communication between two parties is usually cheap, especially when they are near each other. However, many bargains involve three or more parties. Bargaining becomes more costly and difficult as it involves more parties, especially if they are dispersed from one another. This fact may explain why treaties involving many nations are so difficult to conclude. Finally, the parties may want to draft an agreement, and this may be costly because it must anticipate many contingencies that can arise to change the value of the bargain. 12 EITH M See J. K , B ARGAINING G AMES (1992) for a highly readable summary of this literature. For URNIGHAN specific experiments on the Coase Theorem, see Elizabeth Hoffman & Matthew Spitzer, The Coase Theorem: Some Experimental Tests AW & E CON .73 (1982), and Hoffman & Spitzer, Experimental , 25 J. L Te s t s o f t h e C o a s e T h e o re m w i t h L a rg e B a rg a i n i n g G ro u p s , 15 J. L EGAL S TUD .149 (1986). Ian Ayres has recently argued that, contrary to these findings, ambiguous rights induce bargaining. See our website for more.

105 90 CHAPTER 4 Economic Theory of Property An Another obstacle to bargaining is hostility. The parties to the dispute may have emotional concerns that interfere with rational agreement, as when a divorce is bitterly contested. People who hate each other often disagree about the division of the coopera- tive surplus, even though all the relevant facts are public knowledge. To illustrate, many jurisdictions have rules for dividing property on divorce that are simple and predictable for most childless marriages. However, a significant proportion of these divorces are litigated in court rather than settled by negotiation. In these circumstances, lawyers can facilitate negotiations by interposing themselves between hostile parties. Even without hostility, however, bargaining can be costly because negotiators may behave unreasonably—for example, by pressing their own advantage too hard (what lawyers refer to as “overreaching”). An essential aspect of bargaining is forming a strategy. In forming a bargaining strategy, each party tries to anticipate how much the opponent will concede. If the parties miscalculate the other party’s resolve, each will be surprised to find that the other does not concede, and as a result, negotiations may fail. Miscalculations are likely when the parties do not know each other, when cultural differences obscure communication, or when the parties are committed to conflicting moral positions about fairness. Enforcement costs, the third and final element of transaction costs, arise when an agreement takes time to fulfill. An agreement that takes no time to fulfill has no en- forcement costs. An example is simultaneous exchange, in which I give you a dollar and you give me a watermelon. For complex transactions, monitoring behavior and punishing violations of the agreement can be costly. To illustrate, consider the example from the beginning of this chapter of Bloggs’s desire to drain a wetlands on his prop- erty in order to develop it as a residential area. Suppose that the city permits him to build on a small part of the wetlands, provided that he does not harm the rest. Officials must watch him to be sure that he keeps his promise. Furthermore, officials may require Bloggs to post bond, which will be confiscated if he harms the rest of the wetlands and returned to him if he completes construction without doing harm. In general, enforce- ment costs are low when violations of the agreement are easy to observe and punish- ment is cheap to administer. Let us summarize what we have learned about transaction costs. Transactions have three stages, each of which has a special type of cost—search costs, bargaining costs, and enforcement costs. These costs vary along a spectrum from zero to indefinitely large, depending on the transaction. Characteristics of transactions that affect their costs are summarized in Table 4.3. Q 4.9: Rank the following six transactions from lowest to highest UESTION transaction costs. Explain your ranking by reference to the costs of search, bargaining, and enforcement. (There is no uniquely correct answer.) a. Getting married. b. Buying an artichoke. c. Acquiring an easement to run a gas line across your neighbor’s property. d. Selling a Burger King franchise. e. Going to college. f. Purchasing a warranty for a new car.

106 IV. An Economic Theory of Property 91 TABLE 4.3 Factors Affecting Transaction Costs Higher Transaction Costs Lower Transaction Costs 1. Unique good or service 1. Standardized good or service 2. Uncertain, complex rights 2. Clear, simple rights 3. Many parties 3. Few parties 4. Hostile parties 4. Friendly parties 5. Unfamiliar parties 5. Familiar parties 6. Reasonable behavior 6. Unreasonable behavior 7. Instantaneous exchange 7. Delayed exchange 8. No contingencies 8. Numerous contingencies 9. Low costs of monitoring 9. High costs of monitoring 10. Costly punishments 10. Cheap punishments Q UESTION 4.10: Consider the right to smoke or to be free from smoke in the following situations. In which situations do you think that transaction costs are so high that they preclude private bargains, and in which cases do you think that transaction costs are low enough for private bargains to occur? Explain your answer. a. Smoking in a private residence. b. Smoking in a public area, such as a shopping mall, an indoor arena or concert hall, or an outdoor stadium. c. Smoking in hotel rooms. d. Smoking on commercial airline flights. What sorts of arguments might be made for and against a bargaining or more interventionist means of dealing with each issue? To what extent are so- cial norms, not law, determinative of the outcome? C. The Normative Coase and Hobbes Theorems We have been speaking thus far as if the Coase Theorem’s only lesson for property law is that the law should determine the level of transaction costs and react accordingly. But we can go further. Thus far, we have spoken of transaction costs as if they are exogenous to the legal system—that is, as if they are determined solely by objective characteristics of bargain- ing situations outside the domain of the law. This is not always the case. Some transac- tion costs are endogenous to the legal system in the sense that legal rules can lower obstacles to private bargaining. The Coase Theorem suggests that the law can encour- age bargaining by lowering transaction costs. To illustrate numerically, if the surplus from exchange is $25 and transaction costs are $30, then the parties can obtain a net benefit of $25 - $30 =- $5 from a private

107 92 CHAPTER 4 Economic Theory of Property An agreement. In other words, at least one of the parties will lose from private exchange. A rational person will not voluntarily trade at a loss. So, private exchange will not oc- cur among rational people when the net benefit is negative. If, however, law lowers $10 $15. When the transaction costs to $10, then the net benefit of exchange is $25 - = surplus exceeds transaction costs, the net benefit from private exchange is positive, so both parties can gain from private exchange. Private exchange will ordinarily occur among rational people when the net benefit is positive. Lowering transaction costs “lubricates” bargaining. An important legal objective is to lubricate private bargains by lowering transaction costs. One important way for the law to do this is by defining simple and clear property rights. It is easier to bargain when legal rights are simple and clear than when they are complicated and uncertain. To illustrate, the rule “first in time, first in right” is a simple and clear way to determine ownership claims. Similarly, requiring public recording of property claims makes de- termining ownership easier. Further, making those records searchable on the Internet may lower transaction costs even more. You will encounter many examples throughout this book of other ways that law lubricates bargaining. By lubricating bargaining, the law enables the private parties to exchange legal rights, thus relieving lawmakers of the 13 difficult task of allocating legal rights efficiently. Normative Coase Theorem : We can formalize this principle as the Structure the law so as to remove the impediments to private agreements. The principle is normative because it offers prescriptive guidance to lawmakers. The principle is inspired by the Coase Theorem because it assumes that private exchange, in the appropriate circumstances, can allocate legal rights efficiently. To illustrate the principle’s application, the dramatic worldwide trend toward privatization in the 1990s removed many regulatory impediments to private agreements. Besides encouraging bargaining, a legal system tries to minimize disagreements and failures to cooperate, which are costly to society. The importance of minimizing the losses from disagreements was especially appreciated by the seventeenth-century English philosopher Thomas Hobbes. Hobbes thought that people would seldom be ra- tional enough to agree on a division of the cooperative surplus, even when there were 14 no serious impediments to bargaining. Their natural cupidity would lead them to quarrel unless a third, stronger party forced them to agree. These considerations sug- Normative Hobbes gest the following principle of property law, which we may call the Theorem : 15 Structure the law so as to minimize the harm caused by failures in private agreements. 13 As we shall see in Chapter 8, contract law may be seen as an application of the Normative Coase Theorem in that much of that area of the law may be seen as an attempt to lower the transaction costs of concluding consensual agreements. 14 Because Hobbes wrote in the seventeenth century, he did not express himself in quite these terms, but this kind of argument is pervasive in his classic work, L EVIATHAN (1651). The modern idea underlying the pes- simism of Hobbes concerning distribution is the fact that game theory has no generally accepted way to choose among core allocations. 15 This idea is developed at length in Cooter, The Cost of Coase , 11 J. L EGAL S TUD . 1 (1982).

108 IV. An Economic Theory of Property 93 According to this principle, the law should be designed to prevent coercive threats and to eliminate the destructiveness of disagreement. When the parties fail to reach a private agreement where one is, in fact, possible, they lose the surplus from exchange. To minimize the resulting harm, the law should allocate property rights to the party who values them the most . By allocating property rights to the party who values them the most, the law makes exchange of rights unnec- essary and thus saves the cost of a transaction. To illustrate, the Normative Hobbes Theorem requires the law to create “open range” (ranchers’ rights), rather than “closed range” (farmers’ rights) in situations corresponding to our previous example. These two normative principles of property law—minimize the harm caused by private disagreements over resource allocation (the Normative Hobbes Theorem), and minimize the obstacles to private agreements over resource allocation (the Normative Coase Theorem)—have wide application in law. In combination with the Coase Theorem discussed earlier and its corollary, these principles will form the heart of our economic analysis of property law in the remainder of this and the following chapter. D. Lubricate or Allocate? Coase versus Hobbes The Coase and Hobbes Theorems characterize two ways that law can increase effi- ciency when transaction costs are positive. First, law can lubricate private exchange by lowering transaction costs. Second, law can allocate rights to the party who values them the most. Now we consider how a lawmaker might choose between lubricating and allocat- ing. Return to our example of the farmer and the rancher, where fencing costs the rancher $75 and the farmer $50. Assume that law assigns the obligation to fence to the rancher (farmers’ rights). Given these facts, a surplus of $25 could be achieved by transferring the obligation to fence from the rancher to the farmer (ranchers’ rights). Assume, however, that transaction costs of private exchange equal $35, so the transfer is blocked. What is to be done? If law can lower the transaction costs of exchange from $35 to $10, transaction costs will no longer block private exchange. When private ex- change is not blocked, the obligation of the rancher to build the fence can be transferred to the farmer, thus creating a net benefit of $15. Alternatively, assume that the law cannot lower the transaction costs of exchange. The other possible remedy is to change the law and assign the obligation to fence to the farmer (ranchers’ rights), not the rancher (farmers’ rights). If the farmer has the obliga- tion to fence, the legal rights are allocated efficiently. When the right is already allo- cated efficiently, exchange of the right would produce a negative surplus. Exchange is unnecessary and will not occur. Unfortunately, however, lawmakers often do not know who values rights the most, and finding out can be difficult. To illustrate, consider the problem of finding out the cost of fencing the farmer’s crops. When testifying in court, the farmer has an incentive to exaggerate these costs. Knowing this fact, the judge and the jury are not sure whether to believe the farmer. Lawmakers with limited information face a trade-off between transaction costs and information costs. On one hand, by strictly following precedent, courts avoid the

109 94 CHAPTER 4 Economic Theory of Property An information costs of determining who values a right the most. With strict adherence to precedent by courts, the parties must bear the transaction costs of correcting inefficient legal allocations of rights. On the other hand, the courts can attempt to determine who values a legal right the most and adjust the law accordingly. With legal reallocation of rights, the courts or other lawmakers must bear the information costs of determining who values a right the most. Efficiency requires the courts to do whichever is cheaper. To formalize this claim, let denote the information costs to a court of determin- IC ing who values a legal right the most. Let TC indicate the transaction costs of trading legal rights. Efficient courts would follow this rule: Q TC 6 IC allocate the legal right initially to the person who values it the most; TC 6 IC Q strictly follow precedent. To i l l u s t r a t e t h e a p p l i c a t i o n o f t h i s p r i n c i p l e , a s p o p u l a t i o n i n c r e a s e s a n d l a n d u s e i n - tensifies, areas in the western United States convert from open to closed range. Assume that a judge or panel of legal experts must consider whether to leave some range in the country open or to close it. In approaching the question, the judge or commission should balance the transaction costs of private bargains between ranchers and farmers, and the cost to lawmakers of trying to determine the fencing costs of ranchers and farmers. UESTION 4.11: Q a. When transaction costs are low enough, efficient resource allocation will follow regardless of the particular assignment of property rights. When transaction costs are high enough, efficient resource allocation requires assigning property rights to the party who values them the most. Give an example of each case. b. Can you use the Normative Hobbes Theorem to justify legislation regulating the collective bargaining process between employers and employee unions? c. When people strongly disagree, they may try to harm each other, or they may walk away from a potentially profitable exchange. What does the Normative Hobbes Theorem suggest the response of the law should be to these two possibilities? V. H o w A r e P r o p e r t y R i g h t s P r o t e c t e d ? Now we have the tools to answer another of the four fundamental questions of property law that we posed at the beginning of this chapter: “What are the remedies for the violation of property rights?” This question concerns how a court should respond when a private person or the government interferes with someone’s property rights. Our discussion in this chapter will focus on interference by a private person. We consider government interference in the next chapter. A. Damages and Injunctions First, we need some background. The remedies available to a common law court are remedy is the payment of legal . The principal equitable or legal either compensatory

110 V. How Are Property Rights Protected? 95 by the defendant to the plaintiff. These damages are a sum of money money damages that compensates the plaintiff for the wrongs inflicted on her by the defendant. The court determines the appropriate amount of money that will, as the saying goes, “make the plaintiff whole.” The measurement of this sum is a complex subject itself, which 16 Equitable relief consists of an order by the court directing the defen- we discuss later. dant to perform an act or to refrain from acting in a particular manner. This order is fre- injunction quently in the form of an , which is said to “enjoin” the defendant to do or to 17 refrain from doing a specific act. Notice that legal relief is “backward-looking” in the sense that it compensates a plaintiff for a harm already suffered, whereas equitable relief is “forward-looking” in the sense that it prevents a defendant from inflicting a harm on the plaintiff in the fu- ture. Thus, a court may combine the two forms of relief, awarding money damages for past harms and enjoining acts that could cause future harm. Damages are the usual remedy for broken promises and accidents, whereas injunc- tion is the usual remedy for appropriating, trespassing, or interfering with another’s property. In other words, damages are the usual remedy in the law of contracts and torts, whereas injunction is the usual remedy in the law of property. For these reasons, damages are often referred to in the legal literature as a “liability rule,” while equitable relief is typically called a “property rule.” To illustrate, the farmer will have to pay damages to the rancher for breach of a contract to deliver hay or for accidentally shoot- ing the rancher’s cow while hunting. But if the cattle trespass on the farmer’s crops (and if farmers have a right to be free from the depredations of stray cattle), then the court will probably award damages for past harm and enjoin the rancher to constrain her cat- tle in the future. B. Laundry and Electric Company: An Example An injunction may appear to be an absolute proscription on an act. For example, if the court were to enjoin the future invasion of the farmer’s cornfields by the rancher’s cattle, one might interpret that as meaning that the rancher will have to erect a fence. This is a mistake. The injunctive remedy does not prevent the invasion of the farmer’s property by the rancher’s cattle from ever occurring, only from its occurring without the consent of the farmer. The farmer is free to make a contract promising to enforce the not 16 There are two more things you should be aware of. First, if a defendant fails to pay a judgment that a court has awarded against him or her, the defendant’s property may be seized and sold in order to raise the judg- ment amount. Second, compensatory damages are to be distinguished from punitive damages, which are money damages over and above compensatory damages assessed against the defendant. The purpose of punitive damages is to punish the defendant, not to compensate the plaintiff. We discuss punitive damages in Chapter 7. 17 The consequences to a defendant of violating an equitable decree are far more serious than the conse- quences of failing to pay a monetary judgment. A defendant’s failure to abide by an injunction not only leaves the plaintiff at a loss, but it also constitutes an insult to the authority of the court. A defendant who ignores an equitable order may be held in contempt of court and imprisoned until she agrees to abide by the order.

111 96 CHAPTER 4 Economic Theory of Property An injunction. To illustrate, the farmer might agree not to enforce the injunction in 18 exchange for payment of a sum of money by the rancher. Given these facts, the right to an injunction should be regarded as a clear assign- ment of a property right. Once the property right is clearly assigned, its owner may strike a bargain to sell it. Thus, if the court enjoined the rancher from allowing future invasion by her cattle, this could be viewed as a declaration that the farmer has the legally enforceable right to be free from invasion by cattle. If the rancher’s value on be- ing allowed to invade the farmer’s property is greater than the farmer’s value on being free from invasion, there is scope for a bargain in which the rancher buys the right from the farmer. Most legal disputes are settled by bargaining between the parties without going to trial, but the terms of the bargain are affected by the remedy that would be available at 19 trial. Specifically, the terms of the bargain are different depending on whether the remedy is damages or injunction. An example from Chapter 1 will help you to under- stand the relationship between remedies and bargains. ACTS : F E Electric Company emits smoke, which dirties the wash at the L The Laundry. No one else is affected because and L are near each other and far from E E can abate this external cost by installing scrubbers on its stacks, and anyone else. L can reduce the damage by installing filters on its ventilation system. The installation of scrubbers by E or filters by L completely eliminates the damage from pollution. Ta b l e 4 . 4 s h ow s t h e p r o fi t s o f e a c h c o m p a ny, d e p e n d i n g o n w h a t a c t i o n i s t a ke n t o r e - duce the pollution. (The profits that are shown in the matrix exclude any compensa- tion that might be paid or received as a consequence of a legal dispute.) E The numbers in Table 4.4 can be explained as follows. When does not install scrubbers, its profits are $1000 (regardless of what the laundry does). When L does not install filters and does not suffer pollution damages (because E has installed scrubbers), ’s profits are $300. Pollution destroys $200 of L ’s profits. L can avoid this by in- L stalling filters at a cost of $100, or E can avoid it by installing scrubbers at a cost of $500. Check to see that you can use these facts to explain the numbers in the table. The most efficient outcome is, by definition, a situation in which the total profits for the two parties, called the “joint profits,” are greatest. The joint profits are found by adding the two numbers in each cell of the table. Joint profits are maximized in the E does not install scrubbers and L installs northeast cell, where $1200 is attained when filters. The harm caused by pollution represents a source of contention between E and L . They may be able to settle their disagreement and cooperate with each other, or they may fail to cooperate and litigate their dispute. What we are interested in determining here is how the remedy available from a court may induce the parties to achieve the efficient solution and thus to minimize the harm of pollution. 18 This inducement to bargain may be more theoretical than real. For a discussion of research by Ward Farnsworth about post-injunction bargains, see the material at Web Note 4.2 on our website. 19 This is referred to as “bargaining in the shadow of the law.”

112 V. How Are Property Rights Protected? 97 TABLE 4.4 ‡ Profits Before Legal Action LAUNDRY No Filter Filter 100 1000 No Scrubbers 200 1000 ELECTRIC COMPANY 300 200 500 Scrubbers 500 ‡ The electric company’s profits are given first in the lower-left corner of each cell; the laun- dry’s profits are given in the upper-right corner of each cell. litigate their disagreement. Three alternative rules of law Suppose that E L and could be applied in the event of a trial: 1. is free to pollute. Polluter’s Right: E Po l l u t e e ’s R i g h t t o D a m age s : L 2. is entitled to compensatory damages from . (Compensatory damages are a sum of money that E pays to L to make E ’s reduced profits due to E’s pollution.) up for L Pollutee’s Right to Injunction: L is entitled to an injunction forbidding 3. to E pollute. (An injunction is a court order requiring E to stop polluting.) Let us determine the value of the noncooperative solution under each of these rules as depicted in Table 4.5. Beginning with rule 1, if is free to pollute, the most profitable action for E is not E L is to install scrubbers and to enjoy profits of $1000. The most profitable response for to install filters and enjoy profits of $200. Thus, the noncooperative value of the rule of free pollution is $1200. This is the efficient solution, which is in the northeast cell of the table. TABLE 4.5 Profits from Bargaining Under Three Legal Rules Noncooperation Surplus Cooperation EL EL 1000 200 0 1000 200 Polluter’s Right Rule 1 350 Rule 2 Damages 800 300 100 850 Injunction Rule 3 500 400 300 700 500

113 98 CHAPTER 4 Economic Theory of Property An E must pay damages to and also assume that L has Turning to rule 2, assume that L must pay damages to for E L no legal duty to install filters (no duty to “mitigate”). If will not bother to install filters. E polluting, then L equal L will have to pay damages to L enjoys when there is no pollution, $300, and the to the difference between the profits L enjoys with pollution, $100. E profits has a choice between installing the scrubbers and paying damages of $200 to . The more profitable alternative is for E not to install L the scrubbers: It initially realizes $1000 in profits, from which $200 must be subtracted to pay damages, leaving with net profits of $800. L enjoys net profits of $300 ($100 E E ). The noncooperative value under rule 2 (a rule of from its operations plus $200 from liability for compensatory damages) is then $1100 $300 + $800. This is the value = in the northwest cell in the table. Turning to rule 3, if E is enjoined from polluting and responds by installing scrub- bers, E ’s profits equal $500. When E installs scrubbers, L will not bother to install fil- ters, so L ’s profits will be $300. Thus, the noncooperative value under the rule of = $500 $300, which corresponds to the southwest cell enjoining pollution is $800 + of the table. Under the pessimistic assumption that and L cannot cooperate, only one of the E legal rules produces an efficient outcome—namely, rule 1. Instead of making the pes- simistic assumption that the parties will be unable to cooperate, suppose we make the optimistic assumption that the parties can settle their disagreement cooperatively. (We E and L are assuming that transaction costs are very low.) When cooperate, their best strategy is to maximize the joint profits of the two enterprises. The profits are maxi- mized when they take the efficient course of action, which, in this case, is for L to in- stall filters and E not to install scrubbers, yielding joint profits of $1200. This is the efficient solution in the northeast cell. There are, thus, two ways to achieve the efficient solution. One way is for the law to adopt the rule for which the noncooperative solution is efficient. This solution is commended by the Normative Hobbes Theorem. In our example (but not necessarily other pollution examples), the noncooperative solution is efficient under rule 1, which gives the freedom to pollute. The other way to achieve efficiency is for the parties to E cooperate. The cooperative solution is efficient under all three of the possible laws. According to the Coase Theorem, inefficient allocations of legal rights by laws such as rules 2 and 3 will be cured by private agreements, provided that bargaining is successful. If transaction costs equal zero and successful bargaining can cure inefficient laws, what difference does the law make? One answer is that the law affects the distribution of the cooperative product, which affects bargaining. To illustrate this point about dis- tribution, recall how the structure of the law—such as rules 1, 2, and 3—affects the threat values of the parties. A reasonable bargaining solution is for each party to re- ceive his or her threat value plus an equal share of the cooperative surplus. Each party to a bargain would prefer the rule of law that provides him or her with the largest threat value. Specifically, the threat value of the plaintiff in a property dispute is at least as great when the remedy for future harm is injunctive relief as when the remedy is damages. The plaintiff, consequently, prefers the remedy of injunctive relief for fu- ture harm, or, better yet, injunctive relief for future harm and damages for past harm.

114 V. How Are Property Rights Protected? 99 In contrast, the defendant prefers the damage remedy for future harm or, better yet, no remedy. The effect of the rule of law on the distribution of the cooperative product can be and L . Imagine that computed precisely for and L enter into negotiations, and, to E E keep the arithmetic simple, assume that negotiating a settlement or going to trial is costless for the parties (swallow hard!). The noncooperative payoffs—that is, the prof- its the parties can get on their own if negotiations fail—are shown in Table 4.5 under each of the three rules. The cooperative surplus, which equals the difference between the joint profits from cooperation and the threat values, is shown in the middle column. A reasonable bargaining solution is for each party to receive his or her threat value plus half the surplus from cooperation. The payoffs to the two parties from cooperation are given in the two columns on the right side of the table. Notice that in each case the co- operative payoffs sum $1200, but that receives the largest share under the injunctive L rule (rule 3), an intermediate share under damages (rule 2), and the smallest share when E is free to pollute (rule 1). Q UESTION 4.12: In the preceding example, implementing an injunction to end future interference costs the defendant more than damages for future in- terference. Is this fact generally true or just a special feature of this example? C. Efficient Remedies We m e n t i o n e d t h a t i n j u n c t i o n i s t h e u s u a l r e m e d y f o r b r e a c h o f a p r o p e r t y r i g h t . We wo u l d l i ke t o ex p l a i n t h i s g e n e r a l i z a t i o n , a s w e l l a s ex c e p t i o n s t o i t , i n t e r m s o f e f - ficiency. The preceding example showed that damages and injunctions are equally effi- cient remedies when transaction costs equal zero. Consequently, differences in efficiency must depend on transaction costs. If transaction costs are so high as to pre- clude bargaining, then the more efficient remedy is damages, not injunctions. The reason that damages are more efficient than injunctions when transaction costs preclude bargaining is easy to see from the example of the laundry and electric com- pany. If damages perfectly compensate the laundry, its profits remain the same (specifi- cally, $300) regardless of whether the electric company pollutes. So, the laundry is indifferent between the damage and injunction remedies (assuming no bargaining). Under the damage remedy, the electric company can pollute and pay damages, or it can abate and not pay damages. Its profits increase from $500 to $800 when it pollutes and pays damages, rather than abating. In contrast, an injunction (with no bargaining) re- moves this choice. Specifically, the injunction forces the electric company to abate, in which case its profits are $500. In general, when transaction costs preclude bargaining, a switch in remedy from injunction to compensatory damages makes the victim no worse off, whereas the injurer may be better off and cannot be worse off. In the exam- ple of the laundry and electric company, a switch makes the electric company strictly better off. According to Table 4.5, the noncooperative solution yields $800 to the elec- tric company under a damage remedy and $500 under an injunction, whereas the laun- dry enjoys $300 in either case. We h ave ex p l a i n e d t h e s u p e r i o r i t y o f t h e d a m a g e s r e m e d y w h e n t r a n s a c t i o n c o s t s are high. What about the converse proposition? Are injunctions the superior remedy

115 100 CHAPTER 4 Economic Theory of Property An when transaction costs are low? The traditional answer, which we will explain, is “Yes.” Earlier we noted that bargaining tends to succeed when the legal rights of the parties are clear and simple. Injunction is traditionally regarded as clearer and simpler than damages, because the determination of damages by courts can be unpredictable. To illustrate, it is difficult for a court to assign monetary value to the damage caused by the Windsong satellite’s straying into the orbit of Orbitcom’s satellite in Example 2. Similarly, it is difficult for a court to assign monetary value to the damage caused by the intrusion of Potatoes’s house onto 2 feet of Parsley’s land in Example 5. In contrast, the right to an injunction gives the parties a clear position from which to bargain. In the course of bargaining, they may establish the value of the damage themselves. Thus, the traditional argument concludes that the injunctive remedy is more efficient than dam- ages when the parties can bargain with each other. We have reached the conclusion of a famous article by Judge (then Professor) 20 who proposed the following rules for de- Guido Calabresi and A. Douglas Melamed, termining the best remedy for violating a legal right: Where there are few obstacles to cooperation (that is, low transaction costs), the more efficient remedy is to enjoin the defendant’s interference with the plaintiff’s property. Where there are obstacles to cooperation (that is, high transaction costs), the more efficient remedy is to award compensatory money damages. Most property disputes involve small numbers of contiguous landowners. Communi- cation costs are low; the parties can monitor conformity to their agreements; and neigh- bors take a long-run view towards each other, which limits opportunism and strategic behavior. Bargaining is likely to be successful in these circumstances. According to the preceding prescription, the usual remedy in property disputes ought to be injunctive re- lief, and that is the law in fact. Some property disputes, however, involve large numbers of people. As the num- bers increase, communication costs rise, monitoring becomes difficult, and short- sighted behavior increases. Private bargaining is unlikely to succeed in disputes involving a large number of geographically dispersed strangers, such as disputes over nuisances like air pollution and the stench from the feedlot in Example 3. According to the preceding prescription, the usual remedy in nuisance suits with large numbers of people should be damages. Chapter 5 explains that some courts have followed this prin- ciple and others have not. The two preceding rules constitute the “traditional prescription” in law and eco- nomics to choose between damages and injunctive remedies. In most circumstances, the traditional prescription suffices, but more careful thinking about information has refined it. When a person’s activity spills over and affects other property owners, the 20 Calabresi & Melamed, Property Rules, Liability Rules, and Inalienability: One View of the Cathedral , 85 H ARV . L. R EV . 1089 (1972). As the title indicates, the authors consider a third method of encouraging the efficient use of property—inalienability, the forbidding of a bargaining solution to the use of a property right. We discuss the efficiency of that method briefly in the next chapter.

116 V. How Are Property Rights Protected? 101 court needs different information depending on whether its remedy is damages or in- junction. When transaction costs obstruct bargaining, creating efficient incentives by awarding damages requires the court to measure the harm correctly. If the court mis- measures the harm, damages will be set too high or too low, which will distort the in- jurer’s incentives. Chapter 6 explains this point in detail. Alternatively, when transaction costs obstruct bargaining, creating efficient incen- tives requires the court to know which party values the right the most in order to decide 21 between an injunction and no injunction. If the electric company values the right to pollute more than the laundry values the right to be free from pollution, then the court should allow the electric company to pollute and refuse the laundry’s request for an in- junction. Conversely, if the laundry values the right to be free from pollution more than the electric company values the right to pollute, then the court should grant the laun- dry’s request for an injunction against the electric company’s pollution. In sum, when transaction costs obstruct bargaining, what the court should do de- pends on what it knows. The court must know the absolute value of the harm caused by a spillover in order to provide efficient incentives by a damage remedy. The court needs to know the relative value of the spillover in order to achieve efficiency by the injunc- tive remedy. Now we can restate the first prescription’s refinement: When transaction costs preclude bargaining, the court should protect a right by an in- junctive remedy if it knows which party values the right relatively more (even if it does not know how much either party values the right absolutely). Conversely, the court should protect a right by a damage remedy if it knows how much one of the par- ties values the right absolutely (even if it does not know which party values the right relatively more). The second prescription—award an injunction when low transaction costs permit bargaining—also requires qualification in light of problems of information. This pre- scription assumes that voluntary exchange of a right occurs more easily when it is pro- tected by an injunction, because the injunctions are simpler and clearer than damages. While this is usually true, it is not always so. In bargaining, what matters is costs, not physics. No matter how clear the injunction, the cost of complying with it may be un- clear. To lubricate bargaining, each party needs to know the other’s threat value or go- it-alone value. Injunctions do not solve the problem that private information about costs and values inhibits bargaining. To illustrate, the injunction for the electric company to stop polluting is clear, but the cost to the electric company of complying, which may or may not be clear to the electric company, is unclear to the laundry. The truth is more equivocal than the traditional analysis suggests. With the injunc- tive remedy, the obstacle to private agreement includes the plaintiff’s uncertainty about 21 The court knows the relative values of the entitlement if the unobservable elements of individual valua- tions correlates positively with the observable elements. See Louis Kaplow & Steven Shavell, Property Rules Versus Liability Rules: An Economic Analysis , 109 H . L. R EV ARV . 715 (1996). But see Ian Ayres & EGAL .121 TUD S Correlated Values in the Theory of Property and Liability Rules , 32 J. L Paul Goldbart, (2003) (rejecting the correlated values claim—that “liability rules cannot harness private information when the disputants’ values are correlated”).

117 102 CHAPTER 4 Economic Theory of Property An the defendant’s costs of complying with a court order. Conversely, with the damage remedy, the obstacle to private agreement includes the defendant’s uncertainty about 22 the money value of the plaintiff’s harm. Q UESTION 4.13: Use the theory of transaction costs to justify protecting the following rights by injunction or damages: a. A landowner’s right to exclude from his property a neighbor’s gas line. b. A new car owner’s right to have her car’s defective transmission replaced by the seller. c. A homeowner’s right to be free from air pollution by a nearby factory. d. A spouse’s right to half the house on divorce. Q UESTION 4.14: Suppose that two people choose to litigate a dispute. Should the law presume that if two parties are prepared to litigate, transaction costs must be high, and therefore the court should choose damages as the rem- edy, not an injunction? Web Note 4.2 There has been a surprising amount of recent scholarship on the Calabresi- Melamed contention about the efficiency of remedies. We discuss much of that literature on our website, including looking at the empirical literature on whether the issuing of injunctions is typically followed by bargaining. VI. What Can Be Privately Owned?—Public 23 and Private Goods In this section we turn to another fundamental question of property law: should property rights be privately or collectively held? First, we use the economic distinction between public and private goods (developed in Chapter 2) to differentiate those re- sources that will be most efficiently used if privately owned from those that will be most efficiently used if publicly owned. Most examples of property that we have discussed thus far in this book are what economists call “private goods.” Goods that economists describe as purely private have the characteristic that one person’s use precludes another’s: For example, when one per- son eats an apple, others cannot eat it; a pair of pants can be worn only by one person at 22 Taking these arguments into account leads to a more convincing version of the second rule: Where there are few obstacles to cooperation (i.e., low transaction costs), the more efficient rem- edy is the award of an injunction when the plaintiff can estimate the defendant’s compliance costs more readily than the defendant can estimate the plaintiff’s damages. 23 Before reading this section, you may find it helpful to review the material on public goods in Chapter 2.

118 VI. What Can Be Privately Owned?—Public and Private Goods 103 a time; a car cannot go two different directions simultaneously; and so forth. These facts are sometimes summarized by saying that there is rivalry in the consumption of private goods. The polar opposite is a purely public good, for which there is no rivalry in con- sumption. A conventional example of a public good is military security in the nuclear age. Supplying one citizen with protection from nuclear attack does not diminish the amount of protection supplied to other citizens. There is also another attribute that distinguishes private and public goods. Once property rights are defined over private goods, they are (relatively) cheap to enforce. Specifically, the owner can exclude others from using them at low cost. For example, a farm can be fenced at relatively low cost to exclude trespassing cattle. With public goods, however, it is costly to exclude anyone from enjoying them. To illustrate, it is virtually impossible to supply different amounts of protection against nuclear attack to different citizens. Having explained the private-public distinction in economics and law, we can now relate them to each other. The relationship is very simple: Efficiency requires that pri- vate goods should be privately owned and that public goods should be publicly owned. In other words, efficiency requires that rivalrous and excludable goods should be con- trolled by individuals or small groups of people, whereas nonrivalrous and nonexclud- able goods should be controlled by a large group of people such as the state. Thus, the distinction between private and public goods should guide the development of property rules to answer the question, “What can be privately owned?” We c a n ex p l a i n t h e c e n t r a l i d e a , n o t t h e d e t a i l s , f o r t h i s p r e s c r i p t i o n . B e i n g r iva l - rous, private goods must be used and consumed by individuals, not enjoyed equally by everyone. Efficiency requires the use and consumption of each private good by the party who values it the most. In a free market, exchanges occur until each good is held by the party who values it the most. Thus, the law can achieve the efficient allocation of private goods by, for example, lowering bargaining costs by assigning clear and sim- ple ownership rights. Once the state recognizes private property rights, the owner of a private good can exclude others from using or consuming that right, except by the owner’s consent. The owner’s power to exclude channels the use or consumption of pri- vate goods into voluntary exchange, which fosters the efficient use of those goods. This is an example of “lubricating bargaining.” In contrast, the technical character of public goods obstructs the use of bargaining to achieve efficiency. To illustrate, suppose that a particular city block is plagued by crime and some residents propose hiring a private guard. Many residents will volun- tarily contribute to the guard’s salary, but suppose that some refuse. The paying resi- dents may instruct the guard not to aid nonpayers in the event of a mugging. Even so, the presence of the guard on the street will make it safer for everyone, because mug- gers are unlikely to know who has and who has not paid for the guard’s services. Given these facts, there is not much that the payers can do to compel nonpayers to contribute. Those people who do not pay for their consumption of a public good are called “free riders.” To appreciate this concept, imagine that a street car has an electric meter in it and, in order to make the street car move, the riders must put money into the meter.

119 104 CHAPTER 4 Economic Theory of Property An The riders will realize that anyone who pays provides a free ride for everyone else. Perhaps some riders will, nonetheless, put their full fare into the meter; some will put some money in but not their full fare; and some will not put anything in at all. Because of “free riders,” not enough money will be put in the meter, so the street car company will provide fewer street cars than efficiency requires. In general, markets supply too little of a public good because the private supplier cannot exclude users of it who do not pay their share of the costs. We h ave ex p l a i n e d t h a t p r iva t e g o o d s , w h i c h ex h i b i t r iva l r y a n d ex c l u s i o n , o u g h t to be privately owned, and that public goods, which exhibit nonrivalry and nonexclu- sion, ought to be publicly owned. We illustrate this proposition as applied to land. Some efficient uses of land involve a small area and affect a small group of people, such as building a house or growing corn. “Housing” and “corn” are rivalrous goods with low exclusion costs, so markets easily form for housing and corn. Other efficient uses of land involve a large area and affect a large group of people. For example, the use of an uncongested airspace by airplanes or the use of the high seas for shipping are not rivalrous and exclusion is costly. Thus, airspace and the high seas are public goods. As congestion increases from more planes and ships, governments impose rules on the use of the air and seas. These are examples in which private goods are privately owned and public goods are publicly owned, as required for efficiency. There are, however, many ex- amples of private goods that are publicly owned. Public ownership of a private good typically results in its misallocation, by which we mean that it is used or con- sumed by someone other than the person who values it the most. For example, leases for grazing cattle on public lands may be granted to the friends of politicians. Similarly, the officials who administer the leases may not monitor compliance to prevent overgrazing, and the ranchers who overgraze the land may cause it to erode. Much of the impetus for “deregulation,” which was a worldwide movement in the 1990s, came from the realization that much government activity concerns private goods where markets should be lubricated, rather than government intrud- ing directly in the process of allocation. For example, the realization that trans- portation by railroad, airplane, and barge are private services that should be supplied by free markets has led to the dismantling of the Interstate Commerce Commission, the Civil Aeronautics Board, and other regulatory agencies in the United States. One way to contrast private and public ownership is in terms of transaction costs. Private ownership imposes various transaction costs of private enforcement and ex- change. Public ownership imposes transaction costs in terms of public administration and collective decision making. To illustrate the difference, consider two possible ways to control air pollution from a factory. The private property approach is to grant each property owner the right to clean air, protected by the remedy of compensatory dam- ages. This method will result in many landowners suing for damages or bargaining to settle out of court. Alternatively, the public property approach would declare that clean air is a public good, and assign the task of air quality control to a government agency. This method will result in political bargaining and regulations. From this perspective, the choice between private and public ownership should depend on whether the costs

120 VII. What May Owners Do with their Property? 105 of private enforcement and exchange are more or less than the costs of public adminis- tration and political bargaining. In the next chapter we will continue developing these themes by discussing two important questions: For what specific resources is private ownership more efficient than public or communal ownership and vice versa? And under what circumstances 24 should government be allowed to take private property from citizens? If everyone has free access to a public beach, who, if any- 4.15: UESTION Q one, has the power to control the use of this resource? Q Discuss how to adjust private and public property rights 4.16: UESTION to promote ecotourism in Africa. VII. What May Owners Do with Their Property? We u s e d t h e t h e o r y o f p r iva t e a n d p u b l i c g o o d s t o a n s w e r t h e q u e s t i o n , “ W h a t c a n be privately owned?” Closely related to the theory of public goods is the theory of ex- ternalities, which we discussed in Chapter 2. Now we return to that theory in order to answer the question, “What may owners do with their property?” Legislation imposes many restrictions on what a person may do with his or her property. But at common law there are relatively few restrictions, with the general rule being that any use is allowed that does not interfere with other peoples’ property or other rights. Indeed, we could say that common law approximates a legal system of maximum liberty , which allows owners to do anything with their property that does not interfere with other people’s property or other rights. The restriction of noninterference external cost finds justification in the economic concept of . Recall that external costs are those costs involuntarily imposed on one person by another. Because market trans- actions are voluntary, externalities are outside the market system of exchange—hence their name. For example, a factory that emits thick, cloying smoke into a residential neighborhood is generating an externality. In Example 3 at the beginning of this chap- ter, the stench from the cattle feedlot is an externality that interferes with Foster’s en- joyment of her house. In Example 4, the development of Bloggs’s wetlands will interfere with the town’s enjoyment of its rivers and streams. Notice that these types of interference are like a public good in that they affect many property owners. There is, as it were, no rivalry or exclusion from smelling the feedlot’s stench among Foster and her neighbors. These forms of interference are thus like a public good, except they are bad rather than good. 24 We a r e n o t , o f c o u r s e , s u g g e s t i n g t h a t t h e c u r r e n t d iv i s i o n o f r e s p o n s i b i l i t y b e t w e e n p u b l i c a n d p r iva t e providers of goods and services necessarily follows the rules we have just set down. That is, there are cur- rent instances of the government provision or subsidization of private goods and of the private (under-) provision of public goods. The extent to which these anomalies exist and why they persist are two of the central concerns of the branch of microeconomic theory called “public choice theory.”

121 106 CHAPTER 4 Economic Theory of Property An We h ave a l r e a d y ex p l a i n e d w h y m a r ke t s c a n n o t a r i s e t o s u p p l y p u b l i c g o o d s e ffi - ciently. The same set of considerations explains why private bargaining cannot solve the problem of externalities, or, as we called them in a previous section, public bads. To i l l u s t r a t e , s u p p o s e t h a t Fo s t e r h a d e n o u g h m o n ey t o p a y t h e f e e d l o t t o s t o p e m i t t i n g its stench. If she made this private deal with the feedlot, all of her neighbors would also benefit but without having to pay for that benefit. This fact suggests that Foster will not pay the feedlot to stop its malodorous activities. More generally, the free-rider problem prevents private bargaining solutions to the problem of externalities or public bads. Some form of legal intervention is called for. One possibility is a rule forbidding invol- untary invasion, supported by provisions for remedies if that invasion takes place. We have already noted how bargaining theory can help to design the form that remedy should take, namely, the payment of compensatory money damages. An alternative remedy that we will consider in the following chapter is regulation of the public bad or external-cost-generating activity by an administrative agency. By contrast, private bads may be self-correcting through private agreements (recall the rancher-farmer example), so that there may be no need for an intrusive legal solution. Instead, the courts can stand prepared to issue an injunction in the confident expectation that they will seldom be required to do so. VIII. On Distribution We h ave d eve l o p e d a n e c o n o m i c t h e o r y o f p r o p e r t y b a s e d o n e ffi c i e n t ow n e r s h i p . However, some critics of economics believe that property law should be based on dis- tribution, not efficiency. Some people think that government should redistribute wealth from rich to poor for the sake of social justice, whereas other people think that government should avoid redistributing wealth, allowing individuals to receive all the rewards of their hard work, inventiveness, risk-taking, and astute choice of parents. Like the rest of the population, economists disagree among themselves about redistributive ends . However, economists often agree about redistributive means . Given the end of redistribution, economists generally prefer to pursue it by the most efficient means. For each dollar of value transferred from one group to another, a fraction of a dollar is typically used up, as, for example, in administrative costs. The most efficient means of redistribution uses up the least value to accomplish the transfer. Chapter 1 illustrated this fact by the example of ice cream melting during its transfer across the desert from one oasis to another. Another example is the percentage of dona- tions that a charity spends on administrative costs. Many economists believe that redis- tributive goals can be accomplished more efficiently in modern states by progressive taxation than by reshuffling property rights. Besides avoiding waste, more efficient re- distribution generates more support from the people who must pay for it. If the econo- mists are right, redistribution for social justice should focus mostly on taxation and expenditure, not property rights. Progressive taxation and expenditure is usually more efficient than reshuffling property rights to achieve redistribution for a variety of reasons. The most wasteful

122 VIII. On Distribution 107 way to redistribute wealth is for courts to tilt trials in favor of the plaintiff or defen- dant depending on who is poorer. If courts favor the poorer party in legal disputes, each person prefers to avoid interacting with relatively poorer people whenever a law- suit could arise. Thus, a person would want to avoid owning real estate in a neighbor- hood occupied by people who are poorer than he is. Similarly, favoring the poorer party in a contract dispute makes a person reluctant to do business with anyone who is poorer than he is. Several other reasons also make taxation superior to property law as a means of redistribution. First, the income tax precisely targets inequality, whereas property law relies on crude averages. To illustrate, suppose that the rule of law in a particular county in Montana is “ranchers’ rights.” If ranchers are richer than farmers on aver- age in this county, then changing the rule to “farmers’ rights” would redistribute wealth toward greater equality. However, although ranchers are richer than farmers , some farmers are undoubtedly richer than some ranchers. Changing the on average property rights to favor farmers over ranchers will aggravate the inequality between the rich farmers and poor ranchers. In contrast, progressive taxation will ameliorate unequal incomes. A second objection is that reshuffling property rights may not really have the dis- tributive effects anticipated. To illustrate, suppose that both farmers and ranchers rent their land from absentee owners. If property law shifts the cost of fencing from farmers to ranchers, competition among landlords may cause them to adjust rents to offset the change in costs. Specifically, the landlords who own farm land may increase the rent the rent charged charged to farmers, and the landlords who o wn ranch land may decrease to ranchers. Consequently, the reshuffling of property rights may not affect the distri- bution of wealth between farmers and ranchers. Instead, the landlords who own farms may gain and the landlords who own ranches may lose. In general, any change in the value of land gets “capitalized” into rent. Consequently, the wealth effects of reshuf- fling property rights in a world with zero transaction costs tend to fall on the owners of 25 land, not its users. In addition, there is another reason for the relative inefficiency of redistribution by property law. Redistribution by property law distorts the economy more in the long run than does progressive taxation. For example, if property law favors farmers over ranch- ers, some rich ranchers may switch to farming to gain valuable legal rights. In contrast, a comprehensive income tax precludes people from reducing their tax liability by 26 changing the source of their income. For these reasons and more, economists who fa- vor redistribution and economists who oppose it can agree that property law is usually 25 , T Professor Coase made this argument in “ Notes on the Problem of Social Cost ” in T HE F HE M ARKET , IRM AND AW L HE T (1988). In general, taxes and other government impositions finally fall on factors in rela- tively fixed supply, such as land. 26 A fundamental principle in public finance is that taxes distort less when applied to a broad base rather than to a narrow base. Distortion decreases with the breadth of the base because demand becomes less elastic. To i l l u s t r a t e , t h e d e m a n d f o r f o o d i s l e s s e l a s t i c t h a n t h e d e m a n d f o r veg e t a b l e s , a n d t h e d e m a n d f o r veg - etables is less elastic than the demand for carrots. Income is a very broad base.

123 108 CHAPTER 4 Economic Theory of Property An the wrong way to pursue distributive justice. Unfortunately, these facts are not appreci- 27 ated by many lawyers who have not studied economics. We h ave p r e s e n t e d s eve r a l r e a s o n s a g a i n s t b a s i n g p r o p e r t y l aw o n r e d i s t r i bu t ive goals. Specifically, we discussed imprecise targeting, unpredictable consequences, high transaction costs, and large distortions in incentives. While the general principles of property law cannot rest on wealth redistribution, special kinds of redistributive laws can ameliorate these objections and blunt this criticism. An example is laws requiring em- ployers to construct buildings that provide access to people in wheelchairs. If properly designed, these laws can precisely target handicapped people in a predictable way, en- forcement by private legal action can be inexpensive, and the distortion in incentives can be modest. Designing such laws to produce these desirable outcomes, however, requires more careful attention to the underlying economics than regulators typically show. Conclusion Property is a bundle of rights with incentive effects. Efficient property rights create incentives to maximize a nation’s wealth in two different ways. First, property rights are allocative efficiency by moving the legal basis of voluntary exchange, which achieves goods from people who value them less to people who value them more. Second, prop- erty rights are part of the law that makes owners internalize the social costs and benefits of alternative uses of the goods that they own. Owners achieve productive efficiency by balancing the social costs and benefits of what they do with what they own. Suggested Readings Bell, Abraham, & Gideon Parchomovsky, A Theory of Property ORNELL L. R EV .531 (2005). , 90 C The Pointlessness of Pareto: Carrying Coase Further Calabresi, Guido, , 100 Y ALE L. J. 1043 (1991). The Cost of Coase , 11 J. L Cooter, Robert, EGAL TUD . 1 (1982). S Ellickson, Robert D., Property in Land , 102 Y ALE L.J. 1315 (1993). E LLICKSON , R OBERT , O RDER W ITHOUT L AW : H OW N EIGHBORS S ETTLE D ISPUTES (1991). Lueck, Dean, & Thomas Miceli, Property , in A. M , P TEVEN S HAVELL & S EDS ., ITCHELL OLINSKY H L AW A N D ANDBOOK OF CONOMICS , vol. 1 (2007). E Merrill, Thomas W., & Henry E. Smith, Optimal Standardization in the Law of Property: The , 110 Y Numerus Clausus Principle ALE L.J. 1 (2000). Merrill, Thomas W., & Henry E. Smith, What Happened to Property in Law and Economics? , 111 Y ALE L.J. 357 (2001). Polinsky, A. Mitchell, Resolving Nuisance Disputes: The Simple Economics of Injunctive and , 32 S Damage Remedies . L. R EV . 1075 (1980). TA N 27 An important technical conclusion in formal welfare economics (the Second Fundamental Theorem of Welfare Economics) reinforces the general point made in the text—namely, that efficiency and equity are separable. With specific reference to property law, that conclusion can be read to say that property law should seek to al- locate and enforce entitlements so that a society uses resources efficiently and should then use the tax-and- transfer system to achieve distributive equity. See, for example, Steven Shavell, A Note on Efficiency v. Distributional Equity in Legal Rulemaking: Should Distributional Equity Matter Given Optimal Income Ta x a t i o n ? , 71 A M . E CON . R EV .414 (1981), and Louis Kaplow & Steven Shavell, Why the Legal System Is Less Efficient Than the Income Tax in Redistributing Income, 23 J. L EGAL S TUD .667 (1994).

124 CHAPTER 4 APPENDIX The Philosophical Concept of Property property to be an instrument for pursuing fun- HILOSOPHERS GENERALLY PERCEIVE damental values. Some philosophers of property have concentrated on its ability P to advance values such as utility, justice, self-expression, and social evolution. These traditions of thought have influenced the law. This appendix introduces the reader to four of these traditions and relates them to the economic analysis of property. 1. Utilitarianism Utilitarians measure the value of a good or an act by the net pleasure or satisfac- tion that it creates. For utilitarians, the purpose of the institution of property is to max- imize the total pleasure or satisfaction obtained from material and other resources. Bentham thus defines property as an expectation of utility: “Property is nothing but a basis of expectation; the expectation of deriving advantages from a thing, which we 28 are said to possess, in consequence of the relation in which we stand toward it.” The objective of maximizing total utility constitutes a standard against which property rules can be evaluated. In our examples at the beginning of the chapter, each of the disputes could be resolved on utilitarian grounds by establishing a legal rule that seeks to maximize the sum of utilities or pleasure of society as a whole. The utilitarian approach makes a person’s claim to property tentative. It can be taken from him in principle if the beneficiaries of the expropriation gain more in utility than the owner loses. Suppose, for example, that a young son is living with his aged parents in their home. On utilitarian grounds, the young son may be ex- cused for throwing the parents out of the home if their loss in utility from being dis- possessed is less than his gain in utility from having them out of the house. Critics of utilitarianism have often wondered whether the theory makes ownership too ten- tative. Isn’t ownership more than an expectation? Do we really think that a person could be rightfully deprived of his property just because the loss is more than offset by the gain to others? This objection to the utilitarian theory of property applies with equal force to the conventional economic theory that holds that the purpose of property is to maximize wealth. Isn’t ownership more than a right to a stream of income? Do we really think 28 EREMY B ENTHAM , T HEORY OF L J : P RINCIPLES OF THE C ODE 111–113 (Hildreth ed. 1931). EGISLATION 109

125 110 CHAPTER 4 An Economic Theory of Property that a person could be rightfully deprived of her property just because the loss of wealth is more than offset by the gain in wealth to others? 2. Distributive Justice Another philosophical approach to property law emphasizes property law’s ability to achieve distributive justice, rather than pleasure or satisfaction. Aristotle, for exam- ple, held that a conception of distributive justice is implicit in various forms of social organization. For Aristotle, the principle of justice is different for different societies, but it is appropriate for each type of society to promote its own conception of distribu- tive justice through its constitution and laws, including its notion of property rights. He argued that a democracy will favor an equal distribution of wealth, whereas an aristoc- racy (the form preferred by Aristotle) will favor the distribution of wealth according to the virtues of various classes. In Aristotle’s conception, it is just that aristocrats receive an unequal share of wealth because they use it for more worthy ends than do others. From the Aristotelian conception of democratic equality we might infer a policy of redistributive justice whereby the valuable assets of society are periodically redistrib- uted so as to achieve a roughly equal distribution of that property. In general, this sort of redistribution would favor the poor and penalize the wealthy. On the other hand, from the Aristotelian justification of aristocratic inequality we might infer the polar- opposite policy of redistributive justice whereby the assets of society would be periodi- cally redistributed to the aristocrats. To the extent that the aristocracy and the wealthy are the same group, this redistribution of property would favor the rich and penalize the poor. In either case, these notions of distributive justice make property claims as tenta- tive as they were under utilitarianism and, therefore, open to the same criticisms. There is another school of philosophical thought relating to distributive justice and property that emphasizes a just process for defining and enforcing property rights 29 or end result in the distribution of wealth from property. rather than a just outcome According to one version of this theory, any distribution of wealth is just provided that it starts from a just initial distribution of resources and achieves the final distribution by voluntary exchange. In practice, this means that the process of voluntary market ex- change is just and that ownership claims are most justly established and enforced in an unfettered market in which there is free and perfect competition. In Nozick’s memo- rable rephrasing of Marx, “From each as he chooses; to each as he is chosen.” Whatever distribution of wealth results from this just process is also just. Thus, accord- ing to this theory, redistributing property to dilute the effects of competition is unjust. Several criticisms have been made of this notion of distributive justice. The most telling criticism is that the competitive process can lead to a multitude of distributive outcomes, from one in which each individual has an equal share to one in which one individual has 99 percent of the property and everyone else divides up the remaining 1 percent. All of the outcomes are efficient. But clearly not all of them are equitable or just. The notion of the competitive process as distributive justice is not a sufficient 29 TAT E The most forceful modern statement of this view is in R. N , A NARCHY , S OZICK , AND U TOPIA (1974).

126 4. Conservatism and the Origins of Property 111 guide to designing rules of property law. At a minimum, there must be an additional, independent standard by which to appraise various initial endowments of property. 3. Liberty and Self-Expression Besides utility and distributive justice, another value that may underlie property law is liberty. Private property is a precondition for markets, and markets are a decen- tralized mechanism for allocating resources. Most markets can, and do, operate with- out extensive government interference or supervision. The practical alternative to markets in the modern economy is some form of government planning. Government planning involves centralizing power over economic matters in the hands of state offi- cials. Control over economic life provides officials with leverage that can be used to control other aspects of life, whereas private property creates a zone of discretion within which individuals are not accountable to government officials. Private property has thus been viewed by some philosophers as a bulwark against the dictatorial au- 30 thority of governments. It has been argued, for example, that capitalism was deliber- ately invented to thwart absolutism by depriving the king of economic power. The U.S. Constitution was probably drafted with this idea in mind. Another connection between property and liberty focuses on individual self- expression. Hegel stressed the idea that people, through their works, transform nature into an expression of personality, and, by doing so, perfect the natural world. A painter takes materials in no particular order and rearranges them into a work of art. By invest- ing personality in work, the artist transforms natural objects and makes them the artist’s own. It is difficult to imagine a system of property law that did not recognize this fact. Thus, to encourage self-expression, the state needs to recognize the creators’ rights of ownership over their creations. Notice that this proposition extends beyond art to most of the works of humans. 4. Conservatism and the Origins of Property The philosophical theories discussed so far tend to regard the institution of property as serving ultimate values, such as utility, distributive justice, or liberty. Another philo- sophical tradition focuses not on the purposes of property but on its origins. To illustrate, in medieval times there were many encumbrances and restrictions on the use and sale of real estate. The common law of private property emerged from feudalism and acquired its modern character by chipping away at these encumbrances on the marketability of real property. Political conservatives like Burke and Hayek idealize forms of social order that, like the common law of property, evolve over time in much the same manner as the myr- iad species of life. Like organisms, social forms are, in this view, subject to the rules of natural selection. The conservative philosophers condemn institutions imposed on us by planners, engineers, politicians, and other societal decision makers for much the same reasons that environmentalists condemn actions that interfere with an area’s environment. 30 (1786) and in the work of Friedrich Hayek (see, for This is a theme in T F EDERALIST P APERS HE example, The C ONSTITUTION OF L IBERTY (1972)).

127 To p i c s i n t h e E c o n o m i c s of Property Law 5 chapter, we developed an economic theory of property rights and NTHEPRECEDING remedies. We saw that property law creates a bundle of rights that the owners of property are free to exercise as they see fit, without interference by the state or I private persons. Consistent with this freedom is a system of allocation by voluntary exchange. Property law fosters voluntary exchange by removing the obstacles to bargaining. When the obstacles to bargaining are low, resources will be allocated effi- ciently. We used this framework and economic theory to answer the following four questions that must be addressed by a theory of property law: 1. What can be privately owned? 2. How are ownership rights established? 3. What may owners do with their property? 4. What are the remedies for the violation of property rights? To a n s w e r t h e fi r s t q u e s t i o n , w e d i s t i n g u i s h e d b e t w e e n p r iva t e a n d p u b l i c g o o d s , a n d we claimed that the former should be privately owned. Private ownership is appropriate when there is rivalry and exclusion in the use of goods. To answer the second question, we presented a thought experiment to illustrate how property law encourages produc- tion, discourages theft, and reduces the cost of protecting goods. According to this thought experiment, people agree to establish property rights to share the benefits from increased productivity. We answered the third question by developing the theory of externalities, especially the connection between public bads in economics and nui- sances in law. We noted that common law approximates a system of maximum liberty, which allows any use of property by its owner that does not interfere with other peo- ple’s property or protected rights. In answering the fourth question, we used bargaining theory to conclude that the injunctive remedy is preferred for private bads with low transaction costs for private bargaining. Conversely, the damage remedy is preferred for public bads with high transaction costs that preclude private bargaining. These answers given in the previous chapter are very general. In this chapter, we reexamine these questions in detail, with concrete applications. The topics are organ- ized roughly according to the four fundamental questions of property law. I. What Can Be Privately Owned? The economic distinction between public and private goods characterizes two ideal types. Although reality is never ideal, understanding these ideal types increases your 112

128 113 I. What Can Be Privately Owned? understanding of laws governing real goods. In this section we discuss the application of property law to information, which has some features of a public good. Four princi- pal areas of law create property in information and are called “intellectual property law.” The patent system establishes ownership rights to inventions, processes, and other tech- grants ownership rights to authors, artists, nical improvements. The copyright system and composers. The establishes ownership for distinctive commercial trademark system marks or symbols that uniquely identify an individual’s or organization’s output. The area of law known as trade secrets deals with business practices in which commercial enterprises have a property interest. (We discuss trade secrets briefly below and more extensively on our website.) After discussing the economics of information, we will turn to its application to the law of patents, copyright, and trademark. Then we will turn to a new section on the ownership of organizations, specifically corporations. A. Information Economics Five thousand years ago people slept under grass roofs, covered themselves with skins, and fastened sharp stones on sticks to throw at animals. An American Indian friend of Professor Cooter said, “My father lived in the stone age, I grew up in the iron age, and I’m dying in the computer age.” The technical innovations that drove these changes have accelerated. Since the industrial revolution, innovation has caused wealth to grow at compound rates. Compounded over a century, a 2 percent annual growth rate increases wealth more than six times; a 5 percent annual growth rate increases wealth more than 130 times; and a 10 percent annual growth rate increases wealth almost 14,000 times. This section concerns some laws that promote innovation and cause compound growth. To understand how these laws affect growth, we must first explain the basic economics of innovations, beginning with the effects of innovation on welfare. An economic innovation provides a better way to make something or something better to make. A better way to make something lowers its cost, so the supply curve shifts down and to the right. This shift causes the price of the good to fall for consumers. The amount of their gain is measured by the increase in consumers’ surplus in the market for the cheaper good. Similarly, finding something better to make creates a new good that some consumers buy. Consumers benefit from the fall in the price of a good that they buy or from the introduction of a new good. In addition, innovations can make whole industries ap- pear, disappear, or restructure. Only historians remember the American Ice Trust, which was one of America’s largest corporations in 1900. By changing wages and employment, innovation disrupts communities, causing some to grow and others to wither. The mechanization of agriculture in the U.S. emptied the countryside in the early twentieth century and left vacant buildings boarded shut in small towns. Although many agricultural workers moved to the city for higher wages, a plough- man with a team of horses who remained in the countryside found few employers who valued his skill. In Europe, the industrial revolution shoved the nobles with large estates out of the centers of political power. Joseph Schumpeter appropriately called innovation “creative destruction.”

129 114 CHAPTER 5 opics in the Economics of Property Law T Most societies value the gains from faster growth more than they fear its destructive effects. Property law can help to secure rapid economic growth. To understand why, we must shift from consumers and workers to companies. A company that innovates gains a competitive advantage, which immediately creates extraordinary profits. Extraordinary profits reward the innovator for the resources and effort devoted to a very risky activity. In the long run, however, competition causes the innovation to diffuse, and many com- panies make use of it. When the innovation diffuses fully, the innovator loses its com- petitive advantage, and its profits fall to the ordinary level. When diffusion is complete, the economy reaches a new equilibrium whose benefits diffuse even more broadly than the innovation. In this life cycle of an innovation, the innovation causes a disequilibrium, and the innovator earns extraordinary profits as long as it persists. The reward for innovation thus depends on how long the disequilibrium persists. A quick move to equilibrium gives little reward to the innovator for the resources that it invested and the risk that it assumed. Without legal intervention, competition can quickly destroy the profits from innovation, which results in too little innovation. To s e e w h y, w e m u s t u n d e r s t a n d s o m e e l e m e n t s o f t h e e c o n o m i c s o f i n f o r m a t i o n . Everyone with a television or computer buys information, but information differs from other commodities like oranges or razor blades. What special problems exist in defin- ing property rights and establishing markets in information? Information has two char- acteristics that make transactions in information different from transactions in ordinary private goods. The first characteristic is credibility, which we discuss in Chapter 9. The second characteristic, which we discuss now, is nonappropriability. Information is gen- erally costly to produce and cheap to transmit. To i l l u s t r a t e , p o p u l a r m u s i c i s c o s t l y t o m a ke a n d r e c o r d i n g s a r e c h e a p t o c o py. The instant the producer sells information to the buyer, that buyer becomes a poten- tial competitor with the original producer. For example, when someone buys a com- pact disk recording at a music store, the buyer can copy the disk immediately and resell it to others. Furthermore, the reseller bears only the cost of transmission, not the cost of production. Thus, resellers who pay for transmission undercut producers who pay for production. Consumers try to “free ride” by paying no more than the cost of transmission. The fact that producers have difficulty selling information for more than a fraction of its value is called the problem of nonappropriability. To illustrate, Hong Kong shops traditionally resell American software at the cost of a diskette. Producers use various devices to try to protect their products against appropriation, such as writing computer programs that are hard to copy. (The industry calls this “digital rights management.”) But for every program obstructing copying, there is a hack. Consider the connection between nonappropriability and public goods. Information contains ideas. One person’s use of an idea does not diminish its availability for others to use. Thus, information use is nonrivalrous. Excluding some people from learning about a new idea can be expensive, because the transmission of ideas is so cheap. Thus, information is nonexcludable . These are the two characteristics of public goods identi- fied in Chapter 2. Nonappropriability of information is essentially the same problem as non-excludability for public goods.

130 I. What Can Be Privately Owned? 115 Because of these problems, private markets often undersupply public goods. Similarly, economists who developed the original economics of information concluded that a private market would provide less than the efficient amount of information. These theoretical considerations suggest that an unregulated market will undersupply creative works that embody ideas, such as science, inventions, books, and paintings. The problem has four different remedies that we will describe. The first remedy is for the state to supply or subsidize art and science, especially basic research. Thus, the state owns or subsidizes many universities. More relevant to this book are subsidies for trials. In many civil law countries such as Mexico and Chile, the citizens have a right to use the courts for free. In the United States litigants are as- sessed court fees, but fees fall far short of court costs, so trials are subsidized. In Chapter 10 we will argue that common law precedents are a valuable stock of ideas. From this fact we will conclude that U.S. courts should stop subsidizing the resolution of private disputes and continue subsidizing the creation of legal precedents. charitable contributions. A great tradition in the United The second remedy is States and some other countries (but not all) is the expectation that wealthy people will make substantial voluntary contributions to the arts and sciences. Besides social norms requiring such gifts, the tax system in the United States allows for the deduction of charitable donations from the donor’s taxable income. In practice, the charitable deduc- tion means that donors contribute roughly two-thirds of the donation’s value and the U.S. Treasury contributes the other one-third. Other countries such as Switzerland do not allow such deductions, apparently because of sentiment that the state, not the rich, should control the arts and sciences. Charity, however, enjoys this significant advan- tage over government: donors monitor the use of their money by their favorite charities more carefully than taxpayers monitor the government’s use of taxes, and monitoring reduces waste. The third remedy, broadly described as comes from con- trade secrets protection, tract and tort law. An employee or contractor with a Silicon Valley company is rou- tinely required to sign a non-disclosure agreement (NDA). In an NDA, the employee or contractor promises not to disclose any of the company’s secrets. For example, the em- ployee or contractor promises not to speak or write about the company’s machinery, equipment, research, or business practices. Trade secrets protection ideally prevents the transmission of information and allows its producer to appropriate its value. Trade secrets laws, however, have weaknesses that impair their effectiveness. Assume that inventor A employs person B who signs an NDA, and then person B leaks A’s secrets to company C: Third Party Employee Inventor A B C Contract Transmits information includes NDA A has a contract with B and no contract with C. Because C has no contractual obligations to A (in legalese, A and C do not have “privity” of contract), A has lim- ited legal powers to prevent C from using A’s trade secrets or transmitting them to

131 116 CHAPTER 5 opics in the Economics of Property Law T others. If C knew or had reason to know that B violated the NDA, then A could sue C. If C induced B to violate the NDA, then A could sue C. But if C did not know, or have rea- son to know, or induce B’s breach of contract with A, then C did nothing wrong in receiv- ing the information. Furthermore, if the information has thoroughly leaked and become common knowledge in the industry, anyone can use it for free, even if they know that the information originally escaped into the public sphere by breach of contract. Recent survey research concludes that trade secrets protection is not very effective in Silicon Valley. In reality, employees change jobs frequently in Silicon Valley, and they carry many of the old firm’s secrets to the new firm. In fact, many Silicon Valley employees do not understand when they breach trade secrets laws, partly because these laws depart so far from business practices in Silicon Valley. The fourth remedy, which usually supplements trade secrets protection, is intellectual property law. In addition to non-disclosure agreements with his employees, associates, and business customers, inventor A may try to obtain a patent, copyright, or trademark. If his application succeeds, A will have property rights in the information that he produced. For this reason, these three bodies of law belong to the study of intellectual property, which is our next topic. Web Note 5.1 We d i s c u s s t h e bu rg e o n i n g l aw - a n d - e c o n o m i c s l i t e r a t u r e o n t r a d e s e c r e t s o n our website. B. Intellectual Property As with real estate, ownership of the mind’s products implies the right to exclude others from using them. When intellectual property rights are effectively enforced, the owner of a new computer chip or novel can use the power of exclusion to extract a price from other users. The price rewards the creator, which results in more innovations and faster growth—a form of “dynamic efficiency.” After making an innovation, disseminating it allows more people to enjoy its advantages. Intellectual property rights can also increase dissemination. Without prop- erty rights, the innovator may try to keep the innovation secret in order to profit from it. Thus, Renaissance Venetians carefully guarded the secrets of glassmaking, and Shakespeare carefully guarded the texts of his plays so that only his company could perform them. With effective intellectual property rights, however, the innovator need not fear that others will steal the innovation. Instead of keeping it secret, the owner can disseminate it and charge fees for its use, such as licensing fees for patents or perform- ance fees for plays. Replacing secrecy with property increases dissemination, which results in wider use—an increase in “static efficiency.” Although secure intellectual property rights cause the owner to disseminate an innovation, dissemination usually stops short of the point required for static efficiency. Monopoly theory explains why. A valuable invention creates a better product or a better way to make an old product. If the invention has no close substitutes, granting a patent

132 I. What Can Be Privately Owned? 117 or copyright creates “monopoly power,” which means that the seller can raise the price. To m a x i m i z e p r o fi t s , t h e ow n e r- m o n o p o l i s t s e t s t h e u s e r f e e t o o h i g h f o r s o c i a l e ffi - ciency, so use is too low. Thus, intellectual property law may result in less dissemina- tion of an innovation than required for static efficiency. Patents and copyright may be temporary monopolies that can vary in breadth and duration. Narrowing the breadth or shortening the duration of intellectual property rights often decreases monopoly profits and increases dissemination. To illustrate, as- sume that one person writes a novel and another adapts it for a movie. Narrow copy- right law gives the novelist ownership of the novel and the adapter ownership of the movie rights. In contrast, broad copyright law gives the novelist ownership of the novel and the movie rights, which are an example of what are called “derivative works.” Similarly, a patent on a computer chip can last different lengths of time in different countries. Starting from narrow, short intellectual property rights, broadening and lengthening them rewards the creator and encourages more innovation. If the innova- tion can be kept secret, then broadening and lengthening the intellectual property rights rewards dissemination by increasing user fees. Thus, increasing incentives for creation also increases incentives for dissemination, at least up to a point. Beyond this point, however, broadening the scope or duration of the creator’s property rights increases monopoly power, which rewards creation and reduces dissemination. Thus, incentives for creation and dissemination trade off. (Later we explain that increasing the scope or duration of the creator’s property rights still further may eventually reduce creation and dissemination.) To appreciate the problem of dissemination, consider bridge tolls. Efficiency re- quires the toll to equal the marginal cost of crossing the bridge. The cost of allow- ing another motorist to cross an bridge is approximately zero, so the uncongested optimal toll is approximately zero. If the optimal toll is not zero, someone who val- ues crossing the bridge will fail to do so, which is a waste. Suppose the toll is $1. A person who is willing to pay $.75 will not cross, so the toll destroys $.75 in benefits that could have been created at no cost. (The conclusion is different for a congested bridge, where increased congestion is the cost of allowing another motorist to cross.) Similarly, the cost of allowing another person to use a patented computer program or music recording is approximately zero, so the optimal user fee is ap- proximately zero. However, the fee that maximizes profits for the owner is much larger than zero. Thus, intellectual property may result in too-high user fees and too- low dissemination. The innovation-diffusion tradeoff causes major trade tensions in the contempo- rary world. The world’s developed countries create far more innovations that result in patents or copyrights than developing countries do. The developed countries, conse- quently, focus on the benefits of strong intellectual property rights that protect their creators. In contrast, the developing countries benefit from wide diffusion of technol- ogy at low cost. The developing countries, consequently, lack enthusiasm for enforc- ing intellectual property rights that raise prices to their consumers. Thus, Microsoft wants China to suppress illegal copying of its software, and China apparently lacks enthusiasm for this effort. The net result is that the latest Microsoft software sells in Hong Kong street markets for the cost of a diskette, and the U.S. threatens to sue

133 118 CHAPTER 5 opics in the Economics of Property Law T 1 China in the World Trade Organization. These tensions should ameliorate as China finds that weak intellectual property law retards its own development of software and other creative industries. Intellectual property law confronts the innovation-dissemination tradeoff and resolves it somewhat differently in each of its three principal areas—patents, copy- rights, and trademarks. Intellectual property law, however, is a historical accretion that developed without a scientific basis. Only recently has property law come un- der economic analysis. Even today, however, available economic analysis is insuffi- cient to the task. The usual technique of economic analysis involves comparing equilibria with fixed technology (“static equilibrium analysis”), whereas intellectual property law requires an analysis of innovation and changing technology (“growth theory”). Improvements in the economics of information will no doubt produce new, better critiques of intellectual property law. In the meantime, the economic analysis of intellectual property law must proceed with the tools at hand. Besides inadequate scientific tools, intellectual property law aligns poorly with economic efficiency be- cause the legislators respond to politically powerful special interest groups who care about their own profits more than the nation’s wealth. The development of high technology industries challenges both economic theory and the law. Almost all questions regarding intellectual property law are open. This fact makes the subject both exciting and confusing. 1. Patents: Broad or Narrow? To a p p r e c i a t e t h e h i s t o r y o f p a t e n t l aw, c o n - sider its evolution. European patents for inventions began in the Republic of Venice in 1474 and were formalized in England in the Statute of Monopolies in 1623. Article I, Section 8 of the U.S. Constitution gives Congress the power “to promote the progress of science and useful arts, by securing for limited time to authors and inventors the exclusive right to their respective writings and discoveries.” To put this power into action with respect to patents, the U.S. Congress passed America’s first patent law in 1790, which was revised in 1793, 1836, 1952, and 1995. To secure an exclusive right to an invention, the inventor must submit an application to the U.S. Patent Office establishing that the invention is for a “new and useful process, ma- chine, manufacture, or composition of matter, or [a] new and useful improvement thereof.” (35 U.S. Code 101.) The invention must be “non-obvious,” must have “practical utility” (a characteristic that is more or less presumed for all applicants), and must not have been commercialized or known to the public for more than a year before the date of application. A patent examiner—a government official who is, ideally, a lawyer with a strong scientific background—must decide whether to grant the patent. Approximately three-fourths of all applications are granted by the Patent Office. Throughout the 1970s, between 70,000 and 80,000 patents were granted per 1 The Agreement on Trade Related Aspects of Intellectual Property, or T RIPS , applies to all members of the Wo r l d Tr a d e O rg a n i z a t i o n . I n t e l l e c t u a l p r o p e r t y r i g h t s a r e a l s o e n f o r c e d i n t e r n a t i o n a l l y t h r o u g h t h e Wo r l d IPO . Intellectual Property Organization, or W

134 I. What Can Be Privately Owned? 119 2 But in the 1990s patent applications and the number of patents granted in the year. United States exploded to nearly 150,000 per year. The successful applicant now re- 3 No one can use the inven- ceives a 20-year monopoly on the use of the invention. tion except by its owner’s consent. Others who wish to use the invention must purchase the right to do so from the patent-holder. The holder may, at his or her dis- the use of the patent in exchange for the licensee’s payment of a fee cretion, license royalty. known as a If a patent-holder believes that another is using his patent without permission, he or she may bring an action for infringement and seek both injunctive and legal relief. Web Note 5.2 See our website for more on recent developments in patent laws in the United States and other nations, including speculation on the causes of the tremen- dous upsurge in the number of patents in the 1990s and early 2000s. An inventor who applies for a patent risks more than lawyers’ fees. The informa- tion in the application is accessible to the public. If the application fails, competitors will be able to freely use the invention described in the application. If the application succeeds, competitors will have a precise description of the invention, so they can try to emulate it without trespassing on the patent (“engineer around the patent”). For these reasons, some inventors prefer to rely on trade secrets protection and not apply for a patent. More typically, however, an inventor relies on both trade secrets laws and patents to protect his intellectual property. Patents create an exclusive property right in an invention with two dimensions: duration and breadth . “Duration” refers to the number of years between a patent’s regis- tration and its expiration. For example, most U.S. patents last for 20 years from the date of application. “Breadth” refers to how similar another invention can be without infring- ing on the patent for the original invention. To illustrate, the Rubik’s Cube is a popular puzzle in which each of the six sides of the cube are divided into a 3 " 3 grid, and each of the cells in the grid is colored. The object of the game is to manipulate the cube in order to align rows of same-colored cells. An American court ruled that the Rubik’s × 2 Cube did not infringe an earlier patent by Moleculon for a similar game using a 2 4 grid. 2 Of those issued between 1971 and 1975, 51 percent were granted to domestic corporations, 23 percent to foreign corporations and governments, 2 percent to the U.S. federal government, and 23 percent to individ- ual inventors. This distribution represents a trend in the century toward corporate ownership and away from individual ownership of new patents. F REDERICK S CHERER , I NDUSTRIAL M ARKET S TRUCTURE AND E CONOMIC P (2d ed. 1980). ERFORMANCE 3 In 1995, as part of the agreement establishing the World Trade Organization, the U.S. Congress changed the patent life from 17 years from the date of approval to 20 years from the date of application. The change, which brings the U.S. system into conformity with other national patent systems, arose from the approval of the latest international trade agreement. 4 Moleculon Research Corp. v. CBS, Inc., 872 F.2d 407, 409 (Fed. Cir. 1989).

135 120 CHAPTER 5 opics in the Economics of Property Law T An important policy question concerns the efficient breadth of a 1a. Breadth patent. To understand the difference in incentive effects between narrow and broad patents, contrast two inventors, two inventions, and two rules. Assume that two inven- tors are contemplating investing in research on two inventions. The first invention would improve oil-cracking processes, and the second invention would provide a sub- stitute for lead in gasoline. The inventors expect the two inventions to be similar but not identical. Under a broad rule, a single patent would encompass both inventions. Because the party who makes the first invention receives exclusive rights to both inven- tions, the party who makes the first discovery gets all of the profits, and the other party gets nothing. Thus, the broad rule encourages fast, duplicative research. In contrast, un- der a narrow rule, a separate patent would be required for each invention. The party who makes the first invention would receive exclusive rights to it, and the party who makes the second invention would have exclusive property rights to it. Thus, the nar- row rule encourages slower, complementary research. To a p p r e c i a t e t h i s c o n t r a s t b e t w e e n b r o a d a n d n a r r ow p a t e n t s , c o n s i d e r a t y p i c a l relationship between research and development (R&D). Research sometimes yields a pioneering discovery with no immediate commercial value, but with large commercial potential. To realize its potential, a pioneering discovery must be developed and “brought to market.” Development involves a series of small improvements. A patented pioneering invention can be followed by a valuable application patented by another in- ventor. In such cases, U.S. law has an interesting feature: Neither party can use the ap- plication without the other’s permission. As long as both patents endure, the owner of the application cannot use his patent without a license from the owner of the pioneer- ing invention, and the owner of the pioneering invention cannot use the application without a license from its owner. The result is that they have to negotiate with each other and reach an agreement before anyone can use the application and make money from it. U.S. patent law for pioneering inventions and applications creates an incentive for each to bargain with the other. These mutual rights get triggered when the subsequent invention is an application of the prior invention. The legal question is how broadly the pioneering discovery ex- tends over the follow-on inventions. Broad patents encourage fundamental research, and narrow patents encourage development. Thus, suppose that an investment of $100,000 in research yields a pioneering invention that has no commercial value. Subsequently, an investment of $50,000 in development yields an improvement to the pioneering invention that has commercial value of $1 million. If the law grants broad patents, a patent for the pioneering invention would also cover the improvement, but if the law grants narrow patents, separate patents would be required for the pioneering invention and the improvement. What breadth of patents is most efficient? If the social value of investment on fun- damental research exceeds the social value of investment on developing applications, then patents should be broadened. Conversely, if the social value of investment on developing applications exceeds the social value of investment on fundamental research, then patents should be narrowed. In reality, questions of breadth are decided in law according to the “doctrine of equivalents,” which refers to a series of court findings about how nearly equivalent

136 I. What Can Be Privately Owned? 121 two inventions must be before finding patent infringement. This doctrine is obscure and unpredictable. Courts have sometimes reasoned that an improvement with great commercial value should not be interpreted as infringing on a pioneering invention 5 After all, the improvement, not the pioneering inven- with little stand-alone value. tion, is what people really value. Howard Chang, an economist-lawyer, has recently shown that this argument is 6 flawed for purposes of maximizing the social value of inventive activity. If the people who do fundamental research receive the sale value of the pioneering invention, but they do not receive any of the sale value of the commercial applications, there will not be enough fundamental research. To see why, consider an analogy between pioneering inventions and raising sheep. Sheep are sold for mutton and wool. Assume that the mut- ton from a sheep is worth much more than the wool. If shepherds are paid the value of the wool, but not the value of the mutton, then shepherds will not be paid enough, and of rearing sheep. they will raise too few sheep. Mutton and wool are joint products Efficient incentives require that shepherds receive the sale value of their product (sheep), which is the sum of the sale value of mutton and wool. Similarly, commercial applications and pioneering inventions are joint products of fundamental research. Commercial applications require pioneering inventions, and pio- neering inventions require fundamental research. A joint product will be undersupplied if the supplier’s compensation equals the commercial value of only one of the joint prod- ucts. Ideally, the fundamental research and commercial development would be joined together in a single firm. If the activities are joined under a single producer, then the pro- ducer will receive the sum of the value of the fundamental research and commercial ap- plication, just like paying the shepherd the sum of the value of the mutton and wool. Even if one firm conducted fundamental research and another firm developed com- mercial applications, the incentive problem could be solved if transaction costs were zero. If transaction costs were zero, then the Coase Theorem would apply: breadth of patent does not matter to economic efficiency so long as inventors can bargain with each other costlessly and make efficient contracts. Problems arise under the realistic assumption that transaction costs impede bar- gaining between suppliers of fundamental research and commercial development. Two legal remedies are available: lubricate bargaining (Normative Coase Theorem) or allo- cate rights to the party who values them the most (Normative Hobbes Theorem). Instead of pursuing these two remedies, U.S. law has been perverse in both respects. Bargaining among inventors sometimes leads to joint research ventures, in which competing manufacturers share an R&D facility and compete with each other in pro- duction and sales. In America, antitrust laws have inhibited joint ventures for research and development. Thus, the application of antitrust law to R&D obstructed a solution to the problem of the joint production of inventions. Fortunately, American officials have recognized this failure in policy and taken steps to correct it. 5 Westinghouse v. Boyden Power Brake Co ., 170 U.S. 537, 572 (1898). See 6 Pa t e n t S c o p e, A n t i t r u s t Po l i c y, a n d C u m u l a t i v e I n n ov a t i o n , J. E 26 R AND See Howard F. Chang, CON . 34 90 (1995). See also Robert P. Merges & Richard R. Nelson, On the Complex Economics of Patent Scope, C . 839 (1990). EV . L. R OLUM

137 122 CHAPTER 5 opics in the Economics of Property Law T When separate producers make joint inventions, officials face a difficult problem in determining the breadth of the patents. If the pioneering invention has little stand- alone value, then some of the improvement’s value must be paid to the pioneer in order to provide an adequate incentive for pioneering inventions. On the other hand, if the pi- oneering invention has large stand-alone value, then its inventor often will be rewarded adequately already, even if he or she receives no share of the value of the improvement. Thus, patent protection for pioneering inventions should be for those with little broader stand-alone value, and the patent protection for pioneering inventions should be for those with large stand-alone value. This is just the opposite of the result narrower 7 sometimes reached by U.S. courts. UESTION When the patent expired on a drug named “Librium” (a 5.1: Q sedative that was the forerunner of Valium), its price dropped from $15 to 8 Explain why this drop in price occurred. Relate your explanation to $1.10. the problem of efficient incentives for creating and transmitting an idea. Q UESTION 5.2: Recall our example of an investment of $100,000 in research that yields a pioneering invention that has no commercial value, and a subse- quent investment of $50,000 in development that yields an improvement that has commercial value of $1 million. Assume that Firm A is uniquely situated to do the pioneering research, and Firm B is uniquely situated to develop the appli- cation. Predict the difference in investment resulting from a broad patent law and a narrow patent law. In making your prediction, distinguish between a situa- tion in which transaction costs prevent Firm A and Firm B from bargaining with each other and a situation in which transaction costs of bargaining are zero. UESTION 5.3: When inventions take the form of discovery and applica- Q tion, the authorities may issue a “dominant patent” to the pioneering discov- ery and a “subservient patent” to the improvement. The subservient invention cannot be manufactured legally without the agreement of the holders of the dominant patent and the subservient patent. Thus, the two parties are com- pelled to bargain, each having veto power, and agree on the division of future profits before manufacturing the improvement. Absent such an agreement, only the pioneering invention can be manufactured. Answer Question 5.2 un- der the assumption that, instead of prescribing broad or narrow patents, the law grants a dominant patent and a subservient patent. 7 The technical name for the legal doctrine giving perverse results is the “doctrine of equivalents.” Applying this doctrine, courts may find that a pioneering invention with little stand-alone value is not equivalent to an application of it, so the patent for the former does not extend to the latter. In contrast, the courts may find that a pioneering invention with stand-alone value is equivalent to an application of it, so the patent for the former extends to the latter. 8 “‘When Librium, Hoffmann-LaRoche’s forerunner to Valium, came off patent, prices dropped from $15 to $1,’ said William Haddad, president of the Generic Pharmaceutical Industry Association.” See “The Shift to Generic Drugs,” New York Times , July 23, 1984, p. 19.

138 I. What Can Be Privately Owned? 123 As noted, the rights to a patent last for a fixed time period. What is 1b. Duration the optimal patent life? We provide an economic framework for answering this question. Because patents may create a temporary monopoly that rewards the inventor and over- charges buyers, the optimal life of a patent strikes the best balance between encouraging creativity and discouraging dissemination. As the duration of patents increases, society enjoys more benefits from more innovation. However, the rate at which these benefits increase presumably decreases. Consequently, the marginal benefit from more innova- tion decreases as the duration of patents increases. As the duration of patents increases, society suffers more costs from less dissemination. Society responds to long patents by searching for substitutes for patented goods. The longer a society searches, the more substitutes it finds. As with benefits, the rate at which the social costs of patents in- creases presumably decreases with duration. Consequently, the marginal cost from less dissemination presumably decreases as the duration of patents increases. Marginalist reasoning describes the optimal patent life in abstract terms. But what particular life is optimal? Ideally, there would be a different patent life for each inven- tion, depending on its individual characteristics. Such a scheme of individualized patent terms is impractical, but practical alterna- tives exist to granting a 20-year patent for every invention (the current international de- fault patent term). Germany, for example, has established a two-tiered patent system. Major inventions in Germany receive full-term patents, while minor inventions and im- provements receive petty patents for a term of 3 years. In addition, Germany requires patent-holders to pay an annual fee to continue the patent. The annual fee is relatively modest for the first several years of a patent’s life, but thereafter escalates at regular in- tervals until the patent period is exhausted. Consequently, fewer than 5 percent of German patents remain in force for their entire term, the average patent life being a little less than 8 years. This fact is not surprising when you consider that, given an interest rate of 10 percent, a promise to pay $1 in 8 years is worth less than $.50 today, and a promise to pay $1 in 20 years is worth less than $.20 today. Wo u l d e c o n o m i c e ffi c i e n cy i n c r e a s e b y c h a n g i n g t h e U . S . s y s t e m t o r e s e m b l e t h e German system? Perhaps. A convincing answer, however, requires much statistical re- search to provide evidence about broad averages, and that research remains to be done. 1c. Too Much Patent Despite absence of statistical research, evidence exists that patent law has extended too far and threatens to choke creativity in some areas. Pharmaceutical research provides an example of such a problem that legislation cured. To d eve l o p a n ew d r u g , c o m p a n i e s o f t e n h ave t o u s e a n ex i s t i n g d r u g . F e a r i n g c o m p e t i - tion, the owners of patents on drugs are reluctant to license their use in research to com- petitors. This is a case where patent law suppresses the innovation that is the purpose of it. The Drug Price Competition and Patent Term Restoration Act (1984) (amending the Food, Drug, and Cosmetic Act, and known as the Hatch-Waxman Act) addressed part of the problem by allowing the free use of patented compounds in research to develop a generic alternative. In Merck KGaA v. Integra Lifesciences I, Ltd., 545 U.S. 193 (2005), the Supreme Court extended this law to research aimed at developing entirely new drugs. Another example of overextended patent law concerns business methods. In the past, no one thought that a business method could be patented. However, creative

139 124 CHAPTER 5 T opics in the Economics of Property Law Optimal Patent Life: Orphan Drugs We have already remarked on the fact that there is one patent term—20 years. The analysis of this section has implied that this is not optimal; clearly the social costs and benefits of in- ventions and innovations differ, sometimes markedly. Ideally, the patent system would recog- nize these variations by granting different patent terms depending on the net social benefit of each invention. But the administrative costs of making an invention-by-invention determi- nation of optimal patent life—or even of putting inventions into classes with different patent significant terms—are probably prohibitively high. There are, no doubt, social costs—perhaps, social costs—that follow. For instance, there may be a valuable invention that is extremely costly to develop but that simply could not generate enough revenues if sold at a reasonable cost within the 20-year patent term to justify development. The United States Congress has recognized several important examples of such in- ventions. One is the Hatch-Waxman Act (Drug Price Competition and Patent Restoration Act) of 1984. That Act added up to five years of patent life for pharmaceuticals to make up for time lost in the pre-approval testing of new drugs required by the Food and Drug Administration (FDA). The Act also eliminated duplicative safety and effectiveness testing for generic drugs (those that share the chemical composition of drugs that are coming off patent). Congress went even further in the Orphan Drug Act of 1983 and its later amendments. Congress addressed that Act at an instance of the problem we mentioned above—a valuable invention that might not be developed because the standard patent life was not long enough to justify the development costs. An “orphan drug” is one for treatment of “any disease or condition which occurs so infrequently in the United States that there is no reasonable expec- tation that the cost of developing or marketing the drug will be recovered by sales.” A later amendment further defined such diseases or conditions as those affecting fewer than 200,000 people in the United States. The Act gives developers of orphan drugs tax credits for the costs of clinical studies and other subsidies for development costs. In addition, developers of orphan drugs are given a period of seven-year exclusivity, which may be revoked if the de- 9 veloper fails to provide the patient population with the drug or abandons the drug. Finally, the FDA greatly accelerates the approval process for orphan drugs, sometimes taking only eight months for approval. 9 This term of exclusivity may strike some readers as odd. Aren’t all patents grants of exclusivity? Yes, but there is a very important qualification. A normal patent gives the holder exclusive rights to that in- vention or innovation. But others are free to develop distinct but different inventions that substitute for (but do not infringe upon) existing patents. (See our brief discussion of the “doctrine of equivalents” in this section.) So, you may have developed and patented a pharmaceutical that lowers bad blood choles- terol. But others can develop other chemicals directed at the same end, so long as they are not close copies of your drug. (Consider that your ownership of a piece of real property gives you exclusive rights to that property but not to similarly situated pieces of property.) The distinction in the Orphan Drug Act is that once one has developed a pharmaceutical that meets the criteria for being designated an orphan drug, no one else can develop even a different drug addressed to the same condition or disease for seven years (at least under the original formulation of the Act).

140 I. What Can Be Privately Owned? 125 The Act apparently had the desired effect. In the 20 years before 1983, the FDA had approved only 10 orphan drugs. But in 1984 alone it approved 24. During the Act’s first 15 years, the number of orphan drugs increased fivefold, while the number of non-orphan 10 drugs increased by twofold. This record of success notwithstanding, there are some concerns with the Orphan Drug Act. One has to do with the exclusivity period. That seven-year period, for example, encourages initial development but discourages development of competing but chemically different drugs. Congress found this to be undesirable, so in 1993 they passed amendments to the Act that allowed patenting of second and third orphan drugs directed at the same disease or condition as the original orphan drug so long as those second and third drugs were clinically superior in defined ways. There also have been some additional concerns with the status of orphan drugs. Suppose, for example, that the patient population turns out to expand beyond the 200,000 threshold or that the orphan drug turns out to be effec- tive in treating other, non-orphaned conditions or diseases or that the orphan drug turns out to be extremely profitable. Should the orphan status be revoked in these instances? Congress has addressed these issues but has not yet reached agreement on what to do about them. lawyers induced the U.S. Patent Office to issue patents on some business methods. The most famous example is Amazon’s patent on “one-click” Internet orders. Most schol- ars believe that innovators who create new business methods should not be able to patent them. Q One possible pitfall of the renewal-fee system for determina- 5.4: UESTION tion of optimal patent life is that, ideally, we want the patent-holder to compare the renewal fee with the benefit of continuing the patent for another year, social benefit. Can you suggest how, in setting the annual renewal private not just the fee, we might induce patent-holders to make the appropriate social calculation? Q A third means of reducing the social costs of granting a 5.5: UESTION compulsory licensing. This policy, patent life that is too long is a policy of which forms part of the patent systems of most Western European countries, allows frustrated licensees to ask courts to compel patentees to license to them if they can show that patent-holders have failed to use their patents in the do- mestic market within a specified time period, have failed to license when that is essential to bringing a complementary invention into use, or have abused their positions by, for example, excessively restricting the supply of their inventions. If the court is persuaded by the prospective licensee to compel Give an economic . royalty reasonable licensing, then it also determines a evaluation of the policy of compulsory licensing. 10 See Frank Lichtenberg & Joel Waldfogel, “Does Misery Love Company? Evidence from Pharmaceutical Markets Before and After the Orphan Drug Act,” NBER Working Paper No. 9750 (2007).

141 126 CHAPTER 5 opics in the Economics of Property Law T As explained, the original economics of informa- 1d. Conclusion on Patents tion concluded that an unregulated private market will undersupply information. Remedies to the problem include public supply or subsidies for scientific research, charitable donations, and intellectual property rights. This view still dominates most policy discussions. However, special situations can occur in which no regulation or 11 subsidies results in too much information or just the right amount. To s e e w h y, c o n s i d e r t h e i nve n t i o n o f a s u p e r i o r m e a n s o f f o r e c a s t i n g t h e w e a t h e r. The original theory argued that the inventor cannot appropriate the value of the inven- tion because people who buy her forecasts can resell them to others. However, there are alternative means for inventors to earn profits. The inventor of the weather forecast, for example, can profit by speculating on agricultural prices. To see how, let’s suppose that the inventor forecasts a rainy autumn that will reduce harvests and cause the price of corn to rise. She can keep this information secret and buy corn in the summer for deliv- ery in the autumn. Presumably, if everyone else anticipates normal fall weather, the price of corn in the summer for autumn delivery will be low—too low, the inventor of the weather forecasting method knows. When the harvest arrives in the fall, farmers will fulfill their contracts by delivering corn to the inventor at the low, summer price. Subsequently, the inventor can resell the corn on the spot at the high price caused by a rainy autumn. Thus, Aristotle asserts that Thales of Miletus used philosophy to predict 12 the weather and made a fortune on what amounted to olive press call options. In general, the producers of information can obtain profits from speculative in- vestments. In Silicon Valley, an inventor often participates in founding a firm and owns a lot of its stock. The inventor presumably knows more than the public about the firm’s future performance. The invention may give the firm a competitive advantage in several respects beyond its immediate application. For example, the firm may learn many things about applying and marketing the invention in various fields ahead of its competitors. Also, the firm may establish its brand name over products associated with the invention. Once the market learns the firm’s true value, the inventor’s stock will appreciate. Following this line of thought, some scholars have argued that some markets pro- duce too much investment in information. For example, consider the stock market as a whole. An investor who finds out sooner than others that one corporation is buying an- other can make large profits by purchasing the target company’s stock. The gains to so- ciety from faster price movements in the target company’s stocks are modest compared to the vast wealth redistributed from uninformed stockholders to informed investors. This fact is one reason why securities laws in the United States and elsewhere forbid members of a firm from trading its stock based on information that they have not yet insider trading . made public—the prohibition against Investors race to buy a stock whose price will rise before someone else does, which creates the possibility of excessive trading. Similarly, fishermen race to catch the fish 11 J. Hirshleifer The Private and Social Value of Information and the Reward to Innovative Activity , 61 Am. Econ. Rev. 561 (1971). See also R. Posner, The Social Costs of Monopoly and Regulations , 83 J. P OL . E CON . AW 807 (1975), and E. Rice & T. Ulen, , 3 R ES . IN L Rent-Seeking and Welfare Loss & E CON . 53 (1981). 12 Aristotle’s Politics , Book 1, Chapter 11. Thanks to Eric Rasmusen for this example.

142 I. What Can Be Privately Owned? 127 in the sea before someone else does, which causes tragic over-fishing. Inventors race to secure patents. Unlike the Olympics, patent law typically (but not always) has no silver medals—the second-place finisher often gets nothing. Are inventions like fish in the sea? No. The advantages of growth are so vast that society benefits from the innovation race, even when it is frenetic. Beating the competition in a patent race has negative ex- ternalities, but inventions cause much larger positive externalities that the public enjoys as the innovations disseminate. Before concluding this section, we want to mention a reason why patent protection for some inventions is higher than commended by economic efficiency. In addition to the legal monopoly sometimes given by a patent, some inventions create natural mo- nopolies. A natural monopoly exists when average costs fall as the scale of production rises. Given a natural monopoly, the largest firm with the lowest costs can drive out the competition. For example, spreading research and development costs over larger pro- duction volumes reduces the average cost of innovation. Thus, the average cost of de- veloping an operating system for users of personal computers falls as the number of users increases. In information technologies, industry standards provide an additional element of natural monopoly. To illustrate, standardizing the key strokes required to move the cursor in a word processing program lowers the learning cost of word pro- cessing to everyone. As the standard becomes more dominant, users value it more. Consequently, any company that can establish exclusive rights over an industry stan- dard can enjoy an element of natural monopoly and exploit this power in licensing the right to use the standard. If an invention is the basis of a natural monopoly, then the inventor can obtain mo- nopoly profits even without a patent. To do so, the inventor must use his lead-in time to expand his business and innovate faster than the competition. By growing and innovat- ing faster than the competition, the leader enjoys increasing returns to scale, which con- vey monopoly profits. To illustrate, assume that a computer software product begins with a fundamental discovery and then undergoes constant improvement through inno- vation. To finance constant improvement, a company needs a significant level of sales. The original inventor may achieve the critical sales level before anyone else and then price the product low enough to preclude entry by other firms. The price that precludes entry into the market by competitors (the so-called “entry-limiting price”) can still yield supra-competitive profits to the producer. Natural monopoly is such a common feature of networks that its occurrence in networks has a special name— network effects . The economic analysis of network ef- fects began with railways in the nineteenth century. The most efficient organization of a railway usually requires lines to radiate from a central terminal. The central terminal is the “hub” and the radiating lines are the “spokes.” (This same language is now ap- plied to airlines.) The owner of the central terminal can favor connections to its own railway lines and disfavor connections to competing railway lines. This network effect in railways confers a large advantage on the owner of the central terminal for a region. Similarly, information-based industries often rely on connections analogous to the central railway terminal. For example, all the software on a personal computer must use its operating system. An exclusive owner of the operating system for personal computers can favor the use of its own software and disfavor the use of rival software.

143 128 CHAPTER 5 opics in the Economics of Property Law T Such a pattern of abuse was the central allegation of the U.S. Justice Department in its recent antitrust suit against Microsoft. Owning a computer operating system has been analogized to having a patent on use of the English language. 5.6: Q Suppose that the inventor of a weather-forecasting tech- UESTION nique determines that the weather during the growing season will be perfect, causing a bumper harvest. Explain how the inventor could use this informa- tion to make profitable investments. 5.7: The directors of a corporation are often the first people to UESTION Q know about facts that affect its stock price. American law forbids directors and other “insiders” from using “inside information” to speculate on the value of the company’s stocks. Use the theory of first appropriation and the economics of in- formation to make arguments for and against the efficiency of this prohibition. Web Note 5.3 See our website for additional law-and-economics literature on patent issues. Patent (and Other) Prizes The economic argument for patents asserts that giving the developer of a new, useful, and nonobvious invention or innovation an exclusive right encourages investment in and dissemi- nation of new methods, machines, and practices. But there has always been skepticism about the necessity of the patent system. Critics have long argued that the shortcomings of that system—particularly the high prices and restricted output of monopoly—are not worth the 13 alleged benefits. Indeed, because of their deep concerns about the ill effects of the IP system, several European countries, including Sweden and the Netherlands, suspended their intellectual property systems for several decades in the mid- and late nineteenth century. But if there is no patent system, how can society encourage investment in invention and dissemination? One possible method is through the award of prizes. These can be monetary rewards for designated accomplishments or for general innovations, and they can be offered by either public or private parties or both simultaneously. Perhaps the best example of a pub- lic reward designed to induce a particular invention is the English government’s search for an 14 accurate method of measuring longitude. Using sightings of the sun, ships could relatively easily measure latitude, their distance north or south of the equator. But with regard to longi- tude they were—well, at sea. The results of not knowing where one was could be, and some- times were, disastrous. In response to a famous ship disaster, the English Parliament decided to do something. In 1714 they offered a reward of £20,000 to the first person who could 13 See for example, Michelle Boldrin & David Levine, The Case Against Intellectual Property , 92 EV . R (2008). CON Against Intellectual Property See also the authors’ . . 209 (2002) A M . E 14 (1997). , L OBEL S AVA See D ONGITUDE

144 I. What Can Be Privately Owned? 129 accurately measure longitude at sea. To evaluate the submissions, Parliament appointed a Board of Longitude, with Sir Isaac Newton as its Prime Commissioner, and they required a testing voyage to the West Indies with criteria for success. A carpenter and clockmaker in Yorkshire, John Harrison, thought that the key to meas- uring longitude was an extremely accurate clock. (Most of the other inventors who pursued the prize thought the key lay in accurate sightings of celestial objects.) Harrison’s insight was that the Earth turned through 360 degrees, a complete rotation, in the course of 24 hours. As a result, the Earth turns through 15 degrees each hour of each day. A traveler who departed from London to Moscow could set his watch for London time and compare it to the time when he reached Moscow. He would find that his watch said 9:00 am when it was noon in Moscow, which would enable him to deduce that Moscow is east of London by 45 degrees of longitude. If it were possible to measure the time difference between a ship at sea and at a fixed point on the Earth’s surface (such as at London), then one could tell how far around the Earth one had gone. For this method of measurement to work would require having an extremely accurate clock. And that was the task that Harrison set himself. In the eighteenth century, ships’ clocks were inaccurate because the motion of the ship disrupted the clock’s mechanism. In 1759, Harrison finally developed an extremely accurate ship’s clock, which he called H-4. In 1764 the Board of Longitude ordered H-4 to be tested on a ship traveling from Portsmouth to Barbados, and Harrison’s son, William, went to Barbados to oversee the test. The clock performed marvelously, but rivals blocked Harrison from receiv- ing the prize until his son made a dramatic and successful appeal to King George III. Harrison finally received his reward 43 years after he had begun his quest. England was not put off by this experience. Parliament later offered a reward for the first successful vaccine against smallpox. There are many—indeed, an increasing number of—private prizes designed to elicit particular inventive activity. The Ansari X Prize, created in 1996, famously offered $10 mil- lion to the first private team that could finance, build, and launch a spaceship capable of carrying three people to a height of 100 km (62.5 miles) above the Earth, return safely to Earth, and then repeat the trip with the same ship within 2 weeks. A group headed by Burt Rutan and Paul Allen, the cofounder of Microsoft, won the prize in October, 2005. Recently, the Progressive Insurance Company announced a $5 million prize for the first team or indi- vidual to develop a car with an internal combustion engine capable of getting 100 miles per gallon of gasoline. Some have suggested that the successes of rewards for particular achievements can be extended to general inventions. Steve Shavell and Tanguy van Ypersele have argued that a system of general governmental rewards for the developing of new, useful, and nonobvious 15 inventions is superior to the current system of awarding patent rights. Are the social costs and benefits of a reward system clearly superior to those of the current patent system? Could one argue that public and private rewards for inventive activity complement the patent sys- tem so that the two systems should operate together? 15 See Steven Shavell & Tanguy van Ypersele, , 44 J. L AW & Reward Versus Intellectual Property Rights E CON . 115 (2003). Pe r f e c t i n g Pa t e n t P r i z e s , 56 V AND . L. R EV . 525 (2001). See also Michael Abramowicz,

145 130 CHAPTER 5 opics in the Economics of Property Law T In our analysis of patents, we applied the economics of informa- 2. Copyright tion to answer the two fundamental questions about breadth and duration. This same framework applies to other topics in intellectual property, notably copyright and trademark, which we discuss briefly. Copyright grants writers, composers, and other artists property rights in their creations on demonstration that their works are original 16 expressions. Unlike the patent system, the U.S. copyright system does not require creators to register their works in order to receive the protection of copyright. But very much like the patent law, copyright protection is limited in breadth and duration. The breadth of a copyright concerns the uses to which copyrighted material can be put without authorization. A broad copyright forbids any unauthorized use, whereas a narrow copyright permits some unauthorized uses. For example, books are quoted in reviews and satires, or photocopied or distributed electronically for educational pur- poses. The law handles these uses through so-called fair-use exceptions. For example, Sony Corporation of America v. Universal City Studios, Inc., in 464 U.S. 417 (1984), the case, the U.S. Supreme Court held that recording over-the-air copyrighted Betamax fair use when “time-shift ing” television programs on a videocassette recorder is done for purposes, but not necessarily for purposes of “archiving.” A vague line, frequently liti- gated, divides fair and unfair unauthorized copying. Since its eighteenth century beginning, the United States has lengthened the duration 17 of a copyright until it now stands as the creator’s life plus 70 years. The optimal duration 18 of a copyright involves a different problem from patents—specifically, tracing costs. Before producing her own copyrightable material, a creator may want to check to see if her ideas for a novel, say, are original. The costs of searching among all novels to make sure her idea does not, unintentionally, infringe on someone else’s copyright can be exten- sive. To limit these costs, creators are given limited duration and relatively narrow breadth for their creations. However, the increasing ease of copying and the spread of literacy in- crease the ability of others to avoid paying the copyright-holder a royalty. So, the length- ening of copyright protection allows creators a longer time to recoup their just royalties. In some areas, copyright and patent law have extended too far and threaten to choke creativity. To appreciate the problem, imagine that someone obtains copyright to the English language. No one would be able to say anything without paying a license fee. This copyright would suppress language creativity. Similarly, many computer experts believe that fundamental computer languages should remain in the public domain where people can freely modify, adapt, improve, and use them. In this way the Linux operating system has developed into a powerful programming tool. As we move 16 As Lord Macaulay put it, copyright is “a tax on readers for the purpose of giving a bounty to writers.” HOMAS B. M ACAULAY , S PEECHES ON C OPYRIGHT 25 (C. Gaston ed. 1914). T 17 In October, 1998, Congress passed the Sonny Bono Copyright Term Extension Act, which lengthens copy- right protection for works created on or after January 1, 1978, to the life of the author plus 70 years, and extends existing copyrights “created for hire and owned by corporations” to 95 years. Before the change, the 1976 Copyright Act had given protection for the author’s life plus 50 years. Whatever other reasons there may be for the Copyright Term Extension Act, one justification is that it brings U.S. practice into conformity with Western European practice. 18 William Landes & Richard A. Posner, An Economic Analysis of Copyright Law , 18 J. L EGAL S TUD . 325 (1989). See also Wendy Gordon, On Owning Information: Intellectual Property and the Restitutionary Impulse , 78 V A . L. R EV . 149 (1992).

146 I. What Can Be Privately Owned? 131 away from operating systems to more applied programs, however, private owners con- trol the most successful programs. Examples are Microsoft Google . We could Word and analogize operating systems to the English language and applied programs to novels. These facts suggest a natural boundary between open source and proprietary software. Computer programs hotly contest the proper location of this boundary. Their rhetoric can sometimes sound like a religious war of the seventeenth century or the bitter dis- pute between socialists and capitalists in the twentieth century. The historical legacy of copyright law often hinders and obstructs communications among scholars and slows scientific development. Before the Internet, scholars com- municated mostly on paper when they did not talk to each other. Publishing an aca- demic journal on paper is costly, so the publisher has to restrict access by charging high subscription fees. With the Internet, the cost of disseminating journal articles plum- meted; yet, the same academic journals with their high subscription fees dominate many academic fields. To change the situation, some scholars now refuse to transfer copyright over their articles to the publishers of journals with high subscription fees, or they reserve Internet dissemination rights for themselves. An initiative called the “Creative Commons” attempts to create a new, private copyright standard that guaran- 19 tees for authors the right of cheap dissemination of their scholarship on the Internet. What is the future of copyright in the digital age? According to one vision of the fu- ture, most users of digital information will download it from a few large sellers who im- pose uniform charges. In this system, obtaining information resembles putting money in a jukebox to hear a song. According to the “celestial jukebox” model (see Paul Goldstein’s book, cited at the end of this chapter), every user of digital information will resemble contemporary U.S. radio stations that must pay standardized royalties to a cen- tral clearinghouse whenever they broadcast a song. If the celestial jukebox succeeds, copyright will become the dominant law of the digital age. According to an alternative vision, however, copyright law will die because technology will make law unnecessary. In the model of “digital libertarianism,” technical protection through cheap encrypting will be more efficient than legal protection of intellectual property. Cheap encrypting will allegedly enable producers of digital information to control who uses it without much need for law. Are new laws the answer to new machines, or are new machines the answer to new machines? If you think you know whether the future will bring the celestial juke- box or digital libertarianism, then you should immediately go buy technology stocks. Web Note 5.4 Our website considers much more on the economics of copyrights, such as the recent legal controversy regarding downloading copyrightable material from the Internet, constitutional objections to the copyright extensions of the late 1990s, further proposals for copyright reform, and a recent proposal by Judge Richard Posner and Professor William Landes for an indefinitely renewable copyright. 19 The Creative Commons, a project of Professor Lawrence Lessig of the Stanford Law School, allows authors, composers, and other creators to choose among a variety of protections for their expressions. See

147 132 CHAPTER 5 opics in the Economics of Property Law T Many modern businesses and service organizations invest vast sums 3. Trademark of money to establish easily recognizable symbols for their products. For example, children in many countries recognize the golden arches signaling the location of a McDonald’s franchise. Such symbols are trademarks or servicemarks. The common law and statutes protected trademarks from as early as the 13th century in England. Proprietary rights in a trademark can be established through actual use in the market- place, or through registration with the trademarks office. Modern trademark law in the United States stems from the Federal Trademark Act of 1946, commonly called the Lanham Act. The act provides a method for obtaining federal registration for trade- 20 marks or servicemarks. As in the case of patents, the successful applicant must estab- lish that the mark passes certain criteria, the most important of which is distinctiveness. Registration with the U.S. Trademark Office entitles the holder to certain protections and rights, among which is the privilege of placing beside one’s trademark a sign, ®, 21 that indicates a registered trademark. The owner of a trademark can sue for infringe- ment to prevent unauthorized use . Trademarks help to solve the problem of consumer ignorance about the quality of a product. When quality is opaque, the consumer can use the trademark as a signal of quality. Furthermore, trademarks reduce the cost to consumers of searching for a prod- uct with specific qualities. The principal economic justifications for granting property rights to trademarks are that they lower consumer search costs and create an incentive for producers to supply goods of high quality. Marketing in Eastern Europe before the fall of communism in 1989 shows what can happen without trademarks. State stores sold unbranded goods with generic labels—“bread,” “shirt,” “oil,” or “pen.” A consumer would find one or two unbranded pens on a store’s shelf, so he or she could not tell who designed or manufactured them. A purchase was a random draw from the universe of state factories. Because factories could not acquire reputations with consumers, they could not compete to improve quality. In contrast, trademark law enables a company to build up a reputation for high quality and credible advertising, so it can compete with other companies on these dimensions. The general problem of credibility is central to information economics. Buyers of information generally cannot determine its value until they have it. To illustrate, a banker recently received a letter that read, “If you pay me $1 million, I’ll tell you how your bank can make $2 million.” The only way to make this claim credible is by pro- viding the information to the bank. After the bank has the information, however, it has no reason to pay for it. Similarly, to assess the value of innovative software, a large buyer like Microsoft must understand how it works. After learning how the product works, however, Microsoft may produce its own version of the product rather than pay- ing royalties to the small company. Notice that the economic justification for trademarks is different from those for patents and copyrights. Unlike patents and copyrights, the economics of trademarks 20 Note, however, that one does not have to register a mark in order to receive a property right in that mark. 21 Some producers place the symbol TM or SM (for servicemark) on their products, but those symbols have no legal status.

148 I. What Can Be Privately Owned? 133 does not concern innovation, temporary monopoly, or constrained dissemination. Consequently, we cannot make the same economic argument for limiting the duration of the property rights in trademarks as we did in the case of patents and copyrights. Limits on the duration of patents and copyrights were justified as attempts to minimize the social costs of monopoly and tracing. However, trademarks encourage competition 22 and do not impose tracing costs. Perhaps this is why trademarks can last forever, un- til abandoned. In this respect, trademarks are like property rights in land and unlike other forms of intellectual property. The question of breadth in trademarks has an interesting twist. Nothing is more settled in the law of trademarks than the proposition that generic product names can- not be trademarks. For example, no producer of cameras may register the word “camera” as a trademark. To allow such a trademark would enable its owner to sue every camera manufacturer that advertised its product by use of the word “camera.” If generic product names could be trademarks, then the law of trademarks would create monopoly power, rather than facilitating competition. Sometimes, however, a competitive product succeeds so far that its trademark becomes a generic name. For instance, people today speak of “xeroxing” when they mean “photocopying,” or they speak of “Scotch tape” when they mean cellophane tape, or they speak of a “Hoover” when they mean a vacuum cleaner. When this situation arises, the trade- mark owner must protect the trademark by suing rivals who use the generic name to describe their products. Otherwise, the producer loses its property right in the generic name. This sort of thing happened to the Sterling Drug Company in 1921. In that year a U.S. federal district court determined that Sterling’s trademarked name for acetylsalicylic acid, “Aspirin,” had become the common word for any brand of that drug, not just Sterling’s. After this ruling, all producers of acetylsalicylic acid could use the term “aspirin” to describe their product. Bayer has managed to pre- vent this erosion of its trade name Aspirin in Mexico and Canada, where no com- 23 pany but Bayer may describe its acetylsalicylic acid as “aspirin.” To l e a r n h ow manufacturers of very successful products protect their trademarks, read the box on “Coke” on page 134. Besides quality, trademarks also signal prestige. In some east Asian markets a con- sumer can choose an unbranded watch and then choose the brand name to put on it. Thus, a consumer can get the prestige of a watch that proclaims itself to be a “Rolex” without paying the cost. These “knockoffs,” which violate trademark laws, reward the consumer and cheat the manufacturer of the authentic good. Unfortunately, standard economic tools were not designed for prestige, and they do not do a good job of meas- uring the costs and benefits of knockoffs. 22 See, for general information, William Landes & Richard A. Posner, Trademark Law: An Economic CON & E AW . 265 (1987). Perspective , 30 J. L 23 The Bayer Company of Germany had discovered acetylsalicylic acid in the late 1890s. The U.S. govern- ment seized the trademark “Aspirin” during World War I and sold the right to use that tradename to the Sterling Drug Company in 1918. Interestingly, Bayer purchased Sterling in 1994.

149 T 134 CHAPTER 5 opics in the Economics of Property Law 5.8: The duration of copyright increased under U.S. law in sev- Q UESTION eral steps since the eighteenth century until it reached the life of the author plus 70 years. Suppose that a writer completes a novel at age 40. If the writer lives to be 75, then the copyright will last for 105 years. At an interest rate of 10 percent, the present value of $1 paid after 105 years equals much less than 5 cents. What does this fact suggest about whether the efficient duration of copyright is longer or shorter than currently provided by law? In 1939 the composer Igor Stravinsky received $6000 from Q UESTION 5.9: Walt Disney for the right to use “The Rite of Spring” in the animated film “Fantasia,” featuring Mickey Mouse. Should Disney own the exclusive right to release the film in videocassette, which generated $360 million in revenues in the first two years after its release in 1996, or are Stravinsky’s assignees en- 24 titled to some of the money? “Coke” Is It! One of the best-known trademarks in the world is the word “Coke” to describe the Coca- Cola Company’s cola soft drink. Precisely because it is so well known, there is the danger to the Coca-Cola Company that consumers might use the designation “Coke” to refer to any cola soft drink and not just the one the Coca-Cola Company produces. If that should happen, then “Coke” will have become a generic product name that any producer may use. The Coca-Cola trade research department, which has an annual budget of redundant millions of dollars and employs a team of investigators whose job it is to roam the United States asking at restaurants and soda fountains for “Coke” and “Coca-Cola.” The investigators then send samples of what they are served to the corporate headquarters in Atlanta for chemical analy- sis. If the company determines that a restaurateur has served them something other than Coca-Cola, then that business is advised of its wrongdoing. Since 1945, Coca-Cola has sued approximately 40–60 retailers per year. Retailers claim that what lies behind the company’s vigorous campaign is not a fear of trademark infringe- ment but an insidious and anticompetitive attempt to browbeat retailers into dealing only with the Coca-Cola Company. They note that it is frequently too costly for them—as on a busy night—to tell each customer who asks for a rum and Coke that they are really going to get a rum and Pepsi. Rather than face a lawsuit for trademark infringement, many of the re- tailers simply signed up with Coca-Cola as their exclusive supplier, saying that to do so was less costly to them. The retailers point to the fact that Coke has an 80 percent market share in the fountain-soda market but a much smaller share of the supermarket sales as evidence that the trade research department’s work is part of an anticompetitive marketing operation. (See “Mixing with Coke Over Trademarks Is Always a Fizzle: Coca-Cola Adds a Little Life in Court to Those Failing March 9, 1978, p. 1, col. 4.) Wall Street Journal, to Serve the Real Thing,” 24 Fo r b e s James Zinea, “A Discordant Ruling,” , October 5, 1998, p. 66.

150 I. What Can Be Privately Owned? 135 UESTION 5.10: Q No one may use a patent without the patent-holder’s permis- sion. But in a limited set of circumstances, others may use copyrighted material without the copyright-holder’s permission. These circumstances—called the “fair use” exception—allow, for example, reviewers to quote from copyrighted mate- rial without permission, teachers to photocopy or distribute electronically and as- sign limited portions of copyrighted material to their classes, and musical groups to include or “sample” copyrighted music in their own compositions. Use economic theory to explain why it may be efficient to allow the fair use exception. UESTION 5.11: Why is it efficient to limit the duration of patents and Q copyrights, whereas real property rights endure almost forever (with an im- portant exception to be noted later in this chapter)? Q UESTION 5.12: Trademark law does not allow a holder to sell a trademark independent of the good to which it is attached. Thus, Coca-Cola cannot sell its use of the trademark “Coke” to another producer of cola syrup; that mark may be sold only with the syrup produced by or under the supervision of the Coca- Cola Company. Can you provide an economic rationale for this restriction? Web Note 5.5 What are the appropriate remedies for unlawful use of a patent, copyright, or a trademark? See our website for a discussion of the economics of those issues. Web Note 5.6 This section has only skimmed the surface of the remarkable developments in intellectual property of the last 10 years. See our website for more on the is- sues of the law, such as private ownership versus “open source” software, how the fashion industry uses IP, and how magicians, cooks, and comedians pro- tect their intellectual property. C. Organizations as Property Families, clubs, churches, cooperatives, trusts, charities, and the state are organiza- tions that own property, such as land, buildings, and machinery. An organization, however, is not the same as the property that it owns. For some kinds of organizations, the members can buy and sell assets, but no one can buy or sell the organization. To illustrate, no one owns a family, club, church, cooperative, trust, charity, or state. In contrast, corporations have owners who buy and sell, not just the corporation’s assets, but also the corporation it- self. In brief, many organizations own property and some organizations are property. Owned and unowned organizations perform different roles in society. Unowned organizations play the central role in social life, religion, and government, whereas

151 136 CHAPTER 5 opics in the Economics of Property Law T corporations play the central role in production and economic growth. We will explain the connection between the difference in ownership and the difference in function. To b eg i n , c o n s i d e r w h a t a n o rg a n i z a t i o n i s . O rg a n i z a t i o n s g e n e r a l l y h ave a s t r u c - ture of offices created by laws and contracts, such as Chairman, Treasurer, or Ombudsman. While some members of organizations have offices, all members have roles to play. Standardization in the division of labor creates roles like bookkeeper, me- chanic, or purchasing agent. By supplying a structure of offices and roles, an organiza- tion coordinates the behavior of its members so that it can pursue goals. When coordination is tight enough, observers of the organization ascribe goals to it, not just a structure of offices to its individual members. Thus, we can define an organization as and roles capable of corporate action. Organizations adjust their structure to improve performance or change goals. Owned organizations adjust in response to pressure from markets for organizations. For example, corporate officers who fail to perform may find their company bought by a new owner who fires the old managers and replaces them with new managers. In con- trast, an unowned organization avoids pressure from the market for organizations because no one can buy or sell it. We m u s t c o n s i d e r h ow a m a r ke t f o r o rg a n i z a t i o n s c h a n g e s t h e i r b e h av i o r. A c c o r d i n g to the bargain theory of property developed in this book, markets tend to move property from people who value it less to people who value it more. Thus, the market for organiza- tions tends to move organizations from owners who value them less to owners who value them more. Corporations are primarily instruments to make money, so the owners of cor- porations tend to value them according to their profitability. Consequently, the market for corporations tends to bring the ownership of each corporation to the people who can make the most profit from them. Under ideal conditions described in the model of perfect competition, profitability measures the social value created by a corporation. When real- ity approximates these conditions, the market for corporations maximizes the nation’s wealth by transferring ownership to the people who can run corporations most profitably. Because no one owns a family, club, church, cooperative, trust, charity, or state, there are no markets to move control of these organizations to the people who can make the most profit from them. Consequently, the primary purpose of these organizations is not profits. Instead of being an instrument for wealth, most members regard these or- ganizations as primarily serving other purposes. If these organizations were owned, pressure from the market for organizations would divert their purpose to profitability. Consequently, no one should own an organization whose purpose is not profit, which is what we observe in fact. The owner of property enjoys discretionary power over it, including the right to transform it. When an organization is owned, the owner usually has the power to re- structure its offices and roles, and change the people who fill them. This owner’s legal power over an organization often suffices to control it. When an organization is un- owned, however, no one may control its offices and roles. The alternative to ownership is often governance. A system of governance involves politics and collective control. To illustrate the difference, the owner of a small corporation controls it and does with it as he wishes, whereas the members of a club, church, cooperative, or democratic state make collective decisions and engage in politics. Ownership is usually best for pursu- ing wealth, and governance is usually best for pursuing more diffuse goals.

152 I. What Can Be Privately Owned? 137 We h ave ex p l a i n e d t h a t d i ff e r e n t o rg a n i z a t i o n s h ave d i ff e r e n t f u n c t i o n s , a n d the primary function of corporations is to create wealth by pursuing profits. The market for corporations helps to keep management focused on this task. Markets for corporations, however, are often “thin,” by which we mean that there are few buyers or sellers. To illustrate, economic recession at the turn of the 21st century and destruction of the World Trade Center by terrorists caused a significant decline in the number of air travelers. In this environment, many (but not all) airlines are unprofitable. This situation creates pressure for the owners of unprofitable airlines to sell them. The potential buyers are few in number, because airlines are very ex- pensive to buy and running them requires expert knowledge. The market for air- lines is “thin” in the sense of having few buyers and sellers. The problem of thin markets is aggravated by antitrust authorities who may prevent one airline from merging with another. In general, blocking mergers to thicken product markets thins the market for corporations. As a market thins, competitive pressures diminish. Specifically, thin markets for corporations allow their members to pursue goals other than maximizing the com- pany’s profits. Understanding this fact requires appreciation of the history of corporate law. Corporations are very old forms of organization. For example, the British govern- ment financed itself in the past partly by selling exclusive licenses to large corporations to develop trade in the colonies. As a specific example, the Hudson’s Bay Company was formed in 1670 and was soon thereafter given control over fur trading and other businesses in the area amounting to one-third of present-day Canada. Two important legal innovations distinguish these historic corporations from mod- ern corporations. First, like the Hudson’s Bay Company, the charters of the historic companies restricted them by activity and geography. In contrast, modern corporations can enter almost any form of business in any place. To illustrate, a corporation char- tered in Indiana can enter almost any kind of business in any other U.S. state. (Corporations are restricted from entering a few lines of business in the United States that are reserved for partnerships, notably law and accounting, or require separate in- corporation, notably commercial banks.) Removing restrictions on activities and geog- raphy vastly increases competition among corporations. Second, the owners of the historic corporations were liable for the corporation’s debt. To illustrate, if the Hudson’s Bay Company had gone bankrupt in the eighteenth century, then its creditors could obtain repayment by seizing the wealth of its stock- holders. Given unlimited liability of investors in a company for its debts, people who invest must carefully monitor and control the company’s policies. In contrast, the own- ers of modern corporations are not liable for the corporation’s debts. To illustrate, if an airline goes bankrupt, its creditors can liquidate its assets, but its creditors cannot seize the homes, cars, or bank accounts of its stockholders. As a result of limited liability, people who invest in stock run the risk of losing their investment and nothing more. Limited liability allows people to invest in a company without monitoring or control- ling the company’s policies so thoroughly. Limited liability is an aspect of the more general problem of separating the assets of a company from the assets of its owners and managers. Limited liability prevents the creditors of the company from reaching the personal assets of the company’s owners. An equally important body of law prevents the creditors of the owners from reaching

153 138 CHAPTER 5 opics in the Economics of Property Law T the assets of the company. Separating the assets is called “partitioning,” and not sepa- rating the assets is called “co-mingling.” Modern corporate law partitions the assets of corporations and their owners, whereas the law historically co-mingled them. Limited liability has created a situation commonly described as the separation of ownership from control. This phrase refers to the fact that many stockholders in large companies sold on public stock exchanges do little monitoring of it and have no con- trol over it. Sometimes a small number of large investors monitor and control the cor- poration. Often, however, none of the owners exercises control over the corporation. Instead, control over the corporation rests with its management. Most investors want to make money, so they want the managers to maximize profits. The managers, however, have their own goals to pursue. A vigorous market for corporations can prevent managers from pursuing goals other than maximizing the company’s profits. In general, the stock market bids up the price of a company’s stock until it equals the sum of the company’s expected future earnings discounted to present value. If managers fail to maximize the company’s prof- its, then the expected future earnings of the company fall and its stock price declines. Under these circumstances, an outsider may attempt to buy the company and replace its management. As this theory predicts, econometric evidence demonstrates that the stock price of firms rises and remains higher as a consequence of a successful hostile takeover. So, the new managers must make the acquired firm more profitable. Foreseeing the pos- sibility of a hostile takeover helps to prevent managers from departing very far from the goal of maximizing the company’s profits. Conversely, a thin market for corporations makes hostile takeovers unlikely, so managers can pursue other goals than profits. In recent years, much scholarship and research on corporations concerns how the law ameliorates or exacerbates problems created by the separation of ownership from control. For example, managers employ various contractual devices to reduce the pos- sibility that someone will buy the company and bring in new managers (for example, “poison pill,” “golden parachute,” “lock-ups,” and non-voting shares of stock). Also, managers have succeeded in persuading legislators to enact statutes to reduce the effec- tiveness of the market for corporate control (notably the Williams Act). Before beginning a new topic, we want to connect this discussion of organizations as property to the discussion of contracts in Chapter 8. The problem of the separation of ownership from control in the modern corporation has a general analytical form. Owners often placed their assets under the control of someone else. In these circum- stances, economists describe the owner as the “principal” and the controller as the “agent.” The principal-agent problem is to write a contract that gives the agent incen- tives to manage the asset in the best way for the principal. A later chapter uses the prin- cipal-agent model to develop the theory of contracts. Q UESTION 5.13: a. Give a concrete example of the difference between ownership and gover- nance in organizations. In your example, which form of organization has a higher transaction cost of making decisions? b. Find a concrete example of a corporation whose managers faced a hostile take-over bid that succeeded. After the take-over, what happened to the managers of the acquired firm?

154 I. What Can Be Privately Owned? 139 D. Public and Private Property Having discussed the ownership of organizations, we return to a discussion of the ownership of assets like land, buildings, and machinery by organizations. We will use our theory of property to explain the difference between private and public ownership of a resource. Private and public externalities differ according to the number of affected people. Similarly, private and public ownership can be distinguished by the number of owners. A resource owned by a single individual is private. A corporation owned by a small group of stockholders (“closely held corporation” or “close corporation”) is a “private company.” Corporations owned by many shareholders are “public companies.” Similarly, the state is called the “public sector.” When the state owns a resource, such as a public park, we sometimes say that the resource belongs to all of the citizens or that it belongs to no one other than the state. What difference does the number of owners make? In discussing the Coase Theorem, we described bargaining among the owners of separate properties, such as the rancher and the farmer. Bargaining also occurs when several people own the same property. For example, the partners in a business bargain over the allocation of tasks. The difference between private and public ownership can be described as a difference in the structure of bargaining. Private ownership divides people into small groups. So long as externalities are private, private owners can advance their interests by cooperating with a small number of people. Bargaining among small groups of people tends to result in cooperation and to achieve efficiency. Consequently, the case for private ownership is easy to make when production and utility functions are separable, or when externalities affect few people. In these circumstances, public ownership is a costly mistake. An illustration comes from a study of oyster beds along the Atlantic and Gulf 25 coasts of the United States. At an early stage in their lives, oysters attach themselves permanently to some subaqueous material, such as rock. This attachment makes it possible to imagine defining private property rights in oysters for commercial fishing operators. However, the states along the Atlantic and Gulf coasts that have commer- cial oyster industries have not settled on a single system of property rights for oysters. Some states have determined that the subaqueous areas where oysters tend to congre- common property for oyster harvesters; any of them may take oysters gate are to be from those areas, and none may exclude another. Other states have held that these ar- eas are to be available for private leasing from the state and that the lessee will have the usual rights to exclude and transfer (with some limitations). This difference al- lowed Professors Agnello and Donnelly to compare the relative efficiency of the pri- vate and communal property-rights systems. The measure of efficiency they used was labor productivity (output per person-hour in oyster fishing). Their finding was that labor was much more productively employed in the privately leased oyster beds than in the communal oyster beds. Put dramatically, the authors of this study concluded that if all oyster beds had been privately leased in 1969, the average oyster harvester’s 25 See R.J. Agnello & L.P. Donnelly, Property Rights and Efficiency in the Oyster Industry , 18 J. L AW & CON EV . 199 . 521 (1975). See also G. Power, More About Oysters Than You Wanted to Know , 30 M D . L. R E (1970).

155 140 CHAPTER 5 T opics in the Economics of Property Law income would have been 50 percent higher than it was. That implies a sizable welfare loss due to public ownership. The public oyster beds are an example of the depletion of an open-access resource 26 Open access to a con- by overuse, which is called “the tragedy of the commons.” gested natural resource has a remorseless logic with a terrible ending, like a Greek tragedy. There were two clear correctives to the problem: Turn ownership of the re- source over to an individual (who would then have the appropriate incentive to invest in its preservation or use and to exclude others from using it) or devise an enforceable 27 and effective method of restricting access to the common resource. Commons and Anticommons Instead of a tragedy of the commons, the breakup of the Soviet Union in the early 1990s 28 exposed the symmetrically opposite problem of property rights. Rather than too few property interests—the problem of the commons—there were too many property interests. How did this come to be? Private property interests were largely unknown during the 70 years of communist rule, and people came to have ownership claims to resources in idiosyncratic ways. So, for exam- ple, a large apartment with many rooms, which had been privately owned before the 1917 Revolution, had come to be home to several different families. Each family might occupy one of the rooms of the apartment and share the use of the kitchen and bathroom. When communism ended, these families thought that they had continuing ownership claims to their individual rooms and the common spaces. Suppose that if integrated into an apartment for a single owner, komunalka, the apartment—or as it was called—would be worth $500,000. Assume that there are currently four tenant families, each occupying one room and sharing use of the common spaces. If sold separately, the interests of the tenants would fetch, we assume, $25,000—or komunalka into a single apartment would create $400,000 in $100,000 in total. Converting the value. But it was frequently the case that the costs of assembling the individual tenant interests into the more valuable whole were so great as to preclude the more valuable use of the resource. The tragedy of the anticommons occurs when multiple owners are each endowed with the right to exclude others from a scarce resource, and no one has an effective privilege of use. Property interests can be so finely divided as to impose significant assembly costs on later users who would like to consolidate the property interests into a more valuable whole. Heller and oth- 29 ers have argued that precisely this anticommons problem arises in biomedical research. We shall see an additional example in the box on the public domain later in this chapter. The com- mons and the anticommons suggest symmetric problems of “under-propertization” and “over- propertization.” Just as the porridge of the three bears could be too hot or too cold or just right, so, too, the law can define property interests too finely or not at all or in just the right measure. 26 162 S The Tragedy of the Commons, G. Hardin, 1243 (1968). CIENCE 27 LINOR CTION A NSTITUTIONS FOR I VOLUTION OF E HE : T OMMONS C OVERNING THE , G STROM O (1990). See E 28 The Tragedy of the Anticommons: Property in the Transition from Marx to Market, See Michael Heller, 111 H ARV . L. R EV . 621 (1998). 29 Michael A. Heller & Rebecca Eisenberg, Can Patents Deter Innovation?: The Anticommons in Biomedical Research, 280 S CIENCE 698 (1998).

156 I. What Can Be Privately Owned? 141 We have discussed the easy case in which private ownership can separate utility and production functions and in which externalities are private. A more difficult case for choosing between public and private ownership arises when production and utility functions of many owners are interdependent and externalities are public. To address this problem through private ownership, the affected parties must bargain with each other, and the transaction costs are prohibitive. Public ownership is a possible solution. Instead of unstructured bargaining and a requirement that everyone agree, the switch from private to public ownership substitutes structured bargaining and a collective- choice principle, such as majority rule. 30 Dividing the moun- To i l l u s t r a t e , c o n s i d e r p a s t u r e l a n d i n t h e m o u n t a i n s o f I c e l a n d . tain pasture among individual owners would require fencing it, which is prohibitively ex- pensive. Instead, the highland pasture is held in common, with each village owning different pastures that are separated by natural features, such as lakes and mountain peaks. If each person in the village could place as many sheep as he or she wanted in the com- mon pasture, the meadows might be destroyed and eroded by overuse. In fact, the com- mon pastures in the mountains of Iceland have not been overused and destroyed because the villages have effective systems of governance. They have adopted rules to protect and preserve the common pasture. The sheep are grazed in common pasture in the mountains during the summer and then returned to individual farms in the valleys during the winter. The total number of sheep allowed in the mountain pasture during the summer is adjusted to its carrying capacity. Each member of the village receives a share of the total in propor- 31 tion to the amount of farmland where he or she raises hay to feed the sheep in the winter. Some discussions of the superiority of private ownership over public ownership equate public ownership with open access to resources. This equation is too simple. In fact, the general public does not have free access to most public property. To illustrate, the national parks in the United States are publicly owned, but a fee is charged to enter; many activities require reservations in advance (a form of rationing by time), and no one can graze animals or cut wood. The tragedy of the commons, in its fully disastrous form, requires a political paralysis that prevents government from stopping the destruc- tion of a resource. This paralysis seems to have reached an advanced stage for some re- sources, such as fisheries. For other resources, there are symptoms of paralysis, but not the full disaster. For example, the federal government owns vast lands in the American West and sells permits for grazing, forestry, and mining on these lands. The federal do- 32 main is inefficiently managed. As a result, the environment has deteriorated. Communism’s collapse in Eastern Europe identified a kind of property problem that had gone unnoticed. Many shops in Moscow remained closed for several years while busy street kiosks appeared on the street in front of them. Potentially profitable shops remained closed because too many people had the legal or effective power to prevent 30 HRAINN See the discussion of common mountain pastures in Iceland in T GGERTSSON , E CONOMIC B EHAVIOR E (1990). I NSTITUTIONS AND 31 Professor Elinor Ostrom won the 2009 Nobel Prize in Economics for her studies of governance systems of public and common resources. 32 ANDS , T HE F C L LAWSON For an introduction to federal ownership of American land, see M ARION EDERAL (1983). EVISITED R

157 142 CHAPTER 5 opics in the Economics of Property Law T anyone from using them. Multiple vetoes resulted from the overhang of socialist laws enacted under the communist regime. The situation where everyone could prevent any- one from using a Moscow shop is the mirror image of the sea where no one could pre- vent anyone from fishing. The problem of the sea was already called the “tragedy of the commons,” so the problem of the Moscow shops was named the “tragedy of the anti- commons.” Once an anticommons emerges, collecting rights into usable private prop- erty bundles can be brutal and slow. assigns each resource to a person who owns it, and the owner can Private ownership control access by excluding users. Private owners must bear the cost of boundary main- tenance. Private ownership works well when production and utility functions are separa- Public ownership ble or externalities affect few people who can bargain with each other. comes in three forms. First, open access allows everyone to use a resource, and no one can exclude anyone from using it. Nothing is spent on boundary maintenance. Open access works well when the resource is uncongested, but congestion causes tragic over- political control allows lawmakers or regulators to impose rules concern- use. Second, ing access. Limited access is the most common rule for the state’s property, including unanimous consent, which allows no public lands. Third, the opposite of open access is one access unless everyone agrees. The need for unanimous consent among multiple owners causes tragic underuse. In special circumstances where the aim is to preserve a resource in its unused condition, underuse is serendipitous rather than tragic. It would be surprising if a small, homogeneous village in Iceland were paralyzed polit- ically to the point of being unable to manage public resources. However, a large, heteroge- neous country such as the United States faces far more difficult problems in managing public resources. One solution is to reduce public ownership by selling federally owned land. The market value of the products yielded by lands in the American West would surely be higher if the land currently under public control were transferred to private control. want to see the wilder- This argument, however, is unlikely to persuade those who not be managed with ness underutilized. Most ecologists believe that public land should the aim of maximizing the market value that it yields. Everyone tends to think that some things are more valuable than wealth (at least at the margin), such as liberty or truth; for some people, wilderness is such a value. People who love liberty would never decide whether persons have the right to speak by asking whether people would pay more to hear them or to shut them up. Similarly, those who love the wilderness would never de- cide whether to build condominiums on the nesting site of the California condors by ask- ing whether developers would pay more for the land than would the ecologists. Ecologists usually oppose the sale of public lands to private interests because their aim is to limit development rather than to increase yield. Given the scope of disagreement between ecologists and developers, it seems certain that vast resources will be used up in political disputes over the governance of public lands in the western United States. Q UESTION 5.14: Cooperative enterprises are collectively owned, and their affairs are directed through shared governance. Use the preceding theory to discuss the management of some cooperative enterprises with which you are familiar, such as a cooperative dairy, a cooperative apartment building, an Israeli kibbutz, a Hutterite farm, a commune, and so on.

158 II. How are Property Rights Established and Verified? 143 II. How are Property Rights Established and Verified? As explained in the preceding chapter, the clear delineation of property rights typi- cally facilitates bargaining and voluntary exchange. If property rights are unclear, the parties have an incentive to bargain and clarify them. However, delineation and en- forcement of property rights is costly. It is necessary, consequently, to balance the ben- efit from delineating property rights against the costs. In this section we consider how law strikes the balance. A. Establishing Property Rights Over Fugitive Property: First Possession versus Tied Ownership The problem of defining property rights seems straightforward for objects like land and houses, which have definite boundaries and stay put. But what about objects that move around or have indefinite boundaries, like natural gas or wild animals? “Fugitive property,” as such things are called, creates a legal problem as illustrated by the case of Hammonds v. Central Kentucky Natural Gas Co., 255 Ky. 685, 75 S.W.2d 204 (Court of Appeal of Kentucky, 1934). The Central Kentucky Natural Gas Company leased tracts of land above large deposits of natural gas. Some of the leased tracts were sepa- rated from one another by land that the company did not own or lease. The geological dome of natural gas from which the company drew its supply lay partially under the leased land and partially under unleased land. Hammonds owned 54 acres of land that lay above the geological dome tapped by the Central Kentucky Natural Gas Company, but she had not let the subsurface rights in her land to the company. When the Central Kentucky Natural Gas Company extracted natural gas and oil from the dome, she sued the company on the theory that some of the natural gas that was under her land had been wrongfully appropriated by the defendant. It is difficult in this case, if not impossible, to identify which natural gas came from under unleased land and which came from under leased land. Two general principles can solve the problem of establishing ownership: 1. First possession: oil and gas are not the property of anyone until reduced to actual possession by extraction, or 2. Tied ownership: the owner of the surface has the exclusive right to subsur- face deposits. Under the first rule, the Central Kentucky Natural Gas Company was entitled to extract all the natural gas from the dome, regardless of whether it held the surface rights. But under the second rule, the Central Kentucky Natural Gas Company was only entitled to extract the natural gas under the ground that it owned or leased. The consequences of these two rules for the efficient exploration and extraction of natural gas are very different. According to the first rule, fugitive oil or gas is not owned by anyone until someone possesses it, and the first person to possess it thereby becomes the owner. This rule can, consequently, be called the rule of first possession. The rule of first possession applies the legal maxim “first in time, first in right.” This rule has been used to establish ownership rights for centuries. To illustrate, in the arid

159 144 CHAPTER 5 opics in the Economics of Property Law T American Southwest, state law allowed a person to obtain a right to water in a stream by being the first to tap it for use in mining or irrigation. (See the box entitled “Owning the Ocean” on page 156.) By now, there are few opportunities to claim unpossessed land or water, but the rule of first possession applies to important forms of intangible property, such as inventions. A great advantage of the rule of first possession is that it focuses on a few simple facts, so it is relatively easy and cheap to apply. In the event of a dispute about ownership, deter- mination of who first possessed the property in question is usually straightforward. For example, material evidence usually proves who tapped a water supply first. There is, how- ever, an economic disadvantage of the rule of first possession: it creates an incentive for some people to preempt others by making uneconomic investments to obtain ownership of property. The reason why the rule of first possession creates an incentive to invest too much too early is easily explained. According to the rule of first possession, an appropriate investment transfers the ownership of a resource to the investor. The owner of a scarce resource can rent it to others. Rent increases as a resource becomes more scarce. Indeed, rent is the scarcity value of the resource. Under the rule of first possession, an investment thus yields two types of benefits to the investor: (1) production (more is produced from existing resources), and (2) future rent (scarcity value of the resource in the future). To i l l u s t r a t e , a s s u m e t h a t t h e l aw a l l ow s a p e r s o n t o a c q u i r e ow n e r s h i p o f “ wa s t e ” land by fencing it. Fencing land increases its productivity from, say, grazing cattle on it. By assumption, fencing the land also transfers ownership to the person who built the fence. Assume that fencing waste land costs more than the profit from grazing cattle on it at current prices, but everyone expects the use value of the land to increase as popu- lation grows in the future. Investors may build useless fences to “preempt” others and secure title to the land. Preemptive investment illustrates a general economic principle applicable to the rule of first possession. When the state awards property rights, people contest vigor- ously to obtain title. In a contest for title, persons try to get ownership rights transferred production of wealth, not to themselves. Economic efficiency, however, concerns the the of it. Investments for the sake of transferring wealth, not producing it, are transfer socially inefficient. In technical terms, social efficiency requires investors to invest in a resource until the marginal cost equals the marginal increase in productive value. The rule of first posses- sion causes people to invest in a resource until the marginal cost equals the marginal value of the sum of increased production transferred ownership. The transfer effect under plus the rule of first possession thus causes over-investment in the activities that the law de- fines as necessary to obtain legal possession. It is in the self-interest of investors, but not in the interests of social efficiency, to improve property in order to transfer ownership. To i l l u s t r a t e , c o n s i d e r t h e H o m e s t e a d A c t o f 1 8 6 2 i n t h e U n i t e d S t a t e s , w h i c h established rules allowing private citizens to acquire up to 160 acres of public lands in the West. The act required claimants to fulfill certain requirements before they acquired title. For example, the claimant had to file an affidavit swearing that he or she was either the head of a family or 21 years old, and that the claim was “for the pur- pose of actual settlement and cultivation, and not, either directly or indirectly, for the use or benefit of any other person or persons whomsoever.” Moreover, before full title

160 II. How are Property Rights Established and Verified? 145 was acquired for $1.25 per acre, the claimant had to reside on the claim for 6 months and make “suitable” improvements on the land. These requirements were meant to min- imize transfer effects and to encourage production. In practice, however, the require- ments were fleetingly enforced (as was usually the case with the residence requirement) and easily evaded (as when “suitable” improvements consisted of placing miniature houses—on the claim). The occupation and development of houses—really large doll the American frontier occurred at a faster pace than competitive markets or a strictly enforced Homestead Act would have produced. In contrast to the rule of first possession, there is no gap in ownership under the second rule for fugitive gas, according to which all the gas under the ground already belongs to the people who own the surface. By extension, the second rule suggests that wild animals belong to the owners of some piece of land, such as the land where the wild animal was born. Ownership of fish and other marine resources should perhaps be tied to ownership of the ocean floor. In general, the second rule, called the rule of tied ownership, ties ownership of fugitive property to settled property. The common and civil law often tie ownership by applying the principle of accession . According to this principle, a new thing is owned by the owner of the prox- imate or prominent property. Thus, a newborn calf belongs to the owner of the mother cow, new land created by a shift in a river belongs to the owner of the river’s bank; the owner of a brand name has an exclusive right to use it in an Internet domain name; the owner of copyright has an exclusive right to adapt the work to another medium; an owner of an apartment also owns any fixtures that a tenant attaches to the walls; a new business opportunity discovered by a corporate employee in the course of work belongs to the corporation; and a carpenter who unknowingly uses someone 33 else’s wood to make a barrel owns it (but he must pay restitution to the wood’s owner). Ty i n g ow n e r s h i p o f f u g i t ive p r o p e r t y t o s e t t l e d p r o p e r t y avo i d s p r e e m p t ive i nve s t - ment so long as the ownership claims in the resource to which the fugitive property is . To illustrate, all the gas is already owned under the second tied are already established rule because all the surface rights are already owned, so the rule does not provide an incentive to acquire ownership by extracting too much gas too soon. Similarly, if salmon were the property of the people who own the streams where they spawn, the owners would not deplete the salmon by catching too many of them. Hammonds, is the The problem with the second rule, as illustrated by the facts in difficulty of establishing and verifying ownership rights. The homogeneity of natural gas and its dispersion in caverns makes proving its original underground location diffi- cult and costly. Our analysis of fugitive resources reveals a common trade-off in property law: Rules that tie ownership to possession have the advantage of being easy to administer and the disadvantage of providing incentives for uneconomic investment in possessory acts, whereas rules that allow ownership without possession have the advantage of avoiding preemptive investment and the disadvantage of being costly to administer. 33 Thomas A. Merrill, “Establishing Ownership: First Possession versus Accession.” B ERKELEY L AW A N D ORKSHOP E CONOMICS W (26 February 2007).

161 146 CHAPTER 5 opics in the Economics of Property Law T Hammonds requires balancing Choosing the more efficient rule in a case such as the incentive to overinvest under the rule of first possession against the cost of ad- ministering and enforcing ownership without possession. (Besides first possession and tied possession, other ways of allocating initial rights include auctions, lotteries, and preferences based on attributes such as needs, accomplishments, ethnicity, and gender.) 34 5.15: Here is the critical part of the case of Pierson v. Post, Q UESTION “ . . . Post, being in possession of certain dogs and hounds under his command, did, ‘on a certain wild and uninhabited, unpossessed and waste land, called the beach, find and start one of those noxious beasts called a fox,’ and whilst there hunting, chasing and pursuing the same with his dogs and hounds, and when in view thereof, Pierson, well knowing the fox was so hunted and pursued, did, in the sight of Post, to prevent his catching the same, kill and carry it off. A verdict having been rendered for [Post, who was] the plaintiff below, [Pierson appealed] . . . However uncourteous or unkind the conduct of Pierson towards Post, in this instance, may have been, yet his act was productive of no injury or damage for which a legal remedy can be applied. We are of opinion the judgment below was erroneous, and ought to be reversed.” Does this decision implement a principle of tied ownership or a principle of first possession? Note that the case, which is a staple in introductory courses on property law in American universities, seems irrelevant to modern condi- tions because first possession of foxes apparently does not lead to capturing too many of them too soon. Economic analysis suggests that it should not be because of concerns about which hunter owns a fox. Explain the costs and benefits to weigh in an efficiency analysis of this case. UESTION Q Can you make any sense of the proposition that the rule 5.16: of first possession is a principle of “natural justice”? B. When to Privatize Open-Access Resources: Congestion versus Boundary Maintenance We have discussed various examples from history of unowned resources that become private property. do unowned resources become owned? Economics When suggests an answer. The rule of first possession often applies when property is owned in common and accessible to the public. Property that is accessible for use by a broad public is called an open access resource . To illustrate, the seas are common property to which the pub- lic has access. In many cases, the fish and mammals in the sea can be owned by who- ever catches them. Consequently, fish and marine mammals have been hunted far 34 Cal. R. 175, 2 Am. Dec. 264 (Supreme Court of New York, 1805).

162 II. How are Property Rights Established and Verified? 147 beyond the economic level, some to the brink of extinction. Similarly, in much of the world, common hunting land is over-hunted, common pasture land is over-grazed, and public forests are over-harvested. Much of the world’s soil erosion and forest depletion is caused by the open-access rule. Some technical terms follow to help explain the economic irrationality of the situ- ation. The “maximum sustainable yield” is the largest yield sustainable in the long run. To m a x i m i z e t h e y i e l d , t h e a p p l i c a t i o n o f l a b o r a n d c a p i t a l m u s t ex p a n d u n t i l t h e m a r - ginal products of labor and capital are zero. All of the world’s major fisheries are cur- rently fished beyond the maximum sustainable yield, which means that the marginal product of labor and capital is negative. In these circumstances, the catch on the fish- eries would increase simply by making less effort and reducing expenditures on labor and capital. Similarly, the yield on many open-access forests would increase by invest- ing less effort and cutting fewer trees, and the yield on many open-access pastures would increase by investing less effort and keeping fewer animals. Overused fisheries, forests, and pastures are analogous to a factory with so many workers that they get in each others’ way and slow each other down, so the factory’s total product would in- crease merely by reducing its total employment. Nothing could be more irrational than assigning people to work at jobs with negative productivity. Preventing overuse of common resources involves controlling use by means other than the open-access rule. Tied ownership is one method. For example, to prevent over- grazing of common pastures, small communities in Iceland traditionally tied access to common pastures to production on private pastures. Specifically, farmers were allowed to graze animals in the common, high lands in the summer according to a formula based on the number of animals each farmer sustained in the winter from hay grown on 35 private pastures in low lands. Another method to prevent overuse is privatization, which means in this context converting from public to private ownership. To illustrate, many people could home- stead land, fish in the sea, or gather coral from reefs. In contrast, a private owner can exclude others from using his or her resource. Granting private property rights over land, whales, or elephants would close access by limiting it to the owner. Thus, home- steading land converts it from public to private ownership; some salmon streams have been converted to private ownership; and some villages have been given ownership of coral reefs. The conversion from common ownership to private ownership involves this trade- off: A rule of open access causes over-use of a resource, whereas private property rights require costly exclusion of non-owners. This formulation suggests when an economi- cally rational society will change the rule of law for a resource from open access to pri- vate ownership. When the resource is uncongested and boundary maintenance is expensive, open access is cheaper than private ownership. As time passes, however, congestion may increase, and the technology of boundary maintenance may improve. Eventually, a point may be reached where private ownership is cheaper than open 35 See T. Eggertsson, Analyzing Institutional Successes and Failures: A Millennium of Common Mountain ’ & E AW NTN CON L . R EV . L . 423 (1992). 12 I Pastures in Iceland,

163 148 T opics in the Economics of Property Law CHAPTER 5 access. An economically rational society will privatize a resource at the point in time 36 where boundary maintenance costs less than the waste from overuse of the resource. This theory makes definite predictions about privatization. For example, it predicts that the invention of barbed wire, which lowered the cost of boundary maintenance in areas where there were few fencing materials, would promote the privatization of pub- lic lands in the American West. As another example, it predicts that property rights will be created in the electromagnetic spectrum when broadcasters begin to interfere with each other. The predictions of this theory are confirmed by some facts and discon- firmed by others. Apparently, societies are often rational, as the theory assumes, but not perfectly rational. Politics leads to bargains and compromises that violate the require- ments of economic efficiency. For examples of these compromises, read the box enti- tled “Owning the Ocean.” Owning the Ocean Water covers 70 percent of the Earth’s surface in the form of oceans; yet, almost all of that vast amount of water is unaffected by well-defined property rights. In the late sixteenth and early seventeenth centuries, the great voyages of discovery and the resulting sea-borne empires in Europe necessitated internationally accepted rules on rights to use the ocean. These rights were first catalogued in the famous Mare Liberum of Hugo Grotius of Holland. He noted that the “sea, since it is as incapable of being seized as the air, cannot have been attached to the pos- sessions of any particular nation.” In the system that Grotius suggested and that prevailed in in- ternational law for nearly 300 years, each nation was to have exclusive rights to the use of the ocean within three miles of its shoreline, with that area to be called the “territorial seas.” (The three-mile distance was not picked at random; it was the distance that an early seventeenth- century cannonball could carry.) Beyond the three-mile limit, Grotius urged that the “high seas” should be a common resource from which none, save pirates, could legitimately be excluded. Increasing use of the high seas in the early and mid-nineteenth century led to the re- placement of the doctrine of “free use” with that of “reasonable use.” After World War II, the increasing importance of shipping, fishing, offshore oil and gas deposits, and seabed min- ing caused the legal system of ocean rights to crumble. In 1945 President Truman announced that the United States’ exclusive rights to subaqueous organic resources—such as oil and nat- ural gas—extended to the edge of the continental shelf or margin, an area that stretched 200 miles from the Atlantic Coast of the United States. Other nations quickly made similar claims. Unlike these unilateral actions, attempts at international cooperation have achieved mixed results. 36 This is the central point made by Harold Demsetz in To w a rd a T h e o r y o f P ro p e r t y R i g h t s , 57 A M . E CON . R EV .347 (1967). He argues, for example, that American Indians did not establish property rights in land when the costs of administering the rules exceeded the benefits from private ownership. Proceeding along these lines, he tries to explain why certain North American Indian tribes, such as those in the Northeast, whose principal economic activity was trapping animals for their fur, developed a notion of property rights and others, such as the Plains Indians, whose principal resource was the migratory buffalo, did not. The extent to which his arguments can be squared with history or anthropology is still open to question.

164 II. How are Property Rights Established and Verified? 149 To i l l u s t r a t e , w h e n t h e t h i r d U n i t e d N a t i o n s C o n v e n t i o n o n t h e L a w o f t h e S e a ( U N C L O S ) convened in 1973, there was widespread agreement that the territorial sea would be estab- lished at the 12-mile limit and that there should be an “exclusive economic zone,” largely but not completely controlled by the coastal state, stretching to 200 miles beyond the shoreline, the general extent of the continental shelf. There was not general agreement on what to do with property rights to the areas be- yond this 200-mile limit, and it was the disposition of these areas that raised the really hard issues. The developed countries urged a private-property-rights-based system of develop- ment, whereas the developing countries offered a common-property-rights system. In the end a compromise, called the parallel system, was agreed on. There would be both private devel- opment and a UN-funded and UN-operated company, called the “Enterprise.” In order to give the Enterprise the ability to compete with the more advanced countries of the developed world, an International Seabed Authority (ISA) would be created to allocate rights to mine the oceans. The conference specified an ingenious variant of the “I cut, you choose” method of cake-cutting in order to allocate mining rights. Before it could begin operation, a private or state organization had to submit to the ISA two prospective sites of operations. The Authority would then choose one of those sites for later development by the Enterprise and allow the applicant to proceed with the mining of the other. The United States refused to sign the final treaty, although 117 countries eventually signed it in December, 1982. Over time, the U.S. objections to the missing provisions of UNCLOS III have faded or been proven unfounded. The treaty went into effect in 1994. The U.S. has signed the treaty, but Congress has not ratified it. Q UESTION 5.17: In what ways do these historical developments respond to efficiency, and to what extent do they respond to political power and distribution? Q 5.18: Read the following account of the history of water law and UESTION discuss whether the law appears to have evolved toward economic efficiency. Wa t e r h a s a lwa y s b e e n o n e o f t h e m o s t va l u a b l e n a t u r a l r e s o u r c e s , bu t b e c a u s e i t tends to run away, there have always been problems in defining and assigning property rights in water. Centuries ago in England, the general rule was that rights were vested in the “riparian owner,” that is, in the person who owned the land on the bank of the river. The riparian owner’s principal right was to a flow of water past his land. It would be a violation of someone else’s rights for an upstream user to use the water that passed by his property in such a way as to reduce the flow to downstream users. The upstream user could not, therefore, divert so much of the water to his own use that the flow was significantly diminished for those downstream. A riparian was restricted in his ability to sell water to nonriparians (that is, people who do not own land along the water). However, in the nineteenth century, this legal arrangement had to be altered because industrial demand on the natural flow of a river frequently exceeded the supply. In the eastern United States, these issues were resolved by elaborating the natural-flow theory of water rights that had been adopted from the English common law. An alternative theory of water rights appeared in the western United States. Under the reasonable-use theory , the riparian owner is entitled to use the water flow in any reasonable way. It was

165 150 CHAPTER 5 opics in the Economics of Property Law T deemed reasonable for one owner to use all of the water in a stream or lake when oth- ers are making no use of it. Under the reasonable-use theory, a riparian owner does not have a right to the natural water flow. Furthermore, a riparian owner may transfer rights to nonriparians. C. Recording and Transferring Title: Verification Costs versus Registration Costs Branding cattle, stamping a serial number on an automobile engine, stenciling a Social Security number on a TV—these are some ways that private persons try to prove their ownership of valuable goods. In addition to these private remedies, the state some- times provides registries of ownership. Thus, trademarks are registered to avoid dupli- cation or overlap. Brand inspectors employed by the state or private companies may police violations. Despite these devices, people sometimes “buy” goods that were not the seller’s to sell. This section concerns verifying ownership and remedies when a good is “sold” without the owner’s permission. Suppose you decide to fulfill a lifelong dream and buy a farm. You find a parcel in the country that you like and approach the farmer who is living there. After discussing the parcel’s boundaries, fertility, and drainage, the farmer offers to sell the land at an attractive price. You shake hands to seal the agreement. The next week you return with a check, hand it over to the farmer, and shortly thereafter move onto the property. Two weeks later, a man knocks at the cottage door, announces that he is the owner of the property, and explains that he has come to evict the nefarious tenant who rented the cot- tage in which you are living. At this point you recall the joke that begins: “Hey buddy, how would you like to buy the Brooklyn Bridge?” When you buy property, you should ascertain the rightful owner and deal with him or her. A reliable and inexpensive method for determining ownership prevents fraudu- lent conveyances, such as tenants representing themselves as owners. There are various ways to create a record of ownership. Consider the story—presumably apocryphal—of “recording” title in England in the Middle Ages, when few people could read. It is said that the seller handed the buyer a clod of turf and a twig from the property in a ceremony before witnesses known as livery of seisin . Then, the adults thrashed a child who had witnessed the passing of turf and twig severely enough so that the child would remem- ber that day as long as he or she lived, thus creating a living record of the transfer. Fortunately, we now have better methods of recording title in land. In the United 37 States, there is no uniform method of land registration, but each of the fifty states has some system for the public recording of title to land. A change in ownership of real 37 There is an alternative land registration system, known as the after Sir Richard Torrens, To r re n s s y s t e m , who introduced this simplified mechanism into South Australia in 1858, and that system or something like it is in use in many parts of the world. In the Torrens system, the state operates a registry and a title insur- ance fund. Defects in title caused by the state record-keeper are compensated from the insurance fund. Several of the United States tried the Torrens system, but every one of them has abandoned the system, because incompetent bookkeeping caused such a drain on the state-operated title insurance funds that OVENKAMP the funds went bankrupt. (See S K URTZ & H ERBERT H HELDON , A MERICAN P ROPERTY L AW 1151–1244 [1987].)

166 II. How are Property Rights Established and Verified? 151 property must be recorded in an official registry of deeds, such as the county recorder’s office. Recording is a formal process, and the records are open to the public. The record of ownership on file usually contains a formal description of the property’s location, a list of restrictions that apply to the property, and an account of who has owned the property at each point in time. While a system of recording title is maintained for land and a few other valuable items, like automobiles, there is no such system for most goods. In most exchanges the buyer does not devote resources to determining whether the seller truly owns what he or she is selling. For example, you rarely question whether the books you purchase at the bookstore were rightly the bookstore’s to sell. Your presumption is that whoever possesses a book rightfully owns it. Further proof of ownership is in the memory of witnesses to the sale, like the child in the medieval example, or perhaps in a written sales contract. A system of recording the ownership of books would burden commerce and impede the efficient movement of goods. The security of major contracts is strengthened by a system of official witnesses to the event. Official witnesses, called “notaries,” record the event in an official document and fix their seal to it. Some U.S. states license many notaries, so their fees are low. At the other extreme, some countries like Italy restrict notaries to specialized lawyers who pass difficult exams, perform complicated services far beyond witnessing a document, and enjoy high monopoly profits, especially in real estate transactions. We have encountered another trade-off in property law. On the one hand, verifying title by formal means, such as recording the transfer of a deed, reduces the uncertain- ties that burden commerce. On the other hand, the verification of title through formal means is costly. Property law thus has to develop rules that balance the impediments to commerce created by uncertain ownership against the cost of maintaining a system of verification . For costly items like houses and cars, the law reduces the uncertainties that burden commerce by providing a system for recording title, and the law typically forces all sales through the recording process by refusing to protect unrecorded transactions in these items. For small transactions, however, the cost of maintaining a system of ver- 38 ification would exceed the benefit from reduced risk. D. Can a Thief Give Good Title? Let us consider how people respond to laws allocating the responsibility to verify ownership. Imagine that you have made a shrewd deal for the purchase of a television from a person whom you met in the parking lot outside a local bar. The seller told you a tale about his urgent need to raise cash by selling his TV and handed it over from the trunk of his car. One evening while you are enjoying your new television, the police ar- rive at your apartment with the person from whom the TV was stolen. Should the law allow you to keep the TV or require you to return it? This example poses the general question: if a good is stolen from owner A by thief B, and B disappears with the money after selling the good to innocent buyer C, does the good belong to A or C? 38 Yo u s h o u l d r e c o g n i z e t h a t t h i s a r g u m e n t i n f a v o r o f a s y s t e m o f r e c o r d a t i o n o f o w n e r s h i p c l a i m s i s a general instance of the Normative Coase Theorem of the last chapter.

167 152 T opics in the Economics of Property Law CHAPTER 5 This figure depicts the facts: good good B C A r Owner Thief Buye money This question is answered differently in different jurisdictions. According to the rule in America, transferors can usually convey only those property rights that they le- 39 gitimately have. Thus, a person without title cannot convey title to a purchaser. In this example, the thief did not have good title to the television, so he could not give you good title to it. Instead, title rests with the person from whom the TV was stolen. According to the American rule, you must return the television set to its owner. You are entitled to recover your money from the thief (technically, the thief breached his war- ranty of title), if the thief is caught and has money. A different rule prevails in much of Europe, where the buyer acquires title by pur- 40 The good-faith requirement means that the buyer chasing the good “in good faith.” must genuinely believe that the seller owns the good. The good-faith requirement pre- vents a “fence” of stolen goods from hiding behind the law. The law may also require the buyer to make reasonable efforts to verify ownership, such as checking that the se- rial number was not filed off the television. Applied to this example, the European law presumably permits you to keep the television. The original owner may recover your money from the thief, if possible. In general, law must allocate the risk that stolen goods will be bought in good faith. The American rule places the entire risk on the buyer, whereas the European rule places that risk on the original owner. The American rule gives buyers an extra incen- tive to verify that the seller is truly the owner. The European rule gives owners an extra incentive to protect their property against theft. One of these rules is more efficient in the sense of imposing a lower burden on commerce and promoting the voluntary ex- change of property. indicate the lowest cost C Which rule is it? Here is a method for finding out. Let o to the original owner of protecting against theft by, say, engraving his or her Social Security number on the object. Let C indicate the lowest cost to the purchaser of veri- B fying that the seller is the owner by, say, confirming this fact with the party from whom the seller originally obtained the good. For the sake of efficient incentives, liability 39 This is true as a generalization, but there are important exceptions. For example, if a thief steals money and uses it to buy goods from a merchant, the original owner of the money cannot recover the money from Uniform Commercial Code the merchant. A thief can convey good title to money. Moreover, the allows regular dealers in goods sometimes to give better title than they got. Thus, if a television store happens to have taken possession of and sold a stolen television, the buyer is entitled to presume that the dealer had good title to the television. Any liability to the true owner of the television lies with the dealer. Can you suggest an economic reason why this is a sensible rule? 40 German Code of Our simplification of the European rule omits nuances in civil law. Thus, rule §935 of the Civil Law distinguishes an owner who lost possession of a movable good voluntarily as opposed to invol- untarily. An owner who lost possession involuntarily has a relatively strong claim against a good faith pur- chaser of it.

168 II. How are Property Rights Established and Verified? 153 should fall on the party who can verify ownership at least cost. Thus, the efficiency of the competing rules may be determined as follows: 1. If it is generally true that # C C , then it is more efficient for the good- o B faith buyer to acquire good title against the original owner. $ C C 2. If it is generally true that , then it is more efficient for the original o B owner to retain title against the good-faith buyer. Unfortunately, the absence of empirical evidence about the values of C and o prevents us from answering decisively whether one rule is better than the other. C B Indeed, the lack of evidence also prevents different countries from identifying the more efficient rule and adopting it. However, the example of Spain suggests what is probably the best approach. In Spain, the “American Rule” typically applies when the thief steals the good from a household and sells to a merchant. In other words, a Spanish merchant cannot get good title from a thief. Merchants who buy from a thief encourage thievery by making it more profitable. The Spanish practice of applying the American Rule to merchants who buy from thieves discourages merchants from “fencing” stolen goods, thus reducing the profitability of theft. In Spain, however, the “European Rule” that a buyer can acquire good title from a thief typically applies when the thief steals the good from a merchant and sells it to another merchant or a household. Thus, the Spanish practice increases the ease with which goods circulate among merchants in commerce and passes to the final 41 consumer. E. Breaks in the Chain of Title Uncertain ownership burdens commerce and causes deep discounting of the value of an asset by prospective purchasers. Consequently, economic efficiency requires clearing away uncertainties, or “clouds,” from the title to property. This section briefly examines how property law removes the clouds that accumulate over titles. 1. Adverse Possession In the preceding chapter we discussed an example in which Joe Potatoes unwillingly built his house so that two feet of it extended over the property line onto Fred Parsley’s lot. Recall that Parsley did not discover the trespass and sue until 10 years had passed. Has Potatoes acquired any right to the part of Parsley’s property that he has occupied? According to Anglo-American law, he may have. If the owner “sleeps on his rights,” allowing trespass to age, the trespasser may acquire ownership of the property. . The phrase refers to the fact that adverse possession The relevant legal doctrine is 42 Someone can a trespasser’s possession of the land is adverse to the owner’s interest. 41 Seguridad Jurica y Seguridad del Trafico, R EV . DE C. Paz-Ares, ERECHO M ERCANTIL 7–40 (1985). D 42 It is also possible to acquire an easement by adverse use of another’s property. For example, someone who habitually cuts across someone’s property without protest by the owner may acquire the right to continue cutting across the property.

169 154 CHAPTER 5 opics in the Economics of Property Law T acquire ownership of another’s property by occupying it for a period of time specified in a statute, provided the occupation is adverse to the owner’s interests, and the original 43 owner does not protest or take legal action. The economic advantage of adverse possession is that it clears the clouds from ti- tle and allows property to move to higher-valuing users. To illustrate, assume that you want to buy a house that was built in 1910 and sold in the years 1925, 1937, and 1963. Yo u r s e a r c h o f t i t l e r e v e a l s a c o n f u s i o n i n t h e l e g a l r e c o r d s a b o u t w h e t h e r t h e s a l e i n 1937 was legal. However, the current owner has resided on the property since 1963 without a legal challenge. The law for this jurisdiction stipulates that adverse posses- sion for 25 years transfers ownership to the trespasser. The adverse-possession statute and the current owner’s unchallenged occupancy since 1963 have thus removed the cloud from the title dating to 1937. In general, a rule for acquiring title by adverse pos- session lowers the cost of establishing rightful ownership claims by removing the risk that ownership will be disputed on the basis of the distant past. Another efficiency justification for adverse possession was emphasized in the past: adverse possession prevents valuable resources from being left idle for long periods of time by specifying procedures for a productive user to take title from an unproductive user. Under such a rule, persons who neglect to monitor their property boundaries run the risk of losing idle parts of them to someone who makes use of them. In this respect the rule tends to move property from idleness to productive use. Sometimes squatters have acquired land from absentee owners through adverse possession. In the American We s t , s e t t l e r s h i s t o r i c a l l y a c q u i r e d m u c h I n d i a n l a n d t h r o u g h a d ve r s e p o s s e s s i o n . T h e settlers viewed themselves as putting the land to a higher use, whereas the Indians viewed the settlers as thieves. Besides the two types of economic benefit, adverse possession has a cost. The cost is that owners must actively monitor their land to eject trespassers who might otherwise become owners through adverse possession. Without adverse-possession statutes, own- ers might reduce monitoring costs and more trespassers would enjoy using other peo- ple’s land. Q UESTION Apply the concept of adverse possession to the electro- 5.19: magnetic spectrum. 43 To be precise, traditional scholarship distinguishes four conditions that adverse possession must satisfy: 1. The adverse possessor must have actually entered the contested property and have assumed exclusive possession. 2. That possession must be “open and notorious.” This phrase means that the trespass must not be done in secret; an alert owner should be able to detect it. 3. The trespasser’s possession must be adverse or hostile and under a “claim of right.” This condition requires the trespass to be inconsistent with the owner’s use rights and against the owner’s interests. 4. Finally, the trespass must be continuous for a statutorily specified period. Some states in the American We s t a l s o r e q u i r e t h e a d ve r s e p o s s e s s o r t o p a y p r o p e r t y t a xe s f o r a s t a t u t o r i l y s p e c i fi e d p e r i o d b e f o r e acquiring title. See L AW R E N C E F RIEDMAN , A H ISTORY OF A MERICAN L AW 360–361 (2d ed. 1985). Note that these conditions do not inquire into the intentions of the adverse possessor. Despite this, there is evidence that courts are more likely to apply the adverse-possession rule when the trespass is acciden- tal. See Richard Helmholz, Adverse Possession and Subjective Intent , 61 W ASH . U. L. Q. 331 (1983).

170 II. How are Property Rights Established and Verified? 155 UESTION 5.20: Q Why do you think that the statutory time period for ad- verse possession tends to be short in states like Oklahoma where Indians owned a lot of land? Q UESTION Suppose the statute of limitations for adverse possession 5.21: is 10 years. After 9.9 years of trespass owners retain full rights, but after 10 years of trespass owners lose all of their rights. Instead of owners losing their rights abruptly at the end of 10 years, the statute could be written so that the rights depreciate gradually over time. For example, the trespasser could be granted a 10 percent interest in the property for each year of adverse posses- sion, so that after one year the trespasser would own 10 per cent of it and after 10 years the trespasser would own all of it. Compare the efficiency of the “discontinuous rule” and the “continuous rule.” 2. Estray Statutes Suppose that while strolling down an alley in Manhattan you stumble over a brown paper bag. Opening the bag, you find that it contains a diamond brooch. Naturally, you would like to claim it for your own. But clearly someone has lost it. Are you entitled to keep it if the owner does not demand it back after a reason- able period of time? Are you obligated to make efforts to locate the owner, say, by ad- vertising in the paper? Who owns property that has been abandoned, lost, or mislaid? Estray statutes answer these questions. A typical estray statute in the United States stipulates a procedure for the finder to acquire ownership of lost or abandoned property. If the property exceeds a stipulated value, the finder may have to appear before a court official and sign a document con- cerning the facts about the property found. The court official then places an advertise- ment concerning the found item. If the owner does not appear to claim it within a stipulated time period (for example, one year), the finder becomes the owner. A finder who keeps the item without complying with the statute is subject to a fine. Like registering title, estray statutes discourage the theft of property. Given an estray statute, a thief who is caught with another’s property cannot avoid liability by claiming that he or she found it. (“Where did you get that watch?” Sherlock asked the suspect. “It fell off the back of a truck,” he replied.) Thus, an estray statute helps to dis- tinguish a good-faith finder from a thief. Like adverse-possession rules, estray statutes tend to clear the clouds from title and transfer property to productive users. Like adverse-possession rules, estray statutes also provide an incentive for owners to moni- tor their property. Finally, estray statutes induce the dissemination of information by finders and thus reduce the search costs of owners who lose or mislay their property. UESTION 5.22: If the value of a lost object is low enough, the estray Q statutes do not apply. Consequently, the finder has no legal obligation to ad- vertise. Discuss the costs that need to be balanced to the most efficient lower bound in the value of a lost object for purposes of the estray statutes. Q UESTION 5.23: In admiralty law, there have to be rules for allocating ownership rights to property lost at sea. In the United States, the finder of an

171 156 CHAPTER 5 T opics in the Economics of Property Law abandoned ship is generally awarded ownership, but in some cases the gov- ernment takes possession of abandoned ships in its waters. Where that latter condition holds, a salvor (that is, one who salvages an abandoned ship) is usually entitled to a salvage award determined by the court. Does this practice of making awards to salvors encourage dishonesty, or does it attract an efficient number of resources into the business of searching for lost ships? Is the system of awarding complete ownership rights to the finder more or less efficient than the award-to-salvors system? III. What May Owners Do with Their Property? What may owners do with their property? In this section we analyze some tradi- tional restrictions on property rights. We postpone discussing modern government reg- ulations such as zoning ordinances till the final section of the chapter. A. Bequests and Inheritances: Circumvention Costs and Depletion Costs In a feudal or tribal world, law typically stipulates the heirs to land, rather than the owner choosing heirs. To illustrate, the eldest son inherited all of his father’s land in 44 and in matrilineal tribes the land is often inherited by the niece medieval England, from her aunt. Furthermore, feudal and tribal societies typically restrict the sale of land. As law modernizes, owners increase their power to stipulate the terms of inheritance and sales. The law in Western countries has evolved over centuries toward more free- dom for the owner to specify who may have the property after his or her death and what they may do with it. We discuss briefly the economic analysis of this trend. Any restriction on the owner’s choices creates an incentive to circumvent it. To illus- trate, imagine an owner who wants to bequeath her land to a particular friend, and imag- ine that the law will award the property to someone else. The owner can circumvent the law, say, by transferring title to the friend today and leasing it back for $1 per year until her death. Circumventing the law usually requires the assistance of a good lawyer. In gen- eral, owners use costly legal resources to circumvent restrictions on the use of property. Now change the example and imagine that tight laws and costly lawyers prevent the owner from circumventing restrictions on bequests. Because her desire to designate her heir was frustrated, the owner may deplete her property before she dies. For exam- ple, she might cut timber prematurely, or exhaust the soil’s fertility by intensive farm- ing, or postpone needed improvements to buildings. In general, rules that restrict transfer undermine the owner’s incentive to maximize the value of the property. Circumvention costs and depletion costs provide two reasons for allowing an owner freedom in transferring property at death. However, these same reasons justify restricting 44 In most of England from 1066 (the date of the Norman conquest) until 1925, the general rule for disposing of real estate on one’s death was that it passed intact to the decedent’s eldest son, a system called primogeniture . Testators were not free to alter this rule except under very narrow circumstances.

172 III. What May Owners Do with Their Property? 157 the freedom of an owner in special circumstances. Most property rights live forever, but all owners die. Sometimes one generation of owners wants to limit the discretionary power of subsequent owners. To illustrate, suppose that I own my family’s ancestral home, Blackacre, and I stipulate in my will that no one will ever use Blackacre for purposes other than as a residence. Subsequently, I die and my heir wants to develop Blackacre into a golf course. Should the law enforce the restrictions in my will or set it aside and allow my heir to build a golf course? If the law routinely sets aside such restrictions, then I have an in- centive to deplete the resource or circumvent the law prior to my death. If the law enforces such restrictions, then my wishes may be fulfilled but at the social cost of making it diffi- cult, if not impossible, to move Blackacre to a higher-valued use than its use as a residence. In the preceding example, the owner apparently wants to restrict future uses of Blackacre for his own, perfectly legitimate reasons. In other examples, an owner creates a 45 trust (called a “spendthrift” trust) to protect someone from his or her own bad judgment, 46 or a restrictive covenant at- or a bequest attempts to keep property in the family forever, 47 tempts to channel future sales to certain classes of buyers. In general, the principle that the current owner should be free to structure transactions as he or she wishes runs up against a difficulty when the owner wants to restrict future owners. In these cases, a con- flict exists between the freedom of sequential owners of the same property. Any reduc- tion in the freedom of any owner in the sequence may cause economic waste, regardless of whether the reduction in freedom comes from law or a private transaction. English common law responded to these facts generally by being skeptical of “re- straints on alienation,” as they are called, and specifically in the case of bequest by a complicated law called the rule against perpetuities . The rule imposes a time limit on property restrictions imposed by the terms of a gift, sale, bequest, or other transaction. Instead of lasting in perpetuity, restrictions automatically lapse when a legal time limit expires. The legal time limit has the curious formulation “lives-in-being plus 21 years.” To i l l u s t r a t e i t s m e a n i n g , a s s u m e t h a t m y o n l y c h i l d i s a n u n m a r r i e d d a u g h t e r, a n d I stipulate in my will that she will inherit my ancestral home, Blackacre, on the condi- tion that it never be used except as a residence. According to the rule, the restriction 48 must ordinarily lapse 21 years after my daughter’s death. Notice that the rule against perpetuities is a “generation-skipping rule.” By this phrase we mean that it allows an owner to skip over the living generation by restrict- ing their use of the property, but the property passes unrestricted to the unborn when they reach the age of 21 and become legal adults. A generation-skipping rule has an economic rationale. Assume that you must choose a principle concerning the power 45 For example, a trust is created in which the beneficiary receives the interest income from the trust property but cannot touch the capital until she is middle-aged. 46 For example, the owner leaves instructions that, at his death, his land is to be given to his oldest son, at his oldest son, and so on. whose death the land is to be given to 47 In the past in America, covenants sometimes blocked future sales to buyers belonging to certain races. 48 This account of the rule against perpetuities is roughly, but not exactly correct. The “life in being” des- ignated as the “measuring life” does not have to be that of the daughter. It could, for example, be the first child born in Kinshasa the month before the testator’s death. The rule, to be brief, is extremely complicated—so complicated that it invites creativity to avoid it.

173 158 CHAPTER 5 T opics in the Economics of Property Law of one generation to impose restrictions on the use of property by subsequent genera- tions. The principle that you choose will apply to every generation. You know that the world changes in unpredictable ways, so no restriction is good forever. You also know that most owners are prudent and benevolent toward their heirs, and a few are foolish and venal. In effect, you want a principle to protect against an occasional fool in an unending sequence of owners, given a constantly changing world. A prudent owner will not restrict a prudent heir, and a prudent owner will restrict a foolish heir. Given these facts, an attractive principle for you to choose allows each generation to restrict the next generation, but not subsequent generations. When pru- dent owners apply this principle, only foolish heirs will be restricted. Furthermore, the restrictions that prudent owners impose on foolish heirs may prevent the foolish heirs from imposing restrictions on the next generation. So, the rule against perpetuities ap- pears to maximize the value of property across generations. A trust is an organization where one person owns and manages money for the ben- efit of another. Trusts have different purposes, such as transferring wealth to one’s heirs while avoiding inheritance taxes. When a person creates and endows a trust, it pays money to the beneficiary, which is not an inheritance, so no inheritance tax is owed. Eventually, however, the trust is dissolved, and the tax authorities may recapture part of the taxes that the trust avoided. To further reduce tax liability, some U.S. states have enacted laws allowing citizens to create “perpetual trusts” or “dynasty trusts.” Because they never dissolve, they avoid the tax liabilities triggered by dissolution, but they are also inconsistent with the rule against perpetuities. U.S. citizens in one state can establish a trust in another state. States compete to attract trust business by making favorable laws, especially for avoiding taxes owed to the federal gov- ernment or other states. Perpetual trusts are an example. Besides avoiding taxes, competition for trust business can also improve the efficiency of trusts. The management of stock portfo- lios, which trusts often have, illustrates such an improvement. In the nineteenth century, most U.S. states adopted a rule making the trustee liable if the portfolio included speculative stocks that lost their value. This rule caused trustees to buy bonds and very conservative, “blue-chip” stocks. Low risk, however, characterizes the portfolio as a whole, not each stock in it. In a bal- anced portfolio, the risk from one stock offsets the risk from another. In technical terms, hold- ing stock with negatively correlated risk results in low risk for the portfolio as a whole, even though individual stocks are high risk. Some innovative states responded to these facts by changing the rules of trust management. Under the revised rules, the trustee who holds a bal- anced portfolio is not liable for losses caused by a fall in value of individual stocks. This change in the rule caused trust portfolios to shift away from conservative bonds and toward more individually risky stocks. States making the change attracted more trust business, which 49 puts pressure on other states to modernize their rules of trust management. 49 See Max M. Schanzenbach & Robert H. Sitkoff, Did Reform of Prudent Trust Investment Laws Change Trust Portfolio Allocation?, 50 J. L AW & E CON 681 (2007). See also those authors’ Lawyers, Banks, and Money: The Revolution in American Trust Law (2011). As another example of competition among juris- dictions, the trust was developed in the common law, not in civil law. The success of London banks in the trust business has put pressure on Paris banks to modify French civil law to gain all the advantages of the trust in English common law.

174 III. What May Owners Do with Their Property? 159 UESTION 5.24: Instead of “lives-in-being plus 21 years,” the rule might Q be “lives-in-being plus 10 years,” or “lives-in-being plus 35 years.” Compare these rules as means for “generation-skipping.” Q UESTION 5.25: Suppose that a testator imposes a condition that cannot be met. For example, the decedent gives her property to be used for a medical school in Lebanon, Indiana, but after the testator’s death, the State of Indiana abandons its plans to build a medical school there. In this situation, American courts apply the doctrine of cy pres (pronounced “see pray” and meaning, in law French, “so nearly” or “as near as possible”). Under that doctrine the court will find an alternative condition that is as close as possible to the decedent’s intentions. For example, the proceeds from the sale of the decedent’s property in Lebanon, Indiana, might be given to a medical school located somewhere else. Use the concepts of circumvention costs and depletion costs to provide an economic rationale for this rule. We s u g g e s t e d a b ove t h a t a n a n n u a l l y i n c r e a s i n g r e n ewa l 5.26: Q UESTION fee would be an efficient means of setting optimal patent life. Similarly, sup- pose that owners who wanted to restrict future use of their property had to pay a fee for each year that the restriction runs. For example, if my will stipulates that Blackacre should be used exclusively as a residence for 100 years, then I would have to make provision in my will to pay the state for each year that the restriction runs. In effect, the state deducts an annual fee from a bequest for a testator who desires to impose posthumous restrictions on property for a spec- ified number of years. At what level would you set such a fee? Would it be the same for all types of conditions and all types of property? Is such a fee more efficient than the rule against perpetuities? B. Rights to Use Someone Else’s Property In general, no one may use another’s property without the permission of the owner. Use of another’s property without the owner’s permission is an illegal trespass. As we saw in Chapter 4, this rule and moderate transaction costs induce those who want to use another’s property to bargain with the owner. Bargaining leads to the use of property by the party who values it the most, as required for allocative efficiency. Can someone ever use another’s property lawfully without the owner’s permis- sion? We have already seen that the “fair use” exception allows one to use copyrighted material without the owner’s permission—in limited circumstances. (See question 5.11 50 Ploof v. Putnam . on page 135). This issue arose in the famous case of Putnam was the owner of a small island in Lake Champlain, a large body of water in northern Ve r m o n t . I n N o v e m b e r, 1 9 0 4 , P l o o f w a s s a i l i n g o n t h a t l a k e i n a s l o o p w i t h h i s w i f e and two children when a violent storm arose very suddenly. Ploof needed a safe harbor quickly, and the nearest one was Putnam’s island. Ploof moored his sloop to a pier on that island, hoping that his ship and family would be able to ride out the storm in safety. 50 81 Vt. 471, 71 A 188 (Supreme Court of Vermont, 1908).

175 160 CHAPTER 5 T opics in the Economics of Property Law However, an employee of Putnam’s, fearing that the sloop would damage his em- ployer’s property by being cast repeatedly against it during the storm, untied the ship from the pier and pushed it away. The sloop and its passengers were then at the mercy of the storm. The ship was ultimately driven by the storm onto the shore and wrecked. Ploof sued Putnam, alleging that the losses to his ship and the injuries to himself and his family were the result of wrongful action by the defendant, through his em- ployee. Ploof argued that the storm caused an emergency that justified his trespassing on the defendant’s property, even without permission. He asked for compensatory dam- ages for his losses. Putnam replied that every property owner has a right to exclude trespassers. This principle is so firmly settled, he asserted, that the court should award him summary judgment without proceeding to trial. The trial judge denied the defen- dant’s motion for summary judgment, and the defendant appealed. The Supreme Court private necessity like that of Ploof was of Vermont affirmed the decision and held that an exception to the general rule against trespass. In an emergency, one person can use another’s property without permission. However, the user must compensate the owner for the costs of use. To illustrate, a hiker who gets lost in a remote wilderness may break into an uninhabited cabin in order to obtain food and shelter, but the hiker must compensate the owner for damage to the cabin and food consumed. As another example, X becomes deathly ill during the night, the only pharmacy in town is closed, and its owner Z is unreachable, so X breaks into Z’s pharmacy and takes the required medicine. The law will excuse the trespass, but X must pay damages to Z. As a final example, X, who is about to be murdered by Y, picks up the nearest heavy object, Z’s valuable china vase, and crashes it over Y’s head, thereby saving X’s life. X must pay damages to Z for the vase. In brief, the private- necessity doctrine allows compensated trespass in an emergency. Bargaining theory rationalizes the exception to the general rule private necessity against trespass. In an emergency, transaction costs may preclude bargaining. For ex- ample, the suddenness with which the storm arose precluded Ploof from finding Putnam and bargaining with him. When bargaining is precluded, voluntary transactions do not necessarily cause goods to be used by the party who values them the most. A rule allowing compensated trespass assures that trespass occurs only when its value to 51 the trespasser exceeds the cost to the owner. occurred 5.27: Q UESTION An interesting variation on the facts in Ploof 109 Minn. 456, 124 N.W. 221 , . Vincent v. Lake Erie Transport Co in (Supreme Court of Minnesota, 1910). In late November, 1905, the Reynolds, owned by the defendant, was moored to the plaintiff ’s steamship pier in Duluth and discharging cargo. A storm suddenly arose on Lake Reynolds signaled for a tug to take her away from the pier, Superior. The 51 Suppose that Ploof had found Putnam on the pier and bargained with him. The emergency has conveyed monopoly power on Putnam, who has the only nearby pier. Given Putnam’s monopoly and Ploof’s desper- ation, Putnam might demand an exorbitant amount of money for use of the pier. Ploof might promise to pay it, and then refuse to do so after the emergency passes. Litigation of such “bad-Samaritan contracts” is discussed later, when we come to the “necessity doctrine” in contract law.

176 III. What May Owners Do with Their Property? 161 but because of the storm, none could be found. The ship remained moored to the pier during the storm. The violence of the storm threw the steamship repeatedly against the plaintiff’s pier, causing damage in the amount of $300. The plaintiff asked for that amount. The Lake Erie Transport Co. Reynolds contended that its steamship was an involuntary trespasser. The had tried to leave the plaintiff’s property but had not been able to do so . The court held that the plaintiff was entitled to through no fault of its own damages. Argue that this holding is efficient. C. Inalienability The law forbids the sale of some valuable things, such as body organs, sex, give away heroin, children, votes, atomic weapons, or human rights. You cannot even some of these things, such as heroin or your vote in a national election. You cannot lose some of these things by any legal means, such as your human rights. One mean- is losing something, especially an intimate part of yourself. In law, ing of alienation the term inalienable refers to something of yours that you cannot lose by specified means. Thus, body organs, sex, and children are inalienable by sale, your vote is in- alienable by sale or gift, and your human rights are inalienable by any means. The sale of sex or children is prohibited by conventional morality, as well as law. Many forms of inalienability express conventional morality. Other forms of inalien- ability, such as the enactment of human rights, express the aspirations of eminent po- litical theorists. What about economic theorists? What have they had to say about the efficiency of inalienability? Occasionally, a regulation increases the efficiency of a transfer. This fact provides an economic rationale for regulation. However, inalien- ability goes far beyond regulation. Whereas regulations restrict transfers, inalienabil- ity prohibits them. The efficiency of a transfer cannot increase by prohibiting it. In general, prohibitions on transfers are inefficient because they prevent people from get- ting what they want. Following this line of thought, some economic writers have at- 52 economic rationale for any Is there tacked laws that make certain goods inalienable. 53 inalienability? Some theorists argue that the sale of certain commodities undermines their transfer by superior means. For example, consider the supply of blood to hospitals. Two c o m p l e m e n t a r y m e a n s a r e u s e d t o e n s u r e t h a t b l o o d i s f r e e f r o m i n f e c t i o n : A medical history is taken from the individuals who supply blood, and the blood is tested in laboratories. The individual suppliers are more likely to provide an accu- rate medical history when they give their blood away than when they sell it. 52 For example, see Elizabeth Landes & Richard A. Posner, The Economics of the Baby Shortage, 7 J. L EGAL A Market for Babies? S TUD , 34 U. T ORONTO L. J. 341 (1984). See also .323 (1978) and J. Robert Pritchard, the 1987 symposium on the economics of selling babies in the Boston University Law Review. 53 . L. R .931 EV OLUM 85 C Inalienability and the Theory of Property Rights, See Susan Rose-Ackerman, EV . L. R ARV 100 H Market-Inalienability, (1985), Margaret Jane Radin, .1849 (1987), and Richard Epstein, Why Restrain Alienation?, OLUM . L. R EV . 970 (1985). 85 C

177 162 CHAPTER 5 opics in the Economics of Property Law T Consequently, donated blood is freer from infection. This fact provides an economic rationale for obtaining blood by donations rather than purchases, but not a reason 54 for prohibiting the sale of blood. For example, in the United States most blood is 55 obtained by donations, but some blood is purchased. However, assume that the sale of blood undermines voluntary donations. For example, people might feel that giving blood away for free is stupid so long as it can be sold. If these facts were true, then prohibiting the sale of blood might be neces- sary in order to divert transfers into the superior channel of gifts. Similarly, anthro- pologists have argued that markets destroy gift economies among tribal people. Although plausible, the factual support for this theory is not strong enough to pro- vide a convincing defense of inalienability. It seems, then, that inalienability rests on conventional morality and political philosophies that stress values other than Pareto efficiency. UESTION 5.28: Assume that every adult in a particular jurisdiction is eli- Q gible to serve as a juror. Panels of potential jurors are drawn by rotation from the qualified population. Currently, no jurisdiction allows someone called for jury service to hire a qualified replacement. Would society be better off if peo- ple were allowed to engage in a market for jurors? Web Note 5.7 As the technology for making use of transplantable human organs improves, the demand for those organs has far outstripped the supply available under the inalienability rules. See our website (and the box on “Inalienable Bodily Organs”) for a discussion of how a regulated market in human organs might significantly increase the supply. D. Unbundling Property Rights In England, the boundaries of property are often based on enduring natural objects and countours of the land such as rocks, trees, or hills. In the United States, much of the land was surveyed and divided into uniform parcels in the countryside and in 56 towns. Standardizing property simplifies comparing one property to another. Easy 54 See R ICHARD T ITMUSS , T HE G IFT R ELATIONSHIP : F ROM H UMAN B LOOD TO S OCIAL P OLICY (1971), in which the author argues that inalienability is an efficient method of assuring quality control. See also Kenneth Arrow, 1 P HILOSOPHY & P Gifts and Exchanges, A FFAIRS 343 (1972), and Reuben Kessel, Transfused UBLIC Blood, Serum Hepatitis, and the Coase Theorem, 17 J. L AW & E CON . 265 (1974). 55 Blood can be purchased in the United States, but the federal Food and Drug Administration requires labels to distinguish whether the source is a “paid donor” or “volunteer donor.” Note that nonprofit institutions that collect blood from “volunteer donors” usually sell it to hospitals. 56 A grid for land boundaries (“rectangular survey”) was an innovation that spread in the British Empire dur- ing the nineteenth century, replacing the demarcation of land boundaries by natural objects such as trees and rocks (“metes and bounds”).

178 III. What May Owners Do with Their Property? 163 Inalienable Bodily Organs Advances in medical technology have sharply increased demand for transplantable bodily 57 organs. Each year in the United States there are almost 80,000 people waiting for organ trans- plants. But the supply of suitable organs, is much smaller—approximately 10,000 organs per year. Excess demand in a market causes the price to rise, which brings supply and demand into equilibrium. This cannot happen to transplantable organs because all states adopted the Uniform Anatomical Gift Act of 1968, which forbids the sale of organs. Consequently, gifts or donations are the only means by which to supply transplantable bodily organs. The donor may consent to give up transplantable organs in the event of his or her death. People often have the opportunity to consent when renewing a driver’s license. However, less than 20 percent of the United States’ driving-age population has filled out the donor cards. Absent consent, the current system typically requires physicians to ask next of kin whether they may “harvest” the organs of the decedent. This is not the best time to make such a request. To c o p e w i t h e x c e s s d e m a n d , t h e U n i t e d S t a t e s h a s a n o n - m a r k e t m e t h o d o f a l l o c a t i n g organs. The rules are very complicated, but most organs are awarded in the order in which patients have been on an official waiting list. In 2006 the organization overseeing organ transplantation (UNOS) suggested an alternative rule—organs may be given first to those likely to live the longest after a transplant. That controversial proposal is still under discussion. How to increase the supply of organs for transplant? Technology may develop more artificial organs, or technology may make it increasingly possible to transplant organs from other animals into humans. Alternatively, a regulated market in human organs might be allowed somewhere in the world. (The virtues and pitfalls of such a market are explored in the sources that follow.) However, some nations have already implemented a rule that dramatically increases the supply of organs. We called the current donation rule “required consent.” While less than 20 percent of the United States’ driving-age population has filled out the donor cards, 85 per- cent of that same population say that they are willing to make a donation of their organs. An alternative to required consent is a rule of “presumed consent”: Everyone is presumed to have consented to his or her organs being harvested upon death unless they have affirmatively de- clared otherwise. Data suggests that switching from required consent to presumed consent dra- matically increases the supply of organs. The four European countries with a rule of required consent (Denmark, Germany, the Netherlands, and the United Kingdom) have much lower rates of donation (ranging from 4.25 percent in Denmark to 27.5 percent in the Netherlands) than do the six countries (Austria, Belgium, France, Hungary, Poland, Portugal, and Sweden) that use a rule of presumed consent (ranging from a low of 85.9 percent to a high of 99 percent). SOURCES: See Lloyd R. Cohen, Increasing the Supply of Transplantable Organs: The Virtues of a Futures Market, 58 Geo. W ASH EV . 1 (1989). . L. R HIO S T . Overcoming the Legal Obstacles to the Creation of a Futures Market in Bodily Organs, Gregory Crespi, 55 O L. J. 1 (1994). ? (1997). ICHARD E PSTEIN , M ORTAL P ERIL : O UR I NALIENABLE R IGHT TO H EALTH C ARE R CIENCE 1338 (2003). Eric J. Johnson & Daniel Goldstein, “Do Defaults Save Lives?,” 302 S 57 An economist joke about this situation goes like this: A patient waiting for a heart transplant learns from his doctor that there are suddenly two hearts available—one from a 24-year-old marathon runner and one from an elderly economist. Without hesitation the patient chooses to receive the heart of the economist. It explains to his astonished doctor, “It is unused.”

179 164 CHAPTER 5 opics in the Economics of Property Law T comparison of property opens the real estate market to broader competition because potential buyers need less information to compare the value of one property relative to another. Besides real estate, uniformity lubricates sales for stocks, bonds, wheat, oil, and many other goods. Conversely, inconsistent bundles of rights make properties incomparable to each other, so prices must be negotiated individually. Thus, one share of stock issued by Honda is the same as another share of the same class of stock. Honda shares have a pub- lic price in the stock market at which they can be bought or sold. In contrast, investment banks have created bundles of unstandardized real estate mortgages (“derivatives”) whose prices are individually negotiated. Unlike stock market prices, individually nego- tiated prices for securities are not public information. Most people do not know the price at which such a security last sold. When securities prices plummeted in the financial meltdown of 2008, Harvard University held many unstardardized securities without a public price, so it did not know how much value its portfolio had lost. In general, the owners of property possess a bundle of rights. To standardize prop- erty, the law must restrict the owner’s ability to repackage these rights. The owner of a w , x good may have rights y , and z over it. The owner may want to unbundle these , rights and sell w and x to one person, while retaining y and z for himself. Sometimes, however, law only allows sales of the complete bundle. For example, the owner of a city lot can sell it as a whole, but city regulations may prevent him from cutting it in half and selling half of it. Zoning illustrates specific regulations that prevent unbundling some property rights. A deeper question is whether something in the nature of property generally lim- its or restricts unbundling. To illustrate what is at stake, assume that A inherits his fam- ily’s heirloom pocket watch. B, who is A’s brother, would like to wear the watch to a Christmas party each year. B pays some money to A in exchange for A’s promise to let B wear the watch every Christmas. A’s refusal to let B wear the watch on Christmas in a future year would breach their contract, so B could sue A for money damages. Continuing the example, assume that A sells the watch to C. In making the sale, A tells C nothing about B. C remains ignorant about A’s contract with B until Christmas approaches and B asks C for the watch to wear. C refuses. What can B do? Nothing to C. C does not have to let B wear the watch on Christmas. B’s only available remedy is to sue A for compensatory damages for breach of contract. As this example illustrates, the contract between A and B does not give B secu- rity that he will always get to wear the watch on Christmas. What B wants is a right to use the watch on Christmas that he can assert against anyone who owns the watch. B might take a novel legal approach in an attempt to get security: Let A sell B the use rights over the watch on Christmas, and let A retain all other rights over the watch. If A did not own use rights to the watch on Christmas, then presumably A could not sell those rights to anyone else. Further, anyone who tried to prevent B from using the watch on Christmas would presumably interfere with his property rights. Specifically, if C re- fused to let B use the watch on Christmas then B could sue C for “trespass” and obtain specific performance. (We will explain these terms in more detail in Chapters 8 and 9.) Notice what happens when A and B replace A’s contractual promise to B with A’s sale of use rights to B. Damages are the usual remedy for breach of contract. Hence B’s

180 III. What May Owners Do with Their Property? 165 contractual right to wear the watch on Christmas is protected by A’s liability to pay damages for breach. In contrast, injunctions are the usual remedy for trespass on prop- erty rights. Hence B’s ownership of the right to wear the watch on Christmas is pro- tected by his ability to obtain an order from the court requiring C to allow B to wear the watch on Christmas. The example of the watch illustrates how unbundling can hinder commerce. Specifically, if unbundling is allowed, C would be uncertain exactly what rights he ac- quired by buying the watch from A, which would dampen C’s interest in buying the watch. A vigorous market requires certainty of buyers concerning the rights that they acquire. This example raises the general question, “Can the owner of property, who has a bundle of rights, rearrange the bundle of rights freely, transfer them as he wishes, and force courts to protect the transfer of rights by injunctions?” While this problem sel- dom arises with watches or similar objects, it often arises with real estate. To illustrate, assume that I own my family’s ancestral home, Blackacre, and I want to assure that no one will ever use it for purposes other than a residence. To secure this end, I would like to remove the development rights from the bundle of ownership rights. Can I do it? According to the common law of property, I can only restrict the use by the future own- ers of Blackacre for a limited period of time. (See the preceding discussion of the rule against perpetuities.) In general, an owner cannot freely unbundle and repackage real property rights in common law. Similarly, civil law systems in countries like France go beyond these common law restrictions by enumerating rights of real property that the owners cannot change. According to the civil law tradition, the enumerated rights at- 58 tach to the property itself, not to the person who happens to own the property. Another important kind of property that provokes disputes about bundling and un- bundling is the corporation. The stockholders of a corporation are its legal owners. Each share of stock traditionally conveys to its owner the right to one vote at stockholders’ meetings. In recent years, however, some corporations have created new kinds of stock that do not give voting rights to their owners. There are many other examples where cor- porations have unbundled and rearranged the traditional rights enjoyed by their owners. Instead of entangling ourselves in the details of real estate or corporate law, we must focus on the general point underlying these controversies. In the example of the heirloom watch, the fundamental issue is whether the owner of property can give several different people rights over it that they can enforce by specific performance against anyone who interferes. Economic efficiency generally favors allowing unbundling whenever it increases the market value of the property, and prohibiting unbundling when it decreases the mar- ket value of the property. Property owners generally want to maximize its market value, and they are better situated than the state to know how to do this. Consequently, the state seldom has reason to prevent owners who want to unbundle from doing so. Recall, 58 In legal language, numerus clausus refers to a restricted list of rights, including property rights. In prop- erty, these rights are in rem, meaning that they attach to the property regardless of its owner, whereas con- meaning that they attach to the particular people who made the contract. See tract rights are in personam, the article by Thomas Merrill and Henry Smith noted at the end of Chapter 4.

181 166 CHAPTER 5 opics in the Economics of Property Law T however, our previous discussion about the “anticommons.” Unbundling may impose future costs on those who would like to repackage the rights into a new configuration. Insofar as there is an economic argument against unbundling, it is based on this desire to minimize future costs of assembling those rights into a more valuable whole. Some theorists have argued that individuals can sometimes increase the value of their own property by unbundling in ways that increase transaction costs for the sale of other properties. To illustrate, a standard form contract lowers the bargaining costs of everyone in an industry. One seller who departs from the standard form reduces standardization, which imposes costs on other sellers. In general, a common pool of knowledge about contracts lowers transaction costs of exchange, and unbundling drains the common pool. This view implies that property law requires constraints against fragmentation by particularization. This argument, however, is unconvincing. Much of contract law imposes rules that apply unless the parties stipulate otherwise in the contract. (See our discussion of “de- fault rules” in Chapter 8.) The state does not have to police contracts to make sure that they remain sufficiently standardized. State requirements of standardized contracts are typically misguided for the same reason that state restrictions on unbundling property are mis- guided. The law should obligate sellers to disclose improbable restrictions on ownership due to past transactions, but as long as the parties understand what they are purchasing, the law should generally enforce agreements to unbundled property rights. IV. What are the Remedies for the Violation of Property Rights? As noted in Chapter 4, common law approximates a legal system of maximum lib- which allows owners to do anything with their property that does not interfere erty, with other people’s property. When applying this principle, the amount of liberty af- forded to owners depends on disentangling one owner’s use of property from another’s. When uses are separate, the effect of one owner on another occurs through voluntary agreements, such as market exchange. When uses join, one owner affects another in- voluntarily, as when my smoke blows over your property. In this section we discuss the special legal and economic problems caused by entangled uses. A. Externalities and Public Bads When people agree to impose costs and benefits on each other, they often make a contract. In contrast, when the utility or production functions of different people are in- terdependent, they impose benefits or costs on each other, regardless of whether they have agreed. Such interdependence is called an externality, because the costs or benefits are conveyed outside of a market. To illustrate the difference, if I buy so many water- melons at my local fruit store that the seller raises the price, my action affects other buy- ers, but bidding up a price exemplifies the ordinary working of markets, not an externality. In contrast, if my rooster’s crowing annoys my neighbors, my action affects them independent from market transactions; so, the noise is an externality.

182 IV. What are the Remedies for the Violation of Property Rights? 167 Costs or benefits conveyed outside of the market are not priced. Whenever costs or benefits are not priced, the supplier lacks incentives to supply the efficient quantity. Overcoming this incentive problem requires pricing the externality. When an external- internalizing ity gets priced, its supply is channeled through a market, which is called the externality . Thus, the solution to interdependent uses of property is to channel them through the market, or to internalize the externality. The efficient solution to the problem of internalization depends on the number of affected people. If interdependence affects a small number of people, the externality is “private.” For example, the crowing of my rooster affects a few neighbors, so the noise is a private externality. If the interdependence affects a large number of people, the ex- ternality is “public.” For example, the smoke from a factory affects many households, so it is a public externality. Similarly, when one additional car enters a congested freeway, all the other drivers slow down a little, so congestion is a public externality. The private- public distinction in economics rests on a continuum describing the number of people who are affected by someone’s actions. As the number of people affected by someone’s action increases, a vague boundary is crossed separating “private” from “public.” In Chapter 4 we explained that one person’s consumption of a public good does not diminish the amount available to others, and that excluding some people from en- joying a public good is difficult. Public externalities typically have these characteristics of nonrivalry and nonexcludability. For example, when one person breathes dirty air, just as much dirty air remains for others to breathe, and preventing some people in a given air-quality region from breathing the air is difficult. Consequently, harmful pub- lic externalities are also called “public bads.” We s u m m a r i z e t h e s e p o i n t s b y u s i n g s o m e n o t a t i o n . I m a g i n e a s m a l l e c o n o m y . a b , and three private goods, denoted x and , x x , with two people, denoted 2 1 3 Consumption of the first two goods involves no externalities, but consumption of the third good imposes external costs. For example, the first two goods might be apples and pears, and the third good might be cigarettes. We attach a superscript on a good to indi- a can be written as a function of the cate who consumes. Thus, the utility of person a a a a a , x three goods that she consumes: , x . Assume that person x 1 b u = consumes u 2 1 2 3 b the first two goods, but not the third good; that is, person does not smoke cigarettes. Furthermore, assume that person ’s ciga- b dislikes breathing the smoke from person a a b b b b b rettes. Thus, the utility of person b 1 x = , x u , x ’s 2 . (Note that can be written u 3 1 2 x but that her utility will x utility will typically increase if she consumes more of and 2 1 .) The utility functions of b if decrease consumes more x a and are interdependent a 3 ’s consumption of the third good is an argument in b ’s utility function. In because a b ’s utility function bearing the superscript a other words, the presence of a variable in indicates an externality. Let us add additional notation to indicate incomplete markets. Suppose that the ) are purchased in a store at prices ( three goods ( x p , x , x p , p ). The price that per- 3 1 1 3 2 2 x must pay for a presumably reflects the cost at which the store purchases the son 3 x a ’s consumption of im- good. This price does not include the cost of the harm that 3 poses on b . a x Consequently, there is no price associated with the variable in ’s utility func- b 3 tion. In order to attach such a price, persons a and b would have to bargain with each other.

183 168 CHAPTER 5 opics in the Economics of Property Law T Through such bargaining, the externality might be internalized. Our two-person exam- ple is a private externality. Alternatively, assume that there are 1, 2, 3, . . . , people n b . Choose any one of these n people and call this person j just like person j ’s . Person a j j j j n . Now the harm- 2 , x utility function has the form , x , for x 1 j u = % u 1, 2, 3, . . . , 3 2 1 ful externality from ’s consumption of affects so many people that it is a public bad. a x 3 people is presumably prohibitive, so the ex- The transaction cost of bargaining with n ternality cannot be internalized by a private bargain. Instead, an alternative means of pricing the externality must be found. Q UESTION Classify the items in the following list as markets, private 5.29: externalities, or public externalities. Alighthouse warns ships about rocks. a. b. My building blocks your sunlight. c. You outbid me at the auction. Bees pollinate your apple trees. d. e. Noise lowers the sale value of my house. Assume that the third good, , represents miles driven in Q UESTION 5.30: x 3 cars by persons 1, 2, 3, . . . , , and assume that cars are polluting. Rewrite the n utility function of person j in the preceding formulation to represent these facts. B. Remedies for Externalities In property law, a harmful externality is called a nuisance . Remember that our discussion of remedies for nuisance in Chapter 4 distinguished between injunctions and damages, and that the relative efficiency of these remedies has a lot to do with the public-private distinction. If the nuisance is private, few parties are affected by it, and, as a result, the costs of bargaining together are low. When bargaining costs are low, the parties will ordinarily reach a cooperative agreement and do what is effi- cient. Consequently, in those circumstances the choice of remedies makes little dif- ference to the efficiency of the bargaining outcome. The traditional property law remedy—injunctive relief—is attractive under these circumstances, because the court need not undertake the difficult job of computing damages. If one views an injunc- tion as always and forever prohibiting the offensive activity, then its inflexibility is costly. However, if one views an injunction as an instruction to the parties to resolve their dispute through voluntary exchange, then it is an attractive remedy for private nuisances. In contrast, trying to correct a harmful externality of the public-bad type by bar- gaining would involve the cooperation of all the affected parties. Bargaining fails in these circumstances because it requires the cooperation of too many people. The law refers to a harmful externality of the public type as a . Our analysis sug- public nuisance gests that damages will be a more efficient remedy for a public nuisance than an injunc- tion would be. To apply this prescription for choosing between injunctions and damages, the court has to examine the number of people affected by the externality. However, the court does not have to perform a cost-benefit analysis comparing injunctions and damages.

184 IV. What are the Remedies for the Violation of Property Rights? 169 Cost-benefit analysis requires more information than courts typically possess, so legal rules whose application requires a cost-benefit analysis should be avoided. When compensatory damages are perfect, they restore the victim to the same utility curve as he or she would have enjoyed without the harm. Compensatory dam- or ages can be temporary . With temporary damages, the plaintiff receives permanent compensation for the harms the defendant has inflicted on him or her in the past. If harms continue in the future, the plaintiff must return to court in order to receive ad- ditional damages. Thus, temporary damages impose high transaction costs for dis- pute resolution. With temporary damages, reductions in future harms translate directly into reductions in liability. Consequently, temporary damages create incen- tives for injurers to continually adopt technical improvements that reduce external costs. With permanent damages, the plaintiff receives compensation for past harms 59 plus the present discounted value of all reasonably anticipated future harms. One lump-sum payment extinguishes claims for past and future harms at the level speci- fied in the judgment. Unfortunately, future changes in technology and prices are dif- ficult to predict, so the estimation of future harms suffers from error. Thus, permanent damages impose high error costs. Furthermore, by paying permanent damages the injurer “purchases” the right to external harm up to the amount stipu- lated in the judgment. Consequently, permanent damages create no incentive for in- jurers to adopt technical improvements that reduce external costs below the level 60 stipulated in the judgment. As explained, temporary damages impose high transaction costs, whereas per- manent damages impose high error costs and undermine incentives for reducing fu- ture harms. Transaction costs of resolving disputes, whether by trial or settlement, are low when liability is certain and damages are easily measured. Error costs are high when innovation improves abatement technology and changes the understand- ing of the harms caused by externalities. Thus, temporary damages tend to be more efficient given easily measured damages and rapid innovation. Conversely, perma- nent damages tend to be more efficient given costly measurement of damages and slow innovation. We c o m m e n d d a m a g e s a s t h e r e m e d y f o r a p u b l i c n u i s a n c e . H ow eve r, c o m m o n law has not traditionally followed this prescription. When the public is harmed by a nuisance, courts traditionally allow the affected parties to enjoin it. The following case suggests that the common law has become more receptive to damage remedies for public nuisances. Read the case, bearing in mind the difference between the tra- ditional remedy for a nuisance (damages for past harm and an injunction against fu- ture harm), recurring damages, and permanent damages. After reading the case, test your knowledge of externality theory by answering the questions. 59 See the section on asset-pricing in Chapter 2 for more on discounting. 60 In his dissent in Boomer v. Atlantic Cement Co., which we discuss next, Justice Jasen recognized this point in his criticism of the majority’s award of permanent damages. He wrote, “Furthermore, once permanent damages are assessed and paid, the incentive to alleviate the wrong would be eliminated, thereby continu- ing air pollution in an area without abatement.”

185 170 CHAPTER 5 opics in the Economics of Property Law T . 309 N.Y.S.2d 312, BOOMER v. ATLANTIC CEMENT CO., INC 257 N.E.2d 87 (Court of Appeals of New York, 1970) BERGAN, J. Defendant operates a large cement plant near Albany. These are actions for injunction and damages by neighboring land owners alleging injury to property from dirt, smoke and vibration emanating from the plant. [At the trial court and on appeal, the defendant’s cement-making operations were found to be a nuisance to the plaintiff-neighbors. Temporary damages were awarded, but an injunction against future dirt, smoke, and vibration from the plant causing the same or greater harms was denied. Plaintiffs have brought this appeal in order to re- ceive the traditional remedy against a nuisance—an injunction.] The ground for denial of injunction . . . is the large disparity in economic conse- quences of the nuisance and of the injunction. This theory cannot, however, be sus- tained without overruling a doctrine which has been consistently reaffirmed in several leading cases in this court and which has never been disavowed here, namely, that where a nuisance has been found and where there has been any substantial damage shown by the party complaining, an injunction will be granted. The rule in New York has been that such a nuisance will be enjoined although marked disparity be shown in economic consequences between the effect of the in- junction and the effect of the nuisance . . . . The court at Special Term [the trial court] also found the amount of permanent dam- age attributable to each plaintiff, for the guidance of the parties in the event both sides stipulated to the payment and acceptance of such permanent damage as a set- tlement of all the controversies among the parties. The total of permanent damages to all plaintiffs thus found was $185,000 . . . . This result . . . is a departure from a rule that has become settled; but to follow the rule literally in these cases would be to close down the plant at once. This court is fully agreed to avoid that immediately drastic remedy; the difference in view is how best to avoid it. [Footnote by Court: Atlantic Cement Co.’s investment in the plant is in excess of $45,000,000. There are over 300 people employed there.] If the injunction were to be granted unless within a short period—e.g., 18 months— the nuisance be abated by improved techniques found, there would inevitably be ap- plications to the court at Special Term for extensions of time to perform on showing of good faith efforts to find such techniques. The parties could settle this private litiga- tion at any time if defendant paid enough money and the imminent threat of closing the plant would build up the pressure on defendant . . . . Moreover, techniques to eliminate dust and other annoying by-products of cement making are unlikely to be developed by any research the defendant can undertake within any short period, but will depend on the total resources of the cement industry nationwide and throughout the world. The problem is universal wherever cement is made. For obvious reasons the rate of the research is beyond control of defendant. If at the end of 18 months the whole industry has not found a technical solution, a court would be hard put to close down this one cement plant if due regard be given to eq- uitable principles. On the other hand, to grant the injunction unless defendant pays plaintiffs such permanent damages as may be fixed by the court seems to do justice between the

186 IV. What are the Remedies for the Violation of Property Rights? 171 contending parties. All of the attributions of economic loss to the properties on which plaintiffs’ complaints are based will have been redressed. . . . It seems reasonable to think that the risk of being required to pay permanent dam- ages to injured property owners by cement plant owners would itself be a reasonably effective spur to research for improved techniques to minimize nuisance . . . Thus, it seems fair to both sides to grant permanent damages to plaintiffs which will terminate this private litigation. . . . The judgment, by allowance of permanent damages impos- ing a servitude on land, which is the basis of the actions, would preclude future recov- ery by plaintiffs or their grantees. This should be placed beyond debate by a provision of the judgment that the pay- ment by defendant and the acceptance by plaintiffs of permanent damages found by 61 the court shall be in compensation for a servitude on the land. The orders should be reversed, without costs, and the cases remitted to Supreme Court, Albany County, to grant an injunction which shall be vacated on payment by defendant of such amounts of permanent damage to the respective plaintiffs as shall for this purpose be determined by the court. JASEN, J., dissenting. I agree with the majority that a reversal is required here, but I do not subscribe to the newly enunciated doctrine of assessment of permanent dam- ages, in lieu of an injunction, where substantial property rights have been impaired by the creation of a nuisance. . . . I see grave dangers in overruling our long-established rule of granting an injunction where a nuisance results in substantial continuing damage. In permitting the injunc- tion to become inoperative on the payment of permanent damages, the majority is, in effect, licensing a continuing wrong. It is the same as saying to the cement company, you may continue to do harm to your neighbors so long as you pay a fee for it. [Our emphasis.] Furthermore, once such permanent damages are assessed and paid, the in- centive to alleviate the wrong would be eliminated, thereby continuing air pollution of an area without abatement. It is true that some courts have sanctioned the remedy here proposed by the major- ity in a number of cases, but none of the authorities relied on by the majority are anal- ogous to the situation before us. In those cases, the courts, in denying an injunction and awarding money damages, grounded their decision on a showing that the use to which the property was intended to be put was primarily for the public benefit. Here, on the other hand, it is clearly established that the cement company is creating a con- tinuing air pollution nuisance primarily for its own private interest with no public benefit. . . . The promotion of the interests of the polluting cement company, has, in my opinion, no public use or benefit. . . . . I would enjoin the defendant cement company from continuing the discharge of dust particles on its neighbors’ properties unless, within 18 months, the cement com- pany abated this nuisance. . . . 61 A servitude on the land is a restriction or burden on a piece of real property. The servitude typically “runs with the land,” which means that it becomes permanently attached to the particular piece of land and is not, therefore, dependent on the identity of the owner. In your discussion of the case, see if you can explain why the court wishes to make the obligation to pay permanent damages for the nuisance a servitude on the land rather than being a mere obligation to pay particular individuals.

187 172 CHAPTER 5 opics in the Economics of Property Law T UESTION 5.31: Boomer private or public? Q Is the externality in 5.32: Are the transaction costs of bargaining among the parties Q UESTION low or high? UESTION 5.33: Suppose the households had a right to enjoin the cement Q company to stop polluting. What obstacles would the cem ent company face if it tried to purchase the right to pollute from the households? UESTION Explain the remedy given by the court. Suppose that at Q 5.34: some time in the future the cement company doubles its rate of output, thus increasing the noise, smoke, dust, and vibration inflicted on the neighbors. Do the homeowners have a remedy? UESTION 5.35: Contrast the difference between temporary and permanent Q damages on the incentives of people to build new houses near the cement factory. Q UESTION 5.36: To w h a t ex t e n t c a n t h e p r iva t e l aw o f p r o p e r t y s o l ve t h e problem of pollution? Web Note 5.8 See our website for an additional case and some additional questions on using nuisance law to correct externalities. We also summarize there some new lit- erature on the choice between property and liability rules as remedies. C. Graphing Externalities Let us graph how the award of damages can internalize an externality and restore efficiency. We assume that a firm like Atlantic Cement is held liable for the external costs it inflicts on others. The situation facing the firm is shown in Figure 5.1. The com- pany’s marginal private-cost curve, MPC, indicates the private cost to the firm of pro- ducing different quantities of cement. Private costs include the capital, labor, land, and materials but not the external harm caused by pollution. The external costs of pollu tion are added to the private costs to yield the social costs of producing cement. Figure 5.1 depicts two marginal social-cost curves representing two different technologies. Under the old technology, the addition of external costs of pollution to the private costs of production yields the marginal social-cost curve MSC . This curve depicts the true cost to society of each level of production under the old technology. There is, however, a new technology that pollutes less. Its marginal social costs are shown along line MSC' . The superiority of the new technology lies in the fact that it causes half as much pollution at any given level of output as the old technology. For example, the old technology might use filters in the smoke stack, and the new technology might use scrubbers in the smoke stack.

188 IV. What are the Remedies for the Violation of Property Rights? 173 $ Figure 5.1 MSC The incentives to adopt a new, superior ' MSC technology under a rule of temporary damages. C t C MP D t ' B FH P 0 G E A q q q q 0 1 2 0 Under either technology and in the absence of any court or regulatory action, the company’s profit-maximizing rate of output, , is determined at the intersection q 0 of the private marginal-cost curve and the prevailing output price, P . Under the old 0 q technology, the total amount of external cost inflicted by the output rate is the 0 area ABC . Under the new technology, the total amount of external cost inflicted by ABD the output rate . The net social cost inflicted by the last unit of is the area q 0 ¿ ¿ under the new technology. Note that t under the old technology and t & t output is it is easy to see here that, even if there is no legal compulsion for the firm to take external costs into account, society is better off if the firm is producing under the new technology rather than under the old technology. However, if the firm is not required to internalize these external costs, it has no incentive to adopt the new technology. However, matters change if the firm can be made to internalize the social cost of its production of cement. Under the old technology and with the firm held responsible for its external costs, the profit-maximizing rate of output is determined by the inter- q section of P and MSC . At this point the cost of pollution is area AEF. But under at 1 0 the new technology and with the firm held responsible for its external costs, the profit- ¿ P maximizing rate of output is determined by the intersection of MSC at . q and 0 2 q Social efficiency requires the firm to adopt the new technology and produce at . 2 under the old tenchol- q (Can you identify the cost of pollution at production level 1 62 ogy, and at under the new technology? q 2 62 At q under the new technology, the cost of under the old technology, the cost of pollution is AEF. At q 2 1 pollution is AGH.

189 174 CHAPTER 5 opics in the Economics of Property Law T But what about the firm? Is it indifferent between the two technologies? No. Assuming that the firm pays pollution costs, its maximum profits under the old tech- nology are the area F , whereas maximum profits under the new technology are AP . H AP 0 0 AP $ H It is obvious that AP . F 0 0 How do these considerations relate to the question we asked above about the incentives for adopting superior technologies of production under the alternative damage measures? The intuitively plausible answer is that the cement company will adopt the cleaner technology more quickly under temporary damages than un- der permanent damages, and that intuition is borne out by our formal analysis. However, these economic advantages to temporary damages over permanent dam- ages must be balanced against the potentially higher administrative costs of tempo- rary awards. Q UESTION 5.37: The price line P is horizontal in Figure 5.2. What does 0 this fact indicate about competition? 5.38: Assume that science reveals a new health hazard caused UESTION Q by breathing pollution from cement factories. How would such a discovery modify the graph and change the efficient level of production of cement? D. Takings The theory of property developed in Chapter 4 stresses that clear and certain prop- erty rights may facilitate bargaining, which creates a surplus from cooperation and exchange. Conversely, unclear and uncertain property rights may impede bargaining, which destroys the social surplus. The power of the state to take property (that is, to compel its sale to the state) and regulate its use reduces the clarity and certainty of $ Figure 5.2 The incentive effects on private Total cost investors of a difference between compensable takings and R nr noncompensable regulations. (industrial use) R r (commercial use) y y y 0 1 0 Building’s Size

190 IV. What are the Remedies for the Violation of Property Rights? 175 property rights. The resulting destruction in social surplus represents the economic cost of the state’s power to take property and regulate its use. Offsetting the economic cost is the benefit of providing public goods at lower cost. In this section we develop these ideas into an economic theory of the taking and regulatory powers. In many countries, the constitution circumscribes the state’s power to take private property. For example, the takings clause of the Fifth Amendment to the U.S. Constitution reads, “nor shall private property be taken for public use, without just compensation.” Thus, the Fifth Amendment prohibits the state from taking private property except under two conditions: (1) the private property is taken for a public use, and (2) the owner is compensated. We will explain the economic rationale for these two conditions. 1. Compensation To u n d e r s t a n d t h e c o m p e n s a t i o n r e q u i r e m e n t , w e p r o c e e d i n two stages. First, assume that there were no requirement to compensate (as was the case in England centuries ago) so that expropriating private property might be a means of fi- nancing the government. Second, assume that there is a requirement to compensate and examine its incentive effects for the government to use private property. (We will ex- amine compensation’s effect on the private property owner’s use of the property in a subsequent section.) First, contrast takings and taxes as means of financing government. Taxes are as- sessed on a broad base, such as income, property, sales, or bequests. Everyone subject to the tax faces the same schedule of rates. In contrast, a taking involves a particular piece of property owned by a particular person. Tyrannies sometimes finance govern- ment and enrich officials by taking property from individuals. To finance the state by takings, the private owner whose property is appropriated must not receive compensa- tion. If the private property owner received compensation equal to the market value for his or her property, the state could not profit from taking it. So the requirement of compensation can be viewed as a device to channel government finance into taxes and away from takings. Economics provides strong reasons for financing the state by taxes rather than tak- ings. Any kind of expropriation distorts people’s incentives and causes economic ineffi- ciency, but taxes distort far less than uncompensated takings. To see why, consider the basic principle in public finance that focused taxes distort more than broad taxes. Applying this principle, a given amount of revenues can be raised with less distortion by a tax on food rather than vegetables, or a tax on vegetables rather than carrots. This prin- ciple follows from the fact that avoiding broad taxes is harder than avoiding narrow taxes. For example, avoiding a tax on food requires eating less, whereas avoiding a tax on car- rots requires eating another vegetable, such as cucumbers. Broad taxes distort behavior less because many people cannot change their behavior to avoid broad taxes. Thus, effi- ciency requires the state to collect revenues from broad taxes such as income or con- 63 In contrast, takings have a very narrow base. Individual owners will go to sumption. 63 The precise proposition is that goods should be taxed at a rate inversely proportional to their elasticity of demand and supply. Broad taxes fall on aggregates that are inelastically demanded and supplied.

191 176 CHAPTER 5 opics in the Economics of Property Law T great expense to prevent the state from taking their property without compensation. Indeed, the possibility of uncompensated takings would divert effort and resources away from production and toward the politics of redistribution. Now let us examine the effect of the compensation requirement on government’s actions. Courts have held that the compensation requirement necessitates the govern- ment’s paying roughly the fair market value to a property owner if her property is taken. For reasons that we will soon explain, that value may not be exactly what the owner would like or that would be reached in an arm’s-length transaction between the owner and another buyer. Nonetheless, the government cannot make money by paying the market value for property that it takes. This fact discourages the government from excessive takings of private property. The requirement of compensation does not preclude another politi- 2. Public Use cal abuse, in which the state takes one person’s property and sells it to someone else. To a p p r e c i a t e t h e p r o b l e m , c o n s i d e r t h e d i ff e r e n c e b e t w e e n a t a k i n g a n d a s a l e . S a l e s are motivated by mutual gain, which is created by moving property from lower-valued to higher-valued uses. To illustrate, Blair’s purchase of Adam’s 1957 Chevrolet creates a surplus because Blair values it more than Adam does. The fact that both parties must consent to the sale guarantees mutual gain. In contrast, a taking does not require the consent of the property owner, so unilateral gain can motivate a taking. A property owner may value his or her property more than whoever takes it. For example, assume that Samson owns his family’s estate, the market value of which equals $30,000, but Samson does not want to sell it because he values the estate at $100,000 for sentimental reasons. Delilah covets Samson’s estate and would be will- ing to pay up to $40,000 for it. Assume that the state can compel Samson to sell his property at its “fair market value.” So, Delilah contributes $5000 to the campaign fund of a prominent government official, who takes Samson’s estate, pays him $30,000, and resells the estate to Delilah for $30,000. Thus, Delilah and the government official each gain $5000, although Samson loses $70,000. By taking Samson’s property and giving it to Delilah, the state transfers prop- erty from one private person to another, so that Delilah does not have to pay Samson’s subjective price for the estate. The requirement of compensation at mar- ket prices does not prevent this abuse, which occurs because the owner’s subjective value exceeds the market price paid as compensation. To eliminate the abuse, the state could compensate the owner’s subjective price rather than the market price. However, no one but the owner knows the subjective price. In a voluntary sale, the owner receives at least the subjective price or does not sell. If the state wanted to compensate at least the owner’s subjective price, the state would have to buy the property, not take it. The “public-use” requirement avoids the abuse in this example. Delilah’s use of Samson’s estate is private, not public. Consequently, the taking in this example violates the public-use requirement. The public-use requirement forbids the use of takings to bypass markets and transfer private property from one private person to another. Instead, property must be taken for a public use. For example, Samson’s estate could be taken for a park, school, or highway.

192 IV. What are the Remedies for the Violation of Property Rights? 177 The public-use requirement does not solve the problem of inefficiency in involun- tary transfers. To illustrate, suppose that motorists would be willing to pay $40,000 to use a highway through Samson’s estate, the market value of which is $30,000. By tak- ing the land, paying Samson $30,000, and building a highway, the government antici- pates a surplus of $10,000. In reality, Samson values his estate at $100,000, so the net social loss will equal $60,000, and Samson will lose $70,000. This example suggests that the state should not take property with compensation merely to produce a public good. In reality, the state buys most of the resources that it uses to supply public goods. For example, the state buys cement, pencils, trucks, light bulbs, and labor. In fact, takings are circumscribed more than the requirements of com- pensation and public use suggest. 3. Holdouts The government must purchase large tracts of land from many own- ers in order to provide some public goods, such as military bases, airports, highways, and wilderness areas. These projects often demand “contiguity,” which means that the parcels of land must touch each other. To illustrate, the segments of a highway do not connect unless they are on contiguous parcels of land. Contiguity disrupts bargaining by creating opportunities for owners to hold out. To illustrate, assume that the state proposes to construct a road across three parcels of land owned by three different people. The state determines that motorists would pay $200,000 more than the construction costs for such a road. Consequently, efficiency re- quires undertaking the project provided that the land’s value is less than $200,000. The three owners value the land at $30,000 per parcel, so construction of the road would create a social surplus of $110,000. Assume that the state acquires an option to buy one of the parcels for $30,000. The state could pay up to $170,000 for the other two parcels and still come out ahead. Knowing this, each of the owners demands $100,000 for her parcel of land. If the state must buy the land, not take it, the project fails. The last owner frequently “holds out” when the state acquires contiguous parcels of land needed for a public project. In a real-life example, the developers of a new base- ball stadium in Denver purchased all the land except for the property of one “holdout,” whom the newspaper called “the guy who owns first base.” Even when owners do not hold out, the possibility of doing so can dramatically increase the transaction costs of purchasing contiguous property. The taking power eliminates this problem. The gov- ernment should resort to compulsory sale principally when there are many sellers, each of whom controls resources that are necessary to the project. Thus, takings should be guided by this principle: in general, the government should only take private property with compensation to provide a public good when transaction costs preclude purchas- . ing the necessary property Q UESTION 5.39: What if the government needs to purchase a single, large piece of property in order to provide a public good, say, a satellite-tracking station? There is only one private owner with whom to deal. And his property is the only one that is suitable for the station. Should the government be al- lowed to compel this individual, a monopolist for the contemplated public use, to sell at fair market value?

193 178 CHAPTER 5 opics in the Economics of Property Law T UESTION 5.40: Kelo v. City of New London , 545 U.S. 469 (2005), the Q In U.S. Supreme court decided a case in which landowners challenged the power of a city in Connecticut to take their property for redevelopment. The redevel- opment plan did not contemplate that all of the land would be open to the pub- lic. Parts would be privately developed. The plaintiffs alleged that the taking was unconstitutional because it was not for a public purpose. The Supreme Court rejected this claim. Use economic analysis to argue for or against the view that such a mixed development plan should be regarded as serving a pub- lic purpose. (For some recent cases like this one, see Web Note 5.9.) UESTION Q Compare the efficiency of the following two methods of 5.41: amending the just-compensation constraint: Define just compensation to be fair market value (including relocation a. costs) plus, say, 20 percent. b. Allow private property owners to make their own assessments of the value of their property. Property owners agree to pay property taxes on that self- assessed value. If the government ever takes the property, it agrees to pay the self-assessed property value as just compensation. 4. Insurance People typically purchase insurance on assets whose value consti- tutes a significant proportion of their wealth, such as a house. Most homeowners pur- chase fire insurance. Similarly, people want insurance against takings. Private companies provide fire insurance, whereas the state provides insurance against takings by compensating property owners. Why does the private sector provide insurance against fires, and the state sector provide insurance against takings? This question challenges you to relate takings to the economics of insurance. Insurance spreads risk among policy holders. In general, spreading risk more broadly reduces the amount that anyone must bear. The state can spread the risk of takings through the base of all taxpayers, which is broader than the base of all policy holders in any insurance company. So, risk-spreading argues for public insurance. Administrative efficiency argues for private insurance. The discipline of competi- tion causes a higher level of administrative efficiency in private insurance funds than in state insurance funds. Many state insurance funds, such as depository insurance in American savings banks, have a dismal history. Risk-spreading and administrative costs are not decisive. The decisive case for public insurance against takings rests on incentive effects for the state. Decisions about takings are made by the state. If the state did not have to pay compensation, it might take property to finance itself, or it might take property for redistribution to the friends 64 of politicians, or it might purchase too many public goods. 5. Regulations Earlier in this chapter we discussed how interdependent utility or production functions can cause the externalization of social costs. Nuisance suits pro vide 64 For more on takings as insurance, see Lawrence Blume & Dan Rubinfeld, Compensation for Takings: An Economic Analysis, 72 C AL . L. R EV . 569 (1984).

194 IV. What are the Remedies for the Violation of Property Rights? 179 a remedy. State regulations provide another remedy. Regulations restrict the use of the property without taking title from the owner. Enacting regulations involves a political fight between the beneficiaries and victims. Since the outcome depends on politics, not cost-benefit analysis, the total costs of regulations often exceed the total benefits. However, a chapter on property is not the place to develop a full critique of regulations. In this section, we focus on a narrower issue related to takings. Regulations typically cause a fall in the value of some target property, which may prompt a suit for compensation. To illustrate, an industrialist who acquires land to build a factory may be blocked when the local government “downzones” and forbids indus- trial uses. The industrialist may sue, alleging that the state took a substantial portion of the value of the property but not the title. When courts find for the plaintiff in such cases, they say there was a “taking.” When courts find for the defendant in such cases, they say there was a “regulation.” The difference is that a taking requires compensation and a regulation requires no compensation. We wa n t t o d i s c u s s t h e i n c e n t ive e ff e c t s o f t h i s c l a s s i fi c a t i o n i n t o c o m p e n s a t e d restrictions (takings) and uncompensated restrictions (regulations). If the state need not compensate for restrictions, then it will impose too many of them. If there are too many restrictions, then resources will not be put to their highest-valued use. Thus, uncompen- sated restrictions result in inefficient uses. Conversely, if the state must compensate fully for restrictions, then property owners will be indifferent about whether the state restricts them. If property owners are indifferent about whether the state restricts them, they will improve their property as if there were no risk that restrictions will prevent the use of the improvements. If restrictions subsequently prevent the use of the improvements, the in- vestment will be wasted. Thus, compensated restrictions result in wasteful improvements. 65 We illustrate this argument by an example. F ACTS : Xavier is a government official whose wall contains a map with a thick blue line across it. Currently, the land-use planning laws allow the area to the south of the blue line to be used for any commercial, industrial, or residential purpose. The govern- ment proposes to change the law and forbid industrial uses, although commercial uses would still be allowed. Yvonne owns a building that is located on the blue line. She currently uses the building as a retail outlet, but she is contemplating expanding and improving the build- ing for use as a factory. Yvonne must decide how much to invest in improving her building. If she abandons the idea of using her building as a factory, she will make a smaller investment in improving it for use as retail space, and the government’s land- use regulation decision will not affect her. But if she proceeds with the idea of using her building as a factory, she will make a large investment, and the government’s deci- sion will affect her. Should the government carry out its proposed change, she will lose money on the large investment, and a court will then have to decide whether she is en- titled to compensation for the loss. The decision will turn on whether the court declares the change in the governmental land-use plan to be a regulation, in which case no com- pensation is due, or a taking, in which case compensation is due. 65 See Cooter, . 1 (1985). 73 C AL . L. R EV Unity in Tort, Contract, and Property: The Model of Precaution,

195 180 CHAPTER 5 T opics in the Economics of Property Law Consider the incentive effects of the court’s decision on Yvonne. If she is confident that downzoning is a taking and that she will receive compensation, she bears no risk from making a large investment; so, she will invest as if there were no risk of loss from govern- mental action. On the other hand, if she is confident that downzoning is a regulation and that she will not receive compensation, she bears the risk that the value of her investment would be destroyed by the governmental action, and she will restrain her investment. Figure 5.2 on page 174 illustrates these facts. The vertical axis indicates dollars, and the horizontal axis measures the size of Yvonne’s renovated building. The straight line labeled “Total Cost” indicates the amount that she spends on enlarging the build- and ing. Two curves, labeled and R R ,indicate possible revenues yielded by the nr r building as a function of its size. The higher revenue curve, labeled R , indicates the nr revenues obtainable when there is no regulation, so that the building can be used as a factory. The lower revenue curve, labeled R ,indicates the revenues obtainable when r there is regulation, so that the building cannot be used as a factory. Applying the usual economic logic, Yvonne will maximize profits by choosing the size of building for which the marginal cost equals the marginal revenues. Marginal is the point at which y values are given by the slopes of total value curves in the graph. 0 the slope of the lower revenue curve equals the slope of the total cost curve, so is the y 0 profit-maximizing investment level when industrial use is forbidden. If Yvonne were certain that the courts would hold that downzoning is a regulation, then she would max- y . imize profits by investing at the low level 0 y is the point at which the slope of the higher revenue curve equals the slope of the 1 total cost curve; so, y is the profit-maximizing investment level when industrial use is al- 1 lowed. If Yvonne were certain that downzoning would be deemed a taking by the courts, then she would maximize profits (including compensation) by investing at the high level. Now consider the efficient level of investment. Social efficiency requires Yvonne to take account of real risks, including the risk that the value of her contemplated in- vestment will be destroyed by governmental action. If it were certain that government would not alter the land-use regulations in this area, then efficiency would require y Yvonne to invest at the high level . On the other hand, if it were certain that govern- 1 ment would alter the rules, then efficiency would require Yvonne to invest at the low level y . In reality, it is uncertain whether government will make the alteration, so effi- 0 66 y and y . ciency requires Yvonne to invest at a level in between 0 1 No compensation causes Yvonne to internalize the risk. When she internalizes the risk, she invests efficiently, at a level above y no com- and below y . We conclude that 1 0 pensation for the loss of value in investments caused by uncertain governmental action provides incentives for efficient private investment. However, compensation causes her to invest at y full compensation for the loss , as if the risk were zero. We conclude that 1 of value in investments caused by uncertain governmental action provides incentives for excessive private investment . 66 To b e p r e c i s e , e ffi c i e n cy r e q u i r e s h e r t o m a ke a d d i t i o n a l i m p r ove m e n t s u n t i l t h e r e s u l t i n g i n c r e a s e i n h e r profits when there is no government action, multiplied by the probability of no governmental action, equals the loss in profits when there is government action, multiplied by the probability of governmental action.

196 IV. What are the Remedies for the Violation of Property Rights? 181 This argument concerns incentives for private persons, not the state. The effect of the two legal institutions—regulations and takings—is quite different when we turn from private persons to government officials. If the court decides that the alteration in the allowable uses of land in the relevant area is a mere regulation, so that compensa- tion need not be paid, then the alteration costs the government nothing. On the other hand, if the court decides that this particular action is a taking so that compensation must be paid, then this type of action is very costly to the government. Obviously, the noncompensability of regulations gives government officials an incentive to overregu- late, whereas the compensability of takings makes government officials internalize the . When government action is likely to be full cost of expropriating private property judged a taking, the government internalizes the cost of its actions and thus restrains its taking of private property. On the other hand, when government action is likely to be judged a mere regulation, the government lacks material incentives to conserve its use of valuable private property rights. If the state compensates property owners for governmental takings, property own- ers have an incentive toward excessive improvements, whereas if the state does not compensate, the government has an incentive to overregulate private property. This is the paradox of compensation, which we shall meet again in our study of contracts and torts. Officials should consider this paradox when they must decide whether a state ac- tion that reduces private property values is a taking or a regulation. If private owners will respond to compensation by making excessive improvements, then their behavior will improve by declaring the state action to be a regulation. Conversely, if the govern- ment will respond to non-compensation by excessive action that harms property own- ers, then its behavior will improve by declaring the state action to be a taking. In technical terms, elasticity in the supply of private investment with respect to compensa- tion favors regulation instead of takings, and elasticity in the supply of state action with respect to compensation favors takings instead of regulations. Web Note 5.9 There have been some fascinating recent U.S. cases regarding noncompens- able regulations and compensable takings. We review some of those cases and some of the recent literature on these issues on our website. E. Bargaining With the State Now we turn to a famous case where a landowner successfully sued the state for taking a property right by the way it regulated development. North of Los Angeles, the magnificent coastline of California remains largely unspoiled by development, and the California Coastal Commission is responsible for keeping it that way. A property owner named Nollan sought a permit from the Commission to enlarge a small coastal dwelling into a house. The property was located between the beach and a public road, as depicted in Figure 5.3. The house would have diminished and degraded the view of the coast from the road. The Commission wanted to protect the view from the road. To protect the view, the Commission could have refused permission to build the house. The Commission,

197 182 T opics in the Economics of Property Law CHAPTER 5 ocean Figure 5.3 beach proposed path along beach cliffs possible path Nollan’s house to beach public highway however, took another approach because it had another goal: to create a public walking path along the beach, as indicated in the figure. The Commission asked the owner to donate a public path along the beach in exchange for permission to build the house. Private developers often donate land in exchange for permits, as when a housing devel- oper donates land for a school and a road in exchange for a permit to build houses on farmland. Instead of donating the path, however, the owner sued the Commission. The law clearly allows the state to regulate property to protect the public against harm, and the law clearly forbids the state from expropriating selected property owners without compensation in order to finance public goods. Was the Coastal Commission protecting the public or forcing a private person to pay for a public easement? The U.S. Supreme Court reached the latter conclusion in a complex opinion written by Justice Scalia. The Court looked for a “nexus” between the harm caused by the owner (obstructing the public view from the road) and the remedy demanded by the Commission (donating a public path along the beach). The Court reasoned that without such a nexus, the regulation was an ille- gal taking. Because the Court could not find a nexus, the owner won the dispute. A legal principle can be abstracted from these facts. In order for a regulation to the harm. The count as protecting the public from harm, the regulation must mitigate state may condition a permit on mitigating the harm caused by its exercise. A donation of land to mitigate harm is allowed. For example, the Commission might have asked Nollan to donate a path to get around the house and reach the beach. (See “possible path to beach” in the picture.) A donation of land for a purpose un related to the harm does the harm by supplying not mitigate it. Instead, a donation for another purpose offsets something else of value. Nollan can be interpreted as standing for the principle that the state may not condition a permit on offsetting the harm caused by the permit’s exercise. show a problem with this policy of Some hypothetical numbers inspired by Nollan forbidding permits conditional on offsets. According to Figure 5.4, the property owner values building the house at 1000, and the Commission values the public’s loss of view at 300. Figure 5.4 shows the valuations for “build” and “don’t build” in the two columns of the figure. Figure 5.5 shows the valuations for “mitigate” and “offset.” Mitigating requires re- designing the house to improve the view, which costs the owner 300 and benefits the public by 250 as estimated by the Commission. Alternatively, donating a path along the beach costs the owner 250 and benefits the public by 400.

198 IV. What are the Remedies for the Violation of Property Rights? 183 Don’t act Act Figure 5.4 (don’t build (build Value of building and not building. house) house) 0 1000 & Property owner Public commission 300 ( 0 Path along Redesign Figure 5.5 beach house Value of mitigation and offset. (mitigate) (offset) 250 ( 300 ( Property owner & Public commission & 400 250 Act and Act and Don’t Figure 5.6 mitigate offset act Net values. 750 0 700 Property owner ( 0 100 50 Public commission 850 0 Total 650 Figure 5.6 combines the numbers from the two previous figures to give the net benefits of alternative acts. “Don’t act” yields 0 to both parties. “Act and mitigate” 300 300 % 700) and ( 50 to the public ( & yields 700 to the property owner (1000 ( ( 50), for a net benefit of 650. These two choices (“Don’t act” and “Act and mit- %( 250 . Given these two Nollan igate”) are apparently the only ones allowed by the Court in choices, the Commission will presumably refuse to issue a permit, and the result will be 0 benefits to both parties. The Court apparently will not allow the parties to act and offset, which would bene- 250 % 750) ( fit both of them. “Act and offset” yields 750 to the property owner (1000 ( 400 300 & and 100 to the public commission ( % 100) for a total benefit of 850. Nollan results in a payoff of 0 to With these hypothetical numbers, the holding in both parties (the Commission denies the building permit), whereas allowing the Commission to demand an offset results in a payoff of 850 (Commission gives permit, and owner donates the path). These hypothetical numbers show that the principle in Nollan can easily cause inefficient blocking of building permits. The Supreme Court apparently arrived at this principle because it feared that the state will abuse offsets. The state might demand offsets from politically vulnerable property owners instead of collecting taxes. For example, a mayor elected by tenants might demand offsets when- ever landlords need building permits. The mayor could use the offsets to finance public goods instead of imposing taxes that fall partly on tenants. The potential scope for such abusive offsets is large for two reasons. First, the state has extensive powers of regulation, many of which go unused. The state might start to in- troduce unnecessary restriction on those seeking building (and other) permits just to obtain offsets. Second, the state can demand an offset whose value exceeds the harm caused by exercising the permit. In Figure 5.4, building benefits the owner by 1000. Thus, the state can demand up to 1000 in offsets as a condition for allowing the owner to build, and the owner gains from accepting the offer, even though building harms the public by only 300. Fear of abuse is reasonable, but the Court should have solved the problem in a dif- ferent way that avoids inefficiency. A better solution prohibits offsets unless the state

199 184 CHAPTER 5 opics in the Economics of Property Law T also gives the property owner the opportunity to mitigate. This approach implies that the Commission should give the property owner the permit to build the house condi- mitigating or offsetting. The relationship “either . . . or . . .” tional on the owner either is disjunctive. We are proposing a disjunctive conditional permit. The additional choice can benefit both parties. In Figure 5.6, the disjunctive con- ditional permit allows the owner to redesign the house at a cost of 300 (mitigate) or donate a path along the beach at a cost of 250 (offset). The owner will choose the lat- ter, which will benefit the public much more than the former. In general, allowing the state an additional choice—to issue a permit conditional on mitigating or offsetting— cannot make the state worse off. By issuing a disjunctive conditional permit, the state gives the property owner an additional choice. The property owner in Figure 5.6 will choose to offset. In general, allowing the property owner an additional choice—to mitigate or offset—cannot make the property owner worse off. So, allowing the state to choose or reject issuing a disjunctive conditional permit is more (Pareto) efficient than not allowing it to do so. UESTION 5.42: Q Assume that Figures 5.4 and 5.5 describe the facts in Nollan . Why might the property owner challenge the Commission and litigate instead of accepting the Commission’s offer to give a permit in exchange for donating a pathway along the beach? Q UESTION 5.43: The picture of the Nollan case indicates the “proposed path along the beach” and a “possible path to the beach.” The Court did not allow the Commission to give a building permit conditioned on donating a path along the beach. Why might the court have allowed the Commission to give a building permit conditioned on donating a path to the beach? UESTION 5.44: The Federal Government provides disaster insurance that Q helps people to build vacation homes in places subject to flooding, such as sand dunes. Assume the government wants to protect the environment by preventing construction of homes on a specific sand dune near the ocean. If the government takes private property on the sand dune, either by condemning it or by imposing regulations that forbid any construction, should compensation include or exclude the increase in the value of the land caused by government flood insurance? F. Z o n i n g a n d t h e R e g u l a t i o n o f D e v e l o p m e n t Some goods, called are better consumed together, such as hot dogs complements, and sauerkraut, and other goods, called substitutes, are better consumed separately, such as ice cream and sauerkraut. A similar categorization may be made regarding the spatial separation of economic activities: it is best to locate restaurants near offices, and it is best to separate smokestack industries from residences. There is, however, an im- portant difference between culinary and spatial separation: no law prohibits eating ice cream with sauerkraut, but zoning ordinances in most localities do prohibit locating in- dustry in residential neighborhoods.

200 Suggested Readings 185 It is the element of compulsion in the segregation of economic activities by zon- ing laws that we here seek to explain. It is possible to make a case for zoning as a re- sponse to an important kind of market failure. When demand for a good increases, the price rises, and producers respond by supplying more of it. The rise in price is a signal for producers to devote more resources to producing the good. This signal is usually appropriate in the sense that society is better off when resources are shifted to producing goods whose price is rising. There are, however, special circumstances in which the signals get crossed. In these special circumstances, it would be better for society if producers of a certain good responded to a rise in the price of that good by supplying less of it; but in a free market, they will respond to the rise in price by supplying more of it. To i l l u s t r a t e b y a h i s t o r i c a l ex a m p l e , s u p p o s e t h a t i n 1 9 0 0 i n d u s t r y l o c a t e s o n t h e shore of an undeveloped bay in California. Locating industry on the shore gave easy access to boats. By 1960, however, the manufacturers were supplied by truck rather than by boat. Moreover, the harbor now has great aesthetic and recreational appeal. Given the change in circumstances, efficiency requires gradually relocating industry into the interior and constructing residences or recreational parks on the harbor. To c a u s e fa c t o r i e s t o m ove o u t a n d r e s i d e n c e s t o m ove i n , r e s i d e n t i a l d eve l o p e r s should bid up the price of harbor land relative to land in the interior. There is, however, an obstacle to the unregulated market’s accomplishing this end. The problem is that no one wants to live next door to a factory, so that residential developers are unwilling to pay much for harbor land as long as industry is present. Instead of factories’ moving away from the harbor, the opposite may happen: as industry expands, residences may be driven farther away from the water. If the relative price of land near the water falls as residents flee to the interior to escape industry, the unregulated market in this situa- 67 tion gives the wrong signals. Conclusion In Chapters 4 and 5 we developed an economic theory of property and applied it to a wide-ranging set of legal problems. Our theory views property as the institution that gives people freedom over resources; property law can encourage the efficient use of resources by creating rules that facilitate bargaining and exchange and that minimize the losses when bargaining fails. We organized our theoretical discussion of property rules around four questions that a system of property law must answer. In answering these questions, we revealed the economic logic underlying much of property law. Suggested Readings Cooter, Robert D., Organization as Property: Economic Analysis of Property Law Applied to Privatization , 2 J. L EGAL E CON . 77 (1992). (1985). PSTEIN , R ICHARD A., T AKINGS : P RIVATE P ROPERTY AND THE P OWER OF E MINENT D OMAIN E 67 The explanation for why the market gives the wrong signals in this situation is somewhat technical. Our website contains the explanation.

201 186 CHAPTER 5 opics in the Economics of Property Law T , E ISCHEL A., R EGULATORY T AKINGS : L AW ILLIAM CONOMICS , AND P OLITICS (1995). F , W OLDSTEIN , P AUL , C OPYRIGHT ’ S H IGHWAY : T HE L AW A N D L UTENBERG C OPYRIGHT FROM G ORE OF G TO THE C J UKEBOX (1994). ELESTIAL H , M ICHAEL A., T HE G RIDLOCK ELLER CONOMY : H OW T OO M UCH O WNERSHIP W RECKS E M ARKETS , S TOPS I NNOVATION , AND C OSTS L IVES (2008). INDOW AFFE DAM B., & M ANUEL T RAJTENBERG , P AT E N T S , C ITATIONS , AND I NNOVATIONS : A W , A J ON THE NOWLEDGE CONOMY (2002). K E Notes on the Bedouin Horse Trade or Why Doesn’t the Market Clear, Daddy Lubet, Steven, ?, 74 EX . L. R EV . 1039 (1996). T : ICELI , T HOMAS J., & K AT H L E E N S EGERSON , C OMPENSATION FOR R EGULATORY T AKINGS M A E CONOMIC A NALYSIS WITH A PPLICATIONS N (1996). Selling Mayberry: Communities and Individuals Parchomovsky, Gideon, and Peter Siegelman, AL . L. R EV . 75 (2004). in Law and Economics , 92 C Rapaczynski, Andrzej, The Roles of the State and the Market in Establishing Property Rights , CON . P ERSP . 87 (1996). 10 J. E

202 An Economic Theory of Tort Law 6 The early law asked simply, “Did the defendant do the physical act which damaged the plaintiff?” The law of today, except in certain cases based upon public policy, asks the further question, “Was the act blameworthy?” AMES DAMS , J B A ARR L , 22 H . L. R EV .97, 99 (1908) ORALS AW AND M ARV Even if there is no negligence, public policy demands that responsibility be fixed wher- ever it will most effectively reduce the hazards to life and health inherent in defective products that reach the market. UDGE OGER T RAYNOR , J R E -C OLA B OTTLING C OMPANY SCOLA V D 436 (1944) . C OCA , 150 P.2 each other by doing something wrong: Motorists collide on EOPLE OFTEN HARM the highway; a patron in a bar punches the person standing next to him; an in- trauterine birth control device causes infertility; a newspaper inaccurately reports P the arrest of a businessman for soliciting a prostitute; a professor gives an unfair exam; and so forth. Some of these wrongs are accidental and some are intentional; some are serious and others are trivial; some are crimes and others are annoyances. Suppose that the victim in each of these cases initiates a lawsuit. Under what body of law can the victim sue? Because the plaintiff and defendant are private persons (not the state), the suit belongs to “private law,” as does contract and property law. The victim can- not sue under contract law (which we will discuss in later chapters) because a broken promise did not cause the injury in any of these cases. The victim cannot sue under prop- erty law for damage to body, reputation, or scholastic record because these things are not property . (You cannot transfer your body, bequeath your reputation, or sell your scholas- tic record.) Large losses can escape contract or property law, such as the explosion of Deepwater Horizon British Petroleum’s oil rig in the Gulf of Mexico in 2010 that resulted in billions of dollars of losses (as well as dead birds, fish, and aquatic plants). These facts demonstrate the need for a third major body of private law other than property and contracts. The third body of law concerns compensable wrongs that do not arise from breach of contract and cannot be remedied by an injunction against future interference. Here are some more detailed examples: Joe Potatoes has been driven to distraction by the escapades Example 1: of his wife, Joan Potatoes. At the end of a hard night’s work at the loading dock, Joe is approached by Jim Bloggs. Suspecting that Jim has been romancing Joan, 187

203 188 CHAPTER 6 Economic Theory of Tort Law An Joe insults and strikes him, breaking his nose. Bloggs subsequently sues for the injury to his reputation and his nose. Three hunters go into the woods after pheasants. They are Example 2: spread out in a straggling line about 25 yards apart, walking in the same direc- tion. The hunter in the center flushes a bird that flies up, its wings pounding. The hunters to his left and right turn toward the bird in the middle and fire. The bird escapes, but the hunter in the middle is blinded by birdshot. One of the two hunters certainly caused the harm, but there is no way to determine which one of them it was. The victim sues both of them. A manufacturer produces automobile fuel additives that de- Example 3: mand careful control over quality. If quality control is maintained at a high level, the chemical mixture in the product is correct, and it never causes damage to au- tomobile engines. If, however, quality control is relaxed and allowed to fall to a low level, some batches of the chemical mixture will be flawed. A few of the cars using the flawed batch will be harmed, specifically, the engine will throw a rod and tear itself to pieces. After a rod is thrown, an alert mechanic can detect the cause of the harm by examining the car’s fuel and other signs. The manufacturer determines that a high level of quality control costs more than the harm to some automobile engines caused by a low level of quality control, so the manufacturer adopts a low level of quality control. The owner of a damaged car sues the man- ufacturer and asks for punitive damages. In English-language countries, the name for the body of common law relevant for these cases is tort law. After the Normans conquered England in 1066, they soon lost the French language, but they retained a peculiar form of it for writing about law. To r t tortus (twisted). The com- is “law-French,” itself derived from the Latin word mon law of torts overlaps the law of “civil responsibility” in continental Europe. The continental Europeans use this phrase to refer to private suits over injuries, as op- posed to criminal prosecutions. However, different legal traditions locate the bound- aries of these broad areas of law somewhat differently and adopt somewhat different legal doctrines. Example 1 illustrates an “intentional tort,” so named because the injurer inten- tionally inflicted the harm on the victim. Many intentional torts are also crimes, such as assault, battery, false imprisonment, and intentional infliction of emotional duress. The person who commits such an act may be sued for damages under tort law by the victim and also prosecuted under criminal law by the state. Intentional torts are so much like crimes that we shall not discuss them here. Instead, we shall rely upon our analysis of crime in Chapter 12 to serve as an introduction to inten- tional torts. Most of the wrongs that we shall consider in the two chapters on torts are unintentional, that is, inadvertent accidents. To illustrate, Example 2 describes a hunt- ing accident. Example 3 is more complicated. The manufacturer’s low level of quality control is deliberate, and the resulting harm to automobiles is statistically predictable, but the harm to particular cars is accidental. Example 3 also differs from the other two examples in that the injurer sold a product to the victim, so the two parties participated in a commercial transaction.

204 I. Defining Tort Law 189 The law of accidents was one of the first bodies of private law successfully ana- lyzed using formal economic models. Following the pattern throughout the book, this chapter focuses on general theory, and the next chapter turns to particular topics, including proposals to reform the tort liability system. I. Defining Tort Law We b eg a n t h i s c h a p t e r b y l i s t i n g ex a m p l e s o f h a r m f o r w h i c h t h e l aw s o f c o n t r a c t s and property offer no remedy. The victim cannot use these laws to sue when there is no breach of contract, no damage to property, or no continuing harm to enjoin. This gap creates the need for tort law. Now we want to demonstrate that this gap in the law of property and contracts necessarily exists and, by doing so, we shall describe the eco- nomic essence of tort law. A. Economic Essence of Tort Law Bargaining enables people to cooperate over many kinds of harm that one person imposes upon another. Recall the examples that we discussed when explaining the Coase Theorem, such as the rancher’s cows and the farmer’s crop, or the electrical company’s smoke and the laundry’s white clothes, or the sparks from the railroad and the farmer’s wheat fields. For some kinds of harm, however, the costs of bargaining are so high that the parties cannot cooperate together. The hunters in Example 2 could negotiate an agreement to allocate the cost of an accident before they begin shooting pheasants. However, the cost of negotiating (including the unpleasant atmosphere it creates) is large relative to the small probability of a hunting accident. Similarly, every driver cannot negotiate with every other driver and agree among themselves concern- ing how to allocate the costs of future automobile accidents. In Example 1, Joe Potatoes was not in a frame of mind to negotiate when he broke the nose of Jim Bloggs. The obstacle to cooperation in Example 1 is emotions, not costs. In Example 3, where defective fuel additives destroy automobile engines, the manufacturer may think that most consumers will remain ignorant of the dangers caused by defective fuel additives. Consequently, the manufacturer of fuel additives may not want to alert consumers by mentioning the danger in the consumer contract or the product’s warranty. The obstacle to cooperation in Example 3 is consumers’ igno- rance and the producer’s strategic decision to keep information private. Recall that the Coase Theorem treats all obstacles to bargaining—including bargain- ing costs, emotions, cognitive imperfections, private information, and strategy—as “transaction costs.” We can use this idea to explain the boundary between the law of con- tracts and torts. Contract law concerns relationships among people for whom the transac- tion costs of private agreements are relativ ely low, whereas tort law concerns relationships among people for whom transaction costs of private agreements are relatively high. Economists describe harms that are outside private agreements as externalities . The eco- nomic purpose of tort liability is to induce injurers and victims to internalize the costs of harm that can occur from failing to take care. Tort law internalizes these costs by making

205 190 CHAPTER 6 Economic Theory of Tort Law An the injurer compensate the victim. When potential wrongdoers internalize the costs of the harm that they cause, they have incentives to invest in safety at the efficient level. The economic essence of tort law is its use of liability to internalize externalities created by high transaction costs. To r t l i a b i l i t y i s o n l y o n e o f s eve r a l p o l i cy i n s t r u m e n t s ava i l a b l e t o i n t e r n a l i z e ex - ternalities created by high transaction costs. Alternative policy instruments include criminal statutes, safety regulations, and tax incentives. Each alternative has its advan- tages and disadvantages. This chapter will explain the strengths and weaknesses of tort liability as an instrument for internalizing externalities. UESTION 6.1: According to the conclusion to Chapter 4, “. . . property Q rights are part of the law that makes owners internalize the social costs and benefits of alternative uses of the goods that they own.” Torts are also an essential part of that law. Explain why. B. The Traditional Theory of Tort Liability We d e s c r i b e d t h e e s s e n c e o f t o r t l aw i n t e r m s o f i t s e c o n o m i c f u n c t i o n . B e f o r e a n - alyzing these functions, we describe a traditional legal theory of torts. In the early twentieth century, a legal theory specified the essential elements of a tort. This tradi- tional theory of tort law enjoyed substantial acceptance in America 100 years ago. We discuss it now because the essential elements of a tort as stipulated by it serve as build- ing blocks in the economic model of tort liability. Three elements must be present for recovery by the plaintiff under the traditional theory of torts: 1. The plaintiff must have suffered harm ; 2. The defendant’s act or failure to act must cause the harm; and breach of a duty 3. The defendant’s act or failure to act must constitute the owed to the plaintiff by the defendant. We will explain each element in turn and develop an economic account of it. The first element required for a plaintiff to sue in tort is that he or she must 1. Harm have suffered harm. Without harm, there can be no suit in tort, even if the act was dan- gerous. To illustrate, suppose that the manufacturer in Example 3 sold a batch of fuel additives that were harmless in cars with conventional carburetors and dangerous in cars with turbocharged carburetors. The owner of a car with a conventional carburetor might feel outrage when these facts become known, but outrage is not compensable. His car must have actually been damaged. Harm has a simple economic interpretation: a downward shift in the victim’s util- ity or profit function. To illustrate, Charlie’s utility function in Figure 6.1 is defined over two goods—health (along the horizontal axis) and wealth (along the vertical axis). An indifference curve in that figure, such as u or u , depicts all the combinations of 1 0 health and wealth that give Charlie the same level of satisfaction. Higher indifference curves indicate more satisfaction. Thus, any combination of health and wealth that lies

206 I. Defining Tort Law 191 Wealth FIGURE 6.1 Showing harm as a displacement from a higher to a lower indifference curve and the measures of compensation. * W W 0 W 1 u 0 u 1 0 Health H H 1 0 above . is more desirable to Charlie than any combination that lies on or below u u 0 0 The shape of Charlie’s indifference curves indicates that he is willing to trade off one good to get more of the other and maintain overall well-being. To illustrate, as Charlie u moves down , his wealth decreases at a rate that exactly offsets his improving health. 0 u Similarly, as Charlie moves up , his health declines at a rate that exactly offsets his 1 increasing wealth. Suppose that Charlie initially has health in the amount H and wealth in the 0 amount, W ). Now suppose that Amanda injures , which results in utility u W % u ( H , 0 0 0 0 H W . Charlie has been Charlie, causing his health to fall to and his wealth to fall to 1 1 down to u harmed in that he has been pushed from by Amanda. Perfect compensa- u 0 1 u tion requires Amanda to restore Charlie’s satisfaction to level . Money damages are 0 the traditional means of doing this. Assume that costly medical treatment can restore Charlie’s health. Typically, those damages would constitute a sum equal to ( W - W ) 1 0 to compensate for the lost wealth and a sum equal to the cost of providing ( H ) - H 1 0 units of health. This would restore Charlie to his original position before the wrong was done to him. Suppose, however, that the accident did irreparable damage to Charlie’s health, so H forever. Amanda could, nonetheless, restore his preaccident level that he is stuck at 1 of satisfaction by increasing his wealth, not to its preaccident level of W , but rather to 0 level W *. Because Charlie trades off wealth and health, Amanda can give him the mon- etary equivalent of his irreparable decline in health. Figure 6.1 illustrates the ideal of perfect compensation. In reality, tort law limits the harms for which victims can receive compensation from their injurers. Traditionally, courts were willing to compensate for tangible losses that are easy to document, such as medical costs, lost income, the costs of replacing or repairing dam- aged property, and the like. By contrast, courts were traditionally reluctant to compen- sate for intangible losses or those that are difficult to measure, such as emotional harm, distress, loss of companionship, and “pain and suffering.” Over the years, however, American courts have steadily expanded the list of compensable harms to include many intangibles. To illustrate by Example 1, Bloggs may receive compensation for the emotional distress of being reviled and struck by Potatoes. Other countries have also expanded the scope of compensable harms, but not so far as the United States.

207 192 CHAPTER 6 Economic Theory of Tort Law An Expanding the scope of compensable harm has advantages and disadvantages. On the one hand, this expansion allows compensation for real harms that would have gone unredressed, as illustrated by the following historical example. Suppose that a motorist accidentally kills one of the dependent children of a loving family. The death of the child entails no loss of income to the rest of the family; on the contrary, death saves the family the expense of raising the child. This fact once posed a difficult problem for courts: They wished to confine compensable damages to economic losses that are measurable, and yet no such losses follow from the death of dependent children. For the surviving members of the family to recover damages, courts had to allow compen- 1 sation for emotional distress and loss of companionship. Expanding the scope of compensable harm also creates a vexing problem: How is the perfect compen- court to assign a dollar value to intangible (but real) losses? As explained, means a sum of money sufficient to make the victim of an injury equally well off sation with the money and the injury as he or she would have been without the money or the in- jury. Perfect compensation is the right goal for courts that are trying to internalize costs, but implementing the goal is difficult for intangible, but real, harms. Implementation is difficult because the court cannot observe and measure the plaintiff’s subjective valuation of the loss of companionship, emotional distress, or pain and suffering. Even worse, the very idea of perfect compensation sometimes fails in court. Compensation for a child’s death is not an amount of money such that the parents would just as soon have the money as their child. Confusion over intangible damages contributes to liability disparity, which occurs when the same court awards different amounts of compensation to victims who suf- fered the identical injury. Similarly, court-awarded damages to victims with the same injury differ markedly across countries, with Americans giving higher damages than Germans, and Germans giving more damages than Japanese. Fairness and efficiency seem to require reducing liability disparity in each court and harmonizing damages across jurisdictions. Economics suggests how to reduce liability disparity by adopting better grounded and more predictable ways to calculate damages for intangible harms. UESTION Q Suppose that a person who is burned in an accident suffers 6.2: intense pain for 1 week and then fully recovers. What does “perfect compen- sation” mean in principle as applied to the burn? Why do you expect actual compensation to be imperfect? Q UESTION 6.3: Describe some difficulties in implementing perfect com- pensation for the destruction by fire of Blackacre, the estate of the Gascoyne- Stubbs family for 15 generations. 2. Cause According to the traditional theory, the second element of a tort is “cause.” In order for the plaintiff to sue, according to the traditional theory, the defen- dant must have caused the plaintiff’s harm. To illustrate by modifying Example 1, 1 In a similar vein, many legal systems used to hold that a person’s legal causes of action died with him or her. So, if someone was killed in an accident, his estate could not, on this theory, bring an action against the injurer. We shall return to a discussion of this matter, as well as compensation for difficult-to-measure losses, in the next chapter.

208 I. Defining Tort Law 193 suppose that just as Potatoes’s fist was about to strike Bloggs’s nose, the floor board broke under Bloggs, and he fell down, breaking his nose when he struck the ground. The fall enabled Bloggs to avoid Potatoes’s fist, but he broke his nose anyway. In this new example, there is a wrong (throwing a punch), and there is damage (a broken nose), but the former did not cause the latter. Without causation, the wrongdoer who threw the punch is not liable in tort law for the harm. The element of causation sharply differentiates torts from morality. To illustrate, suppose that in Example 2, both of the hunters were equally reckless when they dis- charged their guns at the pheasant. It was a matter of mere chance that one of the hunters actually blinded the victim and the other hunter missed. Because they were equally reckless, they are on the same plane morally. They may be equally blamewor- thy, but they are not equally liable. Under traditional rules of tort liability, only the caused the harm is liable; the hunter who missed is not liable. hunter who actually The idea of causation may seem simple—perhaps an image comes to mind of bil- liard balls colliding with each other—but this impression is misleading. Causation is a notoriously difficult philosophical topic, and that difficulty carries over into law. The law distinguishes two types of causes. The first and more comprehensive is “cause- in-fact.” Lawyers often use a simple criterion, called the “but-for test,” to decide , would was the cause-in-fact of event B : “But for whether action A B have occurred?” A If the answer to this question is “no,” then A is the cause-in-fact of B. If the answer to this question is “yes,” then A is not the cause-in-fact of B . To i l l u s t r a t e , w e a p p l y t h e bu t - f o r t e s t t o E x a m p l e 3 . A n a u t o m o b i l e ow n e r c a n n o t recover unless the defective fuel additive was the cause-in-fact of her engine’s having thrown a rod. But for the defective fuel additive, would the car have thrown a rod? If the answer is “no,” then the defective fuel additive is the cause-in-fact; if the answer is “yes,” then the defective fuel additive is not the cause-in-fact. The but-for test can determine causation in many legal cases, but in some cases it is useless or misleading. It is often useless in cases involving multiple causes of harm. To i l l u s t r a t e b y c h a n g i n g E x a m p l e 1 a g a i n , s u p p o s e t h a t P o t a t o e s t a ke s a s w i n g a t Bloggs, who dodges the punch and lands on some rotten floorboards that collapse un- der him, and the fall breaks Bloggs’s nose. But for Potatoes’s trying to strike Bloggs, would Bloggs have broken his nose? The answer depends upon whether Bloggs would have stepped on the rotten floorboards even if he did not have to dodge the punch from Potatoes. It is unclear whether Potatoes’s punch was the cause-in-fact of the broken nose. The punch might not have been a necessary condition for the harm to occur, al- 2 though it was part of a sufficient set of conditions. Multiple causes can also increase the probability of harm, as when a person whose parents died from lung cancer lives in a house with asbestos siding, works in a factory with carcinogenic chemicals, and smokes. The courts have struggled to develop a workable theory to assign liability when probabilistic harms actually materialize. An economist might use a regression analysis to estimate the increase in probability of 2 A famous article in philosophy argues that a cause is an Insufficient but Necessary part of an Unnecessary and Sufficient set of conditions (INU). See J. L. Mackie, Causes and Conditions, 2 A M . P HIL .Q. 245 (1965).

209 194 CHAPTER 6 Economic Theory of Tort Law An 3 lung cancer caused by heredity, asbestos siding, chemicals at work, and smoking. All variables with positive coefficients are contributing causes, and the variable with the largest coefficient is the most substantial cause. If the person develops lung cancer and sues someone, the court could assign full liability to the most substantial cause, appor- tion liability among the contributing causes, or find no liability. Another problem arises when applying the but-for test to a sequence of events that precede an injury: The but-for test allows distant causes to have the same weight as proxi- 4 mate causes. To i l l u s t r a t e , r e t u r n t o t h e o r i g i n a l E x a m p l e 1 , i n w h i c h P o t a t o e s ’s fi s t b r e a k s Bloggs’s nose. The fist is the cause-in-fact of Bloggs’s broken nose, but so are many other things. For example, but for having been born, Potatoes would not have broken Bloggs’s nose; but for Joe’s parents conceiving him, he would have not been born; so Joe’s parents are a cause-in-fact of Bloggs’s broken nose. The but-for test does not discriminate between the proximate cause (Joe’s fist) and the remote cause (Joe’s conception). The defendant’s act must not only be a cause-in-fact; it must be the proximate cause of the plaintiff’s harm to establish legal liability under the traditional theory. Proximity is a matter of degree, so the question arises, “How close must the connection be in order for a particular cause to be ‘proximate’ in law?” One of the most famous cases addressing this problem is Pa l s g ra f v. L o n g I s l a n d R a i l w a y C o . (248 N.Y. 399, 162 N.E. 99 [1928]). The relevant facts, as determined by the court, were these: Plaintiff [Mrs. Palsgraf] was standing on a platform of defendant’s railroad after buy- ing a ticket to go to Rockaway Beach. A train stopped at the station, bound for another place. Two men ran forward to catch it. One of the men reached the platform of the car without mishap, though the train was already moving. The other man, carrying a pack- age, jumped aboard the car, but seemed unsteady as if about to fall. A guard on the car, who had held the door open, reached forward to help him in, and another guard on the platform pushed him from behind. In this act, the package was dislodged, and fell upon the rails. It was a package of small size, about fifteen inches long, and was covered by 3 “Regression analysis” is a standard statistical technique that economists (and others) use to investigate corre- lations and causal relationships among variables. In a regression, the investigator seeks to investigate how a set of independent or explanatory variables correlates with or causes changes in a dependent variable. In the text example, the dependent variable would be the “probability of contracting lung cancer” (typically meas- ured as the percentage of a particular group—say the residents of the United States in 1990—who have lung cancer. And the independent or explanatory variables would be such things as heredity, the presence of as- bestos siding, exposure to chemicals, whether the subject smoked, age, annual income, and so on. The regres- sion analysis produces values for the coefficients of the independent or explanatory variables and estimates of the statistical significance of those coefficient that allow the investigator to draw inferences about the relation- ship between each of the independent variables (and all of them collectively) and the dependent variable. 4 A famous illustration of how great events can be said to be caused by remote causes comes from Mother Goose: For want of a nail, the shoe was lost; For want of a shoe, the horse was lost; For want of a horse, the rider was lost; For want of a rider, the battle was lost; For want of the battle, the kingdom was lost; And all for the want of a horseshoe nail.

210 I. Defining Tort Law 195 a newspaper. In fact it contained fireworks, but there was nothing in its appearance to give notice of its contents. The fireworks when they fell exploded. The shock of the ex- plosion threw down some scales at the other end of the platform many feet away. The scales struck the plaintiff, causing injuries for which she sues. The New York court determined that the railroad was not liable for Mrs. Palsgraf’s injuries because the railroad guard’s actions in pushing the passenger were too remote 5 As this case in the chain of causes to be deemed the legal cause of the plaintiff’s harm. illustrates, “proximity” in law is imprecise, although sometimes decisive, for liability. A famous philosopher, Bertrand Russell, argued that science advances by replac- ing the imprecise concept of “cause” with the precise mathematical concept of a “func- 6 The idea of cause in tort law connects to functions in economic models. In tion.” economic models, the consumer’s preferences are described by a utility function, and the producer’s technology is described by a production function. The values of the vari- ables in the utility function determine the consumer’s level of utility, and the values of the variables in the production function determine the level of output. The consumer chooses the values of variables that he or she controls in the utility function to maxi- mize it, and the producer chooses the values of the variables that he or she controls in the production function to maximize profits. One person harms another when the vari- ables that he or she controls lower the utility or production of someone else. For exam- ple, the Long Island Railway Company controlled variables affecting its production that also affected Mrs. Palsgraf’s utility. The functional representation of cause in tort law is a variable controlled by one person that appears in the utility or production func- tion of someone else. To illustrate, assume that Amanda enjoys smoking, which we indicate by the func- u tion % u denotes the amount that ( S , . . .), where u S denotes Amanda’s utility, A A A Amanda smokes, and “. . .” indicates all the other variables affecting Amanda’s utility. ). u % u Charlie’s utility depends upon his health and wealth, which we write ( H, W c c Assume that Charlie’s health is a decreasing function of Amanda’s smoking: H % H ( S ). Amanda’s utility function, u ), % u W ( S ), and Charlie’s utility function, u ), % u S ( H ( c c A A S. The variable that Amanda controls directly affects both contain the variable S Charlie’s utility. (By further complicating the preceding functions, we could represent 7 a probabilistic relationship between Amanda’s smoking and Charlie’s health. ) When the same variable appears in different people’s utility or production func- tions, the functions are “interdependent.” Interdependent utility or production functions constitute an externality when obstacles prevent the parties from bargaining together and reaching an agreement to set the interdependent variable at the efficient value. “Cause” in tort law typically involves an externality created by interdependent utility or production functions. 5 As is often true with famous cases, the facts are not as straightforward as generations of law students are M N OONAN , P ERSONS AND OHN ASKS OF THE L AW 127 (1976). led to believe. See J 6 Bertrand Russell, On the Notion of Cause, 13 P ROCEEDINGS OF THE A RISTOTELIAN S OCIETY (1912–1913). 7 To i l l u s t r a t e , l e t % 1 indicate “no cancer,” and H % 0 indicate “cancer.” Let p H indicate the probability of cancer, where p % p ( S ) is an increasing function. Charlie’s expected utility can be written p ( )). ) u W (0, W ) + (1 - p ( S ) u (1, S c c

211 196 CHAPTER 6 Economic Theory of Tort Law An UESTION 6.4: Q Suppose that a car stalls on the railroad tracks because its carburetor is badly maintained. A train collides with the car because the train’s brakes are badly maintained. What is the proximate cause of the accident? Did the train or the car have the “last clear chance” to avoid the accident? (A note in Chapter 3 discusses the doctrine of the last clear chance.) 3. Breach of a Duty In some circumstances, the first two elements that we have just identified—harm and proximate cause—are sufficient to establish liability in tort for the defendant. A rule of liability based upon harm and causation is called “strict lia- bility.” For example, a construction company that uses dynamite to clear rocks from the path of a road is liable in common law for any harm caused by the blasting. In general, the common law applies a rule of strict liability to “abnormally dangerous activities” 8 like blasting with dynamite. In the usual case, however, the victim must demonstrate more than harm and cause in order to recover damages from the defendant. In addition to these two elements, the plaintiff must usually demonstrate that the defendant breached a duty that he or she owed to the plaintiff, and that the breach caused the plaintiff ’s harm. To illustrate, Joe Potatoes in Example 1 breached a duty not to strike Bloggs. When an injurer breaches a legal duty, he or she is said to be “at fault” or to have been “negligent.” For example, one or both of the hunters in Example 2 was at fault in handling a gun because one or both of them breached a duty of care that he or she or they owed to the victim. A rule of liability requiring the plaintiff to prove harm, causation, and fault is a “negligence” rule. Unlike a rule of strict liability, a negligence rule permits the defense when the defendant is the proximate cause of the plaintiff’s harm. Under a negligence rule, the defendant escapes liability if he satisfied the applicable standard of care to avoid the harm that he caused. We wa n t t o d eve l o p a n e c o n o m i c r e p r e s e n t a t i o n o f fa u l t . S o m e fa u l t i s b i n a r y (either-or, yes-no, on-off). For example, either a passenger fastens her seat belt or she does not fasten it; either a swimming pool has a lifesaving ring or it does not have one. Sometimes, however, the legal standard of care applies to a continuous variable. For example, a car can change speed continuously, and the trustee can vary continuously the proportion of the trust’s portfolio in government bonds (a very safe investment). Economists often prefer to develop theory using continuous variables. Consequently, we denote precaution by the continuous variable x , with larger values of x correspon- ding to higher levels of precaution. The plaintiff in a tort suit must usually demonstrate that the defendant breached a duty owed to the plaintiff. A duty of care is a legal stan- ' x dard prescribing the minimum acceptable level of precaution. In Figure 6.2, denotes ' x the legal standard. Precaution below breaches the duty of care, and precaution equal ' ' x x to or exceeding it satisfies the duty of care. Precaution partitions the line in Figure ' 6 x x im- 6.2 and creates two zones—a permitted zone and a forbidden zone. Thus, ' x implies that the actor is not at fault, where plies that the actor is at fault, whereas Ú x x indicates the actual amount of precaution taken by the injurer. Under a negligence 8 §519(1) (1977). ESTATEMENT (S ECOND ) OF T ORTS R

212 I. Defining Tort Law 197 permitted zone forbidden zone FIGURE 6.2 Legal standard of care of continuous < x x > x x ̃ ̃ precaution. x 0 x ̃ Precaution rule, decision makers who take precaution as great as or greater than the legal standard escape liability for another person’s accidental harms. Those who take less precaution than the legal standard may have to pay compensatory damages for another person’s accidental harms. How is fault determined by law? In many nations, the government imposes precise safety regulations upon certain activities, such as speed limits on highways, whereas other legal duties are left vague, such as the legal definition of “reckless driving.” For activities such as reckless driving, the law may draw upon unwritten social norms and community conventions, such as the “rules of the road.” Moreover, what counts as “reckless driving” may depend on the weather conditions, the number of cars on the road, and other particu- larities of the context. Legal traditions differ in their reliance upon broad principles of care and their preferred language for expressing these principles. The common law in the reasonable English-language countries stresses the duty of care. This standard compares the defendant’s actual care and the care that a reasonable person would have taken under the circumstances. The civil codes of Europe are not anchored by the concept of “reason- ableness.” (See the accompanying box in which Lord Herbert pokes fun at the notion of a “reasonable person.”) Continental lawyers often feel discomfort toward a rule of reason- able care, which seems to give too little guidance to people and too much discretion to judges. Consequently, the civil codes often strive for greater specificity in prescribing du- ties. Civilian lawyers (that is, lawyers in civil law countries) sometimes invoke broad principles, such as “abuse of right” (for example, an owner exercises property rights in a way that harms others), or the “paterfamilias” (a person obligated to treat some other peo- ple much like the father treats his family), or “rationality” (choosing effective means to legal ends). As we shall see, economic analysis reveals similarities in behavior underly- ing these differences in legal language and traditions. We h ave u s e d F i g u r e 6 . 2 t o ex p l a i n t h e m e a n i n g o f “ n eg l i g e n c e .” U n d e r t h a t l i a b i l - ity rule, proof of negligence is a necessary condition for liability. In contrast, under a rule of strict liability, proof of causation is a necessary condition for liability, and proof of negligence is unnecessary. Some scholars detect a pattern of movement between these two rules over the history of liability law. (See the quote from Professor Adams at the beginning of this chapter.) Strict liability was the usual rule between clans in stateless tribes. Similarly, strict liability was the usual rule in much of Europe before the nine- teenth century, but, according to legal historians, negligence became the usual rule by the beginning of the twentieth century. Thus, the requirement of fault as a condition for

213 198 CHAPTER 6 Economic Theory of Tort Law An liability triumphed recently. The rule of strict liability, however, enjoyed a renaissance in the second half of the twentieth century, especially for the liability of manufacturers to American consumers. Manufacturers in America are now held liable for the harms caused by their defective products, regardless of whether the manufacturer was at fault. (See the quote from Judge Traynor at the beginning of this chapter.) To illustrate by Example 3, the manufacturer of a defective fuel additive is strictly liable for harm it causes to automobile engines. Web Note 6.1 There is some recent evidence of a discernible trend away from strict products liability—what some authors have described as a “quiet revolution” in prod- ucts liability. On our website (and briefly in the next chapter) we discuss this evidence. Q UESTION 6.5: Adapt Figure 6.2 to represent the rule that motor vehicles must stay within a designated speed limit (say 90 kilometers per hour). Q UESTION 6.6: Offer an economic explanation for why the owner of a dog is liable for the harm it causes due to his negligence, whereas the owner of a tiger is strictly liable for any harm that it causes. Conclusion to Part I The three elements of tort liability fit neatly into a coherent picture of social life. We i m p o s e r i s k s u p o n e a c h o t h e r i n o u r d a i l y l ive s . S o c i e t y h a s d eve l o p e d n o r m s t h a t prescribe standards of behavior to limit these risks. People sometimes cause harm by violating these standards of behavior. The cost of the harm must fall upon someone. The courts trace cause of the harm back to the violation of the standard and assign lia- bility either to the party at fault or simply to the party who caused the harm. Let Us Now Praise Reasonable Men The following famous parody of the reasonable person standard is from an essay entitled “The Reasonable Man” by Lord A. P. Herbert: “The Common Law of England has been laboriously built about a mythical figure—the figure of ‘The Reasonable Man.’ He is an ideal, a standard, the embodiment of all those qual- ities which we demand of the good citizen. . . . It is impossible to travel anywhere or to travel for long in that confusing forest of learned judgments which constitutes the Common Law of England without encountering the Reasonable Man. . . . The Reasonable Man is always thinking of others; prudence is his guide, and ‘Safety First’ is his rule of life. He is one who invariably looks where he is going and is careful to examine the immediate foreground before he executes a leap or bound; who neither stargazes nor is

214 II. An Economic Theory of Tort Liability 199 lost in meditation when approaching trapdoors or the margin of a dock; who records in every case upon the counterfoils of checks such ample details as are desirable, who never mounts a moving omnibus, and does not alight from any car while the train is in motion; who investi- gates exhaustively the bona fides of every mendicant before distributing alms, and will inform himself of the history and habits of a dog before administering a caress; who believes no gos- sip, nor repeats it, without firm basis for believing it to be true; who never drives his ball till those in front of him have definitely vacated the putting-green which is his own objective; who never from one year’s end to another makes an excessive demand upon his wife, his neighbors, his servants, his ox, or his ass; who in the way of business looks only for that nar- row margin of profit which twelve men such as himself would reckon to be ‘fair,’ and con- templates his fellow-merchants, their agents, and their goods, with that degree of suspicion and distrust which the law deems admirable; who never swears, gambles, or loses his tem- per; who uses nothing except in moderation, and even while he flogs his child is meditating only on the golden mean. [He] stands like a monument in our Courts of Justice, vainly appeal- ing to his fellow-citizens to order their lives after his own example. . . .” Most torts correspond to this picture, which makes it useful as an introduction to the subject. The actual practices of the courts, however, have departed from the traditional theory of torts. Modern courts sometimes find liability in cases where one of the three el- ements of a tort is missing. Later we describe some of these departures from the tradi- tional theory, and, in doing so, we sketch the frontiers of liability law in the United States. Q UESTION Describe the three elements of a tort in the following 6.7: situations: a. Motorists driving on crossing streets come to an intersection with a stop light and collide. b. The owner of Al’s Donut Shop spreads the false rumor that patrons of Betty’s Donut Shop got ptomaine poisoning from the jelly in her donuts. c. The escalator in a store rips a customer’s pant leg to shreds. II. An Economic Theory of Tort Liability Philosophy concerns meanings, and science concerns causes. Rather than defining “tort” by its essential elements, economic analysis models the effects of liability. We have explained that, when high transaction costs preclude private agreements, tort lia- bility can induce injurers to internalize the costs that they impose on other people. Now we develop the simplest model of cost internalization by tort law, using the economic interpretations of harm, cause, and fault. A. Minimizing the Social Costs of Accidents The economic model of tort law builds from the simplest elements: the cost of harm and the cost of avoiding harm. We begin with some notation and simple functions.

215 200 CHAPTER 6 Economic Theory of Tort Law An p , decreases with increases in precau- The probability of an accident, which we denote . Thus, x p ( x ) is a decreasing function of x . If an accident oc- p % tion, which we denote curs, it causes harm, such as lost income, damage to property, medical costs, and the denote the monetary value of the harm from an accident. A multiplied by p A like. Let equals the expected harm in dollars (“expected” because of the probabilistic element). 9 x ), the expected harm p ( x ) ( is a decreasing function of precaution x . p To Like A depict this fact, the horizontal axis in Figure 6.3 indicates the quantity of the actor’s precaution, x , and the vertical axis indicates dollar amounts, including the dollar x p ) A . The curve labeled p ( x ) A in Figure 6.3 slopes down, amount of expected harm, ( indicating that expected harm decreases as precaution increases. Ta k i n g p r e c a u t i o n o f t e n i nvo l ve s t h e l o s s o f m o n ey, t i m e , o r c o nve n i e n c e . We a s - w per unit. To keep the analysis simple, we assume that w sume that precaution costs $ x is constant and does not change with the amount of precaution wx . Consequently, wx equals the total amount spent on precaution. The graph of in Figure 6.3 is a straight line through the origin whose slope equals w . Figure 6.3 depicts two kinds of costs of accidents: the cost of precaution and the cost of expected harm. In the simplest model, we assume that accidents have no other social costs. This simplification, which may strike you as artificial at first, was the cru- cial step in Guido Calabresi’s classic book The Cost of Accidents (1970), which sys- tematically compared the incentive effects of alternative tort rules for the first time. Consequently, we may add the costs of precaution and expected harm to obtain the expected social costs of accidents, which we denote SC : (6.1) p + x w = SC 1 x 2 A . The expected social cost curve in Figure 6.3 is thus obtained by adding vertically wx . The result is the x at every level of precaution A the line x ( p and the curve ) SC % wx & p ( x ) A . U-shaped curve, which is labeled exists that cor- x Because the expected-social-cost curve is U-shaped, a value of *in Figure 6.3, is the level of x responds to the bottom of the U. This value, denoted $ FIGURE 6.3 The expected social costs of accidents shown as the sum of precaution costs and the expected cost of harm. ) = ( p + wx x SC ( A ) E wx p A ) x ( 0 x * Precaution x 9 is a constant. The analysis would not be changed by assuming A To keep the graph simple, we assume that p ) x ( that , so long as x is a decreasing function of is a concave function. A A

216 II. An Economic Theory of Tort Liability 201 precaution that minimizes the expected social costs of the accident. Efficiency requires minimizing social costs, so *is the socially efficient level of precaution or, simply, the x efficient level of precaution. *mathematically. The cost of a little more precaution (mar- x Let us characterize w . A little more precaution reduces the expected ginal cost) equals the price per unit cost of harm (marginal benefit). This reduction in the expected cost of harm equals the , multiplied by the cost ¿ reduction in the probability of an accident, which we denote p 10 . of harm A When precaution is efficient, the cost of a little more precaution (mar- ginal cost) equals the resulting reduction in the expected cost of harm (marginal bene- fit). Thus, the efficient level of precaution x *can be found by solving the following equation: p ( x %( A. *) w ' marginal social benefit marginal social cost (6.2) (Those of you who are familiar with calculus can obtain Equation 6.2 by setting the first derivative of Equation 6.1 with respect to precaution equal to zero.) This equation solves the problem, “choose precaution to minimize the cost of accidents and avoiding accidents.” If precaution is less than the efficient amount, then the marginal social cost of precau- x [ ¿ p 1 6 w *] 1 : 2 * x 6 x 1 A 2 tion is less than the marginal social benefit: When the . marginal social cost of precaution is less than the marginal social benefit, efficiency requires taking more precaution. In these circumstances, we say that more precaution is “cost-justi- fied.” Similarly, if precaution exceeds the efficient amount, then the marginal social cost of ¿ x * 2 : 1 w 7 1 p 1 [ x *] A 2 . x 7 precaution exceeds the marginal social benefit: In these circumstances, efficiency requires taking less precaution. Figure 6.3 describes the effects of precaution on social costs. We have not said whose precaution is depicted in Figure 6.3. Sometimes the potential injurer can take precaution and the potential victim cannot, as when a surgeon operates on an uncon- scious person. Sometimes both the injurer and the victim can take precaution, as when the manufacturer assures the purity of a drug and the consumer takes the recommended dosage. Figure 6.3 can be taken to represent the relationship between social costs and precaution by the victim or the injurer. Remember that precaution refers to any behav- ior reducing the probability or magnitude of an accident. Table 6.1 gives some exam- ples suggesting the range of possibilities. B. Incentives for Precaution Under No Liability and Strict Liability Having characterized the efficient level of precaution, we now consider the incen- tives needed to obtain it. Incentives for precaution in the simple model depend upon who can take precaution against accidents, and how the law allocates the costs of harm. To create efficient incentives, law should align the private benefits and costs of the 10 The prime ( ) after p indicates the slope of the graph of the function p ( x )at ¿ . The slope is negative in x Figure 6.3, so that minus sign in front of the p makes the expression - p ( x )positive. ¿

217 202 CHAPTER 6 Economic Theory of Tort Law An TABLE 6.1 Example of Accidents and Precaution Accident Injurer’s Precaution Victim’s Precaution Manufacture wiring more Faulty electrical wiring Fireproof house carefully causes house fire Moving car hits parked car Drive more safely Park car in safer space Drive more safely Car hits pedestrian Walk more safely Software fails Better design of software Back up data at risk Exploding coke bottle Handle bottles carefully Improve quality control by bottler Improve medicine Study war ning on warning on Medicine causes side effects medicine actors with the social benefits and costs. We shall contrast the incentive effects of sev- eral different legal rules for allocating the costs of harm. First, we consider the case in which there is no liability for accidental injuries. Let us 11 and denote her precaution by x . consider first the decisions of the victim The victim v v on and w . The victim pays chooses precaution, which we indicate by placing subscript x w x units of precaution. Now consider the cost of harm A , which is suffered the cost for v v p ( x by the victim. Because there is no liability, the victim bears the expected harm ) A . v The total costs that the victim expects to bear equal the cost of precaution plus the ex- ( w x . The victim has an incentive to minimize the costs that + pected cost of harm: A x ) p v v v he or she bears. Consequently, the victim chooses x . The min- to minimize w A x ) & p ( x v v v v imum occurs at the level of precaution, denoted *, where the victim’s marginal cost of x v precaution equals the resulting reduction in the expected cost of harm: w * ( x ' %( v p A. ) v ¿ victim’s marginal cost victim’s marginal benefit (6.2 ) ¿ Equation 6.2 corresponds to the efficiency condition given by Equation 6.2. Thus, we have shown that the rule of no liability causes the victim to internalize the marginal costs and benefits of precaution, which gives the victim incentives for efficient precau- (We’ll consider the incentive effect for injurers shortly.) tion. Now we repeat the analysis with a different legal rule. Consider the victim’s incen- tives for precaution when the injurer is . As before, the victim bears the strictly liable ) x , and the victim also bears the expected cost of harm, x A . In p ( cost of precaution, w v v v addition, the victim receives damages when an accident occurs. Thus, total net costs D that the victim expects to bear under the rule of strict liability are 1 x 2 A - x ( x 2 D . w + p p v v v v 11 Our exposition assumes that parties who engage in risky behavior know in advance which one will get hurt if an accident occurs. In reality, one usually—but not always—does not know ex ante whether one will be a victim or an injurer.

218 II. An Economic Theory of Tort Liability 203 D % . (Although Further, assume that the damages compensate the victim perfectly: A unrealistic, the assumption of perfect compensation is very useful analytically.) With net w x . perfectly compensatory damages, total costs reduce to the cost of precaution: v v The victim has an incentive to minimize the costs that he or she bears. Consequently, . Because to minimize w the victim chooses x cannot fall below zero, the mini- x x v v v v % 0. Thus, we have shown that the rule of x mum occurs when precaution is zero: v strict liability with perfectly compensatory damages gives the victim no incentive to take precaution. This conclusion has a simple explanation. With a rule of strict liability and perfect compensation, the victim is indifferent between an accident with compensation and no accident. The victim pays the cost of his or her own precaution and gains no advantage from reducing the probability or severity of accidents. In other words, the victim inter- nalizes the costs of precaution and externalizes the benefits. So, the victim has an in- centive not to take any precaution. We h ave a n a l y z e d t h e e ff e c t s o f t h e r u l e o f n o l i a b i l i t y a n d t h e r u l e o f s t r i c t l i a b i l - ity on the victim’s incentives for precaution. The first rule gives incentives for efficient precaution by the victim, and the second rule gives the victim no incentives for precau- 12 tion. Now we consider the effect of these two rules on the injurer’s incentives for pre- caution. We denote the amount of precaution taken by the injurer as x . The injurer pays i w A for x the cost units of precaution. The harm , however, is suffered by the victim. i i Unless the law reallocates the cost of the harm, the injurer will externalize it. Assume that the rule of law is strict liability with perfect compensation. Thus, whenever an accident occurs, the injurer must pay damages equal to the cost of the D % A . The injurer’s expected liability equals the probability of an accident mul- harm: ) A . The total costs that the injurer expects to bear tiplied by the harm caused by it: ( x p i under the rule of strict liability with perfect compensation equal w . The in- x A + p ( x ) i i i jurer has an incentive to minimize the costs that he or she bears. Consequently, the in- x to minimize w jurer chooses x . The minimum occurs at the level of + p ( x A ) i i i i precaution, denoted, x *where the injurer’s marginal cost of precaution equals the re- i sulting reduction in the expected cost of harm: * p ¿ ( x % ) A . - w i i – (injurer’s marginal cost) (injurer’s marginal benefit) (6.2 ) – Equation 6.2 corresponds to the efficiency condition given by Equation 6.2. Thus, we the rule of strict liability with perfect compensation causes the injurer have shown that to internalize the marginal costs and benefits of precaution, which gives him or her in- . centives for efficient precaution Finally, we consider the effect of the rule of no liability on the injurer’s incentives for precaution. Assume that precaution x is chosen by the injurer, so the injurer bears i the cost of precaution x , however, is suffered by the victim, and, under w A . The harm i i remains where it falls on the victim, and the injurer pays no A the rule of no liability, 12 Again we note our assumption—frequently not true—that ex ante an accident a party knows that he will be the injurer.

219 204 CHAPTER 6 Economic Theory of Tort Law An TABLE 6.2 Efficiency of Incentives Created by Liability Rules* yes indicates efficient incentives; no, inefficient incentives; and zero, no incentive. Legal Rule Precaution Activity Level Victim Injurer Victim Injurer No liability yes zero yes no yes Strict liability no yes zero Simple negligence no yes yes yes no yes yes yes & contributory negligence Negligence yes no yes yes contributory negligence & Strict liability yes no Comparative negligence yes yes *assumes perfect compensation and legal standards equal to efficient precaution 0. The total costs paid by the injurer thus equal % w damages: x D . The injurer has an i i incentive to minimize the costs that he or she bears. Consequently, the injurer chooses to minimize w cannot fall below zero, the minimum occurs when pre- x x . Because x i i i i x the rule of no liability gives the in- % caution is zero: 0. Thus, we have shown that i . This conclusion has a simple explanation: With jurer no incentive to take precaution no liability, the injurer is indifferent between an accident and no accident. Thus, the in- jurer internalizes the costs of precaution and externalizes the benefits. Table 6.2 summarizes many conclusions about the incentives of alternative tort rules. For now, focus on the first two rows and the first two columns of Table 6.2, which summarize our conclusions about the rules of no liability and strict liability. Notice the symmetry: The victim’s incentives for precaution under “no liability” are the same as the injurer’s under “strict liability,” and vice versa. The table suggests how the law could create incentives for efficient precaution. If only the victim can take precaution, then a rule of no liability provides incentives for efficient precaution. If only the injurer can take precaution, then a rule of strict liability with perfect compensation provides incentives for efficient precaution. C. Bilateral Precaution We h ave ex p l a i n e d t h a t a r u l e o f n o l i a b i l i t y c a u s e s t h e v i c t i m t o i n t e r n a l i z e t h e cost of harm and the injurer to externalize it. Consequently, the victim has efficient incentives, and the injurer has inefficient incentives. Conversely, a rule of strict lia- bility with perfect compensation causes the injurer to internalize the cost of harm and the victim to externalize it. Consequently, the injurer has efficient incentives, and the victim has inefficient incentives. We have arrived at a dilemma: Neither the rule of strict liability nor the rule of no liability creates incentives for efficient precaution by . both parties

220 II. An Economic Theory of Tort Liability 205 Unilateral precaution de- We w i l l r e s t a t e t h i s p r o p o s i t i o n i n t e c h n i c a l t e r m s . scribes circumstances in which only one party to an accident can take precaution against it. describes circumstances in which the victim and the injurer Bilateral precaution can take precaution, and efficiency requires both of them to take it. (Bilateral precau- tion is also called “joint precaution.”) With bilateral precaution, the social cost function has the form . A ) x , x ( p + x w + x SC = w i v v v i i Under strict liability, the injurer chooses x , but the victim does not to minimize SC i x choose SC . Under no liability, the opposite is true. Under bilateral pre- to minimize v caution, neither the rule of strict liability nor the rule of no liability creates incentives for efficient precaution by both parties . We c a n n o t e s c a p e t h i s d i l e m m a b y d iv i d i n g t h e c o s t s o f h a r m b e t w e e n t h e v i c t i m and injurer. Dividing the costs of harm between them causes each of them to externalize 13 We c a l l t h i s fa c t t h e part of it, so both of them have incentives for deficient precaution. “paradox of compensation.” We will resolve this paradox by the end of Section E. Q UESTION 6.8: Assume that you park your car in a legal parking space on a corner, and a driver who comes around the corner too fast rams the bumper of his truck into your car, damaging your car but not his truck. A rule of no lia- bility gives the driver of the truck the same incentives to avoid such accidents as the incentives given to you to park your car in a safe place under a rule of strict liability with perfect compensation. Explain why. Q UESTION 6.9: Explain why the incentive problem in the previous question cannot be solved by a rule of strict liability with imperfect compensation (say, actual compensation equal to 50 percent of perfect compensation). D. Incentives for Precaution Under a Negligence Rule The solution to the paradox of compensation lies in a negligence rule. We shall the in- and now prove that a negligence rule can give efficient incentives to the victim jurer. A negligence rule imposes a legal standard of care with which actors must comply 13 To s e e w h y, a s s u m e t h a t t h e r u l e i s s t r i c t l i a b i l i t y w i t h deficient compensation, by which we mean that actual compensation falls short of the amount required for perfect compensation Under strict 6 (D A). ex ternalizes the fraction of harm liability with deficient compensation, the injurer in ternalized by the D victim (specifically, ), and the injurer externalizes the fraction of harm internalized by the victim (specifically, A ). Consequently, the rule of strict liability with deficient compensation does not - D provide incentives for efficient precaution by the injurer. To repeat the argument in notation, efficiency ) + p ( x requires the injurer to choose x x to minimize A , whereas a rule of strict liability with com- w x i i i i v D + p ( x causes the injurer to minimize , x w ) D. If D % A, then the injurer’s pensatory damages x i v i i D 6 A, then the injurer’s incentives are deficient. incentives are efficient; if This same argument can be repeated for the victim.

221 206 An CHAPTER 6 Economic Theory of Tort Law in order to avoid liability. We assumed that courts apply a definite standard requiring a fixed amount of precaution, and this assumption permitted us to represent the legal ' x as partitioning precaution into permitted and forbidden zones in standard, denoted , Figure 6.2. Then, we developed the economic analysis of incentives to take care using Figure 6.3. Now, we combine these two ideas into a representation of a negligence rule in Figure 6.4. ' x x and , The legal standard in Figure 6.2 is denoted *denotes the efficient level ' x of precaution in Figure 6.3. To combine the figures, we must say how relates to *. The simplest assumption, which we justify later, is that the legal standard equals x ' = the efficient level of care: * . This assumption permits us to combine the fig- x x ' in Figure 6.4 corre- ures as represented in Figure 6.4. The forbidden zone 2 6 (x x and the sponds to deficient precaution relative to the efficient level * x 6 (x ), ' x permitted zone (x Ú corresponds to excessive precaution relative to the efficient 2 x Ú (x Precaution at the boundary between the two zones equals efficient ). * level = (x precaution ). * x Consider the injurer’s costs as a function of his level of precaution. In the per- mitted zone, injurers are not liable, so they bear the cost of their own precaution w x , i i but they do not bear the cost of the victims’ harm. Thus, the injurer’s costs in the per- ' in Figure 6.4. In the for- 2 x x Ú (x w are indicated by the straight line mitted zone i i i bidden zone, injurers are liable, so they bear the cost of their own precaution x w and i i p the expected harm to the victim ) A . Thus, the injurer’s expected costs in the ( x i ' x 2 w forbidden zone x are indicated by the curve + p(x 6 )A in Figure 6.4. (x i i i i Thus, the injurer’s costs under a negligence rule are indicated in Figure 6.4 by a ' 14 = and then becomes a straight line. smooth curve that jumps down at The low- x x est point on this curve occurs when the injurer’s precaution equals the legal stan- ' . The injurer has an incentive to set precaution at this level in order to x = x dard: minimize costs. We have shown that a negligence rule with perfect compensation and the legal standard equal to the efficient level of care gives the injurer incentives for efficient precaution . To illustrate the incentive effects of a negligence rule, consider how the injurer would find his or her preferred level of care. Assume the injurer sets his precaution equal to x in Figure 6.4, in which precaution costs him $ wx and he expects to pay 0 0 x A ) $ in liability for accidents. The cost to the injurer of taking one more unit of pre- p ( 0 caution beyond x is less than the resulting savings in expected liability because of the 0 lower probability of an accident. Consequently, the rational injurer will take more pre- x *, caution. He or she will continue taking more precaution until he or she reaches *, the injurer has no incentive to increase where liability falls to zero. Having reached x *, they pay only for their own precaution, precaution. If injurers’ precaution exceeds x 14 The jump occurs to the extent that the negligent injurer is held liable for the accidents that he caused, not just for the accidents that his negligence caused. To illustrate, if a railway negligently fails to install a filter to trap sparks emitted by the train, the railway will be held liable for fires caused by sparks emitted by the train, not just for fires caused by sparks that a filter would have trapped. Insofar as courts solve this prob- lem and only find liability for accidents that nonnegligent behavior would have prevented, injurer’s costs do not jump at the legal standard.

222 II. An Economic Theory of Tort Liability 207 $ FIGURE 6.4 permitted zone forbidden zone x Expected costs with a discontinuity a *. x ) x < x x ̃ ̃ Expected cost wx p ( x ) A + + A p wx ( x ) 0 0 wx wx 0 x 0 * x x x = ̃ 0 w per unit, but their liability remains zero, so they will not take additional which costs i 15 *. x precaution beyond Recall that we began this section with a dilemma: How can a liability rule provide incentives for efficient precaution by the injurer and the victim? We have explained how a negligence rule can provide incentives for efficient precaution by the injurer. Now it is simple to explain how a negligence rule can provide incentives for efficient precaution by the victim. As explained, a rational injurer takes precaution at the legal standard ' (x in order to avoid liability for the harm caused by accidents. When the injurer x Ú 2 i is not liable, the victim of an accident receives no compensation for accidental harm. Consequently, the victim responds as if the rule of law were no liability. We have already proved that a rule of no liability causes the victim to internalize the marginal costs and benefits of precaution, which gives incentives for efficient precaution. In general, a neg- ligence rule that induces the injurer to escape liability by satisfying the legal standard 16 Our conclusions about the provides incentives for efficient precaution by the victim. incentives created by a negligence rule are summarized in the third line of Table 6.2. 15 We c a n p r ove t h i s m o r e f o r m a l l y. G ive n a n eg l i g e n c e r u l e w i t h p e r f e c t c o m p e n s a t i o n a n d t h e l eg a l s t a n - dard equal to the efficient level of care, the injurer faces the following cost function: )A; p(x + x w = injurer’s costs : ) forbidden zone ( * x 6 x i i i permitted zone ) : injurer’s costs = w * Ú x ( x . x i i In the forbidden zone, the injurer’s costs approach a minimum as approaches x x *. In the permitted zone, the injurer’s costs are minimized when x x *. Therefore, the injurer minimizes costs by setting equals equal to *. x x 16 Note that under our formulation the potential injurer and potential victim may both take precaution that may be efficient but It is possible that the precaution of one or the other of them would have duplicative. prevented the accident or minimized its severity so that the precaution by the other party adds nothing by way of marginal benefit. However, because of our (realistic) assumption that parties cannot negotiate be- fore an accident takes place, they have no opportunity to discover that only one of them needs to take care. Suppose that A ’s marginal cost of precaution is $50 and that the expected marginal benefit of that precau- tion is $60. Further suppose that ’s marginal cost of precaution is $53 and the expected marginal benefit B is also $60. Each party, acting independently, will reckon that he or she should take care because the mar- ginal cost of precaution is less than the anticipated mar ginal benefit. The total amount spent of precaution— $103—is, however, excessive. The same benefit could have been realized if only A had incurred a precautionary cost of $50 (or if only B had acted at a cost of $53). This duplicative investment in precau- tion seems wasteful but unavoidable, in light of our assumption that the transaction costs of the two parties’ bargaining together are high.

223 208 An CHAPTER 6 Economic Theory of Tort Law A game is in equilibrium when no player can increase his UESTION Q 6.10: or her payoff by changing strategy, so long as the other players do not change 17 Prove that the simple liability game is in equilibrium when their strategies. the injurer and the victim take efficient care. E. Contributory Negligence and Comparative Negligence The negligence rule has several different forms. We have been discussing its sim- plest form, which holds the injurer liable for accidents that he or she causes if, and only if, precaution is below the legal standard, regardless of the victim’s level of precaution. Symbolically, we may describe simple negligence as follows: simple negligence: * x injurer at fault, : injurer liable; # x i i * Ú : x injurer not liable. injurer faultless, x i i Chapter 3 explained that English common law originally developed the simple neg- ligence rule and later developed a more complex rule allowing a defense of contributory negligence. Under the rule of negligence with a defense of contributory negligence, the negligent injurer can escape liability by proving that the victim’s precaution fell short of the legal standard of care. The defense of contributory negligence imposes a legal stan- dard of care upon the victim. Symbolically, we may represent this form of the negli- gence rule as follows: negligence with a defense of contributory negligence: * * : # , and victim faultless, x injurer liable; ) x x x injurer at fault, v i i v * * , or victim at fault, x ) # injurer faultless, x x injurer not liable. : x v v i i Here’s an example of the difference between (simple) negligence and negligence with a defense of contributory negligence. Someone dives into a swimming pool and strikes her head on the bottom. She sues the owner of the pool for failing to post signs warning that the pool was too shallow for diving. The pool owner admits that he posted no warnings, but he also asserts that the victim was negligent for diving without check- ing the depth of the water. If both parties are negligent, the pool owner is liable under a rule of simple negligence, and the pool owner is not liable under a rule of negligence with a defense of contributory negligence. These two forms of the negligence rule, however, have been displaced by a new form of the negligence rule for most accidents in the United States. Under the rules of simple negligence or negligence with a defense of contributory negligence, one party is responsible for all the costs of accidental harm, even though both parties are at fault. The new form of the negligence rule, called “comparative negligence,” divides the cost 17 This is the definition of a Nash equilibrium.

224 II. An Economic Theory of Tort Liability 209 of harm between the parties in proportion to the contribution of their negligence to the accident. For example, if the victim’s negligence is 20 percent responsible for her acci- dental harm, and the injurer’s negligence is 80 percent responsible for her accidental harm, then the victim may recover 80 percent of her losses from the injurer. Symbolically, we may represent the rule of comparative negligence as follows: comparative negligence: * * : injurer at fault, , and victim faultless, x x ) x # x injurer bears 100 percent; v v i i * * x injurer faultless, , and victim at fault, x ) # x : x victim bears 100 percent; v v i i * * injurer at fault, x : x x # x # , and victim at fault, bear cost in proportion to v v i i 18 negligence. We have discussed the rules of simple negligence, negligence with a defense of contributory negligence, and comparative negligence. Other forms of the negligence rule exist. For example, the rule of strict liability with a defense of contributory negli- assigns the cost of accidental harm to the injurer, regardless of his or her level of gence precaution, unless the victim was at fault: strict liability with a defense of contributory negligence: * # injurer not liable; victim at fault, : x x v v * victim faultless, injurer liable. ) x : x v v To illustrate, consumer products are sometimes subject to the rule of strict liability with a defense of contributory negligence. Under this rule, the manufacturer of a defective product is liable for the harm it causes to nonnegligent consumers and not liable for the 19 harm it causes to negligent consumers. We h ave c h a r a c t e r i z e d f o u r d i ff e r e n t f o r m s o f t h e n eg l i g e n c e r u l e . T h e e c o n o m i c analysis of law proved a startling fact about the simple model of tort liability: Assuming perfect compensation and each legal standard equal to the efficient level of care, every form of the negligence rule gives the injurer and victim incentives for effi- 20 cient precaution. ' ' 18 x x . x - The extent of the injurer’s negligence equals x . The extent of the victim’s negligence equals - i v The proportion of each party’s negligence, which can be used to divide liability under a rule of compara- tive negligence, is given as follows: ̃ ̃ ̃ ( x )] % x ) & ( x x negligent injurer’s proportion of liability; ( ( x /[( x i v v i i i ̃ ̃ ̃ x ) % negligent victim’s proportion of liability. ( & x x ( x /[( x ( x )] ( v v i i v v To i l l u s t r a t e , i f a c a r g o i n g 4 0 k p h c o l l i d e s w i t h a c a r g o i n g 3 5 k p h o n a s t r e e t w i t h a s p e e d l i m i t e q u a l t o 30 kph, then the two motorists divide liability in the proportions 2/3 and 1/3, respectively. 19 The different forms of the negligence rule have an elegant mathematical symmetry, which we describe in the appendix to this chapter. 20 This result is sometimes referred to in the professional literature as the “equivalence result.”

225 210 CHAPTER 6 Economic Theory of Tort Law An It is easy to explain why. Recall that the simple negligence rule provides incen- tives for efficient precaution by both parties: A rational injurer takes precaution equal to the legal standard in order to escape liability, and, knowing this, a rational victim internalizes the harm from accidents, which gives incentives for efficient pre- caution. We can generalize this proof to every form of the negligence rule. Assume perfect compensation and each legal standard equal to the efficient level of precau- tion. Under every form of the negligence rule, one of the parties can escape bearing the cost of harm by satisfying the legal standard. This party will take efficient pre- other party will, consequently, inter- caution in order to avoid the cost of harm. The nalize the cost of the harm from accidents, which creates incentives for efficient precaution. Table 6.2 summarizes our conclusions about liability rules and incen- tives for precaution. We h ave b e e n a n a l y z i n g b i l a t e r a l p r e c a u t i o n , w h i c h w e d e fi n e d a s a s i t u a t i o n where efficiency requires the injurer and the victim to take precaution. Another pos- sibility is redundant precaution , which we define as a situation where both parties can take precaution and efficiency requires only one of them to do so. To illustrate, the manufacturer and the homebuilder can check electrical wire for defects, but the manufacturer can check at less cost than the homebuilder. The preceding analysis of alternative legal rules applies to redundant precaution that is continuous, such as ex- penditure on quality control by a manufacturer of electrical wire. The preceding analysis of alternative legal rules, however, can fail for technical reasons when redundant precaution is discontinuous. To illustrate, assume that the driver of a car can fasten a seat belt with less effort than the manufacturer can de- sign a seat belt to fasten automatically. By assumption, efficiency requires the driver to fasten the seat belt and the manufacturer not to install automatic fasteners. However, a (simple) negligence rule might cause manufacturers to install automatic 21 fasteners. Notice that buckling a seat belt is a discontinuous choice (yes–no). For discon- tinuous precaution, the relative efficiency of different rules depends upon particular facts. In general, discontinuous variables and cost functions yield messy results about optima, whereas continuous variables and cost functions yield clean results. It is usually best to build theory from clean results and then handle any messy results as exceptions. Q UESTION 6.11: Suppose that B ’s faulty driving causes an accident that in- jures driver . A was not at fault in her driving, but she was not wearing her A seat belt, and this fact aggravated her personal injury. Discuss liability under 21 Suppose that the manufacturer does not install an automatic fastener, the driver fails to fasten his seat belt, and an accident occurs. The driver sues the manufacturer and argues that the manufacturer was neg- ligent for not installing an automatic fastener. (Installing an automatic fastener is cheaper than the harm from accidents). The driver might win the suit under a (simple) negligence rule. Foreseeing this fact, the manufacturers might install automatic fasteners. This is inefficient because it is cheaper for drivers to fas- ten their seat belts.

226 II. An Economic Theory of Tort Liability 211 the rules of simple negligence, negligence with a defense of contributory neg- ligence, and comparative negligence. We have been discussing accidents in which one party, called the injurer, harms the other party, called the victim. Both parties can take precaution to reduce the probability and magnitude of an accident. In technical language, these accidents involve unilateral harm and bilateral precaution. We concluded that every form of the negligence rule can provide incentives for efficient precaution for both parties. In many accidents, however, both parties suffer harm, such as when two cars collide. These accidents involve bilat- eral harm and bilateral precaution. Does our major conclusion about incentives still ap- ply when harm is bilateral? With rare exceptions, the law allows the injured parties in an accident to sue each other. If, for example, my car collides with yours, you may sue me for the damage to your car, and I may counterclaim for the damage to my car. Such a suit can be factored into two parts and analyzed as if it were two separate accidents. Think of the damage to my car as one accident in which I was the victim and you were the injurer, and think of the damage to your car as another accident in which I was the injurer and you were the victim. Applying the analysis developed in this chapter to each accident separately usually reaches the same conclusions as would a more complicated analysis applied to both ac- 22 cidents simultaneously. UESTION Q Would the efficiency of a rule of simple negligence in- 6.12: crease by imposing a standard of care on victims? Explain your answer by ref- erence to the simple model. F. A c t i v i t y L e v e l s In the simple model, the rules of no liability and strict liability provide incen- tives for efficient precaution by the victim or injurer, but not both, whereas the vari- ous forms of the negligence rule create incentives for efficient precaution by the injurer and victim. Thus, the simple model provides a policy reason to prefer a negli- gence rule whenever precaution is bilateral. The simple model does not, however, provide a reason for preferring one form of the negligence rule to another. A compli- cation of the model will provide an efficiency argument for distinguishing different forms of the negligence rule. In the simple model, the injurer and victim choose precaution. Now we compli- cate the model by allowing them to make an additional choice. The probability of an automobile accident depends upon the level of precaution when driving, and the amount that one drives. By driving 10,000 miles a year, the probability that you will 22 Any form of the negligence rule will induce efficient precaution by the injurer-victims when the legal standard is set by the Hand rule, which is discussed later in this chapter. See Jennifer H. Arlen, Re- OF examining Liability Rules when Injurers as Well as Victims Suffer Losses, NTERNAT . R EV . 10 I L AW & E CON .233 (1990).

227 212 CHAPTER 6 Economic Theory of Tort Law An injure someone in an accident is approximately 10 times higher than it would be if you drove only 1000 miles per year. We shall compare the incentive effects of different li- 23 ability rules on the amount of risky activities, such as driving, that people engage in. First, we contrast the rules of simple negligence and strict liability. Under a negli- gence rule, a driver can escape liability by conforming to the legal standard of care, no matter how much he or she drives. So, the driver can increase driving by tenfold, which increases the risk of harm to others by tenfold, without increasing his or her expected liability. Under a negligence rule the marginal risk of harm to others from more driving is externalized. The incentive structure is quite different under a rule of strict liability. If a driver is strictly liable for the harm caused, then he or she internalizes the social costs of accidents from whatever source—whether from the activity level or a lack of precaution. Strict liability induces the potential injurer to set every variable af- fecting the probability of an accident at its efficient level. So, the rule of strict lia- bility can induce both efficient precaution and an efficient activity level by 24 drivers. We c a n g e n e r a l i z e t h i s c o n c l u s i o n t o a l l a c t iv i t i e s a n d a l l l i a b i l i t y r u l e s . S o m e l i a - bility rules induce some actors to avoid liability by satisfying the legal standard of care. In the end, however, someone must bear the cost of accidental harm. We call that per- ultimate son the bearer of harm. To illustrate by the simple model, the victim is the ul- timate bearer of harm under the simple negligence rule, whereas the injurer is the ultimate bearer of harm under the rule of strict liability with a defense of contributory negligence. In general, the ultimate bearer of harm internalizes the benefits of any of his or her actions that reduce the probability or severity of accidents, including more precaution and less activity . We can use this generalization to expand Table 6.2. The last two columns show the effect of alternative liability rules on the incentives for the activity levels of the victim and injurer. Under each rule, the ultimate bearer of harm has incentives for an efficient activity level, whereas the party who escapes bearing the cost of accidental harm has incentives for an inefficient activity level. Table 6.2 provides a useful guide for lawmakers to choose among liability rules. First, consider the problem of efficient incentives for precaution. If efficiency re- quires only one party to take precaution, then “no liability” and “strict liability” are just as efficient as a negligence rule. If efficiency requires bilateral precaution, then a negligence rule provides more efficient incentives for precaution than “no liabil- ity” and “strict liability.” Second, consider the problem of efficient incentives for the activity level. Usually one party’s activity level affects accidents more than the other party’s activity level. Efficiency requires choosing a liability rule so that the 23 See Aaron Edlin & Pinar Karaca-Mandic, The Accident Externality from Driving, 114 J. P OL . E CON .931 (2006). 24 The original statement of this result is found in Steven Shavell, Strict Liability Versus Negligence, 9 J. EGAL S TUD . 1 (1980). L

228 II. An Economic Theory of Tort Liability 213 party whose activity level most affects accidents bears the ultimate costs of acciden- tal harm. Besides providing a useful guide, Table 6.2 shows some limits of liability law in creating efficient incentives. To illustrate, the different liability rules can provide incen- tives for an efficient activity level by either one of the parties but not by both of them. In other words, create a dilemma for lawmakers. In general, bilateral activity levels policymakers have difficulty hitting two targets with one policy variable. To hit two policy targets, two controls are usually required, just as two stones are usually needed to hit two birds. Thus, an additional control variable from outside liability law may be needed to control activity levels. For example, the number of miles driven by motorists can be influenced by a gasoline tax or an insurance policy whose premiums increase with the number of miles driven. Q 6.13: Who is the ultimate bearer of the costs of harm under a UESTION rule of comparative negligence? Explain your answer. UESTION 6.14: In Table 6.2, no liability and strict liability have the oppo- Q site incentive effects upon activity levels. Why? Q UESTION 6.15: For purposes of the theory of accidents, how would you define the activity level of a railroad? An airline? For some activities, the relevant to the probability of an accident is difficult to define. level Can you define an activity level relevant to a homeowner’s maintenance of her front steps? A pharmaceutical company’s sale of a drug with danger- ous side effects? G. Setting Legal Standards: The Hand Rule Our discussion of negligence rules assumes that the legal standard equals the effi- ' x 1 cient level of precaution = x * . Now we want to explain how lawmakers can iden- 2 tify the efficient level of precaution when setting the legal standard. An American judge developed a famous rule to solve this problem in the case called United States v. 25 . Carroll Towing Co The case concerned the loss of a barge and its cargo in New York Harbor. A number of barges were secured by a single mooring line to several piers. The defen- dant’s tug was hired to take one of the barges out of the harbor. In order to release the barge, the crew of the defendant’s tug, finding no one aboard in any of the barges, readjusted the mooring lines. The adjustment was not done properly, with the result that one of the barges later broke loose, collided with another ship, and sank with its cargo. The owner of the sunken barge sued the owner of the tug, claiming that the tug 25 159 F.2d 169 (2d Cir. 1947).

229 214 CHAPTER 6 Economic Theory of Tort Law An owner’s employees were negligent in readjusting the mooring lines. The tug owner replied that the barge owner was also negligent because his agent, called a “bargee,” was not on the barge when the tug’s crew sought to adjust the mooring lines. The bargee could have assured that the tug's crew adjusted the mooring lines correctly. In deciding the case, Judge Learned Hand formulated his famous rule as follows: L. HAND, J . . . It appears from the foregoing review that there is no general rule to determine when the absence of a bargee or other attendant will make the owner of a barge liable for injuries to other vessels if she breaks away from her moorings. . . . Since there are occasions when every vessel will break away from her moorings, and since, if she does, she becomes a menace to those about her; the owner’s duty, as in other similar situations, to provide against resulting injuries is a function of three variables: (1) the probability that she will break away; (2) the gravity of the resulting injury, if she does; (3) the burden of adequate precautions. Possibly it serves to bring this notion into relief to state it in algebraic terms: if the probability be called ; the injury, L ; and the burden, B ; liability depends upon whether P is less than L B multiplied by , i.e., whether B # PL. . . . [Judge Hand subsequently applied the P B # PL in this case, formula to the facts of the case and concluded that, because the barge owner was negligent for not having a bargee aboard during the working hours of daylight.] Judge Hand’s statement of his rule is unclear as to whether the variables refer to marginal values or total values. If we assume that he was a good economist who had marginal values in mind, then we can translate his notation into our notation as used in the simple model of precaution: Hand’s name Hand’s notation Our notation Our name Marginal cost w B Burden i of precaution Cost of accidental Liability A L harm Probability Marginal probability P p ¿ Substituting our notation into Hand’s formula, we obtain the following rule: : w marginal Hand rule: #( p ' A injurer is negligent. i The marginal Hand rule states that the injurer is negligent if the marginal cost of his or her precaution is less than the resulting marginal benefit. Thus, the injurer is liable un- der the Hand rule when further precaution is cost-justified. Further precaution is cost- justified when precaution falls short of the efficient level (x 6 x * ).

230 II. An Economic Theory of Tort Liability 215 To escape liability under Hand’s rule, the injurer must increase precaution until the inequality becomes an equality: * A. ( x w p %( ' ) mar ginal social benefit (6.3) marginal social cost * ), then the marginal social cost equals x % x If the injurer’s precaution is efficient ( % w the marginal social benefit ( - pA ). At this point, further precaution is not ¿ i cost-justified. 26 American courts frequently use the Hand rule to decide questions of negligence. Repeated application of the Hand rule enables adjudicators to discover the efficient level of care. In a series of cases, the adjudicators ask whether further precaution was cost-jus- tified. If the answer is “yes,” then the injurer has not satisfied the legal standard, and the injurer is liable. Injurers will presumably respond to this decision by increasing their level of precaution. Eventually a case will reach the adjudicators in which further precaution is not cost-justified. Just as a climber can reach the peak of a smooth mountain in a fog by always going up, so the court can discover the efficient level of care by holding defen- dants liable for failing to take cost-justified precautions. In fact, the Hand rule follows the 27 same search pattern used by some computer programs to maximize a function. To a p p l y t h e H a n d r u l e , t h e d e c i s i o n m a ke r m u s t k n ow w h e t h e r a l i t t l e m o r e p r e - caution costs more or less than the resulting reduction in expected accident costs. ) Calculating the expected accident costs, p ( x A ,can be difficult. For example, if you in- crease your driving speed from, say, 40 mph to 50, will the average loss resulting from an accident increase by $1,000,000, or by $10, or something in between? Cost-benefit analysis demands a lot of information from anyone who uses it, whether an injurer, a court, a legislature, or an administrator. Liability law should take into account who is in the best position to obtain information about accidents. Case-by-case application of the Hand rule is one way for courts to find an efficient legal standard. At trial, courts will hear expert witnesses give testimony on the relevant probabilities. If courts can obtain accurate information about accidents at moderate cost, this fact favors case-by-case adjudication. Another approach is to draft regulations or statutes specifying a legal standard that equals the efficient level of precaution. For example, highway officials may compute the efficient speed for motorists on a particu- lar road, taking into account the value of the time of motorists and the reduction in ac- cidents from driving more slowly. The officials can then declare the efficient speed to be the legal speed limit. Politicians and bureaucrats sometimes behave in this way. If a legislature or regulator can obtain accurate information about accidents at moderate cost and is willing to use it, these facts favor a system of public law for accidents, like workers’ compensation for on-the-job injuries. Another approach is for the law to enforce social customs or the best practices in an industry. In this approach, the lawmakers do not try to balance marginal costs and 26 The Hand rule is enshrined in the definition of negligence offered by the American Law Institute in the (S ESTATEMENT R . ORTS T OF ) ECOND 27 The maximum of a continuous, concave function can be found by going in the direction where the deriva- tive is largest.

231 216 CHAPTER 6 Economic Theory of Tort Law An benefits. Rather, the lawmakers rely upon the community of people who created the norm, or the industry that engages in the practice, to balance costs and benefits. For ex- ample, a residential community has norms concerning the maintenance of steps leading to houses, and the accounting industry has practices concerning careful auditing. When enforcing these “community standards,” the courts need much less information than when they compute the marginal costs and benefits of precaution. Before enforcing the community standard, however, the lawmakers should ascertain whether the community actually balances costs and benefits. In Chapter 11 we will return to this topic when we consider the evolution of social norms toward efficiency. American courts have persistently erred in applying the Hand rule in a way that significantly affects results. In applying the Hand rule, the court must balance the in- full jurer’s burden against the benefit of precaution. The full benefit includes the reduc- tion in risk to plaintiff (“risk to others”) and reduction in risk to injurer (“risk to self”). Courts have, remarkably, overlooked the reduction in self-risk and, consequently, set the standard too low. To illustrate, assume the bank robber injures a bank’s customer during the robbery of an unguarded bank. The customer sues the bank alleging that the bank should have had a guard at the bank to deter robberies. If the court applies the Hand rule to determine whether the bank was negligent, the court must compare the cost of hiring a guard with the expected reduction in harm. The expected reduction in harm includes protecting customers from getting hurt (“risk to others”) and protecting the bank from getting robbed (“risk to self”). The court will leave out more than half of the 28 benefit of having a guard if it fails to consider the reduction in the bank’s risk. As another example, assume that the court must determine whether the speed at which a driver took a curve was unreasonably dangerous. The court must balance slowing down and the benefit of reducing the risk of accidents to others and the driver. In applying the Hand rule, however, courts typically focus on reducing the risk to others and lose sight of the value of reducing the risk to the injurer. Losing sight of self-risk will cause the court to allow more speed than allowed by the correct application of the Hand rule. Omitting self-risk is a logical error in applying the Hand rule. Instead of being logi- cal, people often make predictable errors of which tort law ought to take account. Psychologists have investigated systematic biases that affect perception. Especially strong biases affect the perception of probabilities. One of these biases concerns the dif- ference between foresight and hindsight estimates of probability. Assume that a citizen estimates in May that the probability equals 0.5 of a particular candidate’s winning the presidential election in November. When November comes, the candidate wins. In December the citizen is asked what he thinks the candidate’s probability of winning was back in May. The citizen says that it was 0.7. The hindsight estimate of 0.7 is higher than the foresight estimate of 0.5. Another example of the “hindsight bias” is the investor who observes an increase in the price of a stock and thinks that its rise was a “sure thing.” In general, the hindsight-probability is higher than the foresight-probability for 28 Robert Cooter & Ariel Porat, Does Risk to Oneself Increase the Care Owed to Others?, 29 J. L EGAL S TUD . 19 (2000). We recognize that the principal goal of tort law is to induce the internalization of precaution that confers a benefit on another. Tort law does not generally seek to induce potential injurers to take care to minimize their own harms.

232 II. An Economic Theory of Tort Liability 217 events that materialize. Applied to accidents, the hindsight bias may cause courts to overestimate the effects of untaken precaution on the probability of accidents that actu- ally occurred. Hindsight probabilities can thus result in liability under the Hand rule in circumstances where foresight probabilities result in no liability. As a result, injurers may feel that they are being treated unfairly: They took what seemed to them, at the time, to have been sufficient care but were later deemed to have been at fault. If this re- sult is widespread, it is possible that potential injurers will respond by taking more pre- caution than they really believe to be necessary. There is, thus far, no empirical evidence on this matter, but it is intriguing. UESTION Q Suppose that the sunken barge in United States v. Carroll 6.16: Towing Co . and its cargo are worth $100,000. Assume that the probability that the barge would break loose if the bargee is not present equals 0.001. If the bargee is present, then the probability of the barge’s breaking loose is reduced by half, to 0.0005. Paying the bargee to stay on the barge will cost the barge owner $25. If the barge owner does not incur this $25 expense, is his behavior negligent under the Hand rule? Q UESTION 6.17: Courts have to decide whether to defer to community norms when setting a standard of negligence or to set a legal standard inde- pendently from the community norm. A community of homeowners has norms for maintaining the safety of steps leading to the front porch of a house. Similarly, hospitals and private companies that collect blood have norms for storing it safely. Make arguments for why a court might appropriately show more deference to community standards for porch steps than to a community standard for storing blood. H. Errors We h ave ex p l a i n e d t h a t a n eg l i g e n c e r u l e c a n c r e a t e e ffi c i e n t i n c e n t ive s f o r i n j u r e r and victim, whereas strict liability can only create efficient incentives for the injurer. Despite this fact, the twentieth century saw the scope of strict liability rules expand and the scope of negligence rules contract, especially with respect to consumer product in- juries. What justifies this change? The answer concerns information. Proving causation is much easier than proving negligence. To illustrate, it is much easier to prove that an exploding Coke bottle harmed a restaurant worker than to prove that the manufacturer followed negligent bottling procedures. If liability requires the victim to prove negli- gence, as with a negligence rule, then many manufacturers will avoid liability, and they will take little precaution. Conversely, if liability only requires the victim to prove cau- sation, as with a rule of strict liability, then few manufacturers will avoid liability, and most of them will take much precaution. In tort disputes, mistakes are often made concerning the extent of harm, the cause of the accident, and the actor’s fault. Such mistakes are unavoidable by courts and law- makers because accidents are shrouded in a fog of uncertainty, interested parties such as the plaintiff and defendant provide biased information, and few people have expert

233 218 CHAPTER 6 An Economic Theory of Tort Law information about risks and precaution. In this section we explain how courts and law- makers should take account of their own fallibility. First, consider how a mistake by the court in estimating harm affects precaution. The effects are different under a rule of strict liability and a rule of no liability. The injurer’s incentives for precaution are efficient under a rule of strict liability with perfect compen- sation. But suppose the court consistently estimates harm inaccurately and consistently fails to set damages equal to perfect compensation. If the damages actually awarded by the court consistently fall short of perfect compensation, then the injurer will externalize part of the cost of accidental harm; so, he or she will have incentives to take deficient pre- caution. Conversely, if the damages actually awarded by the court consistently exceed perfect compensation, then the injurer will have incentives to take excessive precaution. In general, consistent court errors in setting damages under a rule of strict liability cause the injurer’s precaution to respond in the same direction as the error . Second, consider mistakes in determining who caused an accident under a rule of strict liability. Specifically, assume that the court sometimes fails to hold someone liable who caused an accident. This kind of error lowers the expected liability of the injurer, just like awarding deficient damages. The effect of lowering the probability of liability is the same as the effect of lowering the amount of damages: Future potential in- consistent court errors in failing to hold injurers jurers take less precaution. In general, liable under a rule of strict liability cause subsequent injurers to take less precaution . (Conversely, consistent errors in the direction of holding a person liable for acci- dents that she did not cause may induce other persons to avoid activities where mis- 29 taken liability can occur.) The situation is different under a negligence rule. Under a negligence rule, the in- jurer is not liable if his precaution equals the legal standard, and he is liable if his pre- caution falls below the legal standard. Thus the injurer’s expected costs jump up as his ' precaution falls below the legal standard as depicted in Figure 6.4. To the left of this x p ( x ) A ]; to the right of this dis- discontinuity, the injurer’s expected costs are $[ wx + continuity, the potential injurer’s expected costs are $ wx . To escape liability and avoid ' . 2 the jump in costs, the injurer satisfies the legal standard x = (x This is true whether the jump in costs is large or small. So, the injurer will want to satisfy the legal standard and escape liability even if the court makes errors in measuring damages. In general, injurer’s precaution does not respond to modest court errors in setting damages under 30 . a negligence rule A This fact is illustrated in Figure 6.5, where lines through D indicate different lev- els of expected accident costs. When the court awards perfectly compensatory dam- ages, assume that the injurer’s expected liability costs in Figure 6.5 are given by curve B . 29 Thanks to Nick Tideman for correcting imprecision in an earlier formulation of this principle. 30 Here is a more precise, and more technical, statement of the contrast: Many injurers respond a little to changes in damages under a rule of strict liability (response on the intensive margin), whereas a few injur- ers respond a lot to change in damages under a negligence rule (response on the extensive margin, with nonconvexity in the expected-cost function).

234 II. An Economic Theory of Tort Liability 219 $ FIGURE 6.5 A A single legal standard and different expected accident costs. B Expected costs x w i i C D P x P 0 x 0 x x ̃ 0 , the courts award excessive damages, which results in an expected-cost B Above curve . Below curve curve such as B A , the courts award deficient damages, which results in an expected-cost curve such as . Regardless of these court errors, the injurer’s ex- C pected costs jump down to when the injurer satisfies the legal standard; so, the injurer still minimizes expected costs by setting his or her precaution equal to the legal stan- ' To change the injurer’s cost-minimizing precaution, the error made by the . dard, x = x D court in awarding damages must be very large, as illustrated by the curve labeled . In that case, the cost-minimizing level of care will be less than the legal standard. Rather than interpreting Figure 6.5 as depicting errors by courts, we can interpret , D , and C , B A the figure as depicting errors by injurers. For example, think of curves B as depicting the expected costs of four different injurers. Curve depicts the injurer depicts the injurer who errs by over- A who predicts court behavior accurately, curve estimating court damages, and curve C depicts the injurer who errs by underestimat- ing court damages. Regardless of these errors, the injurer’s expected costs jump down when he or she satisfies the legal standard. So, each injurer still minimizes ex- x w to i ' x To change the . x = pected costs by setting precaution equal to the legal standard, injurer’s cost-minimizing precaution, the error in predicting damages must be very D large, as illustrated by the curve labeled . There the erring injurer perceives the cost- minimizing level of precaution to be x , far below the efficient level. In general, injurer’s precaution does not respond to injurer’s modest errors in predicting dam- ages under a negligence rule . We h ave i n t e r p r e t e d t h e d i ff e r e n t ex p e c t e d - c o s t c u r ve s i n F i g u r e 6 . 5 a s i n d i c a t i n g a n error by the court in computing damages or the injurer in predicting damages. Alternatively, the different expected-cost curves could be interpreted as indicating an error injurer’s precaution does not respond in determining who caused the accident. In general, to a court’s modest errors in determining who caused an accident under a negligence rule . Having discussed errors in computing damages and determining causes, we turn to errors in setting the legal standard. By “errors,” we mean situations in which lawmakers set the legal standard at a level different from the efficient level of precaution. Most in- jurers minimize their costs by conforming exactly to the legal standard, regardless of whether it exceeds or falls short of efficient precaution. Consequently, an excessive legal

235 220 An Economic Theory of Tort Law CHAPTER 6 $ FIGURE 6.6 Expected cost when the legal standard is less than the social optimum. Expected costs x 0 * x x ̃ standard causes excessive precaution, and a deficient legal standard causes deficient injurer’s precaution responds exactly to court errors in setting precaution. In general, . the legal standard under a negligence rule To illustrate, Figure 6.6 depicts the injurer’s expected costs under a negligence rule ' x 6 x . The solid * when the legal standard is less than the efficient level of precaution: curves in Figure 6.6 indicate the injurer’s costs as a function of the level of precaution. ' The injurer minimizes costs by setting precaution equal to the legal standard: x = x . His or her precaution is less than the efficient level: . * x Consequently, too many 6 x accidents occur, and the harms they inflict are too severe. Q UESTION 6.18: Use a graph to explain the efficiency consequences of a ' x x 7 legal standard that exceeds the efficient level of care: . * Q UESTION 6.19: “In general, the injurer’s precaution responds to court errors in setting the legal standard under a negligence rule.” Is this state- ment true for all forms of the negligence rule, or only for the simple negli- gence rule? I. Vague Standards and Uncertainty We have analyzed precise rules—both precisely efficient rules and precisely ineffi- cient rules—that are called “bright-line rules” because their meaning is as clear as a bright line. In reality, however, legal commands are often vague and unpredictable, fre- quently referred to as “standards.” Vague and unpredictable tort standards leave people uncertain about the legal consequences of their acts. We shall discuss how people ad- just their precaution in response to legal uncertainty. Assume that the court makes purely random errors, or, what amounts to the same thing, assume that the injurer makes purely random errors in predicting what courts will do. By “purely random,” we mean that excess is just as probable as deficiency, so that the average error is zero. (Technically, we assume that errors follow a random distribu- tion with zero mean.) We shall consider purely random errors in damages and standards. First, consider purely random errors by the court in computing damages or by the injurer in predicting damages. A purely random error in damages does not change the

236 II. An Economic Theory of Tort Liability 221 expected liability of the injurer. Expected liability remains unchanged because errors of excess offset errors of deficiency on average. Because expected liability remains un- changed, an injurer who minimizes expected costs does not change his or her precaution 31 in response to purely random errors in damages. This is true for every liability rule. In general, the injurer who minimizes expected costs does not change his or her precaution in response to random errors in computing or predicting damages under any liability rule . The situation is different, however, for random errors concerning the legal standard in a negligence rule. To keep the analysis simple, consider the injurer’s legal standard of ' x under a rule of simple negligence. Assume that the court makes random errors , care, i ' in setting the legal standard or the court makes random errors in comparing the in- , x i ' or the injurer makes random errors in pre- x to the legal standard jurer’s precaution , x i ' dicting the legal standard . Given any of these possibilities, injurers are uncertain about x whether a particular level of precaution on their part will result in the court’s finding them liable or not liable for accidents. If the court finds that their precaution exceeded the legal standard, then they will have taken unnecessary precaution. Unnecessary pre- cautions cost them a little. Alternatively, if the court finds that their precaution fell short of the legal standard, then they will be liable. Liability costs them a lot. This asymmetry gives injurers an incentive to take more precaution in order to create a margin of error small random errors in the legal stan- within which they will not be liable. In general, dard imposed by a negligence rule cause potential injurers to increase precaution . Ta b l e 6 . 3 , w h i c h s u m m a r i z e s o u r c o n c l u s i o n s a b o u t p r e c i s e e r r o r s a n d va g u e s t a n - dards, suggests some prescriptions for lawmakers and courts. First, with a rule of strict li- ability, consistent errors by the court in computing damages distort precaution; so, the court should avoid these errors. Second, with a rule of negligence, consistent errors by the court in setting standards distort precaution more than consistent errors in computing TABLE 6.3 Consequences of Errors of Excess Effect on Injurer Liability Rule Court’s Error Injurer’s Error Excessive precaution Strict liability Excessive damages Overestimates damages Overestimates Excessive damages None Negligence damages Negligence Excessive legal Excessive precaution Overestimates legal standard standard Strict liability Random error in Random error in None damages damages Random error in Random error in Negligence Excessive precaution legal standard legal standard 31 with & A ( is A In technical terms, the solution to Equation 6.2 does not change if we replace E E μ), where an expectation operator and μ is a random variable with zero mean and constant variance.

237 222 CHAPTER 6 Economic Theory of Tort Law An damages; so, the court should concentrate on avoiding errors in setting the standard of care. Given these two prescriptions, a court that assesses damages more accurately than standards for a given class of cases should favor a rule of strict liability, whereas a court that assess standards more accurately than damages for a given class of cases should favor a rule of negligence. Third, with a rule of negligence, vague standards cause ex- cessive precaution; so, the court should apply vague standards leniently in order to avoid aggravating the problem of excessive precaution. UESTION 6.20: “Excessive damages increase expected liability under a Q negligence rule, which results in excess precaution.” Explain the mistake in this proposition. Q 6.21: “If the legal standard of care in a negligence rule is neces- UESTION sarily vague, the court should set it below the level of efficient precaution.” Explain the economic argument in favor of this proposition. Rules V. Standards A law can be precise like “The speed limit is 50 kilometers per hour,” or a rule can be impre- cise like “Drive at a reasonable speed.” Law and economics scholars call precise laws “rules” 32 and they call imprecise laws “standards.” Determining whether behavior complies with a precise rule is easier than an imprecise standard. Officials who enforce laws, and citizens who must obey them, appreciate the certainty and predictability of rules. The human imagination, however, cannot anticipate all of the circumstances in which a precise rule prescribes the wrong behavior, as when the policeman stops the car for speeding to the hospital with a pas- senger who is about to give birth to a baby. A system of rules tries to overcome inflexibility through exceptions, such as the rule that speed limits do not apply in emergencies. The ex- ceptions to a rule, however, are an open set; so, no rule can enumerate all of them. As un- foreseen circumstances arise, exceptions mount and a system of rules becomes increasingly complex. Conversely, a system of standards reaches precision through cases. When a case arises, its resolution precisely specifies the standard’s application to the circumstances. The novel application of the standard in a case constitutes a precedent. Common law is a system of standards with many cases, whereas regulatory law is a system of rules with many excep- tions. Civil codes also contain many imprecise standards. Which is better, rules or standards? In Chapter 9 we will discuss precise contract terms like “Pay $100 for each day that delivery is late,” and vague contract terms like “Make your best ef- forts to deliver on time.” Our discussion of contracts will conclude that parties prefer precise terms when they can stipulate efficient behavior in advance, and they prefer imprecise terms when they want courts to decide whether behavior was fair and efficient after it occurs. Verifiable and unverifiable terms in contracts resemble rules and standards in tort law. Tort law should use rules when it can stipulate efficient and fair behavior in advance, and the law should use standards when courts can identify efficient and fair behavior in cases after disputes arise. 32 See Louis Kaplow, Rules Versus Standards: An Economic Analysis, 42 D UKE L. J. 557 (1992). Note that instead of “standards,” philosophers often use “principles” to refer to imprecise laws.

238 II. An Economic Theory of Tort Liability 223 J. Administrative Costs and Tailored Rules In the simple model, the economic goal of the tort liability system is to minimize the sum of the costs of precaution and the harm caused by accidents. A more complex model includes another important element of costs: administration. Administrative costs are incurred to allocate the costs of accidental harm. For example, a system of pri- vate law incurs the costs of lawyers, judges, and other officials involved in resolving legal disputes. Similarly, a public system to compensate workers injured on the job must collect taxes, decide claims, and pay benefits. We b eg i n b y a n a l y z i n g a d m i n i s t r a t ive c o s t s i n i s o l a t i o n f r o m t h e c o s t s o f p r e c a u - tion and accidental harm. In private law, injurers compensate victims, whereas in pub- lic law, injurers pay fines to the state. Private law can lower administrative costs because the victims, who know a lot about the cause and extent of their injuries, sue the injurers. In contrast, public law requires an administrator to discover injurers who vio- late rules. For many injuries, but not all, private enforcement is more efficient than pub- lic enforcement. We postpone a more systematic comparison between public and private enforcement in order to focus on the administrative costs of three rules: no lia- bility, strict liability, and negligence. The rule of no liability leaves the costs of accidental harm where they fall, without attempting to reallocate them. Consequently, a rule of no liability eliminates the admin- istrative costs of reallocating the costs of accidental harm. In contrast, the rule of strict liability and the rule of negligence reallocate the costs of accidental harm under certain conditions. Thus, a rule of no liability saves administrative costs relative to a rule of strict liability or a rule of negligence liability. This fact has led reformers to advocate adopting the rule of no liability for most motor vehicle accidents. Under a so-called “no fault” rule, each of the parties to an au- tomobile accident bears his or her own costs of accidental harm. In practice, this means that each accident victim recovers from his or her own insurance company, rather than 33 recovering from the insurance company of the injurer. The rule of no liability has the disadvantage that it gives injurers no incentive to take precaution. For example, the owners of trucks with steel cattle guards welded to the front of the vehicle may respond to a rule of no liability by driving aggressively. Thus, the no-fault systems presumably save administration costs and erode incentives for precaution. Now we compare the administrative costs of a rule of strict liability and a rule of negligence. Recall that a rule of strict liability requires the plaintiff to prove harm and cause, whereas a rule of negligence requires the plaintiff to prove harm, cause, and fault. The additional element of proof in negligence requires an additional decision, a rule of strict liability lowers administra- which increases administrative costs. Thus, tive costs relative to a rule of negligence by simplifying the adjudicator’s task . This advantage of strict liability may be offset by a disadvantage. A rule of strict liability gives more victims the right to recover damages than a rule of negligence. Specifically, a rule of strict liability gives every victim who suffers harm caused by the 33 There has been, in the recent past, discussion of implementing a no-fault regime for medical harms. We discuss this proposal in the next chapter.

239 224 CHAPTER 6 Economic Theory of Tort Law An activity the right to recover, whereas a rule of negligence gives every victim injurer’s the right to recover. Thus, a rule of neg- who suffers harm caused by the injurer’s fault ligence lowers the administrative costs relative to a rule of strict liability by reallocat- . In summary, a rule of strict liability results in more ing the cost of harm in fewer cases claims that are simpler to settle, whereas a rule of negligence results in fewer claims that are more complicated to settle. We have contrasted the administrative costs of strict liability and negligence. Besides the form of the liability rule, administrative costs also depend upon the sim- plicity and breadth of the rules. Simple rules are based upon easily proven facts, and broad rules lump together many different cases. Conversely, complicated rules are based upon facts that are difficult to prove, and narrow rules apply to a few cases. We may characterize the extremes of simplicity and breadth as rules, and we may wholesale case-by-case adjudication. characterize the extremes of complicated and narrow as Wholesale rules are cheaper to make, enforce, and understand. However, wholesale rules distort incentives by treating people alike who have different utility and cost func- tions. In general, wholesale rules save administrative costs and distort the relationship between the marginal cost of precaution and the marginal reduction in harm, whereas case-by-case adjudication has the opposite effects . Besides allocating the cost of accidental harm, the law also allocates the costs of administration. Different countries allocate administrative costs differently. To illus- trate, an accident victim who successfully sues in the United States recovers damages for the harm suffered but does not usually recover costs of litigating. In contrast, many European countries require the loser of a lawsuit to pay the litigation costs of the win- ner. The allocation of administrative costs decisively affects the incentives of the vic- tim to sue and the incentives of the parties to settle out of court. We shall analyze these incentives in a later chapter. Because administrative costs are purely instrumental, reducing them without in- creasing accidents is a pure gain. To retain the same level of deterrence of injurers, the law can increase the magnitude of liability and reduce its probability. To illustrate, as- sume that negligent injurers must pay damages of 100. Now change the rules and as- sume that a flip of a coin will determine whether a negligent injurer pays damages of 200 or pays nothing. After randomizing, the expected liability remains 100, so deter- rence will not change for many injurers. Administrative costs, however, should fall be- cause damages are collected from half as many injurers. In general, increasing liability and reducing the frequency of trials can often save administrative costs without affect- ing the number of accidents. These facts suggest that efficiency requires a high magni- tude and low probability of liability. Increasing the magnitude of liability, however, encounters obstacles. Private law typically restricts the injurer’s liability to the damages required to compensate the victim. Some theorists want to circumvent this obstacle by “decoupling” dam- 34 ages, so that the injurer pays compensation to the victim and also a fine to the state. 34 A. Mitchell Polinsky & Yeon-Koo Che, Decoupling Liability: Optimal Incentives for Care and Litigation, 22 RAND J. E CON . 562–570 (1991).

240 II. An Economic Theory of Tort Liability 225 In principle, decoupling enables the law to save administrative costs by increasing the magnitude of liability and decreasing its probability. You will encounter this same principle in Chapter 12 when we analyze the optimal magnitude and certainty of criminal punishments. Q UESTION 6.22: Doctors are liable when their negligence injures patients. Suppose the rule was changed from negligence to strict liability. How would administrative costs change? 6.23: Q UESTION The rungs of ladders must be constructed to support the weight of the people who climb them. Compare the relative efficiency of a precise government standard for all ladders concerning the weight that the rungs must support, as opposed to the rule that the strength of the rungs should be determined as suits arise on a case-by-case basis using the Hand rule. K. Consumer Product Injuries: Between Torts and Contracts At the beginning of this chapter we explained that tort law uses liability to inter- nalize externalities created by high transaction costs. The model of torts applies when transaction costs prevent the injurer and victim from dealing with each other before the accident, as with most automobile accidents. When the parties have a market relation- ship, however, the analysis must change, as we now show with an example of consumer product injuries. Table 6.4 reproduces the numbers from a hypothetical example developed by 35 Polinsky. Consumers face a choice between buying soda in bottles or cans. Bottles are cheaper to produce than cans, as indicated by column 1, but bottles are twice as likely to cause an accident to the consumer, as indicated by column 2, and the accidents involving bottles are more severe, as indicated by column 3. The expected loss in col- umn 4 equals the probability of an accident in column 2 multiplied by the loss in TABLE 6.4 Cost of Soda Firm’s Cost of Probability of Expected Production Accident to Accident Behaviour Loss if Full Cost Accident Per Unit Consumer Loss of Firm Per Unit (1) (2) (4) (5) (3) Use bottle 1/100,000 $10,000 10 cents 50 cents 40 cents Use can 43 cents 1/200,000 $4000 2 cents 45 cents 35 (2d ed. 1989), Table 11, p. 98. ITCHELL P OLINSKY , A N A M NTRODUCTION TO L AW A N D E CONOMICS I

241 226 CHAPTER 6 Economic Theory of Tort Law An column 3. The full cost per unit, indicated by column 5, equals the sum of the cost of production in column 1 and the expected accident loss in column 4. Notice that the full cost of bottles (50 cents) in this hypothetical example exceeds the full cost of cans (45 cents). Thus, efficiency requires the use of cans, not bottles. Let us consider whether consumers will actually use cans instead of bottles. The be- havior of consumers depends upon the information that they possess, liability law, and the market for sodas. We assume that the market is perfectly competitive. Competition drives the price of a good down to its cost, as explained in Chapter 2. The cost of sup- plying soda depends upon production and liability. We assume that the price of a unit of soda equals the production cost plus the cost of the manufacturer’s liability. Under a rule of no liability, the price of a unit of soda thus equals the production cost as shown in column 1 : 40 cents per bottle and 43 cents per can. Under a rule of strict liability, the price of a unit of soda equals its full cost as shown in column 5 : 50 cents per bottle and 45 cents per can. First, consider the behavior of consumers under a rule of no perfectly informed . Being perfectly informed, the consumers know the expected accident liability costs and the fact that they must bear these costs. Consequently, consumers will prefer the soda whose full cost to them is lower, specifically, soda in cans. Thus, perfectly informed consumers will choose the most efficient product under a rule of no liability . Second, consider the behavior of imperfectly informed consumers under a rule of no liability . Being imperfectly informed, the consumers do not know the expected acci- dent costs. If consumers overestimate the greater danger associated with bottles, they will buy cans. If consumers underestimate the greater danger associated with bottles, or if they disregard the danger, they may buy bottles to obtain the (perceived) lower price of 40 cents per bottle, as opposed to the higher price of 43 cents per can. Thus, imperfectly informed consumers will not necessarily choose the most efficient product under a rule of no liability . Third, consider the behavior of imperfectly informed consumers under a rule of strict liability . Strict liability and perfect competition cause the price of soda to equal its full cost, which is 50 cents per bottle and 45 cents per can. Consumers will prefer cans rather than bottles, regardless of whether they overestimate, underestimate, or disregard the greater danger associated with bottles. Thus, imperfectly informed con- sumers will choose the most efficient product under a rule of strict liability . This example provides the basic rationale for holding manufacturers strictly liable for the harm that defective products cause consumers: The cost of liability will be cap- tured in the price, thus directing consumers toward efficiency despite having imperfect information. This analysis, however, ignores many shortcomings of a system of strict liability for consumer product injuries, such as administrative costs, the lack of incen- tives for precaution by victims, and overinsurance of consumers by producers. We will discuss these shortcomings in detail in the next chapter. Q UESTION 6.24: In effect, a rule of strict liability requires the seller to pro- vide the consumer with a joint product: soda and insurance. What inefficien- cies arise from such a compulsory purchase?

242 Suggested Readings 227 Conclusion In communist countries like the former Soviet Union, planners could not get the information that they needed to manage an increasingly complex economy, which caused the economy to deteriorate. An increasingly complex economy must rely in- creasingly upon markets, which decentralize information. In this respect, making law resembles making commodities. As the economy grows in complexity, central officials cannot get the information that they need to make precise regulations. Instead of cen- tralized lawmaking, the modern economy needs decentralized lawmaking analogous to markets. Tort liability removes many decisions about accidents from bureaucrats and politicians and allows judges to make laws, plaintiffs to decide when to prosecute vio- lators, and courts to determine how much the violators must pay. Thus, the liability sys- tem decentralizes much of the task of internalizing externalities. In this chapter we developed the fundamental theory required to understand tort law. The next chapter re- fines the economic theory in order to address the problems that beset tort law every- where in the world. Suggested Readings Brown, John P., , 2 J. L EGAL S TUD To w a rd a n E c o n o m i c T h e o r y o f L i a b i l i t y . 323 (1973). ALE L. J. 799 (1983). Grady, Mark, A New Positive Economic Theory of Negligence , 92 Y (1987). ANDES , W ILLIAM , & R ICHARD A. P OSNER , THE E CONOMIC S TRUCTURE OF T ORT L AW L L , S TEVEN , A N E CONOMIC A NALYSIS OF A CCIDENT HAVELL AW (1987). S ITCHELL P OLINSKY & S TEVEN S HAVELL , , in A. M Shavell, Steven, Liability for Accidents EDS ., H ANDBOOK OF L AW A N D E CONOMICS v. 1 (2007).

243 CHAPTER 6 APPENDIX Liability and Symmetry imposes a standard of care upon the injurer, which we HE NEGLIGENCE RULE depicted as partitioning the injurer’s precaution into permitted and forbidden zones. The defense of contributory negligence imposes a legal standard of care T upon the victim, which can be represented by partitioning the victim’s precaution into permitted and forbidden zones. Figure 6.7 shows the injurer’s precaution on the horizontal axis and the victim’s precaution on the vertical axis. The two legal standards partition Figure 6.7 into four quadrants. The following table summarizes the relationship between the four quadrants and the fault of the parties: Victim Injurer Quadrant I no fault fault II no fault no fault fault no fault III IV fault fault ' x For example, in quadrant I, the injurer is at fault because x 6 , and the victim is i i ' 7 x x not at fault because . v The following table summarizes the way different liability rules allocate the costs of accidental harm between the parties, depending upon their precaution by quadrant: Victim bears Injurer bears cost of harm cost of harm Liability rule Simple negligence I, IV II, III Negligence with defense II, III, IV of contributory negligence I Strict liability with defense of contributory negligence I, II III, IV Strict liability with defense I, II, IV of dual contributory negligence III 228

244 Liability and Symmetry 229 x FIGURE 6.7 v II I Victim’s x ̃ v precaution III IV x 0 x ̃ i Injurer’s precaution If we switch the labels of the axes in Figure 6.7 so that the injurer’s precaution is on the vertical axis and the victim’s precaution is on the horizontal axis, then compare how the liability rules allocate the burden of harm, we shall find some interesting rela- tionships. “Simple negligence” is the mirror image of “strict liability with a defense of contributory negligence,” and “negligence with defense of contributory negligence” is the mirror image of “strict liability with defense of dual contributory negligence.” UESTION 6.25: Explain why the victim bears the costs of accidents under a Q rule of strict liability with a defense of contributory negligence in quadrant IV. Q UESTION 6.26: Explain why the injurer bears the costs of accidents under a rule of strict liability with a defense of contributory negligence in quadrant II.

245 To p i c s i n t h e E c o n o m i c s of Tort Liability 7 HE PRECEDING CHAPTER introduced the fundamental concepts of tort law and developed an economic analysis of tort liability. In this chapter we wish to advance T the understanding of the economic analysis of the tort liability system in two ways. First, we relax some simplifying assumptions in order to bring the model closer to reality. Second, we shall examine some arguments that the tort liability system does not work well and needs thorough reform. In the course of this examination, we shall look at some recent evidence on how well the tort system minimizes the social costs of accidents. I. Extending the Economic Model The model that we introduced in the last chapter made some implicit simplifying assumptions. The grand tradition in economics would have us assert our intention to relax these simplifications but then forget to do so. But we aspire to do better. We turn immediately to the task of exploring the conclusions of our simple model when we relax our simplifying assumptions. A. Relaxing the Core Assumptions In the previous chapter we implicitly made five simplifying assumptions before we developed our economic analysis of tort law: 1. Decision makers are rationally self-interested. 2. There are no regulations designed to reduce external costs. 3. There is no insurance. 4. All injurers are solvent and pay damages in full. 5. Litigation costs are zero. The purpose of this section is to relax these assumptions and to see the effect, if any, on the conclusions from the economic theory of tort liability. One of the central assumptions in economic theory is that decision 1. Rationality makers are rationally self-interested. As a technical matter, this means (as we saw in our review of microeconomics in Chapter 2) that decision makers have stable, well- 1 ordered preferences, which implies something about the decision maker’s cognitive 1 Recall that such preferences are stable in the sense that they do not change too rapidly or quixotically and is preferred to that they are well ordered in the sense that they are transitive, which means that if A B B and is preferred to C , then A must be preferred to C. 230

246 I. Extending the Economic Model 231 and reasoning abilities. Specifically, it suggests that decision makers can calculate the costs and benefits of the alternatives available to them and that they choose to follow the alternative that offers the greatest net benefit. There is a vital connection between the assumption of rationality and the eco- nomic model of tort liability in Chapter 6. We saw that the rules for assigning tort lia- bility are, economically speaking, designed to send signals to potential victims and potential injurers about how they ought to behave. For the tort liability system to have this effect, it must be the case that those whose behavior the law is seeking to affect are rational: If they do not behave in the manner predicted by the assumption of ra- tional self-interest, then we may need to amend the tort liability system in light of how people actually behave. But do people really make decisions about potential liability in this way? Some people do, and others do not. Recent academic literature suggests that many decision makers commit predictable errors in making calculations of the sort that tort liability encourages them to make. For instance, Kahneman and Tversky report two disturbing 2 conclusions. First, they find that most people simply cannot accurately estimate low- probability events; they seem to deal with them by assuming that “low probability” means that the event will never happen—that the probability of the event’s happening is zero. Second, they find that, for some well-publicized, potentially catastrophic most outcomes—such as accidents from nuclear power plants— people systematically exaggerate the probability of an accident’s occurring, regardless of objective informa- tion to the contrary. These opposite errors—underestimating most low-probability events and overesti- mating some low-probability events—apparently have a common cause: the frequency and vividness with which people are reminded of these risks. Infrequent and dull reminders of risk cause people to underestimate them, whereas frequent and vivid reminders cause people to overestimate them. Most low-probability events are seldom discussed or portrayed in the media; so, people tend to act as if their probability is close to zero, whereas potentially catastrophic events such as nuclear risks are much dis- 3 cussed and portrayed in the media, so people tend to overestimate their probability. These findings have implications for the economic model of tort liability. If many people do not accurately estimate risks, then they cannot make the appropriate calcu- lations of net benefits and costs that the economic theory assumes that they make. Using the symbols of the previous chapters, some people may inaccurately set p ( x ) equal to 0 for low-probability events and, therefore, take no precaution, when, in fact, 2 See generally D ANIEL K AHNEMAN & A MOS T VERSKY , EDS ., J UDGMENT U NDER U NCERTAINTY : B IASES AND H (1981). For behavioral insights applied to law, see Russell Korobkin & Thomas S. Ulen, Law EURISTICS and Behavioral Science: Removing the Rationality Assumption from Law and Economics, 88 C AL . L. R EV . 1051 (2000). 3 A common example of this phenomenon arises from this question: “Which is more common—homicide or suicide?” Many people answer, “Homicide,” largely because information about homicide is vivid and widely reported while that on suicide is typically not reported. In fact, suicide is approximately twice as common as homicide. The U.S. Centers for Disease Control and Prevention reports that in 2009 there were approximately 18,000 homicides in the United States and about 34,500 suicides.

247 232 CHAPTER 7 opics in the Economics of Tort Liability T should take precaution. The inability of these de- that probability is positive, and they cision makers to make accurate calculations may lead to too many or too severe acci- over estimate p x )—that is, they may think dents. In other cases, decision makers may ( that an accident is far more likely than it, in fact, is—and may, therefore, take far too much precaution. As a result of these inabilities to calculate correctly, the tort liability system—to the extent that it presumes that people can and do calculate, may not induce people to take actions that minimize the social costs of accidents. The economic theory of tort liability not only draws our attention to the impor- tance of the rationality assumption in analyzing tort law, but it also suggests a correc- tive measure when that assumption is violated. Consider accidents involving power tools. One might suppose that precaution in such cases is bilateral: There is something that both the consumer and the producer can do to reduce the probability and severity of an accident. As a result, the economic theory would suggest that some form of the negligence rule should be used to induce efficient precaution by both consumers and producers. However, suppose that there is strong evidence that consumers do not accu- rately assess the risks associated with the use of power tools. They might presume that the tools are so safe that they need not take any particular care in how they are used. In short, consumers might mistakenly assume that the probability of an accident is zero and take very little precaution. That fact would make this a situation of unilateral, rather than bilateral, precaution: Only manufacturers could realistically be expected to 4 take steps to reduce the probability and severity of an accident. In these circumstances, manufacturers might be held liable for failing to design a product that would prevent foreseeable misuse by less than fully rational consumers. Besides misperceived probabilities and other cognitive errors, many accidents re- sult from tangled feet, quavering hands, distracted eyes, slips of the tongue, wandering minds, weak wills, emotional outbursts, misjudged distances, or miscalculated conse- quences. Described more abstractly, accidents result from clumsiness, inattention, mis- judgment, misperception, or weakness of will. Occasional acts of this kind are called “lapses.” Chapter 12 explains how lapses can cause crimes. Here we focus on lapses that cause unintended negligence, which in turn causes an accident. In these cases an actor aims for a given level of precaution and fails to achieve it. Negligence rules deter- mine liability by comparing the legal standard to the injurer’s actual level of care, not the injurer’s intended level of care. So, actors are liable under a negligence rule for the harm caused by their lapses. Here is an example. Example 1: Unintended Negligence by a Motorist: A motorist sets out on the long, straight drive from San Francisco to Los Angeles on Interstate 5. The road is uncongested, it is night, and the speed limit is 70 miles per hour. Under these conditions, a reasonable driver of a car with a mechanism to main- tain constant speed (“cruise control”) would set it at the speed limit of 70 miles per hour. The car, however, lacks such a mechanism. Not being a machine, the 4 Note, further, that if the rationality assumption fails, then there is not a great deal to be said for a policy of better informing the parties about the objective values of the risks. They either discount or ignore that information.

248 I. Extending the Economic Model 233 driver cannot possibly go 70 all the time. The driver aims for 65. Occasional lapses in attention cause the driver to exceed or fall short of the intended speed of 65. Near the end of the trip, the driver has an accident while going 73 that he would have avoided if he had been going 70. Under a negligence rule, the motorist is liable for harm caused by the accident. In this example, a safe driver is held liable for an accident that he caused by acciden- tally going too fast. Now consider the symmetrically opposite example. Intended Negligence by a Motorist: The facts in the preced- Example 2: ing example remain the same except that the driver aims for 75, so he intends to un drive at an reasonable speed. Occasional lapses in attention cause the driver to fall short of the intended speed of 75. Near the end of the trip, the driver has an accident while going 67. Under a negligence rule, the motorist is not liable for harm caused by the accident. In this example, a dangerous driver is held not liable for an accident that occurred while he was accidentally going at a safe speed. The first driver was intentionally nonnegligent most of the time and accidentally negligent part of the time. He had “bad moral luck”: He accidentally went too fast at just the wrong time and caused an accident. The second driver, in contrast, was inten- tionally negligent most of the time and accidentally nonnegligent part of the time. He had “good moral luck” with respect to liability: He accidentally went too slow at just 5 the right time and escaped liability. Allowing moral luck to determine liability may seem unfair to you. Fairness aside, reducing the role of moral luck in liability improves incentives and reduces inefficien- cies. To see why, we construct a graph to represent the safe driver who had bad moral luck. The vertical axis in Figure 7.1 represents the probability of driving at a particular FIGURE 7.1 margin Probability of a lapse causing negligent of error precaution. Probability probability of lapse causing negligence ~ * x x intended legal Precaution 5 Because he could not have avoided this accident by driving 67, speeding was not the cause of this accident, so he should not be held liable even if he had been speeding. In practice, however, the court may be unsure of these facts, and it is likely to find him liable if he were going 75 when the accident occurred.

249 234 CHAPTER 7 T opics in the Economics of Tort Liability speed. The horizontal axis represents precaution, which corresponds to driving slowly in the preceding example. We model a lapse as a probabilistic connection between in- tended and actual precaution. The actor in Figure 7.1 intends to achieve precaution x the actor achieves depends on his intention x * level x *. The actual level of precaution x To provide for a margin of error, the actor e x = plus a random variable so * + e . , ' An actor lapses when actual precau- . x * intends to exceed the legal standard, so x 7 6 x * . x tion falls below intended precaution, or In Figure 7.1, the probability of a lapse resulting in negligence is the shaded area under the probability density function that lies below the legal standard. In Figure 7.1, the actor gains a private advantage by exceeding the legal standard, to exceed the legal standard. We already ex- but social efficiency requires the actor not plained this fact in the preceding chapter, which we restate briefly. Recall that precau- tion is socially optimal when the cost of taking a little more equals the social benefit of fewer accidents. If the legal standard is set at the social optimum, then exceeding the legal standard of precaution has more social costs than benefits. For the actor, however, private benefits increase significantly when his precaution reaches the legal standard because he escapes liability. So the actor takes excessive precaution. (Moral luck also 6 has another bad incentive effect that we cannot discuss here. ) We h ave ex p l a i n e d t h a t a l l ow i n g m o r a l l u c k t o a ff e c t l i a b i l i t y s e e m s u n fa i r a n d d i s - torts incentives for precaution. Replacing a rule of liability for accidents caused by negli- gence with a rule of liability for accidents caused by intentional negligence would reduce the role of moral luck in determining liability. Unfortunately, this remedy is usually worse than the problem. Compared to a rule of liability for objective negligence, a rule of liabil- ity for intentional negligence requires the plaintiff to prove much more before recovering damages. If the plaintiff had to prove intentional negligence in order to recover damages, the burden of proof would be crushing, and recoveries would seldom occur. Thus, the vic- tims of automobile accidents could seldom recover if they had to prove that the speeding driver intended to speed. Practical problems of information cause courts to condition lia- bility on objective negligence rather than intentional negligence. (Consider, however, that global positioning systems or some other technological advance may someday provide a complete record of a driver’s speed on any journey, which would often allow a driver to prove that his speeding was merely an unintended lapse.) These thoughts raise concerns about whether tort liability induces the appropriate precautionary action by potential injurers and victims. We shall tentatively maintain the rationality assumption but shall be ready to amend our conclusions about efficient tort rules when there is sound evidence that the appropriate decision makers are not behav- ing rationally. We a r i n g s e a t b e l t s a n d s h o u l d e r h a r n e s s e s i s a n e ffi c i e n t 7.1: Q UESTION means of minimizing the costs of automobile accidents. Assuming that the 6 While people cannot choose whether to lapse, they can control the frequency and magnitude of lapses through concentration, preparation, conditioning, and training. Moral luck causes excessive investment in these activities by a rational actor. We relegate this fact to a footnote, however, because irrational people who invest too little in cultivating self-control pose a greater danger to society.

250 I. Extending the Economic Model 235 benefits of these passive restraints exceed their costs, but that not all drivers and passengers use seat belts, how might the rules of tort liability be changed so as to induce a greater number of people to wear seat belts and shoulder harnesses? Web Note 7.1 We have previously mentioned the burgeoning literature in behavioral law and economics. Much of that literature relates to the examination of the econom- ics of tort liability. See our website for much more on the connections between behavioral law and economics and tort law. 2. Regulations Fire regulations usually require a store to have a fire extinguisher. Inspectors will check from time to time to confirm that the store complies with the reg- ulation. If it fails to comply, the regulators may impose a fine. Even if the store com- plies and a fire injures a customer, the store may be liable to that customer in a private cause of action. In this example, the store is subject to safety regulations and liability. In Chapter 6, the basic model assumed that injurers face liability but not regulations. The fact that injurers often face both liability and regulations poses the question, “Why have both safety regulation and liability?” If, in our example, liability law is adequate at inducing safety precaution, the store will presumably keep a fire extinguisher even without the regulation. And if the store complies with the regulation, perhaps the in- jured customer should seek compensation from his insurance company, not the store. Comparing liability and regulation, sometimes one is more efficient than the other, and sometimes the two together are more efficient than either one by itself. A general theory of safety regulation and tort liability must distinguish these alternatives. Instead 7 of attempting a comprehensive theory, we will sketch some determinants. Administrators have the power to order potential injurers to correct a hazard be- fore an accident occurs, whereas courts have the power to order injurers to compensate victims after an accident occurs. Regulation is ex ante enforcement by administrators, and liability is ex post enforcement by victims. This difference determines many of the advantages and disadvantages of each. Administrators and courts differ with respect to information. Administrators can often acquire technical knowledge needed to evaluate the safety of specialized indus- tries, whereas courts of general jurisdiction have difficulty accumulating technical knowledge about specialized industries. In these circumstances, administrators may set standards better than courts, so the court may use a safety regulation as the standard of care for determining liability. By accepting safety regulations as defining the legal stan- dard of care for tort liability, courts defer to administrators. If safety regulation and lia- bility law impose the same standard of care, then potential injurers will conform to that ex ante fines and ex post liability. standard in order to avoid both 7 See Steven Shavell, Liability for Harm versus Regulation of Safety, 13 J. L EGAL S TUD .357–374 (1984), and Charles Kolstad, Thomas Ulen, & Gary Johnson, Ex Post Liability for Harm vs. Ex Ante Safety M . E CON . R EV . 888 (1990). Regulation: Substitutes or Complements? , 80 A

251 236 CHAPTER 7 opics in the Economics of Tort Liability T Sometimes, however, courts have better safety information than administrators do. For example, a trial may provide judges and juries with better information about the harm caused by an accident than administrators can predict. In addition, courts often have fewer political motives than administrators. Problems of information or motiva- tion can cause a court to distrust the legal standard imposed by a safety regulation. Courts may feel that the regulators set the standard too low in order to avoid liabil- ity for politically powerful businesses. In these circumstances, the standard of care im- posed by the court for liability may exceed the safety regulation. If liability law imposes a higher standard than safety regulations, then most potential injurers will con- form to the higher standard in order to avoid liability. Alternatively, courts may feel that the regulators set the standard too high in order to reduce competition. For example, U.S. automobile manufacturers may seek high safety standards to increase compliance costs for foreign competitors. If safety regula- tions impose a higher standard than liability law, then most potential injurers will con- form to the regulation in order to avoid fines. Safety regulations provide a rich source of bribes for corrupt officials in many coun- tries. Sometimes officials want tough regulations to guarantee that bribing an official is cheaper than conforming to the regulations. In countries where the administrators are more political and corrupt than judges, liability has a distinct advantage over regulation. When tort liability exceeds an injurer’s wealth, the injurer is bankrupt. Some risky activities attract undercapitalized firms that can escape liability through bankruptcy. Highly capitalized firms may avoid these same activities to avoid the risk of liability. In those industries where undercapitalized firms risk bankruptcy, safety regulations have an advantage over liability. By collecting fines before an accident occurs, officials can force an undercapitalized firm to comply with safety standards that it would violate if the only sanction were liability. Finally, consider the administrative costs of regulations and liability. Sometimes accidents impose small harm on a large group of people. When the cost of trial for each victim exceeds his damages, making liability law work requires aggregating claims, as in a class action suit. Sometimes claims are easier to aggregate in an administrative pro- ceeding than in a court trial. In general, safety regulations dominate liability as a rem- edy for accidents that impose small harm on a large group of people. Web Note 7.2 The remarkable story of the attempts to regulate the harms from tobacco use and to hold the tobacco companies liable for those harms constitutes an in- structive case study of the relationships between liability and regulation. See our website for a discussion of the tobacco cases and the settlement reached in the U.S. litigation. 3. Insurance How does the availability of insurance affect our analysis of tort lia- bility? So far, our analysis of alternative tort rules and institutions has proceeded as if no one were insured. In reality, insurance is pervasive for accidents and tort liability.

252 I. Extending the Economic Model 237 Now we need to discuss how insurance interacts with tort liability and consider whether insurance advances or retards the goals of tort law, which we formulated as minimizing the sum of the costs of precaution, accidental harm, and administrative costs. A person who faces the risk of accidental harm may buy insurance. When an acci- dent occurs, a victim with insurance files an insurance claim for compensation with his insurance company. In addition to recovering from his insurance company, the victim may have a right in tort law to recover from the injurer. In principle, the accident victim could recover twice—once from the insurance company and once from the injurer. The insurance contract, however, usually transfers the victim’s recovery rights to the insur- ance company by means of what is called “subrogation”: The insurance company stands in place of the insured in the tort suit for the harm covered in the insurance claim. To il- lustrate, the accident may cause the victim to lose $100 in medical costs and $200 in pain. The victim may have health insurance to cover the medical costs and no insurance to cover pain. So, the victim will recover $100 from the insurance company and $200 from the injurer, and the insurance company will recover $100 from the injurer. Besides insurance against accidental harm, many people buy insurance against li- ability. In the preceding example, the injurer is liable for $300. If the injurer has full liability insurance, the injurer’s insurance company will pay the injurer’s liability of $300 ($200 to the victim and $100 to the victim’s insurance company). In the preceding example, the victim’s insurance is in complete (it covers medical costs but not pain), and the injurer’s insurance is complete (it covers medical costs and pain). As insurance becomes more complete, we approach a situation where victims re- cover all of their compensation from insurance companies, injurers recover all of their liability from insurance companies, and the insurance companies resolve disputes among themselves. In effect, insurance is a private system of liability law that reallo- cates the costs of accidents according to contracts between insurer and insured. As this private system becomes more complete, injurers and victims deal directly with their in- surance companies, not with each other. In these circumstances, people care more about insurance rates and terms of coverage, and they care less about the underlying law of accidents (except insofar as the latter affects the former). Insurance companies set premiums, which provide revenues. They also process claims and pay them, which are costs of doing business. In perfectly competitive mar- kets, companies earn zero profits. Applied to insurance markets, this proposition im- plies that the premiums equal the claims plus administration costs. Earlier we formulated the goal of tort law as minimizing the sum of the cost of the harm from ac- cidents, the costs of avoiding accidents, and the costs of administration. In a system of universal insurance and competitive insurance markets, the goal of tort law can be described as minimizing the total cost of insurance to policyholders. To i l l u s t r a t e t h i s p r o p o s i t i o n , w e c o n t r a s t n o l i a b i l i t y a n d t h e r u l e o f s t r i c t l i a b i l i t y. With a rule of no liability, potential victims buy accident insurance, and potential injur- ers have little need for liability insurance. In contrast, with a rule of strict liability po- tential injurers need liability insurance, and potential victims have little need for insurance against those accidents for which the injurers are liable. So, a rule of no lia- bility causes victims to buy relatively more insurance, and a rule of strict liability causes injurers to buy relatively more insurance.

253 238 CHAPTER 7 opics in the Economics of Tort Liability T Which rule is more efficient? This policy debate is important historically. In the nineteenth century, consumers injured by defective products seldom recovered in court, 8 so consumers who wanted insurance had to buy it themselves. In the twentieth cen- tury, the emergence of strict products liability in tort law effectively caused manufac- turers to insure consumers, and manufacturers often bought liability insurance for themselves. These facts provoked an argument about whether victims’ insurance is more or less efficient than injurers’ insurance. We cannot answer this question fully, but we can give the flavor of debate. In general, insurance transfers risk from the insured party to the insurer. Transfer externalize. Externalizing risk gives the insured an incentive to re- is another name for duce precaution. The insurance industry, which is old and has its own language, calls the reduction in precaution caused by insurance To i l l u s t r a t e m o r a l h a z - moral hazard. ard, a person who insures his car against theft may not be so careful about locking it. Insurance companies employ various means to reduce moral hazard, notably coin- surance, deductibles, and experience rating. Under a deductible, the insured pays a fixed dollar amount of his accidental losses. Under coinsurance, the insured pays a fixed percentage of his accidental losses. Under experience rating, the insurance com- pany sets the insured’s rates according to the experience of the insured’s claims. A claim in year two, for example, usually means a rate increase in year three. While these devices reduce moral hazard, they cannot eliminate it. Consequently, insurance in- 9 evitably undermines the insured’s incentives for precaution. To combat this problem, liability insurers impose safety standards that policyhold- ers must meet to remain covered by insurance. To illustrate, a fire insurance company may require a business to maintain fire extinguishers as a condition for writing an in- ex ante ex post surance policy. In the preceding section, we contrasted regulation and liability. Insurance companies impose standards ex ante. Officials of the company may inspect for compliance. Insurance safety standards are private regulations imposed by contract and enforced by private parties, as opposed to public regulations imposed by law and enforced by state officials. On balance, legal scholars generally think that in- 10 surance promotes the goals of tort law and should be encouraged. Having discussed the incentive effects of insurance, we return to the question of whether no liability or strict liability is a better rule for consumer product injuries. The rule of strict liability has a distinct advantage over no liability in terms of the efficiency of insurance markets. As explained, insurance companies usually set rates according to the history of an individual’s claims through the process of “experience rating.” Many claims trigger a surcharge, and few claims trigger a discount. Under a rule of strict liability, 8 Note, however, that many forms of insurance that we take for granted were unavailable in the nineteenth century. Insurance markets took time to develop. 9 An additional problem for insurers is adverse selection , which we discuss in the section on insurance in Chapter 2 and also discuss below as a possible source of periodic insurance crises. Will adverse selection, if uncorrected, create efficiency issues in tort liability? Describe and contrast those problems in regimes of no liability and strict liability. 10 Some states, however, prohibit liability insurance for punitive damages, presumably for the same reason that states prohibit insurance against criminal fines.

254 I. Extending the Economic Model 239 a company that produces many defective products makes many claims to its insurer and thus pays higher rates. This fact creates incentives for more precaution by the manufac- turer to reduce its claims by reducing consumer accidents. However, these incentives for producers disappear under a rule of no liability, where consumers must buy their own in- surance. One of the main arguments in favor of strict liability for consumer product injuries is that this rule causes liability insurers to monitor the safety of manufacturers. Some scholars argue against the rule of strict liability on the ground that it provides consumers with unwanted insurance. By “unwanted” we mean that consumers would not voluntarily buy the insurance if they had to pay for it. To illustrate, a well-insured U.S. motorist who injures his knee when his car slips on ice and crashes will receive compen- sation from his insurance company for medical costs, lost wages, and damage to the car. If, however, the motorist suffers the identical injury due to the fault of another driver, the motorist will also receive additional compensation in tort for pain and suffering. In gen- eral, the tort liability system effectively provides consumers with insurance against pain and suffering that they would not buy for themselves. In personal injury cases, pain-and- suffering compensation can be relatively large, which implies that consumers have a lot of unwanted insurance. (Later we discuss how a market for tort claims can solve this problem by allowing potential accident victims to sell unwanted liability rights.) We have introduced the complex interaction of tort liability rules and insurance markets. Before leaving the topic, we want to explain a problem with insurance mar- kets. In 1985 and 1986 and again in the mid-1990s, a “crisis” over liability insurance— particularly with respect to medical malpractice insurance—occurred in the United States and elsewhere. During the crisis, insurance companies abandoned some lines of insurance, refused to renew policies for some persons and companies, lowered the lim- its on some insurance coverage, and sharply increased some premiums. The crisis poses the question, “Is the insurance industry inherently unstable?” Answering this question explains some fundamental characteristics of the insurance industry. The answer may be “Yes” for two reasons. The first reason concerns the “reserves” held by an insurance company. Sound business policy and state regulations require in- surance companies to hold a fraction of their revenue from premiums in reserve to cover future claims. For some risks, however, many claims can occur at once. To illustrate, earthquake insurance results in no claims in most years and vast claims when a large earthquake actually occurs. As a consequence, the insurance company must use the pre- miums in years with no claims to build up its reserves (“reserve funding”). Sometimes an insurance company has larger reserves than it needs to cover a risk. If an insurance company has excess reserves, it can expand the supply of insurance at little cost. At other times, insurance companies have no excess reserves, so they cannot write more in- surance policies without increasing their reserves or liquidating the investments they have made with their other premium revenues. Changing the level of reserves can be 11 One theory holds that insurance crises occur very costly because of tax consequences. 11 Capital removed from reserves becomes taxable as profit; so, insurance companies do not like to remove capital from reserves except in years when they have losses to offset their tax liability. Similarly, additions to reserves can reduce tax liabilities (especially under the U.S. tax law before the 1986 reforms), so insur- ance companies prefer to add to reserves in years when they have large profits from their other activities.

255 240 CHAPTER 7 opics in the Economics of Tort Liability T because insurance companies exhaust their reserves and must raise premiums relatively quickly to replace those reserves. The second explanation is quite different in character. Suppose that insurance pre- miums rise, and some people stop purchasing insurance. The people who retain their insurance represent the worst risk, so the insurance company may have to increase its premiums again. To illustrate, suppose there is a 20 percent chance that I will suffer an accident costing $10,000 and only a 15 percent chance that you will suffer such an ac- cident. If we are both insured, I expect to recover $2000 from the insurance company in claims, whereas you expect to recover $1500 in claims. Suppose the insurance com- pany offers us the same insurance policy for the same premium, say $1500. It does not charge me more than you because it does not have enough information to tell us apart (or perhaps the regulators won’t permit “price discrimination”). Both of us purchase the insurance because the premium is equal to or (in my case) less than the expected value of the claim, and we are both probably risk-averse. The insurance company col- lects $3000 in premiums from the two of us and expects to pay $3000 in claims, so it earns zero profits, as required in perfect competition. Observe what would happen if the insurance company increased the rates to $1600. You are more likely than I am to decide to drop your policy. (Why?) But if you drop your policy, the insurance company loses a good risk (you) and retains a bad risk (me). Now the insurance company collects $1600 in premiums and it expects to pay out $2000 in claims, so it expects to lose $400. To overcome this loss, it must raise its rates again. (To what level does the company now need to raise its premium?) The rates have to be raised a second time because the first rate increase caused good risks to stop buy- ing the policy while bad risks continued buying it. This phenomenon, whereby an increase in insurance premiums drives out good risks while retaining bad risks, is called “adverse selection.” The second explanation of the insurance crisis holds that increased claims set off a cascade of increased premiums due to adverse selection. Exhaustible reserves and adverse selection can create instabil- 12 ity in the supply of insurance. Q 7.2: Are subrogation clauses efficient? Be sure to review your UESTION answer in light of the section below about litigation costs and their effect on the efficiency of the tort liability system. Under assumptions explained in Chapter 6, strict liability causes 4. Bankruptcy the firm to internalize the social costs of accidents, so it chooses the socially optimal activity and care levels. The possibility of escaping liability through bankruptcy changes this conclusion. When potential damages to tort victims exceed the firm’s net worth, the firm externalizes part of the risk, thus eroding its incentives to take precau- tion and restrain its activity level. Limited liability can cause too little precaution and too much dangerous activity. 12 See Ralph Winter, The Liability Crisis and the Dynamics of Competitive Insurance Markets, 45 Y ALE J. R .455 (1988); and Michael J. Trebilcock, The Role of Insurance Considerations in the Choice of EG RG . & O . 243 (1988). , E CON AW 4 J. L Efficient Civil Liability Rules,

256 I. Extending the Economic Model 241 Consider the example of a disposal company for hazardous waste. If such a com- pany planned to remain in business indefinitely, it might use extreme care in dumping hazardous waste in order to avoid future liability. Alternatively, it might follow the strategy of dumping recklessly and accumulating potential tort liabilities that exceed its assets. Anticipating future liability and bankruptcy, the firm continually distributes profits and remains undercapitalized. When harm materializes and suits begin, the firm declares bankruptcy, and its tort victims take their place with other unsatisfied creditors. This scenario suggests that firms in risky industries may have too many accidents and too little capital, thus lowering production and distorting the capital labor ratio. In addition, if tort liability causes bankruptcy and liquidation, the firm’s nontransferable assets are destroyed, such as its reputation (“goodwill”), organization, and its employ- ees’ knowledge of how the company conducts business (“firm-specific human capi- tal”). Thus, avoiding liability through insolvency causes significant inefficiencies. A recent article, however, proposes that new judgment-proofing techniques enable 13 corporations to avoid tort liability without being undercapitalized. First, a corpora- tion can place risky activities in a subsidiary, which is a separate company owned by the parent corporation. Courts seldom reach past a bankrupt subsidiary to the parent’s assets. Some evidence exists that liability causes U.S. firms to divest and locate haz- 14 ardous activities in smaller firms. Some scholars urge U.S. courts to “pierce the cor- porate veil” and extend tort liability to the parent of a subsidiary, or even to people who own shares in bankrupt corporations. Research by Richard Brooks on the Exxon Valdez , which was an Exxon oil tanker whose wreck contaminated the Alaskan coast in spring 1989, demonstrates that the oil companies apparently believe that courts will pierce the 15 corporate veil. Specifically, large oil companies responded to massive liability by shipping more oil in their own tankers, which they control, rather than attempting to escape liability by contracting with tanker companies to ship their oil. Second, in bankruptcy the secured creditors get priority over other, unsecured creditors, including tort victims. By lending a greater proportion of the corporation’s debt to secure creditors, a firm can shield a larger portion of its assets from the claims of tort victims. Third, firms often have expected income, such as future payments from buyers of the firm’s products (“accounts receivable”). In a process called “securitization,” firms 16 After securitizing, convert expected income into securities and sell them to investors. the future income belongs to the owners of the securities, so tort victims cannot tap this income as a source of compensation. 13 The Death of Liability, 106 Y ALE L. J. 1 (1996). Lynn M. LoPucki, 14 Al H. Ringleb & Steven N. Wiggins, Liability and Large-Scale, Long-Term Hazards, 98 J. P OL . E CON . 574 (1990). 15 Richard R. W. Brooks, Liability and Organizational Choice, 45 J. L AW & E CON . 91 (2002). 16 The bonds allow the issuer to convert the stream of future income into a lump sum. One of the first to use the method of securitization was the rock singer David Bowie, who issued bonds that gave the bondhold- ers a claim on Bowie’s future income. In honor of this use, securitization bonds are sometimes called “David Bowie bonds.”

257 242 CHAPTER 7 opics in the Economics of Tort Liability T The distortion of incentives for precaution caused by insolvency has no perfect so- lution. Imperfect solutions include compulsory insurance, posting bond, or replacing ex ante regulations. In addition, replacing rules of strict liability ex post liability with with negligence rules ameliorates the problem. A negligence rule allows a firm to es- cape liability by conforming to the legal standard of care. Having escaped liability, the firm has no need to shield assets from tort suits. In contrast, a rule of strict liability only 17 allows a firm to escape liability by insolvency. 5. Litigation Costs The final core assumption of the economic theory of tort lia- bility was that litigation is costless. Of course, nothing could be further from the truth: Litigation is expensive and sometimes ruinously so. A more complete analysis of the efficiency of the various liability rules we have discussed should introduce these costs 18 explicitly. ers. Costly litigation will have different effects on potential victims and potential injur Moreover, these different effects will have very different implications for the efficiency analysis of Chapter 6. Consider, first, the impact of costly litigation on potential victims. If victims must incur a cost to assert their claims for compensation, then they may assert fewer claims. Consider an extreme case in which litigation costs exceed the expected compensatory damages. Victims will not bring suit, and so the potential injurers will not receive the signal from the tort liability system that what they are doing is unacceptable. They may, as a result, take less precaution than they should, with the consequence that there may be more accidents (and more severe accidents) than there should be. However, costly litigation may have a contrary effect on the decisions of potential injurers. If it is expensive for an injurer to litigate, then it may make sense to take more precaution than would be the case if litigation were costless. By taking more precau- tion, the potential injurer makes an accident less likely or less severe; if the cost of this additional precaution is less than the cost of litigation, then we should expect potential injurers to take precaution when litigation is costly. Similarly, high litigation additional costs may cause investors to withdraw funds and reduce activities that risk lawsuits. As a result, there should be fewer and less severe accidents. Because the effects of costly litigation on potential victims and on potential injurers pull in different directions (one suggests less precaution; the other suggests more precau- tion), we cannot be sure of the net effect of relaxing the assumption of costless litigation. High litigation costs have an unsettling, counterintuitive implication, which we il- lustrate by contrasting two possible rules of legal procedure. Under the first procedure, assume that when a plaintiff complains that a wrongdoer caused harm of $100, the judge hears the case and awards damages of $100 whenever the plaintiff proves the 17 For a detailed analysis of how bankruptcy impacts alternative tort rules, see Alexander Stremnitzer & Avraham Tabbach, Insolvency and Biased Standards—The Case for Proportional Liability , Yale Law School Faculty Papers, No. 24 (2009). 18 See Janusz Ordover, Costly Litigation in the Model of Single Activity Accidents, 7 J. L EGAL S TUD .243 (1978); and A. Mitchell Polinsky & Daniel Rubinfeld, The Welfare Implications of Costly Litigation in the Theory of Liability, 17 J. L EGAL S TUD . 151 (1988).

258 I. Extending the Economic Model 243 necessary facts. Under the second procedure, assume that when a plaintiff complains that a wrongdoer caused harm of $100, the judge flips a coin and dismisses the com- plaint without a trial whenever the coin shows “heads.” If the coin lands “tails,” how- ever, the court decides the case and awards damages equal to 200 percent of the actual harm. The injurer’s expected under 1.0 * 100 liability is the same for both procedures— .5 the old procedure, and under the new procedure. If potential injurers decide * 200 how much precaution to take based on expected liability, then the change in procedure will not affect their behavior, so the sum of the cost of harm from accidents and the cost of avoiding accidents apparently remains the same. However, the new procedure has reduced the number of trials by 50 percent, so administrative costs are much lower un- 19 der the second procedure. Changing our legal system from the first to the second procedure would save costs, but this will not happen. A judge who actually decided a case by flipping a coin would provoke outrage and censure. Even so, our example makes this important point: A le- gal system can save administrative costs by reducing the probability of liability and off- setting this fall with an increase in damages. Chapter 13 returns to the equivalent point in criminal law when we discuss criminal fines rather than civil liability. Q UESTION 7.3: Use the economic theory of bargaining to characterize the torts in which the transaction costs of settling disputes are likely to be large. Hint ( : Recall the distinction between public bads and private bads.) For which liability standard would you expect the litigation 7.4: UESTION Q costs to be greater—negligence or strict liability? Why? Is that an additional efficiency argument for preferring one standard to the other? 6. Conclusion Ta ke n a l t o g e t h e r, w h a t i s t h e u l t i m a t e r e s u l t o f r e l a x i n g t h e c o r e assumptions for the conclusions of the previous chapter? Perhaps somewhat surpris- ingly, the conclusions of the economic model survive almost intact. We have seen that relaxing the rationality assumption may be warranted, and that where it is relaxed, the economic theory helps us to see how tort law ought to take into account the cognitive imperfections of those whose behavior it seeks to affect. We also saw that relaxing the assumption that there is no first- or third-party insurance does not change the results of the economic theory of tort liability. Coinsurance, deductibles, subrogation clauses, and the implied threat of higher premiums or of policy cancellations preserve the incentives of potential injurers to take optimal care and of potential victims (through their insur- ers) to bring actions in order to induce potential injurers to internalize the social costs of their carelessness. Nor does the presence of other social policies, such as safety reg- ulation, necessitate our changing any of the economic conclusions. These alternative social policies require some account of how best to coordinate tort liability and safety regulation, and that coordination is likely to require an understanding of the economic does not necessitate that litigation is costly tradeoffs involved. Finally, the fact a change in our economic model. Rather, we have seen that costly litigation points in different 19 See David Rosenberg & Steven Shavell, A Simple Proposal to Halve Litigation Costs , 61 V A . L. R EV . 1721 (2005).

259 244 CHAPTER 7 opics in the Economics of Tort Liability T directions: On the one hand, it may induce potential victims not to file actions (thus allowing potential injurers not to bear the full costs of their carelessness and inviting them to take less care in the future), but, on the other hand, it may induce potential in- jurers to take more care (if taking additional care makes accidents less likely or less severe and is cheaper than the costs of litigating). B. Extending the Basic Model The economic model that we have been exploring in this and the previous chapter explains not just the broad questions of tort liability’s purposes and the differences be- tween negligence and strict liability, but it also helps us to understand some of the more special doctrines of tort liability. In this section we shall show how the economic the- ory applies to certain special cases—for example, the liability of employers for the torts of their employees—and to some issues at the frontiers of tort liability. 1. Vicarious Liability There are circumstances in which one person may be held responsible for the torts committed by another. Where this happens, the third party is said to be for the tortfeasor’s acts. Vicarious liability may extend vicariously liable from an agent to his or her principal or from a dependent child to a parent, but by far the most common instance of vicarious liability is that of employers’ responsibility respondeat superior for the tortious wrongs of their employees under the doctrine of (“let the master answer”). The bare bones of this doctrine are that an employer will be held to answer for the unintentional torts of an employee if the employee was “acting within the scope of [his or her] employment.” To illustrate, an employer tells an em- ployee never to drive the company’s truck faster than the speed limit. The employee speeds, and the truck has an accident. The employer is liable. Does induce efficient behavior by employers and employees? respondeat superior The rule creates an incentive for the employer to take care in selecting employees, in assigning them various tasks, in deciding with which tools to equip them, in training them, in monitoring them, and more. This is efficient if it is the case—as it generally would seem to be—that employers are better placed than are employees to make pre- 20 cautionary decisions. In discussing tort liability, we often distinguish between two rules: strict liability and negligence. Our analysis of the difference applies to vicarious liability. Under a rule of strict vicarious liability, the employer is liable for harms caused by an employee. Under a rule of negligent vicarious liability, the employer is liable for harms caused by of an employee. A switch from negligence to strict liability light- negligent supervision ens the plaintiff’s burden of proof. To illustrate, a careless nurse employed by a hospital harms a patient. To recover damages from the hospital under a rule of strict vicarious liability, the patient must prove that someone in the hospital caused the harm, which is relatively easy. To recover damages from the hospital under a rule of negligent vicarious liability, the patient must prove that the hospital negligently supervised the nurse, which 20 For a full discussion of the economics of this issue, see Alan Sykes, The Economics of Vicarious Liability, ALE L. J. 1231 (1984). 93 Y

260 I. Extending the Economic Model 245 is relatively hard. You already encountered this argument in favor of strict liability when we discussed consumer product injuries. We h ave g ive n a n i n f o r m a t i o n - c o s t a rg u m e n t f o r favo r i n g a r u l e o f s t r i c t v i c a r i o u s liability for employers rather than a rule of negligent vicarious liability. Another argu- ment goes in the opposite direction. To illustrate, a sailor on a tanker might negligently discharge oil onto a public beach at night. Informing the authorities quickly about the accident will reduce the resulting harm and the cost of the cleanup. The captain of the ship might be the only person besides the sailor who knows that the harm occurred or who can prove that pollution came from its ship. Strict vicarious liability gives the cap- tain an incentive to remain silent in the hope of escaping detection. In contrast, a rule of negligent vicarious liability gives the captain an incentive to reveal the harm to the authorities immediately. As long as the captain can prove that he carefully monitored the sailor, the rule of negligent vicarious liability allows the captain to escape liability. As compared to a rule of strict vicarious liability, a rule of negligent vicarious liability 21 encourages employers to report more wrongdoing by employees. Q 7.5: What if an accident has occurred because an employee was UESTION performing a job for which he was not qualified after the employee had falsely told the employer that he qualified? Should the employer still be liable for was respondeat superior the victim’s losses under ? Q UESTION 7.6: The common law did not hold parents liable for their chil- dren’s unintentional torts unless the parents’ negligent supervision led directly to the tort. But the common law did hold husbands vicariously liable for their wives’ torts (a rule since abrogated by statute). Can you provide an efficiency explanation for these common law rules? Q 7.7: In many states, a bartender (under so-called “dram shop UESTION laws”), friend, party host, or other person who serves liquor to an already- intoxicated person may be held vicariously liable for any damages that person subsequently inflicts on other people or their property. Does this form of vi- carious liability make economic sense? 2. Joint and Several Liability With and Without Contribution When several parties cause harm to someone, a question arises concerning whom the victim can sue and how damages should be allocated among them. To illustrate, suppose that you suffer a loss of $100 in an accident caused by two people called A and B. They are jointly liable if you can sue both of them at once, naming A and B as codefendants and receiving a judgment of $100 against them. They are liable if you can sue severally either A or B separately, naming each of them as a defendant in a distinct trial and re- covering $100 from each. 21 Jennifer Arlen & Reinier Kraakman, Controlling Corporate Misconduct: An Analysis of Corporate EV . 687 (1997). Liability Regimes, 72 NYU L. R

261 246 CHAPTER 7 opics in the Economics of Tort Liability T Suppose that the plaintiff chooses to recover from only one of several injurers. May that defendant then force the other injurers to contribute to paying the damages? At com- mon law for unintentional torts, the defendant did not generally have a right to contribution, as this is called, from other joint tortfeasors. This harsh rule against contribu- tion has been abrogated, usually by statute but sometimes by judicial decision, in almost 22 all the states. The law usually subtracts the contribution of one party from the compen- sation owed by the other. For example, if A and B jointly cause you harm equal to $100 and you settle with A for $40, then the upper limit on a trial judgment against B is $60. Defendants are said to be “jointly and severally liable” if each of them is liable for all the victim’s full losses, not just a portion of them. The plaintiff may proceed jointly against all his injurers or may elect to recover all damages from only some of them or only one of them. (Typically, the plaintiff proceeds against the defendant or defendants who have “deep pockets,” that is, the resources to compensate him.) In the United States, the actual law in most cases involving multiple injurers is “joint and several lia- bility with contribution.” Because liability is “joint and several,” the plaintiff can sue the injurers jointly or separately, as he prefers. Because the law allows “contribution,” the recovery is limited to 100 percent of the value of the harm. (The common law rec- 23 ognized two circumstances in which joint and several liability would hold.) There are several economic reasons for joint and several liability. One is that it re- lieves the victim of the potentially high costs of proving who caused her harm. The doctrine allows the victim to assert that one of these people, and perhaps many of them, caused her injuries without incurring the special costs of showing which one or more of them were responsible and in what proportion. In essence, the doctrine shifts the costs of establishing exactly what happened to the defendants. Imagine a situation in which a patient is anesthetized and taken into surgery. During the operation someone injures the patient. Later she sues all those who were in the operating room, but for ob- vious reasons she cannot tell who precisely caused her injury. Another economic reason for joint and several liability is that it makes the victim’s recovery more certain by allowing him to proceed against the defendant or defendants who have the most assets with which to pay damages. Suppose that an uninsured mo- torist is going at high speed, strikes a pothole in the road, loses control of his car, and hits another passenger car, seriously injuring its driver. Assume for the sake of argument that 90 percent of the fault is attributable to the speeding driver, and 10 percent of the fault is attributable to the city government for not filling the pothole. The victim will have difficulty recovering anything from the speeding driver because he lacks insurance and may have limited resources. However, if the law allows the victim to hold the 22 This is true only for unintentional torts; for intentional torts, such as a violation of the antitrust statutes, there is still no right of contribution among joint tortfeasors. 23 First, the defendants acted together to cause the victim’s harm, as when two cars driven by A and B are racing down a street and one of them hits C, a pedestrian. The two drivers acted together by illegally rac- ing each other. Second, the defendants acted separately, but victim’s harm was indivisible between them. Thus, two hunters using identical ammunition fire at a pheasant and both of them accidentally hit a third person. They acted separately to cause the harm, but no one can disentangle the harm caused by one of them from the harm caused by the other.

262 I. Extending the Economic Model 247 motorist and the city jointly and severally liable, and if the victim can prove that the city was negligent in maintaining the road, then the victim can recover 100 percent of his losses from the city. The city then faces the hopeless task of trying to recover 90 percent of the damages it paid from the speeding driver who lacks insurance and resources. Another economic issue concerns contribution and efficiency. Is a rule of contribu- tion or no contribution more efficient? The no-contribution rule makes all defendants internalize the cost of accidents, thus creating incentives for optimal precaution by each of them. In contrast, the rule of contribution causes each defendant to internalize part of the cost of accidents and to externalize part of the cost. Because costs are partly ex- ternalized, the rule of contribution may not create incentives for optimal precaution by each defendant. To illustrate, in the example where A and B race their cars and strike C, optimal incentives require A to bear the full cost of the accident and B to bear the 24 full cost of the accident. Although the rule of no-contribution creates efficient incentives for precaution by joint injurers, it can also, as we have noted, change reluctant victims into eager victims. For example, if C receives perfectly compensatory damages from A, then C is indiffer- ent between no accident and an accident. If C receives perfectly compensatory damages from A and also from B, then C prefers an accident to no accident. Perhaps the phenom- enon of eager victims explains why law favors contribution rather than no contribution. Many states have reformed joint and several liability to reduce the ability of the victim to recover all the costs of the injurer from the injurer with the deep pockets. After these reforms, the victim must recover some damages from injurers with shallow pockets. A careful econometric study found that these reforms caused reductions in the accidental death rate in the United States. The authors’ explanation is that reforms in- crease the incentives for precaution by injurers with shallow pockets, and their precau- 25 tion reduces accidents the most. Web Note 7.3 When there are multiple defendants, it sometimes happens that one or more of the defendants make an agreement to settle their claims with the plaintiff and then keep the existence of that agreement secret from the other defendants. Such agree- ments are called “Mary Carter agreements” after the case in which they first arose. See our website for a history and economic analysis of Mary Carter agreements. Web Note 7.4 We d e s c r i b e s o m e r e c e n t e m p i r i c a l l i t e r a t u r e o n “ h i g h - l ow a g r e e m e n t s ” between plaintiffs and defendants. 24 Multiple Tortfeasors: An Economic Analysis, 9 J. L EGAL S See Landes & Posner, .517 (1980); and TUD Polinsky & Shavell, Contribution and Claim Reduction Among Antitrust Defendants: An Economic Analysis, 33 S TA N . L. R EV . 447 (1981). 25 Accidental Death and the Rule of Joint and Several W. B e n t l e y M a c L e o d , J a n e t C u r r y, & D a n i e l C a r v e l l , Liability , B ERKELEY (October 29, 2009). AW A N D E CONOMICS W ORKSHOP L

263 248 CHAPTER 7 opics in the Economics of Tort Liability T 26 In the pre- 3. Evidentiary Uncertainty and Comparative Negligence vious chapter we discussed the several forms of the negligence rule: simple negligence, negligence with contributory negligence, and comparative negligence. For most of the last 200 years, negligence with contributory negligence has been not only the dominant form of the negligence rule but the dominant tort liability rule in the common law coun- tries. However, within the last 40 years all this has changed. Today, all but a handful of the states in the United States have altered their law of accidents so that the prevailing liability standard is one of comparative negligence for non-product-related torts. The change has been effected principally by statute, with a minority of states adopting the rule by judicial decision. In most civil law jurisdictions of Europe, the principle of comparative negligence was adopted long before the United States made this change. In this section we shall explain briefly how the comparative-negligence rule works and how it differs from the rule of negligence with contributory negligence. Then we shall show how something called “evidentiary uncertainty” can give rise to an efficiency ar- gument for comparative negligence. The simple reason for the rise of comparative negligence is an increasing dissatis- faction with the rule of contributory negligence. Recall that a contributorily negligent plaintiff could not recover anything from the defendant, even from a negligent defen- dant. This rule struck most people as exceedingly harsh. To see why, imagine that an automobile accident has occurred; both the plaintiff and the defendant were driving. Suppose that violation of the speed limit constitutes negligence and that the evidence shows that the plaintiff was going 35 miles per hour in the 30 mile-per-hour zone and that the defendant was going 65 miles per hour in that same zone. Under the rule that bars recovery for a contributorily negligent plaintiff, the plaintiff will not be able to re- cover. This seems harsh in that the plaintiff’s negligence was trivial in comparison to the defendant’s. To avo i d t h i s s o r t o f h a r s h r e s u l t , m o s t j u r i s d i c t i o n s f o u n d a m e a n s o f l i m i t i n g t h e scope of the rule of contributory negligence—for example, by means of the last-clear- 27 But eventually these limitations on the application of the rule of con- chance doctrine. tributory negligence gave way to comparative negligence. The principal difference between comparative negligence and the rule of negli- gence with contributory negligence is that under comparative negligence the plaintiff’s contributory fault is a partial but not a complete bar to recovery from a negligent defen- dant. Thus, under comparative negligence the negligent injurer usually owes some- 28 thing, but not full compensation, to the negligent victim. The equitable argument is the principal justification for the switch to compara- tive negligence. However, there are economic efficiency arguments that can be made on behalf of comparative negligence. To make these arguments requires relaxing at 26 The material in this section draws on Cooter & Ulen, 61 An Economic Case for Comparative Negligence, EV . 1067 (1986). NYU L. R 27 Each of these limitations allowed an otherwise contributorily negligent plaintiff to recover all losses. Note how this differs from the result under comparative negligence described below. 28 There are three different forms of comparative negligence: pure, modified, and slight-gross. These are extremely interesting but are not central to our economic analysis.

264 I. Extending the Economic Model 249 least one of the core assumptions that we made in the previous chapter. Recall that all the basic economic theory of tort liability of Chapter 6 showed that forms of the negligence rule (simple, contributory, and comparative negligence) were equally effi- cient. The only way we can draw efficiency distinctions among them is to relax one of the core assumptions. Suppose that, in a negligence case, we assume that litigation is costly in the sense that it is not certain how the court will evaluate the evidence de- veloped at trial. Thus, neither the plaintiff nor the defendant can be certain whether the court will determine that their precautionary behavior was sufficient to absolve one of them of fault. It is possible, for example, that the court will determine that the precaution of one of the parties was insufficient, even though that party thought that he or she had complied with the relevant duty to take due care. Or the court may find one of the parties nonnegligent when in fact the party was violating the legal stan- dard of care. We may call this condition “evidentiary uncertainty.” These possibilities of error may influence the precautionary decisions of a po- tential injurer. We assume, as seems realistic, that the probability that potential in- jurers will be found not liable increases as their precaution increases. Figure 7.2 shows the impact of this fact on expected costs. The effect of evidentiary uncertainty is to smooth the discontinuity in expected liability at the (presumed) legal standard that we developed in Chapter 6. Smoothing occurs because injurers’ expected costs are a weighted average of their costs when liable and their costs when not liable, with the weights given by the probability that they will be found liable. The effect is indicated in Figure 7.2 by the sloping curve that connects the expected-cost curve and precautionary-cost line. Uncertainty about the court’s assessment of a party’s precautionary level with regard to the legal standard of care induces most injurers to take more precaution than is prescribed by the legal standard of care. In effect, they give themselves a margin of error to be sure that they avoid liability. This behavior is represented in Figure 7.2, which illustrates the fact that an injurer’s costs are min- + imized on the smoothed curve at , which is a higher level of precaution than the x *. legal standard x $ FIGURE 7.2 Evidentiary uncertainty smooths the discontinuity at the legal standard of care and induces extra precaution by x ) wx + p ( x ) A ( the potential injurer. wx ( p ( x ) A ) x 0 x * + x x

265 250 CHAPTER 7 opics in the Economics of Tort Liability T Evidentiary uncertainty causes potential injurers to go beyond the level of precau- 29 tion that might just barely exonerate them. That is, evidentiary uncertainty will cause overprecaution relative to the efficient level of precaution. This result is true under any form of the negligence rule. What efficiency advantage, if any, does comparative negligence provide when there is evidentiary uncertainty? The overprecaution caused by evidentiary uncertainty is less under comparative negligence than it is under any other form of the negligence rule. The simple reason is that under comparative negligence, if either party makes a mistake in choosing the level of precau- tion that is necessary to satisfy the legal standard of care, the consequence of that mis- take is not visited entirely on the person who made it, as it would be under any other form of the negligence rule, because, under comparative negligence, the losses are shared between the two parties rather than being concentrated on one party. One frequent criticism that is made of comparative negligence is that its admin- istrative costs are high. The rules to be used in apportioning fault are vague, it is said, even when the parties are engaged in the same activity: No one is quite sure how to apportion fault when A was going 45 in a 30 mile-per-hour zone and B was going 60. But things are even worse when the parties are engaged in different activities. How, for instance, would you have apportioned fault in Butterfield v. Forrester, the case in Chapter 3 involving an obstruction in the road left by Forrester and a negligent horse- man, Butterfield, who crashed into the obstruction? Given this difficulty, it is alleged that litigants and juries will spend inordinately large amounts of effort trying to establish exact percentages of fault when such exactitude is impossible to achieve. There may be some truth in the contention that comparative negligence has high administrative costs. If so, there is a balance to be struck between the efficiency gains of comparative negligence and these administrative costs. Until we can examine care- ful empirical studies, we cannot say whether there is a net efficiency gain from moving to this new liability standard. Web Note 7.5 There has been considerable writing about the economics of comparative neg- ligence. We review that literature on our website. Q UESTION 7.8: Admiralty law—the law that deals with controversies aris- ing on navigable waters—used a rough-and-ready method of dealing with the problem of the administrative costs of comparative negligence. Rather than try to fine-tune the degrees of culpability between the contending parties, admi- ralty law simply split the losses 50-50 whenever there was negligence on the part of both parties. Comment on the efficiency of this method of reducing the administrative costs of comparative fault. Would you recommend that the ad- miralty rule be adopted in apportioning losses in, say, automobile accidents where both parties are at fault? Why or why not? 29 This is an instance of the point we made earlier in this chapter—namely, that the prospect of costly litiga- tion will induce potential injurers to take more precaution than they would otherwise. A little extra precau- tion makes an accident (and thus, a lawsuit) less likely.

266 I. Extending the Economic Model 251 Incentives for Invisible Actors How can authorities create incentives for someone who is invisible to them? The State of Florida has a clever solution. Florida farmers fertilize their fields with phosphorus, which rain carries into that massive, marvelous, fragile swamp called the Everglades. To control phospho- rus, regulators have adopted a novel incentive system. Beginning in 1995–1996, phosphorus loadings are compared to a baseline derived from loadings recorded from 1979–1988. If basin-wide reductions in nutrient load into the Everglades do not meet statutory targets, all of the farmers in a designated area must pay the “Agricultural Privilege Tax.” The farmers can escape the tax increase by exceeding an overall 25 percent basin-wide phosphorus reduction goal. Under this system, each farmer’s abatement efforts reduce his own liability (and the lia- bility of every other farmer) by the resulting reduction in pollution. Each farmer, consequently, internalizes the marginal benefits and costs of abatement, as required for efficiency. This incentive system is remarkable in two ways. First, each farmer has incentives for effi- The au- without the authorities knowing how much any one of them abates. cient abatement farmers. Second, if the authorities have all thorities only need to know the total abatement by chosen the phosphorus reduction goal correctly, the farmers will continue abating until they Theorists describe this approach as none of the farmers will actually pay the tax. reach it; so, “Total liability” refers to the fact that each actor’s a rule of total liability for excessive harm. actors cause. “Excessive harm” refers to the fact that all liability depends on the harm that 30 liability applies to the amount by which the harm caused by all actors a baseline. exceeds Fifty years ago products liability was a minor part of tort 4. Products Liability law, but recently it has become a large and important specialty and the focus of much of the public dissatisfaction with the entire tort liability system. The liability standard 31 in product-related accidents is called “strict products liability.” For a defendant- manufacturer to be held liable under this standard, the product must be determined to be defective. A defect can take three forms: A defect in design, as would be the case if the design of automobile gas 1. tanks made them liable to rupture and explode (see our website for more information); 2. A defect in manufacture, as would be the case if a bolt were left out of a lawn mower during its assembly, causing a piece of the mower to fly off and injure a user; and A defect in warning, 3. as when the manufacturer fails to warn consumers of dangers in the use of the product. What liability standard would economic theory recommend for product-related hether accidents? Recall that our discussion of negligence and strict liability focused on w precaution for reducing the likelihood and severity of the accident is unilateral or 30 Robert Cooter & Ariel Porat, To t a l L i a b i l i t y f o r E x c e s s i v e H a r m , 36 J. L EGAL S TUD . 63 (2007). 31 ) ESTATEMENT (S ECOND R OF T ORTS (1965), §402A, published by the American Law Institute, lays out this standard.

267 252 CHAPTER 7 opics in the Economics of Tort Liability T bilateral. If it is bilateral (that is, if both parties can take precautionary action to reduce the probability and severity of an accident), then a form of the negligence rule is the appropriate standard. If precaution is unilateral (that is, if only the in- jurer can be looked to for actions to reduce the probability and severity of an acci- dent), then strict liability is the appropriate liability standard. Using this economic analysis, which standard would modern products-liability law apply? The more efficient standard would seem to be strict liability because in most in- stances of product-related harms, for clarity precaution lies unilaterally with the manu- facturers. It is they who are in control of the design of the products and of the manufacturing process and who are most likely to be aware of any special dangers that their products present and, therefore, can most efficiently convey information about those dangers through warnings. However, on further reflection, one finds elements of precaution in the bilateral Users can also take precautions to reduce the probability product-accident situation. and severity of accidents. For example, they can pay heed to the warnings and use the products only for their intended uses. There are stories about some consumers picking up their gasoline- or electric-powered lawn mowers and turning them sideways in order to trim their hedges, and being injured as a result. No manufacturer intends a lawn mower to be used in that fashion. Products-liability law can steer a middle course between the view that precaution is unilateral (and, therefore, that strict liability is the appropriate standard) and the view that precaution is bilateral (and, therefore, that negligence is the appropriate standard). It can do so by holding defendant-manufacturers strictly liable for defective design, manufac- ture, or warning but allowing them to escape liability if the victim voluntarily assumed the risk of injury or misused the product. These defenses encourage the efficient alloca- tion of risk of loss from product-related injuries between the consumer and manufacturer. If the lawn mower manufacturer could not exclude liability for consumer misuse or for voluntarily assumed risk, it would be forced to insure each of its consumers. To cover the cost of this insurance policy, the manufacturer would have to raise the prod- uct price. The difficulty with this result is that all consumers must pay the higher price, not just those who are careless. Consumers who are careful would prefer to pay a lower price for the product and to purchase insurance against loss elsewhere. We h ave d i s c u s s e d a l l ow i n g m a n u fa c t u r e r s t h e d e f e n s e o f c o n s u m e r m i s u s e o f d e - fective products. In practice, a more decisive consideration is often the information that the court uses to decide whether a product has one of these defects. The court can ei- ther use the information available when the product was manufactured or when the case was tried. In the mean time, scientific progress uncovers much about risk that was pre- viously unknown. Asbestos was originally celebrated as a lifesaver that miraculously protects people from flames, and later it was vilified as a deadly cause of lung cancer. A company that manufactured asbestos insulation for ships in 1947 did not produce a product known to be defective at the time, but the product was shown to be defective by 1977 when a worker brought suit. In the United States, courts have found asbestos to be defective by using the scientific knowledge available at the time of trial, thus holding the manufacturer liable for harm that it could not have foreseen by using the scientific knowledge available at the time of manufacture. Products liability is most

268 II. Computing Damages 253 “strict” when, besides disallowing manufacturers’ defenses of reasonable care, the law also holds products to a standard of defect based on science available at trial and un- available at manufacture. Q UESTION 7.10: Some scholars discern a trend in modern products-liability law toward absolute liability or what is sometimes called “enterprise liability.” Under that theory, manufacturers would be held liable for almost every injury resulting from the use of their outputs. Give an economic analysis of that lia- bility standard for product-related harms. II. Computing Damages In the previous chapter we noted that the ability of liability rules to induce efficient precaution depends in part on the ability of the court to award truly compensatory dam- ages to the victims of a tort. These damages accomplish two things simultaneously: First, they put the victim back onto the utility level or indifference curve occupied be- fore the tortious act, and second, they are the “price” that the injurer must pay for hav- ing harmed the victim. In this section we elaborate the ways in which microeconomics can help to determine the appropriate amount of damages. Additionally, we use micro- economics to discuss the efficiency aspects of punitive damages in tort awards. A. Hand Rule Damages Compensatory damages are intended to “make the victim whole.” In some circum- stances, this is impossible. For example, when a child is killed in a tortious accident, damages cannot be computed on the formula, “find a sum of money such that the par- ents are indifferent between having the money and a dead child, and not having the money and having their child alive.” The same difficulty arises in a more attenuated form for irreparable physical injuries, such as those resulting from a crippling accident. There are, in fact, two distinct concepts of compensatory damages in tort law. One concept is the standard economic concept of indifference: Compensation is perfect when the victim is indifferent between having the injury and the damages, and having neither. Compensatory damages are thus perfect when the potential victim is indiffer- ent about whether there is no accident or an accident with compensation. This concept is relevant for injuries in which a substitute for the lost good is available in the market. When a substitute is available, the market price of the substitute measures the value of the good to the plaintiff. This concept is also relevant for goods that are bought and sold from time to time but for which there is no regular, organized market. For example, a handwritten letter by James Joyce and a 1957 Chevy convertible are sold from time to time, but these items are so rare that a regular market for them does not exist. The own- ers of these rare goods usually have prices at which they are prepared to sell them, and 32 these prices measure perfectly compensatory damages. 32 Economists use the term “reservation price” to refer to the minimum price at which the owner of a good is willing to sell it. Determining the owner’s reservation price for a unique good is a difficult practical prob- lem, but it is not a problem conceptually.

269 254 CHAPTER 7 opics in the Economics of Tort Liability T This concept of perfect compensation, based on indifference, is fundamental to an economic account of incentives. If potential injurers are liable for perfectly compensa- tory damages, then they will internalize the external harm caused by accidents. And this creates incentives for the potential injurers to take efficient precaution. Compensation of this kind is most easily computed for those losses for which there is a ready market substitute. But for some tortious injuries there is no ready market substitute. For example, there is no price at which a good parent would sell a child. The idea that a person could be “indifferent” between a sum of money and a child is repugnant. And, for some peo- 33 ple, there may be no price at which they would sell an arm or a leg. So, for injuries involving the loss of a child or a limb, compensation simply cannot be perfect. Courts must, nevertheless, award damages for the wrongful death of a child or for grievous personal injuries. Our task, then, is to provide a more satisfactory understanding of their computation. When U.S. courts award damages for incompensable losses, such as the death of a child, juries usually set the amount. Unfortunately, judges provide juries with no coher- ent instructions for how to compute damages. To illustrate, the recommended jury instruction for Massachusetts reads: Recovery for wrongful death represents damages to the survivors for the loss of value of decedent’s life. . . . There is no special formula under the law to assess the plain- tiff’s damages. . . . It is your obligation to assess what is fair, adequate, and just. You must use your wisdom and judgment and your sense of basic justice to translate into dollars and cents the amount which will fully, fairly, and reasonably compensate the next of kin for the death of the decedent. You must be guided by your common sense and your conscience on the evidence of the case. . . . It is common sense that money cannot compensate for a loved one’s death, so how is common sense supposed to lead the jury to a dollar value? Rather than common sense, the California jury instructions refer to “reasonableness”: Also, you should award reasonable compensation for the loss of love, companionship, comfort, affection, society, solace or moral support. If no amount of money can compensate for loss of a loved one, then adding “reasonable” to “compensation” deepens the puzzle rather than clearing it up. Besides courts, regulators must assign value to loss of life for purposes of cost- benefit analysis. Unlike court practice, the regulators have some clear methods devel- oped by economists. We will describe such a method and explain its modification for use by courts. A necessary part of living is being exposed to the risk of death or serious injury. For example, flying on an airplane or driving down the expressway involves such a risk. These risks can often be reduced, but doing so is costly. To illustrate, we may note that airplanes must be inspected and repaired at regular intervals, which is costly, but the 33 For some people, there may be an amount of money at which selling an arm is an attractive bargain, but their concept of morality would not permit them to do it.

270 II. Computing Damages 255 shorter the intervals, the fewer the accidents. Similarly, heavy cars with special safety features provide extra safety to passengers. But these cars are more expensive to pro- duce and, therefore, more costly to consumers. When a parent decides what features of a car to buy or a commercial air carrier decides how frequently to inspect planes for safety, a decision is being made that balances the cost of additional precaution against reductions in the probability of injury. A rational decision about these risks involves balancing the costs and benefits of precaution. By reasoning in this way, it is possible to compute damages for the loss of life. To illustrate, we may suppose that the probability of a fatal automobile accident falls by 1/10,000 when an additional $100 is spent on automotive safety. If expendi- tures on automotive safety are rational, then the reduction in the probability of a fatal accident, multiplied by the value of fatal risk, equals the marginal cost of care: = 10,000)(value of fatal risk) > (1 100, or (value of fatal risk) 100 >1 1 > = 2 , 10,000 which suggests that the value of fatal risk is $1,000,000. This method of computing damages for wrongful death, which is called the “value of a statistical life,” takes actual market purchases as a guide to how much the pur- chaser values safety and, by implication, the value of being alive. For example, suppose that a consumer may purchase a safety device, such as an air bag, by paying extra to the retailer. If we know how much the safety device costs the consumer and by how much that device reduces the likelihood of death, then we may infer the consumer’s valuation of safety, which implies a value of fatal risk. Using the figures from the pre- vious paragraph, we may assume that the device costs $100 and that it reduces the like- lihood of death by 1/10,000. (Remember that this implies a $1,000,000 value on being alive.) If consumers purchase the device, then they must value safety at a level that im- plies that the value of fatal risk equals at least $1 million. To a p p l y t h i s m e t h o d i n a l eg a l d i s p u t e , t h e c o u r t s h o u l d c o n s i d e r t h o s e s i t u a t i o n s in which risk is “reasonable” and well known. In those circumstances, there will be p some value for the burden of for the probability of a fatal accident, and some value B precaution. Efficiency requires taking additional precaution until the burden equals the multiplied by the loss L , or (Notice that this is the change in probability p pL. = B Hand rule.) Thus, the court would compute the value of fatal risk by solving the equa- tion for = L p. B L , yielding > Notice that his method uses the Hand rule in an unusual way. In the usual way, the court uses the Hand rule to determine whether the injurer’s precaution satisfied the legal standard. In its unusual use, the decision maker uses the accepted legal standard of care that an individual violated to determine his liability. We have described two distinct methods for computing compensatory damages: the indifference method and Hand rule damages. The first method is appropriate for market goods—that is, for losses for which there is a market substitute; the second method is appropriate when there are legal and moral barriers to such markets. Only when the indifference method is appropriate can damages be perfectly compensatory.

271 256 CHAPTER 7 opics in the Economics of Tort Liability T However, both methods, when applied without error, provide incentives for an efficient level of precaution by potential injurers. Empirical evidence suggests that Hand rule damages are several times higher than the U.S. average for damages that courts award in automobile accident cases involving 34 For example, the National Highway Traffic Safety Administration loss of life. (NHTSA) often values a traffic fatality at $2.5 million. Implementing Hand rule dam- ages would, consequently, cause a significant increase in damage awards and insurance costs for some important kinds of accidents. Hand rule damages would also tend to 35 smooth large differences in damages in individualized cases. Besides bringing coher- ence to legal doctrine, implementing Hand rule damages would provide incentives for more rational safety expenditures and create a safer world. The same accident results in larger damages in the United States than in Germany, and larger damages in Germany than in Japan. Damages cannot be different in similar countries for identical accidents and also be optimal in each country. Substantial re- form seems to be required somewhere. Our view is that substantial reform is required everywhere. Creating a safer society by improving incentives for precaution begins by using economics to think more clearly about the problem. Hand rule damages suggest that damages for personal injuries are mostly too low to deter injurers, even in the United States. This is especially true for automobile accidents and other harms caused by ordinary people, as opposed to harms caused by corporations or governments, where damages are higher. A substantial increase in damages for personal injuries involving automobiles would increase insurance rates, which would reduce the amount of driving and make drivers more cautious. The lack of systematic calculation for damages in per- sonal injury cases in the United States also means that damages vary randomly, which causes liability disparity. Liability disparity is even greater when corporate defendants are held liable for punitive damages, which is our next subject. UESTION Q Victim V works at a job where he might be exposed acci- 7.9: dentally to a chemical that increases the probability from .01 to .02 of dying from lung cancer in 20 years. V would pay $15,000 to avoid exposure to this risk, or he would accept $15,000 to expose himself to this risk. No matter how hard he tries, V cannot imagine any sum of money that he would accept in ex- change for certain death by lung cancer. V’s employer accidentally exposes him to the chemical. The risk materializes after 20 years, and V dies abruptly from lung cancer. How much are Hand rule damages for V’s heirs? After ex- posure and before dying, V spent $1000 to move to another neighborhood with better air quality. Should $1000 be added to Hand rule damages, or is it already implicitly included? 34 See Robert Cooter, “Hand Rule Damages,” conference entitled “Theories of Compensation,” Institute for Law and Philosophy, University of San Diego Law School, February 28, 2003. 35 It is interesting to note that one of the first recorded legal codes, the Code of Hammurabi, stipulates the same amount of damages for the wrongful death of a free man or woman, whereas the individualized system in the United States awards higher damages on average for the wrongful death of a man than a woman.

272 II. Computing Damages 257 Web Note 7.6 There is extensive literature on how regulators and other legal decision mak- ers should place a value on a lost life—referred to as the “value of a statistical life” or VSL. We review that literature, with examples, on our website. Web Note 7.7 Another difficult category of damage to evaluate for the purposes of compen- sation is “pain and suffering.” (We saw earlier in this chapter that there is a principled argument to be made for not awarding pain-and-suffering damages. But most jurisdictions do so.) On our website we report on some recent em- pirical evidence that seeks to understand how jurors make decisions about how much money to award for “pain and suffering.” B. Punitive Damages In 1984 Getty Oil allegedly agreed to sell itself to Pennzoil, but the Texaco oil com- pany encroached on the deal and bought Getty. In a lawsuit a Texas jury awarded $7.53 billion in compensatory damages to Pennzoil and $3 billion in punitive damages. (In the end, the plaintiff settled out of court because the full judgment would have bankrupted the defendant.) Commentators on the case do not agree as to whether the defendant ac- tually committed the wrong, which is unusual and has the name “tortious inducement to breach a contract.” In any case, the award of punitive damages of $3 billion, which broke previous records, was unforeseeable. Earlier we mentioned the problem of liability dis- parity that arises when like cases result in different judgments. Punitive damages are a “Fortunately for My Client, the Victim Died.” Would you rather be dead or crippled? In most tortious accidents, victims and their families prefer the person alive and crippled rather than dead. It is, consequently, worse to cause someone’s death in a tortious accident than to cause him or her to be crippled. Ye t , t h e d e a t h o f t h e v i c t i m c a n b e f o r t u n a t e f o r t h e i n j u re r, b e c a u s e t h e d a m a g e s awarded by courts are often greater when the victim of a tortious accident is crippled than they are when he or she dies. Someone who is injured severely but has a relatively long life still ahead will require extraordinary compensation. The income that the victim can no longer enjoy must be replaced, and the fact that he or she may require constant, expensive medical attention every day must be taken into account in the assessment of damages. By contrast, if the victim is killed, the family (or other dependents) will receive only what they would have received from the victim if he or she had been alive. Thus, if the decedent would have made $100,000 per year for the next 20 years and would have given his or her dependents two-thirds of that income each year, then the dependents are entitled to receive the two-thirds of $100,000 for 20 years, discounted to present value.

273 258 CHAPTER 7 opics in the Economics of Tort Liability T significant source of liability disparity. They cause much uncertainty and fear among corporate and government defendants. We will analyze punitive damages in the hope of understanding them better and seeing how to improve them. Punitive damages are, by definition, damages given to the plaintiff as a way of punishing the defendant. We must begin our economic analysis of punitive damages by answering two questions: 1. Under what conditions might punitive damages be awarded? 2. How is the amount of punitive damages computed? In most states there is a statute describing the conditions under which punitive damages may be awarded. These are usually attempts to state the common law prac- tices actually followed by the courts. According to the usual formulation, punitive dam- ages can be awarded when the defendant’s behavior is malicious, oppressive, gross, 36 willful and wanton, or fraudulent. These statutes merely provide guidelines for awarding punitive damages. Because the guidelines have not been formulated into ex- act rules, there is much uncertainty about when punitive damages can be awarded. Studies in cognitive psychology demonstrate conclusively that people can order acts consistently according to how bad they are, but people cannot attach consistent num- 37 Because moral orderings do not map con- bers to the appropriate level of punishment. sistently into dollar sanctions, the law must devise rules for computing dollar sanctions to avoid arbitrary disparity in the treatment of people. There is much uncertainty concerning how to compute punitive damages under current laws. Statutes typically contain no specific instructions for computing punitive damages. Punitive damages are supposed to bear a reasonable relationship to compen- satory damages and to the ability of the defendant to pay, but the courts have not speci- fied what “reasonable” or “ability to pay” mean in this context. It is uncertain, for example, whether punitive damages may be only double the amount of compensatory damages or up to 1000 times compensatory damages. In several recent cases, described in Web Note 7.9, the United States Supreme Court held that punitive damages that are a double-digit multiple of compensatory damages will attract close scrutiny as possibly being unconstitutionally excessive. Judges apparently have an idea of how much is enough, and jury awards have often been reduced by judges, but there are no rules re- 38 There is a compelling need in torts for garding the computation of punitive damages. a more coherent account of punitive damages, and economic analysis can provide guidelines for the development of this account. 36 The following is the section on “Exemplary Damages” (which is another name for punitive damages) from the C ALIFORNIA C IVIL C ODE , §3294: “For Oppression, Fraud or Malice. (a) In an action for the breach of an obligation not arising from contract, where the defendant has been guilty of oppression, fraud, or malice, the plaintiff, in addition to the actual damages, may recover damages for the sake of the example and by way of punishing the defendant.” (b) That is not much detail to govern actions on which millions of dollars turn. Notice that nothing is said about how to compute punitive damages. 37 Daniel Kahneman, Cass Sunstein, et al., Assessing Punitive Damages, 107 Y ALE L. J. 2071 (1998). 38 See State Farm Mutual Automobile Ins. Co. v. Campbell, 123 S. Ct. 1513 (2003).

274 II. Computing Damages 259 Organizations as Victims Economists routinely impute utility functions to individual consumers and workers. But what if the victim seeking compensation is an organization, such as a partnership, a corporation, a government, or a club? Like individuals, organizations can be regarded as decision makers, and their choices can be regarded as revealing organizational preferences. Like those of an in- dividual, the preferences of a rational organization can usually be represented by a well-ordered utility function. So the question arises, “Can the utility analysis of the idea of compensation be extended to organizations?” In applied welfare economics, benefits or harms to institutions are traced to individu- als, at least in principle. For example, the loss in profits suffered by a business is traced back to a loss in income to the business’s owners. A common practice is to assume a one- to-one relationship between the loss in profits to the organization and the loss in income to individual owners, and to assume that the owners are interested in the business only for the sake of profits. Under these assumptions, the company’s profits “stand in” for the util- ity of affected persons. Because the changes in profits to the business equal changes in in- come to its owners, compensating the organization is equivalent to compensating its owners. In the case of business firms, the conventional assumption in economics is that they max- imize profits. Thus, when a utility function is imputed to a business, it has a simple form: Profits are the only thing that the business cares about. For a business, the fall from a higher indifference curve to a lower indifference curve corresponds to a fall in profits that can be compensated for, when the fall results from another’s wrongdoing, through an award of damages to the business equal to the lost profits. In general, when there is a one-to-one relationship between the loss as measured by the institution’s preferences and the losses to individuals, the institutional preferences can be used as a surrogate for the welfare of affected individuals. However, the extension of the utility analysis of compensation to organizations that are not profit-seeking, such as governments, clubs, and nonprofit corporations, is problematic because there is less agreement about the behavioral theories used in describing them. In the absence of an accepted behavioral theory, there cannot be agreement about how to trace the conse- quences of harm suffered by these organizations back to its effects on the welfare of individuals. To b eg i n t h e e c o n o m i c a n a l y s i s o f p u n i t ive d a m a g e s , l e t u s s u p p l y s o m e n u m b e r s to the situation described in Example 3 of the preceding chapter. F : A manufacturer of a fuel additive for automobile engines is ACTS keeping a careful eye on costs. He can set quality control at a high or a low level. High-level quality control costs $9000 per year and guarantees that the fuel additive is pure and never causes damage to automobile engines. Low- level quality control is costless (thus saving $9000) but results in some batches of the fuel additive’s being flawed. A few of the cars using the flawed batch will be harmed; specifically, the expected damage to cars is $10,000 per year ($1000 in expected damages to each of 10 cars).

275 260 opics in the Economics of Tort Liability CHAPTER 7 T From an economic viewpoint, efficiency requires the manufacturer to make the quality-control expenditures because the company can expect to save consumers $10,000 per year by spending $9000 per year on quality control. Will making the manufacturer strictly liable for compensatory damages produce this result? The answer is “yes” if the tort liability system is perfect, but “no” if it is im- perfect. Suppose that the tort liability system is perfect in the sense that disputes be- tween the manufacturer and consumers can be resolved without cost and error, and damages are perfectly compensatory. With a perfect tort liability system and a rule of strict liability, every car owner harmed by the product will recover from the manufac- turer without having to spend anything to resolve the dispute. The manufacturer thus faces $10,000 in expected liability if he does not take precautions costing $9000. A ra- tional manufacturer maximizes profits net of expected tort liability, so our manufac- turer will set quality control at the high level. But suppose we make the more realistic assumption that the tort liability system works imperfectly. Specifically, let us suppose that for every two consumers whose cars suffer damage, only one actually brings suit and recovers. The other consumer does not sue because she does not know that the fuel additive caused the harm, or she knows and cannot prove it. Call the ratio of compensated victims to total victims, which is 1/2 in this example, the “enforcement error.” Given an enforcement error of 1/2 and assuming the successful plaintiff only receives compensatory damages, the manufacturer’s expected liability will be $5000 if he adopts the low level of quality control. He can, however, save $9000 by reducing his quality control from high to low. So, enforcement error in this example creates a situation in which a profit-maximizing manufacturer, whose expected liability is limited to compensatory damages, will choose low-level quality control, which is inefficient. The efficiency loss due to enforcement error can be offset by augmenting com- pensatory damages with punitive damages. Suppose, as above, that the actual dam- ages are $1000 per car but that the court doubles this compensatory amount so that total damages are $2000 per car. If we call the amount in excess of compensation “punitive damages,” then the punitive damages are $1000 per car. We might also refer to the multiplicative factor by which we adjusted the compensatory damages in order to offset the enforcement error as the “punitive multiple.” In our example, a punitive multiple of two exactly offsets the enforcement error of 1/2 and restores the manufacturer’s liability to the level that would have prevailed under perfect 39 enforcement. 39 Implicit in this argument is the assumption that the rate at which consumers successfully bring suit against the manufacturer does not change when punitive damages are added to compensatory damages. This is a strong and unrealistic assumption. When damage awards are high, victims and their attorneys have stronger incentives to bring action against those who have injured them. This then causes a second-round effect, in that, as the number of actions increases, the enforcement error falls, and therefore the punitive multiple should fall. It is an open question whether the existence of a punitive multiple can increase the number of actions just enough to correct for the inefficiency caused by enforcement error or whether it leads to overenforcement.

276 III. An Empirical Assessment of the U.S. Tort Liability System 261 We can state this method of computing punitive damages more abstractly by using L some notation. Without punitive damages, decision maker’s liability is limited to compensatory damages, A , which are imposed with enforcement error e in the event of an accident. Thus, L = Ae. so that liability is given by the equation m, To o ff s e t t h e e r r o r, i m p o s e t h e p u n i t ive m u l t i p l e Aem. L = By mathematical definition, the “reciprocal” of any value x equals 1/ x. Set the punitive = 1/ Thus, the punitive multiple equal to the reciprocal of the enforcement error: m e. multiple exactly offsets the enforcement error, and the decision maker’s liability . A = L reduces to The law might adopt as a rule that, when punitive damages are awarded, the puni- tive multiple should equal the inverse of the enforcement error. If such a rule were writ- ten into the law, either by statute or by judges, juries would have some guidance in setting the punitive multiple. For example, if there were proof that an injurer had failed to take the appropriate amount of care, because she suspected that only a fraction of those injured would bring an action against her, the court could impose punitive dam- ages in an amount determined by application of a punitive multiple equal to the inverse 40 of the enforcement error. Web Note 7.8 In addition to the Kahneman, Sunstein, et al. piece cited in footnote 36 on page 258, there has been much additional interesting literature on the econom- ics of punitive damages, including an important article by Polinsky and Shavell. We review that literature on our website. Web Note 7.9 The United States Supreme Court has handed down several important recent decisions on the constitutionality of punitive damages. We describe these holdings and relate them to the material of this section on our website. III. An Empirical Assessment of the U.S. Tort Liability System How well does the tort liability system achieve its economic goal of minimizing the social costs of accidents? Many people—including some legislators and other leading de- cision makers—believe that the U.S. tort liability system is chaotic, unfair, and inefficient. 40 A recent opinion by the United States Supreme Court— Philip Morris v. Williams (2007)—seems to sug- gest that the instrumental use of punitive damages that we suggest in this section may be unconstitutional. See Web Note 7.9.

277 262 CHAPTER 7 opics in the Economics of Tort Liability T Their evidence is largely anecdotal, not systematic, but those anecdotes are striking. For example, many people are aware that in the mid-1990s a woman who was scalded when she spilled coffee from a drive-through window at McDonald’s recovered $640,000 in compensatory damages and $2.9 million in punitive damages for her in- 41 juries. And many municipalities are said to have removed play structures and swing sets from their public parks and diving boards from the public swimming pools because of the fear of liability. Congress and many state legislatures consider numerous tort re- form bills each year, all motivated by a desire to reduce high liability insurance costs (triggered, it is said, by adverse liability judgments). Anecdotes should not be the basis for assessing something as complex as the U.S. tort liability system. Such an assessment requires quantitative empirical evi- dence, which is quickly improving but still remains at an early stage of development. We w i l l r ev i ew t h e ev i d e n c e a n d s h ow t h a t t h e U . S . t o r t l i a b i l i t y s y s t e m p e r f o r m s b e t - ter than its harshest critics claim. We begin with some descriptive number and then briefly consider the empirical literature on products liability, medical malpractice, 42 and mass torts. A. Some General Facts About the U.S. Tort Liability System Over the past 150 years the most numerous controversies in federal and state courts arose under contract law. However, some time in the mid-1990s tort cases 43 became the most common form of adjudicated controversy. In the United States, tort law, like contract and property law, is largely state law. And as we have indicated at several points in the text, there are some signifi- cant differences among the states in these substantive areas of law. In one of the most recent assessments of the civil justice system, there were, in 1994, slightly more than 41,000 tort cases resolved in federal district courts (some of which were in federal court on the ground of diversity but were resolved by the federal court by the application of state law). During the same time period there were more than 378,000 tort cases resolved by state courts in the largest 75 counties in the United States. Of these state and federal tort cases, 94 percent involve an individual plaintiff. This is in clear contrast to contract cases, where a significant fraction involve multiple plaintiffs. Slightly more than 60 percent of the tort cases in the 75 largest counties in the United States deal with accidents involving automobiles. The next most common type of tort dispute (accounting in 1992 for just over 17 percent of all tort cases) is 41 Libeck v. McDonald’s Restaurants, P.T.S., Inc., See No. D-202 CV-93-02419, 1995 WL 360309 (Bernalillo County, N.M. Dist. Ct. Aug. 18, 1994). 42 We h ave r e l i e d o n D a n i e l Ke s s l e r & D a n i e l R u b i n f e l d , Empirical Study of the Civil Justice System , in A. M ITCHELL P OLINSKY & S TEVEN S HAVELL , EDS ., H ANDBOOK OF L AW A N D E CONOMICS , V .1 (2007). Also see our website for some additional material on the empirical assessment of the tort liability system. 43 See our discussion of other trends in litigation in the last part of Chapter 11.

278 III. An Empirical Assessment of the U.S. Tort Liability System 263 that arising from “premises liability” for, say, slips and falls or other injuries at resi- dences, governmental offices, or commercial establishments. The third most common form of tort case is medical malpractice, accounting for just under 5 percent of all 44 torts. And the fourth is products liability, accounting for 3.4 percent of the total. Critics of the tort liability system in the United States contend that juries award puni- tive damages too often and too liberally and that judges do little to restrain these punitive awards. However, punitive damages are extremely rare. In all product-liability cases be- tween 1965 and 1990 there were only 353 punitive awards, and those averaged $625,000 (in 1990 dollars). Appellate panels reduced many of these punitive awards so that, after appeal, the average fell to $135,000. More than 25 percent of those 353 awards involved asbestos. Over the entire period there was an average of 11 punitive-damages awards per year in product-liability cases in all state and federal courts. A careful study of punitive damages in product-liability cases found that at the trial level the ratio of punitive to com- pensatory damages was 1.2 to 1; in more than one-third of the cases in which punitives 45 More than half were awarded, compensatory damages were larger than the punitives. the states prohibit or cap punitive damages or raise the evidence standard that must be 46 met before they can be awarded. Recall that the usual standard in civil actions is “pre- ponderance of the evidence,” which is generally taken to mean 51 percent believability. The “clear and convincing” evidence standard is more demanding, but not as demanding as the criminal law’s standard of “beyond a reasonable doubt.” The theme of much of the empirical literature is that the tort liability system (perhaps in conjunction with the administrative agency regulatory system) works rea- sonably well at deterring accidents. In most situations in which accidents might hap- pen, the recent trend in the United States has been toward fewer and less severe accidents. For instance, the number of motor vehicle deaths and injuries peaked around 1970 and has declined ever since. The death and injury per capita has rate shown a dramatic drop. Web Note 7.10 A central issue for the economic analysis of tort law is the extent to which expo- sure to tort liability induces parties to behave in an efficient manner. In the last few years there has been an outpouring of scholarship designed to explore this matter with careful empirical studies. We review this literature on our website. 44 We w i l l s e e i n C h a p t e r 1 1 t h a t t h e r e i s ev i d e n c e t o s u g g e s t t h a t t h e t o t a l n u m b e r o f t r i a l s o f a l l k i n d s h a s been declining in the United States. We will also consider some additional facts about litigation, such as the success rate of plaintiffs in different kinds of actions. To the extent that there is specific information about success in torts cases, we will describe it in the next two sections of this chapter. 45 Michael Rustad, Demystifying Punitive Damages in Products Liability Cases: A Survey of a Quarter Century of Verdicts, The Roscoe Pound Foundation (1991). 46 Twelve states require a “clear and convincing” evidence standard for punitive damages but do not limit the amount. Another twelve states cap the amount of damages and require the “clear and convincing evidence” standard. Seven states require a portion of the punitive award to be paid to the state. Four states prohibit punitive-damages awards.

279 264 CHAPTER 7 opics in the Economics of Tort Liability T B. Medical Malpractice Even though disputes about iatrogenic injuries (those arising in the course of health care delivery) are a relatively minor portion of all tort cases (accounting for about 5 per- cent of the total), there has been a great deal of concern about medical malpractice liti- gation. And with some justification. The Institute of Medicine reported in 2000 that 47 medical errors are the “leading cause of accidental death in the United States.” Exact figures are hard to pin down, but estimates made in 1997 range from 44,000 to almost 100,000 deaths per year. “Medication errors alone account for approximately 7000 48 juries.” A com- deaths per year, exceeding the number of deaths due to workplace in year in the 1980s prehensive study of hospital admissions in New York State during 1 49 found that 1 percent of admissions involved serious injury due to negligent care. The most careful studies of medical malpractice litigation indicate that the “num- ber of malpractice claims per physician and the award paid per claim increased rapidly in the United States from the 1960s to the 1980s. Claim frequency increased at more than 10 percent per year, reaching a peak of 17 claims per 100 physicians in 1980s. 50 Aw a r d s p a i d p e r c l a i m i n c r e a s e d a t r o u g h l y t w i c e t h e r a t e o f i n f l a t i o n .” There is some evidence to suggest that in at least some jurisdictions the rate of increase of both claims against physicians and award levels ceased or slowed significantly in the 1990s and re- mained at those lower levels through the early 2000s, perhaps as a result of statutory reform, which we will discuss at the end of this section. The tort liability system should provide an incentive for physicians and other health care professionals to take precautions against injuries. Are the incentives currently pro- vided by the system deficient, efficient, or excessive? With current evidence, we can only speculate. Physicians have monetary incentives to be careful when they bear the cost of the accidents that they cause. Liability insurance transfers the cost of accidents caused by physicians to the insurer. The insurance rates paid by individual physicians bear respond only weakly to the history of tort claims against them, so physicians may 51 Furthermore, a study of New York only a fraction of the costs of patient injury. State hospital patients by Weiler found that only about 10 percent of those who were injured—even seriously—filed a complaint against their health care provider. These facts suggest that monetary incentives for care by physicians are deficient. Evidence about “defensive medicine” can be interpreted as implying the opposite con- clusion. This phrase refers to procedures and treatments motivated by reducing liability 47 ANET C ORRIGAN , L INDA T. K OHN , & M OLLA S. D AV I D S O N J O E RR IS H UMAN : B UILDING A S AFER H EALTH , T S YSTEM (2000). 48 See Daniel Kessler in the Winter 2000 edition of the NBER Reporter , available at reporter/winter00/kessler.html. 49 EWHOUSE AUL EILER , H OWARD H IATT , J OSEPH P See P C. W , W ILLIAM G. J OHNSON , T ROYEN A. B RENNAN , & . N L UCIAN L. L EAPE , A M EASURE OF M ALPRACTICE : M EDICAL I NJURY , M ALPRACTICE L ITIGATION , AND P AT I E N T C OMPENSATION (1993). 50 . N , in A. J. C ULYER Patricia Danzon, OSEPH P Liability for Medical Malpractice EWHOUSE , E DS ., & J H ANDBOOK OF H EALTH E CONOMICS , V . 1B (2000). 51 . Experience Rating: Does It Make Sense for Medical Malpractice Insurance?, 80 A M See Frank Sloan, CON . R EV . 128 (1990). E

280 III. An Empirical Assessment of the U.S. Tort Liability System 265 more than by medical needs. Thus, doctors and hospitals take too much care in the hope of forestalling injury or demonstrating in later litigation that they did “everything pos- sible” to prevent harm. Patients have little reason to resist unnecessary procedures that do no harm so long as insurance companies pay the bill. In 2005, U.S. health care 52 Plausible spending was 16 percent of gross domestic product, or $6697 per person. estimates suggest that defensive medicine accounts for, at most, 5 percent of total health care costs. If these figures are right order of magnitude, then defensive medicine costs each American around $300 per year. Societal concerns about the cost and availability of health care and the possible link between medical malpractice and those concerns have motivated many states to re- 53 form their medical malpractice systems. Those reforms have taken two particular forms—limitations on the total amount and kind of damages available in medical mal- practice actions and abrogation of the collateral source rule in medical malpractice. These reforms may sometimes have perverse results. In the mid-1980s, Indiana capped medical-malpractice awards at a maximum of $500,000 for all damages and in- stituted a professionally administered patient-compensation fund to decide all losses above $100,000. The unexpected result was that malpractice awards in Indiana became one-third higher than those in Michigan and Ohio, which had kept the traditional method of compensation. Perhaps the reason for the Indiana result was that the profes- sional administrators were better able than lay jurors to calculate damages and, there- fore, came closer to the “true,” higher losses of the victims. The intended effect of the limitation on damages for medical malpractice is, we hope, obvious. Some states limited the total amount that could be recovered in any tort action, while others capped noneconomic damages, such as those on pain and suffer- ing. Some state supreme courts, such as that in Illinois, have struck down those limita- 54 tions. But most caps have survived litigation and attempts at legislative reform. 52 Aaron Catlin, Cathy Cowan, Stephen Heffler, & Benjamin Washington (the National Health Expenditure Accounts Team), National Health Spending in 2005: The Slowdown Continues , 26 H EALTH A FFAIRS ,142 (2007). 53 Health care costs in the United States in 2009 account for almost 18 percent of the $13 trillion Gross Domestic Product, and in late 2009 there were approximately 47 million uninsured people (of a total pop- ulation slightly greater than 310 million), two-thirds of whom are low income. 54 At least one state, Florida, sought to reduce malpractice litigation by abrogating the American rule in favor of the English rule for attorney’s fees in some malpractice actions. (The American rule, which we will dis- cuss in Chapter 11, calls for each party to pay its own attorney’s fees. The English rule calls for the losing party to pay not only for its attorney but also for the winning party’s attorney.) The thought was that there would be less incentive to bring a speculative cause of action under the English rule. Florida abandoned the experiment after only five years, 1980–1985. See James W. Hughes & Edward A. Snyder, Litigation and Settlement under the English and American Rules: Theory and Evidence, 38 J. L AW & E CON .225 (1995) (which found that plaintiff success rates, average jury awards, and the size of out-of-court settlements all in- creased under the English rule, perhaps because the average quality of those claims brought forward increased under the English rule), and A. Mitchell Polinsky & Daniel Rubinfeld, Does the English Rule .517 (1998) (which argues that, TUD EGAL S , 32 J. L Discourage Low-Probability-of-Prevailing Plaintiffs? taking the settlement process into account, the English rule encourages more litigation by low-probability- of-prevailing plaintiffs).

281 266 CHAPTER 7 opics in the Economics of Tort Liability T In an earlier discussion of insurance, we explained that an accident victim’s compensation from an insurance company does not reduce the tort damages owed dant- by the injurer. Suppose that the plaintiff seeks $100,000 in damages from the defen injurer and has already been paid $80,000 from her insurer for her injuries. According to the legal principle called the “collateral source rule,” the plaintiff does not have to reduce the amount she seeks from the defendant—to, say, $20,000—by deducting the collateral benefits. Some states changed this rule, mandating deduc- tion of collateral benefits for injuries received in the course of health care delivery. The thought was that the collateral source rule created an incentive for plaintiffs to litigate on the theory that they could recover more than their actual losses. So, re- moving the rule would, all other things equal, reduce the incentive to bring medical malpractice complaints. Both types of reform seek to reduce health care costs by reducing medical mal- practice awards. Were the reforms responsible for the slowdown in the number of malpractice actions in the 1990s and early 2000s and the cessation in the rate of in- crease of the average malpractice award? Or were there other factors—such as an increase in the technology of treatment and levels of precaution—that explain these effects? The evidence is still not clear. There is some evidence to suggest that re- forms in the 1980s reduced defensive medicine expenditures by 5 to 9 percent and that the supply of physicians was about 12 percent greater in those states with caps on noneconomic damages, by comparison to the supply in states without those 55 But other evidence suggests that the medical malpractice problems observ- caps. able in the United States are not specific to the structure of the U.S. civil justice system but are happening worldwide, perhaps because the great advances in med- ical technology have made a much wider range—a perhaps a riskier range—of medical interventions possible. Web Note 7.11 Some prominent legal scholars have been using a remarkable data set from the State of Texas to explore many issues in medical malpractice. We summarize their work on our website. Web Note 7.12 Product liability might be triggered by a design defect, a manufacturing de- fect, or a failure to warn consumers (and intermediaries) of risk of harm. On our website we discuss some economics of the duty to warn and some recent empirical evidence on the effectiveness of that duty. 55 See Kessler & Rubinfeld, supra n. 42, for citations.

282 III. An Empirical Assessment of the U.S. Tort Liability System 267 C. Reforming Products Liability Products liability law is the focus of much of the public dissatisfaction with the en- tire tort liability system. A survey of chief executive officers by the Conference Board (a business interest group) found that liability concerns caused 47 percent of those sur- veyed to drop one or more product lines, 25 percent to stop some research and develop- ment, and 39 percent to cancel plans for a new product. In some instances, insurers have decided that the products liability area is so uncertain that they have withdrawn from the market entirely. Some of the manufacturers and others who have been left without insur- ance coverage have decided to stop making their products, or they have raised prices to the early 1980s in the United States cover the cost of additional risks of liability . Since there has been a powerful political interest in reforming products-liability law both at the federal and state level. But until very recently no reform occurred. Manufacturers have long argued for reform at the federal level for two reasons. First, they contend that a uniform federal products-liability law would save costs, with consequent savings to consumers. Second, many manufacturers believe that the prod ucts-liability law that has become the norm in the states is seriously flawed. Specifically, they believe that plaintiffs win too easily, and that juries are overly gener- ous to successful plaintiffs (as evidenced, they believe, by the example of the award against McDonald’s for a hot coffee spill). The argument that the manufacturers make is that these inefficiencies could be corrected by Congress enacting a sensible uniform federal products-liability law. Although reform measures have been introduced in Congress for many years, they have never been passed by both houses. At the state level, there was a spate of reforms in the mid-1980s and a second round in the mid-1990s. The reform movement has not revived in the early 2000s. State reform has typically been limited to putting a cap or upper limit on the amount and kind of damages that victims can recover. Sometimes the states place this cap only on what is perceived to be the offending element in damage awards, such as pain-and-suffering or punitive damages. For example, Illinois’ 1995 Civil Justice Reform Act put a cap on noneconomic damages of 56 $500,000 and limited punitive damages to three times compensatory damages. We s h o u l d n o t e , i n l i g h t o f t h e m a t e r i a l a t t h e b eg i n n i n g o f t h i s c h a p t e r, t h a t f e d e r a l r eg - ulatory agencies do a significant job of promoting product safety. For example, the Consumer Product Safety Commission, the National Highway Transportation Safety Administration, the Occupational Health and Safety Administration, the Federal Aviation Administration, the Food and Drug Administration, and the Environmental Protection 57 Agency issue and enforce product safety regulations for a wide variety of products. An ex ante safety regulation and ex post important issue is whether this joint system of liability exposure achieves the socially optimal amount of care. Or does it do too little or too much? As was the case with medical malpractice, the effects are unclear. The empirical literature on the effects of products liability, regulations, and the reforms instituted in 56 The Illinois Supreme Court found this act to be unconstitutional in 1997. 57 See C ONGRESSIONAL B UDGET O FFICE , T HE E CONOMICS OF U.S. T ORT L IABILITY : A P RIMER (2003), available at Recall, too, that in Web Note 7.2 we described the story of liability for harms arising from cigarette use.

283 268 CHAPTER 7 opics in the Economics of Tort Liability T the 1980s and 1990s is still young and has not yet reached a consensus. There is some evidence to suggest that the reforms eased the liability pressure on manufacturers, and thereby caused liability insurance premiums to stop their long pattern of increase. And there is some evidence that accidental injuries and deaths have declined in the early 2000s, although how much of that decline is due to law is not clear. Q UESTION 7.11: Analyze caps and limitations on litigation awards using the analysis of rent control in Chapter 2. UESTION 7.12: Use the graphical analysis of liability of the previous chap- Q ter to show the effect on the precautionary decisions of a potential injurer when the amount of compensatory damages that a victim may receive is capped. UESTION Suppose that any punitive damages awarded to the plain- Q 7.13: tiff were to be paid, not to the plaintiff, but rather to, say, a charity designated by the plaintiff. How might plaintiffs’ incentives to seek punitive damages be affected by such a scheme? How might the jury’s disposition to award puni- tive damages be affected? Notwithstanding specific problems, there are other indications that the system is working reasonably well. Products-liability actions in the United States increased in the mid and late 1980s, but the vast majority of those cases involved asbestos. If we exclude asbestos claims, the number of products-liability cases in the federal courts between 1985 and 1991 decreased by 40 percent and has remained at that low level through the early 2000s. Another interesting recent change regards plaintiff success rates. Between 1981 and 1987 the defendant won 51 percent of the verdicts in products-liability cases. Between 1988 and 1994 defendants won 64 percent of the cases. The best recent figures for the early 2000s suggest a retreat to a roughly 50 percent success rate for defendants. Finally, products-liability insurance costs amount to one-quarter of one cent for each 58 dollar of product purchase price—an insignificantly small amount. Web Note 7.13 In a recent article in the , Professors Polinsky and Harvard Law Review Shavell discuss the “Uneasy Case for Product Liability.” We discuss that arti- cle and several comments on it in this web note. D. Mass Torts A “mass tort” is not a formal legal term but rather a term used to describe a situa- tion in which a large number of tort claims arise from a single incident or use of the 59 same product. An example might be the Bhopal disaster in 1984 in India in which a 58 See James A. Henderson & Theodore Eisenberg, The Quiet Revolution in Products Liability: An Empirical Study of Legal Change, 37 UCLA L. R EV .479 (1990). The figures cited in this study are for actions filed in federal courts. Most tort actions are filed in state courts, but the authors feel that the federal statistics also reflect trends in state courts. 59 Mass torts are related to but distinct from class actions, which may be an administratively tractable method of dealing with mass torts. We will discuss the economics of class actions in Chapter 11.

284 III. An Empirical Assessment of the U.S. Tort Liability System 269 cloud of a highly toxic chemical escaped from a Union Carbide plant and killed be- tween 15,000 and 20,000 people and injured thousands more. Dealing with an incident of this sort may overwhelm the normal institutions and practices of the tort liability sys- tem. As a result, the law has increasingly tried to deal with the problems of mass torts through novel arrangements. Consider the problems arising from asbestos. Asbestos has remarkable fire-retardant properties, which made it a valuable construction material. It was used extensively in the United States from the 1930s through 1979, when use virtually ceased. The cessation oc- curred because it became increasingly obvious that asbestos could be extremely danger- ous to one’s health, including killing some of those who inhaled asbestos fibers. Inhaling asbestos causes cancer, but the gap in time between exposure to asbestos and the appear- ance of cancer can be 20 years. During the 50 years of asbestos use and the decade or so during which removal of asbestos was a common practice (before being suspended as causing more harm than good), more than 25 million U.S. workers were exposed to am- bient asbestos fibers and could, therefore, contract a debilitating disease or die. It is esti- mated that more than 225,000 premature deaths occurred between 1985 and 2000 because of exposure to asbestos fibers. And estimates are that an additional 10,000 peo- ple will die each year for the next decade or more because of exposure to asbestos. Much larger numbers of people have been injured but not killed by exposure to the fiber. Naturally, when these health risks became widely known, a large number of claimants stepped forward to seek compensation from the asbestos manufacturers and others. Indeed, 600,000 claimants had come forward by the year 2000 to proceed against 6000 defendants representing 75 out of 83 possible industries (suggesting that this problem touches almost every branch of the U.S. economy). Several important firms have filed for bankruptcy be- cause of earlier or reasonably anticipated adverse judgments involving asbestos. A large number—perhaps a majority of claimants—may never de velop an asbestos- related disease. Liability law does not compensate for exposure to risk, as opposed to realization of a risk. A person exposed to asbestos must wait until she actually de- the velops an asbestos-related disease before suing. However, the victims who develop such a disease must assert their claims without delay. Every jurisdiction in the United States has a statute of limitations that requires all those who seek compensation to 60 come forward within a relatively short time to assert their claim against others. Failing to do so may cause the victim’s cause of action to lapse. In light of these statutes, claimants who think that they may develop an asbestos-related disease come forward as soon as they can. They sue when X-rays are consistent with the early stages of disease, even though disease may not develop fully. This uncertainty makes the claimants extremely uneasy but also creates an incentive for the defendants to contest liability (and to delay settlement as long as possible in the hope that asbestos-related diseases will never become manifest). 60 Every legal system has a similar set of rules for encouraging those with legal claims to come forward. The period during which a victim must assert her claim or lose it is called a “prescriptive period” in the civil law systems. The law also uses the phrases “statute of repose” and laches to describe situations similar to those covered by a statute of limitation.

285 270 CHAPTER 7 opics in the Economics of Tort Liability T Dealing with this litigation has been extremely expensive. One estimate suggests that more than $50 billion has been spent on asbestos litigation. More than half of that amount has, it is alleged, gone to pay for transaction costs, rather than redounding to the benefit of victims. There are plausible estimates that total litigation costs have reached more than $250 billion, with almost all asbestos cases resolved, as of late 2009. To d e a l w i t h m a s s t o r t s , t h e c o u r t s a n d l eg i s l a t u r e s h ave b e e n w i l l i n g t o e n t e r t a i n novel practices. One reason for these novelties is a fear that relying upon standard tools of tort liability might lead to injustices. The slow development of asbestos-related diseases creates a conflict between the timeliness of claims required by statutes of lim- itation and the need to get compensation to deserving plaintiffs. To address this and other perceived problems with resolving the large number of asbestos claims through private litigation, Congress has proposed (in “The Fairness in Asbestos Injury Resolution Act” (2005)) for several years (but not enacted, as of July, 2010) the cre- ation of a trust fund to provide limited compensation to victims of asbestos-related diseases and to limit liability of defendants. Consider one more example—problems of proving causation arising in a mass tort having to do with the drug DES (diethylstilbestrol). DES was administered to pregnant women in the 1950s to prevent miscarriages. However, the drug caused genital diseases, in- cluding cervical cancer, in some of the adult women whose mothers had taken DES 20 or more years ago. By the time the connection between the adult diseases and the DES was discovered, it was all but impossible for the plaintiffs to produce evidence about which man- ufacturer had produced the DES taken by their mothers 20 years or more before. Standard theories of causation in tort required the plaintiff to demonstrate by a preponderance of the evidence that the defendant was responsible for the plaintiff ’s harm. In these instances, plaintiffs had been harmed by one of the manufacturers of DES, but they could not demon- strate which one or ones. Rather than allow the plaintiffs to leave the court empty-handed, the California Supreme Court fashioned a novel theory of liability—“market share liabil ity”—according to which all the manufacturers who might have been selling DES to the plaintiff’s mother would share liability for the plaintiff’s damages in proportion to their 61 market shares in the market for DES at the time of the mother’s having taken the drug. Web Note 7.14 The tragic events of September 11, 2001 gave rise to mass torts. See our web- site for a discussion of the methods by which the federal government put to- gether an administered compensation package for those who lost relatives and others in the tragedy. UESTION Q Explain how a potential victim’s waiving a future claim 7.14: (that is, an employee’s agreeing not to seek compensation from his employer if he is injured on the job) is like a transaction in a UTC (which we explain in the box on pp. 272–73). 61 See Sindell v. Abbott Laboratories, 26 C AL . 3 D 588, 607 P.2 D 924, 163 C AL . R PTR . 132, cert. denied, 101 S. C T . 285 (1980).

286 III. An Empirical Assessment of the U.S. Tort Liability System 271 Va c c i n e s a n d P ro d u c t s L i a b i l i t y Many recent products-liability cases involve the duty of pharmaceutical manufacturers and doctors to warn those taking drugs of the potential risks involved. One such case involved two polio vaccines. The first vaccine against this crippling disease was the Salk vaccine or IPV, which is a so-called killed-virus vaccine. The killed-virus vaccine prevents polio in the person who receives it without presenting the risk that the recipient will contract polio. The second vaccine was the Sabin vaccine or OPV, a “live-virus” vaccine. The recipient retains the live virus in his or her system and can pass it to others, who are them- selves immunized against polio. This external benefit is so considerable that public-health au- thorities strongly recommended that young children take the Sabin vaccine instead of the older Salk vaccine. When only the Salk vaccine was available, there were 2500 cases of polio a year. After the development of the live-virus vaccine, polio virtually disappeared. 62 However, the live-virus presents a risk. Approximately one of every 4 million people who take the vaccine or come in close contact with those who have taken OPV contracts polio. The law should require vaccine manufacturers to warn recipients of the risk from the live- virus vaccine. That is precisely what the U.S. Court of Appeals for the Fifth Circuit held in Reyes v. Wyeth Laboratories, Reyes, it became standard practice 498 F.2d 1264 (1974). After for vaccine manufacturers to include package inserts warning of the risks of the OPV vaccine. However, that resolution was only temporary. The more general trend toward absolute or enterprise liability for product-related harms has been felt in this market, too. In many re- cent cases, children, whose parents had been warned in accordance with Reyes but who, nonetheless, took the live-virus vaccine and developed polio, sued the manufacturers and re- ceived large awards. Without the defense of assumption of the risk after an adequate warn- ing, the manufacturer cannot avoid liability. Therefore, the company must build this higher expected-liability cost into the costs of production. Pharmaceutical manufacturers are so fearful of products-liability awards that they have become reluctant to manufacture and distribute beneficial drugs. In 1976, after an outbreak of swine flu, a dangerous illness, manufacturers of a swine flu vaccine refused to market it because private insurers, fearful of the product-liability consequences of 100 million or more injections, would not issue liability insurance. The companies offered the inoculations only af- ter the federal government agreed to be the exclusive defendant in any actions for harms aris- 63 ing from the vaccine. The DPT vaccine against whooping cough is in short supply in this country because the largest manufacturer, Eli Lilly & Company, has stopped producing the drug due to its fear of adverse products-liability judgments. Currently the following vaccines that were once manufactured by a number of firms in the United States are now produced by a single firm: measles, mumps, Sabin polio, Salk polio, and rabies. Worse still, the threat of product-liability suits may reduce the incentive of pharmaceutical companies to invest in re- search and development of potentially beneficial new drugs. 62 EGULATION R Va c c i n e s a n d P ro d u c t L i a b i l i t y : A C a s e o f C o n t a g i o u s L i t i g a t i o n , See Edmund Kitch, (May/June 1985). 63 The vaccine’s manufacturers proved particularly astute in this matter. The vaccine seems to have caused a potentially paralyzing or fatal disease called Guillain-Barré syndrome in a small fraction of those who were inoculated. Numerous plaintiffs brought actions against the federal government, as the sole defen- dant, on a theory of inadequate warning. The federal government relatively quickly stopped the program of inoculation for swine flu.

287 272 opics in the Economics of Tort Liability CHAPTER 7 T 64 Contractual Solutions to the Tort Liability Crisis A victim’s right to compensation for accidental harm is a form of insurance. Victims buy these rights from insurance companies by contract and the tort system gives these rights to potential victims by law. The tort system, however, gives people far more rights to compensation than they buy from insurers. Critics of the tort liability system complain that it gives people insurance that they do not buy when they have to pay for it themselves. Thus, parents seldom insure their children’s lives, and few people buy insurance against emotional distress or pain and suffering. It is easy to see why people do not buy insurance for some kinds of harm that tort law compensates. Insurance transfers money from the uninjured state (the premiums paid by the customers for insurance policies) to the injured state (the claims made by the injured policy- holders). For some tort claims, the cost of the transfer is very high. Thus, claims for nonpecu- niary damages are very costly to assess and administer, and negligence is costly to prove in, say, medical malpractice cases. For other tort claims, the transfer is inappropriate because money is not more useful in the injured state than in the uninjured state. Thus, the death of a dependent child reduces the parents’ need for money. In principle, allowing potential victims to sell unwanted tort rights can solve the problem of unwanted insurance caused by tort liability. Here is how sales would work. A potential victim’s right to damages in the event of a future accident is an “unmatured tort claim” (UTC). Imagine a market for UTCs. Potential tort victims could sell their right to recover and could include in the sale whichever of their tort rights they chose to sell and retain others for their own use. For example, a victim might sell the right to recover her nonpecuniary losses in an automobile accident but retain her right to recover her major pecuniary losses. Or she might sell the right to recover in the event of medical malpractice but keep the right to recover in the event of a product-related injury. If someone had sold her tort claims to a third party and was later injured, she could not recover from the injurer; she could, however, recover from an insurance company if she had bought insurance. A market for UTCs could be extremely flexible. Consider, for example, how a regime of no-fault automobile insurance could result from a market in UTCs. Suppose that drivers sell some of their rights to recover for tortious injuries in automobile accidents to their own insur- ance companies. Their own insurers might then waive these rights in exchange for payment from the insurance companies of other drivers. If it were legal to sell and buy UTCs, potential victims would probably substitute first- party insurance for the current method of compensation through the tort liability system. This first-party insurance would probably be a cheaper means of compensating victims than is the tort liability system. But what about the deterrence function of tort law? How will the cre- ation of a market for UTCs induce potential victims and injurers to take care? Interestingly, there might be no significant difference in deterrence from the current system, and there might be an improvement. There will, after all, be someone proceeding against the injurer for recovery in the event of an accident; it just might not be the victim. Indeed, the deterrence effect under UTCs may be better than under the current system: Third parties who have pur- chased UTCs may have a strong incentive to monitor the behavior of potential victims and in- jurers for optimal precaution. 64 The material in this box is based on Robert D. Cooter, To w a rd s a M a r k e t i n U n m a t u re d To r t C l a i m s , 75 V AUL A . L. R EV . 383 (1989). See also P R R UBIN , T (1993). ONTRACT C EFORM BY ORT

288 III. An Empirical Assessment of the U.S. Tort Liability System 273 Current American law prohibits victims from selling tort claims to lawyers. Thus, the plaintiff cannot contract with her lawyer to receive a fixed fee before the trial in exchange for giving the lawyer all, or almost all, of the damages eventually awarded by the court. Current law, however, does not prohibit nonlawyers from buying some matured tort claims, and a small market has already developed on the Internet. Q UESTION Imagine a system of contractual or elective no-fault with 7.15: respect to product-related injuries. Manufacturers would offer with their prod- ucts schedules of benefits that they would pay if consumers should be injured while using the products. In the event of an injury, there would be no inquiry into the product’s defect or the user’s fault; benefits would simply be paid to the injured consumer according to the contractual schedule. Pain and suffer- ing would not be compensable; collateral benefits would be deducted; and a few other restrictions would apply. Those manufacturers who chose not to of- fer elective no-fault would still be strictly liable for product-related injuries under the current system. Explore the efficiency of this elective no-fault sys- tem. (See J. O’C ONNELL (1975).) NJURY I , E I NDING NSULT TO Workers’ Compensation The most prominent form of no-fault liability in the United States is the system for dealing with employee accidents that occur on the job, which are common. In any given year approx- imately 3 percent of all industrial workers will be injured while on the job sufficiently to result in lost work time. This risk of on-the-job accidents is slightly higher than the risk of accidents off the job—for example, in the home. Through the late nineteenth century, the common law of job-related accidents made it extremely difficult for plaintiff-employees who had been injured on the job to recover 65 from their employers or from anyone else. Early in the twentieth century, most industri- alized countries, including the United States, adopted an alternative to tort liability for dealing with on-the-job accidents—namely, a system of compulsory compensation of in- jured employees without regard to fault. Today all but three states in the United States have a compulsory system for nearly all workers, and more than 90 percent of the United States labor force is covered by workers’ compensation systems. The systems typically work in the following way. Employers contribute sums to the state workers’ compensa- tion system based on the dollar amount of their payroll. When an employee is injured, he ( ) Continued 65 There were three defenses available to the employer: (1) common employment (also known as the “fellow servant rule”), under which the employer could escape liability by claiming that the proximate cause of the plaintiff’s harm was the negligence of another employee; (2) assumption of the risk, under which the employer could argue that the employee willingly assumed the risk of a job-related injury (on the economics of job- IP ISCUSI (1983); and (3) contributory negligence, under which the em- related risks, see K V HOICE C ISK BY , R ployer could escape liability by showing that the employee’s own negligence had contributed to the harm.

289 274 opics in the Economics of Tort Liability CHAPTER 7 T files a claim with the state governmental agency that administers the system. If the agency determines that the harm is job related, then it awards the employee compensa- tion according to a statutory schedule of benefits. For example, the compensation for a lost finger may be $5000. For other injuries, the benefits may be determined in a rela- tively brief evidentiary hearing. For example, the victim may be awarded two-thirds of the lost wages and full compensation of medical and rehabilitation expenses. In the event of a dispute between the employee and the workers’ compensation commission, a process of appeal and adjudication is available. In the workers’ compensation system, workers relinquished their right to sue their em- ployers in tort law for on-the-job injuries and, in exchange, employers assumed strict liability for injuries suffered on the job. Is this an improvement? Almost all states in the United States compel employers to participate in the workers’ compensation system, but Texas allows em- ployers to opt out. Texas generates some data to compare a workers’ compensation system and a system of tort liability. When large Texas firms opt out, they create their own system for compensating injured workers. If injured workers do not want to accept compensation of- fered under the employer’s plan, then they must sue the employer in tort law and prove that the employer’s negligence caused the injury. Morantz investigated the claims for on-the-job injuries by employees of two large com- panies. These two companies opt out of workers’ compensation for the retail outlets inside Te x a s , a n d t h e y m u s t r e m a i n i n s i d e t h i s s y s t e m f o r t h e i r r e t a i l o u t l e t s o u t s i d e Te x a s . M o r a n t z found a lower frequency of indemnity claims in Texas than outside of it, and she also found lower average per-claim costs. While she demonstrated cost savings to employers, the wel- 66 fare effects on workers remains to be determined by future research. Conclusion The tort liability system plays a significant role in reducing the frequency with which we accidentally lose our property, health, and lives. By allocating the cost of accidents, the tort liability system provides incentives for precaution, much as markets allocate costs and provide incentives for production. Improving the efficiency of the tort liability system can make the world safer at no more cost. Observers note various signs of inefficiency in tort liability law, such as significant differences in the level of compensatory damages for the same injury in different countries of similar wealth, unpredictable decisions about liability and damages from one case to another (“liability disparity”), defensive medicine, and vaccine shortages. Moving beyond anecdotes requires careful statistical studies that remain in short supply. The statistical knowledge that we do possess at this time, which we reviewed, is enough to debunk some myths about the tort liability system. 66 For a report on work in progress, see Alison Morantz, Rethinking the Great Compromise: What Happens L When Large Companies Opt Out of Workers Compensation? , B ERKELEY ORKSHOP AW A N D E CONOMICS , W 14 April 2008.

290 Suggested Readings 275 Suggested Readings (2005). , T HE M EDICAL M ALPRACTICE M YTH , T OM B AKER 5 A The Uneasy Care for Comparative Negligence, Bar-Gill, Oren, & Omri Ben-Shahar, M . L CON AW EV . 433 (2003). & E . R Stability, Not Crisis: Medical Black, Bernard, Charles Silver, David A. Hyman, & William M. Sage, . L EGAL . S TUD .207 (2005). MP Malpractice Claim Outcomes in Texas, 1988-2002, 2 J. E EWEES , D ONALD , D ONALD D UFF , & M ICHAEL J. T REBILCOCK , E XPLORING THE D OMAIN OF D A L AW (1996). CCIDENT AWA N D E , A TUL , C OMPLICATIONS : A S URGEON ’ S N OTES ON AN I MPERFECT S CIENCE (2002). G Hyman, David A., Medical Malpractice: What Do We Know and What (If Anything) Should We EX . L. R EV . 1639 (2002). Do About It?, 80 T ORT ORAT , & A LEX S TEIN , T RIEL L AW U N D E R U NCERTAINTY (2002). , A P The Beginning and the Possible End of the Rise of Modern American Tort Schwartz, Gary T., . 601 (1992). A . L. R EV 26 G Law, ., EDS ITCHELL P OLINSKY & S , S HAVELL TEVEN Shavell, Steven, , in A. M Liability for Accidents H ANDBOOK OF L AW A N D E CONOMICS , v. 1 (2007). S , & W. K , C ASS R., R EID H ASTIE , J OHN W. P AY N E , D AV I D A. S CHKADE UNSTEIN IP V ISCUSI , P (2002). D AMAGES : H UNITIVE J URIES D ECIDE OW

291 An Economic Theory of Contract Law 8 [T]he movement of the progressive societies has hitherto been a movement from Status to Contract. , M H ENRY AINE A 170 (1861) AW L NCIENT Whoever offers to another a bargain of any kind, proposes to do this: Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. MITH DAM A S , T EALTH OF N W 22 (5 TH ED . 1789) HE ATIONS A promise invokes trust in my future actions, not merely in my present sincerity. F HARLES C RIED , C ROMISE P 11 (1981) ONTRACT AS EOPLE CONTINUALLY MAKE promises: sales people promise happiness; lovers promise marriage; generals promise victory; and children promise to behave bet- ter. The law becomes involved when someone seeks to have a promise enforced P by the state. Here are some examples: Example 1: The Rich Uncle. The rich uncle of a struggling college stu- dent learns at the graduation party that his nephew graduated with honors. Swept away by good feeling, the uncle promises the nephew a trip around the world. Later the uncle reneges on his promise. The student sues his uncle, asking the court to compel the uncle to pay for a trip around the world. Example 2: The Rusty Chevy. One neighbor offers to sell a used car to another for $1000. The buyer gives the money to the seller, and the seller gives the car keys to the buyer. To her great surprise, the buyer discovers that the keys fit the rusting Chevrolet in the backyard, not the shiny Cadillac in the driveway. The seller is equally surprised to learn that the buyer expected the Cadillac. The buyer asks the court to order the seller to turn over the Cadillac. 276

292 I. Bargain Theory: An Introduction to Contracts 277 The Grasshopper Killer. A farmer, in response to a magazine Example 3: advertisement for “a sure means to kill grasshoppers,” mails $25 and receives two wooden blocks by return post with the instructions, “Place grasshopper on Block A and smash with Block B.” The buyer asks the court to require the seller to return the $25 and to pay $500 in punitive damages. Should the courts enforce the promises in these examples? A promise is enforce- able if the courts offer a remedy to the victim of the broken promise. Traditionally, courts have been cautious about enforcing promises that are not given in exchange for something. In Example 1, the promise of a trip around the world is a gift to the nephew. The rich uncle does not receive anything in exchange; so, according to the traditional analysis, the courts should not enforce the uncle’s promise. In Example 2, money ex- changes for a promise, but the seller thought that he gave a different promise than the buyer thought she received. Courts often refuse to enforce confused promises. In Example 2, the courts would probably require the seller to return the money and the buyer to return the car keys. Example 3 involves deception, not confusion. A “sure method to kill grasshoppers” means something more than what the seller delivered. The courts ordinarily offer a remedy to the victims of deceptive promises. If an enforceable promise was broken, what should the remedy be? One remedy requires the promise breaker to keep the promise. For example, if the court decided that the seller in Example 2 broke his promise, then the court might order the seller to de- liver the Cadillac to the buyer. This kind of remedy is unavailable in Example 3 because the seller cannot exterminate grasshoppers as promised. Instead, the remedy in Example 3 must involve the payment of money damages as compensation for the fail- ure to provide an effective grasshopper killer. Our examples illustrate the two fundamental questions in contract law: “What promises should be enforced?” and “What should be the remedy for breaking enforce- able promises?” Courts face these questions when deciding contract disputes and legis- latures face these questions when making statutes to regulate contracts. A theory of contract law must guide courts, legislatures, and private parties (and their lawyers) who make contracts. I. Bargain Theory: An Introduction to Contracts In the late nineteenth and early twentieth centuries, Anglo-American courts and legal commentators developed the bargain theory of contracts to answer the two fun- damental questions of contract law. The bargain theory held that the law should enforce promises given in a bargain. To implement this answer, theorists isolated and abstracted the minimal elements of a typical bargain, and these distinctions remain fundamental to the way lawyers think about contracts. We will explain the bargain theory and use its elements in an economic theory of contracts. A. What Promises Should Be Enforceable at Law? “What promises should be enforceable at law?” The bargain theory has a clear an- swer to this question, which, following Professor Mel Eisenberg, we call the bargain

293 278 CHAPTER 8 Economic Theory of Contract Law An principle: A promise is legally enforceable if it is given as part of a bargain; otherwise, a promise is unenforceable. The bargain theory makes enforcement hinge upon classi- fying promises as “bargains” or “nonbargains.” Consequently, the theory requires an exact specification of the necessary and sufficient conditions for the court to conclude that a bargain occurred. Bargaining is a dialogue on value to agree on a price. The bargain theorists distin- guished three elements in the dialogue: offer, acceptance, and consideration. “Offer” and “acceptance” have the same meaning in this theory as they do in ordinary speech: One party must make an offer (“I’ll take that rusty Chevy over there for $1000”), and the other must accept it (“Done”). Sometimes business practices and social conventions prescribe the signals for making and accepting offers. For example, a buyer at an auc- tion may signal an offer to buy by raising his or her hand, and the auctioneer may sig- nal acceptance by shouting “Sold!” Sometimes contract law and statutes specify procedures for offer and acceptance. For example, most states require written contracts and registration for sales of land. The “promisor” refers to the person who gives a promise, and the “promisee” refers to the person who receives a promise. In a bargain, the promisee induces the promisor to give the promise. The inducement may be money, as when the farmer pays $25 for the promise of a device that kills grasshoppers. The inducement may be goods, as when an automobile dealer delivers a car in exchange for the promise of future pay- ment. The inducement may be a service, as when a painter paints a house in exchange for the promise of future payment. Or the inducement may be another promise, as when a farmer promises to deliver wheat to a wholesaler in the fall, and the wholesaler prom- ises to pay a certain price upon delivery. The forms of a bargain thus include money- for-a-promise, goods-for-a-promise, service-for-a-promise, and promise-for-a-promise. reciprocal inducement Regardless of form, each bargain involves : The promisee gives something to induce the promisor to give the promise, and the promisor gives the promise as inducement to the promisee. Common law uses the technical term consideration to describe what the promisee gives the promisor to induce the promise. Thus, the farmer’s payment of $25 is consideration for the promise to supply a device that kills grasshoppers. The delivery of a car, the painting of a house, or a promise to deliver crops may be consideration for a promise of future payment. According to the bargain theory, the contract remains incomplete until the promisee gives something to the promisor to induce the promise. When completed, the contract becomes enforceable. In other words, consideration makes the promise enforceable. The bargain theory holds that promises secured by consideration are en- forceable and promises lacking consideration are unenforceable. Let us illustrate the bargain theory by applying it to the three examples at the be- ginning of this chapter. In Example 1, the nephew apparently did not give anything as inducement for his rich uncle’s promise of a trip around the world. Apparently there was no consideration, so the promise is unenforceable. In general, the promise to give a pure gift, which is not induced by the promise of something in return, is not enforce- able under the bargain theory. In contrast, consideration was given in Example 2 in exchange for the promise to supply the used car. The question raised in Example 2 is whether there was offer and

294 I. Bargain Theory: An Introduction to Contracts 279 acceptance. The seller thought they were discussing the rusty Chevy and the buyer thought they were discussing the immaculate Cadillac. The seller offered to sell one good and the buyer agreed to buy another good. There was no “meeting of the minds.” Without a meeting of the minds, there is no offer and no acceptance, just a failure to communicate. In Example 3, the seller offered a sure method for killing grasshoppers in exchange for $25, the buyer accepted the offer, and consideration took the form of the payment of $25. Therefore, the promise is enforceable according to the bargain theory. The re- maining question is whether the seller did what he promised. We conclude this section by relating bargains to fairness. Most people have beliefs about fair bargains. In a fair bargain, each party gives equivalent value. In the language of law, a contract is fair when the value of the promise is proportional to the value of the consideration. Conversely, in an unfair bargain, the value of the promise is dispro- portional to the value of the consideration. To illustrate an unfair bargain, the elder brother (Esau) in a famous Bible story promised to give his inheritance rights to a younger brother (Jacob) in exchange for a bowl of soup. According to bargain theory, a court should enforce promises induced by consider- ation, regardless of whether the consideration was equivalent in value to the promise. It is enough for enforceability under the bargain theory that the promisor found the con- sideration adequate to induce the promise. Bargain theory holds that courts should de- termine whether a bargain occurred, not inquire into whether the bargain was fair. Consequently, the doctrine of consideration requires courts to enforce some unfair 1 promises, such as exchanging one’s inheritance for a bowl of soup. An alternative theory would limit courts to enforcing fair bargains. To apply such a the- ory, a court would have to ask whether the value of the promise was equivalent to the value of the consideration. People often disagree about the value of goods, and litigants often dis- guise values from courts. Supervising all bargains for fairness would burden the courts and inhibit commerce. Consequently, most people want the courts to enforce bargains, not to supervise them. Perhaps this fact explains why courts do not routinely examine bargains for fairness. However, some bargains are so one-sided that most people require little informa- tion to condemn them as unfair. Modern U.S. courts sometimes refuse to enforce extremely one-sided bargains. (See the discussion of “unconscionability” in the next chapter.) In most English-speaking countries, traditional common-law doctrine requires “consideration” for a promise to be enforceable. (See accompanying box entitled “Humpty-Dumpty Jurisprudence.”) Instead of relying upon “consideration” to identify the essential element of an enforceable promise, however, the civil law tradition that prevails in continental Europe sometimes invokes the equally mysterious idea of “cause.” Just as the bargain theory attempts to explain “consideration,” so various theo- ries have been advanced to explain “cause,” such as the will theory. According to the will theory, a binding contract requires an intention by the parties to be bound. When each party intends the promise to bind, their wills meet, which creates the contract. The meeting of minds resembles Pareto efficiency, as we will explain. 1 If Esau were starving to death when he promised his inheritance for a bowl of soup, the contract might not be enforceable under the bargain doctrine because of an exception, discussed in the next chapter, called the “necessity defense.”

295 280 CHAPTER 8 Economic Theory of Contract Law An Humpty-Dumpty Jurisprudence: The Life History of the Word “Consideration” “When I use a word, it means just what I choose it to mean—neither more nor less.” —Humpty-Dumpty in L EWIS C ARROLL , Through the Looking-Glass In the bargain theory of contracts, “consideration” means something the promisee gives the promisor to induce the promise. According to the bargain theory, consideration makes the promise enforceable. Anglo-American courts accepted the bargain theory in the early years of the twentieth century and adopted the legal principle that consideration makes a promise en- forceable. Then, as the years passed, exceptions to the principle accumulated. Courts, how- ever, are slow to discard the abstract principles that they adopt. Instead of renouncing the principle of consideration, the courts did something characteristic of them: They changed the meaning of “consideration.” Instead of meaning “something the promisee gives the promisor to induce the promise,” the word “consideration” as used by the courts came to mean “the thing that makes a promise enforceable.” A tautology is a proposition that is true by definition of the words, such as “All husbands are married.” When the courts changed the meaning of “consideration,” they reduced the legal principle of consideration to a tautology. If “consideration” means “the thing that makes a promise enforceable,” then the principle “consideration makes a promise enforce- able” has no bite. When reduced to a tautology, a legal principle merely draws our attention to the meaning of a word, rather than telling us something about the legal consequences of our actions. Having made the principle of consideration into a tautology, the courts could as- sert its truth without fear of being wrong. Hence, we have an example of Humpty-Dumpty jurisprudence. Q UESTION People often change the form of a promise in an attempt to 8.1: increase their certainty that courts will enforce it according to its terms. For example, suppose the rich uncle in Example 1 wanted to assure his nephew of the enforceability of the promise of a trip around the world. He might do this by changing the form of the promise from a gift to a bargain. According to tra- dition, the uncle would solemnly offer to give his nephew a trip around the world in exchange for a peppercorn from the dinner table, and the nephew would solemnly give the uncle a peppercorn. Will this charade make the un- cle’s promise enforceable under the bargain theory? Answer this question by using the doctrine that courts inquire into the presence of consideration but not its adequacy. Also answer this question using the doctrine that courts should refuse to enforce extremely unfair bargains. B. What Should Be the Remedy for the Breach of Enforceable Promises? The bargain theory also had an answer to the second fundamental question of contract theory: “What should be the remedy for the breach of enforceable promises?” According to

296 I. Bargain Theory: An Introduction to Contracts 281 the bargain theory, the promisee is entitled to the “benefit of the bargain”—that is, to the benefit he or she would have obtained from performance of the promise. Computing com- pensation under this formula involves answering the counterfactual question “How well off would the promisee have been if the promise had been kept?” The counterfactual question concerns the benefit that the promisee could reasonably expect from performance. Consequently, the damage measure under the bargain theory is called expectation damages. Note the connection between the answers to the questions “What promises should be enforced?” and “What should be the remedy for breach of enforceable promises?” Promises should be enforced, according to the bargain theory, if they are part of a bar- gain, and the remedy for the breach of an enforceable promise is an award of the value expected of the bargain. The fact of a bargain establishes enforceability, and the ex- pected value of a bargain measures damages. Assume that the promises are enforceable in the three examples at the beginning of the chapter. What measures expectation damages? The student’s expectation damage in Example 1 equals the value to him of a trip around the world. The buyer’s expectation damage in Example 2 equals the difference in the value that she places on the rusty Chevy and the value that she places on the immaculate Cadillac. In Example 3, the farmer’s expectation damage equals the value of the crops destroyed by grasshoppers. Counterfactual values are difficult to compute. The cost of a trip around the world, as in Example 1, depends on the route taken and, among other things, whether the trav- eler goes first class or economy class. The value of a unique, old Cadillac, as in Example 2, depends upon, among other things, the buyer’s subjective preferences. The value of killing the grasshoppers in Example 3 depends upon the value of the crops that would have been harvested if they had not been destroyed by insects. C. A Criticism of the Bargain Theory The answer that the bargain theory gives to the first question of contract law is clear. Unfortunately, as a description of what courts actually do (and what they ought to do), the answer is also wrong. Sometimes the person who makes a promise wants it enforced and so does the person who receives it. Contract law should enforce such a promise in order to help the people get what they want. However, the bargain theory denies enforcement when the promise did not arise from a bargain. For example, assume that a buyer begins her search for a car by taking a new Chevrolet for a test drive. After the test drive, the buyer plans to continue her search by visiting other car dealers. The seller wants to induce the buyer to consider carefully the purchase of the new Chevrolet. Consequently, the seller promises to sell the new Chevrolet to the buyer for a stated price, provided that the buyer accepts within 1 week. In other words, the seller makes a “firm offer” and promises to “keep it open” for 1 week. The buyer does not want to waste her time by considering the offer carefully and then finding that the seller has reneged. Consequently, the buyer wants the promise to be en- forceable. The seller knows that the buyer is more likely to consider the offer carefully if the promise is enforceable, so the seller wants the promise to be enforceable. Thus, both the promisor and the promisee want the promise to be enforceable. Despite the wishes of both parties, the bargain theory withholds enforcement of the promise

297 282 CHAPTER 8 Economic Theory of Contract Law An because the buyer gave nothing to the seller in exchange for the seller’s promise to keep the offer open (“no consideration”). As another example, assume that a prominent alumna promises to give Old Siwash University the funds to construct a new building. The university wants to begin con- struction immediately. The alumna also wants the university to begin construction im- mediately. To obtain cash for the donation, the alumna must liquidate assets, which will take some time. The university dare not begin construction without an enforceable promise. In this example, both parties want the promise to be enforceable, but the bar- 2 Gift-promises are not induced by gain theory withholds enforcement of this promise. the prospect of gain, so they always lack consideration. In the two preceding examples, both parties to the promise want it to be enforce- able, yet the bargain theory withholds enforcement. A legal theory that frustrates the desires of the people affected by the law can be called dogmatic. In contrast, a legal theory that satisfies the desires of the people affected by the law can be called responsive. In general, a responsive theory maximizes the well-being of people, whereas a dogmatic theory sacrifices the well-being of people in favor of other ends. Contemporary courts in America prefer to be responsive rather than dogmatic. Consequently, contemporary courts in America often enforce firm offers and gift- 3 4 promises. As a result of such facts, the bargain theory is typically regarded as wrong. There is a second problem with the bargain theory—it calls for the routine enforce- ability of bargain, just so long as it is a bargain and regardless of how outrageous any the terms may be. As we saw earlier in this chapter, the farmer and the seller of a “sure means to kill grasshoppers” have, according to the bargain theory, a bargain. Enforcing this promise against the farmer leaves a bad taste in one’s mouth. There is deception and trickery by the seller. And although one could argue that “buyers should beware,” the seller’s behavior here violates widespread community norms of fair dealing. Indeed, most modern courts would not enforce this contract against the farmer, pre- cisely because it is deceptive. (We discuss fairness in the following chapter.) The bargain theory sharpened the distinctions among offer, acceptance, and con- sideration, which theorists still use in analyzing the formation of contracts. However, the bargain theory of contract is not a good theory of contracting because it is both overinclusive (in arguing for the enforceability of contracts that, on most other grounds, ought not to be enforced) and underinclusive (in not arguing for the enforceability of promises that both parties truly want enforced). Consequently, the theory fails to de- scribe what courts actually do. 2 The original when issued in 1932, generally embraced the bargain theory in Restatement of Contracts, Section 75. Section 90 of the Restatement rejected the bargain theory and established enforceability of gift promises upon which a reasonable person had detrimentally relied without consideration. 3 The Uniform Commercial Code Section 2-205 allows for some firm offers to be enforceable for a period not exceeding three months, but not all. (The is described in a box at the beginning of Chapter 9.) UCC American courts generally enforce gift-promises to the extent of reasonable reliance. Where the promisee is a nonprofit organization like a university, American courts sometimes enforce gift-promises to the full extent of the promise. We discuss the economics of gift promises on our website. 4 One famous commentator on the history of contract theory—G RANT G ILMORE , T HE D EATH OF C ONTRACT (1974)—believed that the classical or bargain theory was dead almost as soon as it was born.

298 II. An Economic Theory of Contract Enforcement 283 II. An Economic Theory of Contract Enforcement We want to replace the bargain theory with a better answer to the two fundamental questions in contract law. The enforceability of a contract usually makes the parties bet- ter off, as measured by their own desires, without making anyone worse off. Making someone better off without making anyone worse off is a “Pareto-efficient” change. Economic efficiency usually requires enforcing a promise if the promisor and promisee both wanted enforceability when it was made. We w i l l d eve l o p t h i s c e n t r a l i d e a i n t h e economic theory of contracts to answer the first question of contract law, “What prom- ises should be enforced?” A. Cooperation and Commitment Many exchanges occur instantly and simultaneously, as when a shopper pays cash for goods in the grocery store. In a simultaneous, instantaneous exchange, there is little reason to promise anything. The making of promises, however, typically concerns deferred exchanges —that is, transactions that involve the passage of time for their com- pletion. For example, one party pays now and the other promises to deliver goods later (“payment for a promise”); one party delivers goods now and the other promises to pay later (“goods for a promise”); or one party promises to deliver goods later, and the other promises to pay when the goods are delivered (“promise for a promise”). The passage of time between the exchange of promises and their performance cre- ates uncertainties and risks. Thus, the seller asks the buyer to pay now for future deliv- ery of goods. The cautious buyer wants a legal obligation of the seller to deliver the goods, not just a moral obligation. The buyer may be willing to pay now for an promise, but not for an unenforceable promise. Recognizing these facts, enforceable both parties want the seller’s promise to be enforceable at the time it is made. The seller wants enforceability in order to induce the buyer to make the purchase, and the buyer wants enforceability to provide an incentive for seller’s performance and a remedy for seller’s breach. By enforcing such promises, the court gives both parties what they want and facilitates cooperation between them. To d eve l o p t h e s e i n s i g h t s , w e d e s c r i b e a s i t u a t i o n c a l l e d t h e “ a g e n cy g a m e ” t h a t often arises in business. In this game, the first player decides whether to put a valuable asset under the control of the second player. The first player might be an investor in a corporation, a consumer advancing funds to purchase goods, a depositor at a bank, the buyer of an insurance policy, or a shipper of goods, to list some possibilities. If the first player puts the asset under the second player’s control, the second player decides whether to cooperate or appropriate. Cooperation is productive, whereas appropriation is redistributive. Productivity could take the form of the profit from investment, the sur- plus from trade, or the interest from a loan. The parties divide the product of coopera- tion between them, so both of them benefit. In contrast, appropriation redistributes from the first player to the second player. We d e p i c t t h e s e a l t e r n a t ive s i n F i g u r e 8 . 1 a n d a t t a c h n u m b e r s t o t h e m . T h e n u m - bers indicate the difference in the wealth of the two players before playing the agency game and after playing it. The first player to move in Figure 8.1 decides whether to

299 284 An Economic Theory of Contract Law CHAPTER 8 Cooperate: FIGURE 8.1 (.5, .5) invest 1 Agency game without contract. to make 2 Agent Appropriate 1 Invest 1 (–1, 1) Principal Don’t invest (0, 0) make an investment of 1. If no investment is made, the game ends, and the players re- ceive nothing. If an investment is made, the second player decides whether to cooper- ate or appropriate. Cooperation produces a total payoff of 1. The players divide the total payoff equally: The first player recovers the investment of 1 and also receives a payoff of .5, and the second player receives a payoff of .5. Thus, the two players bene- fit equally from playing the agency game. Alternatively, the second player can appro- priate. Appropriation enables the second player to acquire the first player’s investment, while producing nothing: The first player loses 1, and the second player gains 1. Consider the best moves for each player to make in Figure 8.1. If the first player invests, then the second player receives more from appropriating than cooperating. 5 The first player may Consequently, the second player’s best move is to appropriate. anticipate that the second player will appropriate. Consequently, the first player’s best move is “don’t invest.” We have shown that the solution to the agency game in Figure 8.1 is “don’t invest.” The payoffs to the agency game in Figure 8.1 assume that the parties cannot make an enforceable contract. The barrier to an enforceable contract might be unprovable be- havior, costly litigation, or bad judges. Now consider how the payoffs change if we assume that the parties can make an enforceable contract. We assume that the second player offers to cooperate in exchange for an investment by the first player, and the first player accepts the offer by investing. The first player’s investment is consideration for the second player’s promise. We as- sume that the law will hold the second player liable for compensatory damages if he breaks the promise and appropriates. Figure 8.2 depicts the revised payoffs in the agency game when the first player enforceable offers to invest in exchange for an promise by the second player to coop- erate. Consider the payoffs to the first player. If the first player invests and the second player performs, the first receives a net payoff equal to .5. If the first player invests 5 Game theorists describe a move that is best against any possible move by the other side as a “dominant strategy.” In Figure 8.1, the second player has a dominant strategy. The first player does not have a domi- nant strategy, but the first player has a best reply to the second player’s dominant strategy.

300 II. An Economic Theory of Contract Enforcement 285 Perform: FIGURE 8.2 (.5, .5) invest 1 Agency game with contract. to make 2 Breach: return Agent investment of 1 & pay damages of .5 Invest 1 Principal (.5, –.5) Don’t invest (0, 0) and the second player breaches, the first player receives compensatory damages. We assume that compensatory damages restore the first player’s payoff to the level that he or she would have enjoyed if the second player had performed. If the second player had performed, the first player would have recovered the investment of 1 and received a payoff of .5. Thus, the first player receives a net payoff of .5 from investing, regard- less of what the second player does. Alternatively, the first player can receive a payoff of 0 from not investing. Faced with these two alternatives, investing is the first player’s best move. Assume that the first player invests and consider the payoffs to the second player. The second player receives a payoff of .5 from performing as promised (cooperating). In contrast, breaching the contract (appropriating) yields a payoff of 1 to the second player, from which the second player must pay compensation to the first player. As compensation, the first player must receive 1 that he or she invested and .5 that was ex- pected in profits. Consequently, liability of 1.5 must be subtracted from the second player’s payoff of 1, yielding a net payoff of –.5 for breaching the contract. So, the best move for the second player is to cooperate. Figure 8.1 shows that the first player does not invest when promises are un enforceable. Figure 8.2 shows that the first player invests and the second player co- operates when promises are enforceable. Thus, an enforceable contract converts a game with a non-cooperative solution into a game with a cooperative solution. The first pur- pose of contract law is to enable people to cooperate by converting games with non- cooperative solutions into games with cooperative solutions. Modern business activity provides countless examples of the agency game. Thus, an innovator in Silicon Valley asks a venture capitalist to invest $1 million in a start-up company to develop a new computer chip. By developing the chip, the innovator can turn $1 million into $2 million. The innovator promises to develop the chip and share the profits of $1 million equally with the investor. Instead of developing the chip, how- ever, the innovator might try to appropriate the investor’s $1 million. An enforceable promise to develop the chip will prevent the innovator from appropriating the money; so, the investor will trust the innovator and invest the money.

301 286 CHAPTER 8 Economic Theory of Contract Law An est” We h ave s h ow n t h a t t h e u n i q u e s o l u t i o n o f t h e a g e n cy g a m e w i t h a c o n t r a c t i s “ i nv and “perform” (cooperate). So far, we have discussed the best move for each player from that player’s viewpoint. Now consider the sum of the payoffs to both players. The numbers sum to 1 when the first player invests and the second player cooperates. Otherwise, the numbers sum to zero. Investing and cooperating are productive, whereas “don’t invest” changes nothing and “appropriate” merely redistributes money from the first player to the second player. Given these facts, we could restate the preceding con- clusion: The first purpose of contract law is to enable people to convert games with in- efficient solutions into games with efficient solutions. The language of game theory clarifies how enforceable contracts promote cooper- commitment forecloses an opportunity. To illustrate from a ation. In game theory, a classical book on the art of war, the Chinese philosopher Sun Tzu writes, “When your army has crossed the border [into hostile territory], you should burn your boats and 6 bridges, in order to make it clear to everybody that you have no hankering after home.” Burning the boats and bridges commits the army to attack by foreclosing the opportu- nity to retreat. Similarly, making a contract commits the second player in Figure 8.2 to cooperate. Commitment is achieved by foreclosing the opportunity to appropriate. The opportunity to appropriate is foreclosed by the high cost of liability for breach. A com- credible when the other party observes the foreclosing of an opportunity. mitment is The chef at the resort asks whether you would prefer a menu of chicken or beef for dinner, or a menu of chicken or beef or fish. Perhaps you think to yourself, “A wider choice cannot make me worse off, and it might make me better off.” This is true for many restaurant choices, but it is false for coordinating with others in situations like not to make certain choices in order to the agency game. You may need to commit induce the other party to cooperate with you. Here’s how we answered the first question of contract law: A promise usually should be enforced if both parties wanted it to be enforceable when it was made. The agency game shows why both parties usually want enforceability: So the agent can credibly commit to performing and the principal has sufficient trust to put an asset un- der the agent’s control. UESTION Explain why the economic theory of contracts would enforce Q 8.2: a firm offer to sell a Chevrolet and the promise of a gift to Old Siwash University. Q UESTION 8.3: Explain why the numbers in Figure 8.2 indicate that the second player is liable for damages in the event of breach. expectation Q UESTION 8.4: In Figure 8.2, both parties desire enforceability of the sec- ond player’s promise when the promise is made, but when the time comes to perform, the promisor may not want enforceability. What do these facts say about the Pareto efficiency of enforcing the second player’s promise? (Hint: Distinguish between the Pareto efficiency of enforceability when the 6 S UN T ZU , T HE A RT OF W AR ,section IX, part 3. This is the oldest written treatise on war, dating back to the sixth century B . C . E .

302 III. An Economic Theory of Contract Remedies 287 ex ante Pareto efficiency, and the Pareto promise is made, which can be called efficiency of actually enforcing the promise when the time comes to perform, ex post Pareto efficiency.) which can be called Q 8.5: As an exercise in legal vocabulary, let us modify the facts UESTION about the contract in Figure 8.2 and describe it differently. Assume that the first player offers to invest in exchange for the second player’s promise to co- operate, and the second player accepts by promising to cooperate. What is the “consideration” in this contract? UESTION 8.6: Figure 8.2 describes a game based upon a bargain. Q Construct a similar figure to describe a game based upon a firm offer. Web Note 8.1 Our website describes some recent literature on liability for precontractual bargaining costs and the economics of gift promises. III. An Economic Theory of Contract Remedies We h ave o u t l i n e d t h e a n s w e r t o t h e q u e s t i o n , “ W h a t p r o m i s e s s h o u l d b e e n f o r c e d ? ” Now we turn to the second question of contract law: What should be the remedy for breaking enforceable promises? Example 4: Yvonne owns a restaurant for economists that is called the Waffle Shop. Her business prospers, and she needs a larger facility. She contracts with Xavier, a builder, who promises to expand the restaurant and complete the work by September 1. Her restaurant will remain closed while he builds. Xavier knows that events could jeopardize completing the construction on time. He is especially concerned that city officials may delay issuing the permits needed to begin construction. With good luck, he will get the permits early enough to com- plete construction on time at low cost. With bad luck, he will suffer a delay in get- ting the permits, and he will have to choose between completing construction on time at high cost, or breaching the contract and de laying completion of the building. Figure 8.3 depicts the Waffle Shop in numbers. The contract requires Yvonne to pay 1 to Xavier in advance and to pay .5 on timely completion of the construction. If com- pleted on time, the construction will be worth 2 to Yvonne. Thus, Yvonne stands to gain .5 from the construction project. With good luck, officials issue construction permits on time and Xavier does the work for the low cost of 1, so he gains .5. (Remarkably, these numbers for the “good luck” branch in Figure 8.3 are the same as in Figure 8.2!) With bad luck, officials delay issuing the permits. Xavier can complete construction on time at the high cost of 2.5, so he will lose 1 and she will gain .5. Alternatively, Xavier can breach the contract and complete construction late at a cost of 1, in which case Xavier will owe Yvonne .5 in damages; so, he will lose .5 and she will gain .5.

303 288 CHAPTER 8 Economic Theory of Contract Law An (.5, .5) FIGURE 8.3 Perform Contract with luck affecting Xavier performance. Breach Good luck (.5, –.5) (.5, –1) Contract Perform Xavier Yvonne Bad luck Breach (.5, –.5) Don’t contract (0, 0) Figure 8.3 shows Xavier’s perform-or-breach choice. Given good luck, Xavier is - .5. Given bad luck, better off to perform with payoff .5 than to breach with payoff - Xavier is better off to breach with payoff - 1. Since .5 than to perform with payoff Yvonne is fully compensated for breach, she is no worse off for breach. Modern business activity provides countless examples where the promisor prefers to breach and pay damages, rather than to perform at a loss. Thus, a venture capitalist in Silicon Valley pays $1 million for preferred stock in a start-up company that promises to develop a new computer chip. According to the contract, the startup company must de- velop and market the chip within three years. If the startup fails to do so, it must pay damages of $1.5 million. The innovator subsequently discovers a technical problem that vastly increases the cost of developing the chip. Instead of continuing to develop it, the innovator abandons the project and pays $1.5 million to the venture capitalist. The parties to a contract sometimes take a short-sighted view of their self-interest, especially in one-time transactions or transactions with large stakes. Traveling carni- vals, used-car salespersons, and ordinary people who buy or sell a house often deal sharply with each other. With sharp dealing, the promisor may not care about the harm that breach causes the promisee or his own reputation, but he still cares about legal lia- bility. He will perform if his net benefits from performing exceed his net benefits from breaching minus his liability; otherwise he will breach. denote N and To f o r m a l i z e t h e s h a r p - d e a l i n g p r o m i s o r ’s b e h av i o r, l e t N px bx Xavier’s net benefits from performing and breaching respectively. Let L denote bx Xavier’s liability for breaching. Xavier follows this decision rule: Q L - N Ú N perform bx px bx N . breach Q ... L - N bx px bx so =- .5, N Thus, when Xavier has good luck in Figure 8.3, = .5 L - and N bx bx px N and Xavier performs. Conversely, when Xavier has bad luck in Figure 8.3, 1 =- px L =- - .5, so Xavier breaches. N bx bx

304 III. An Economic Theory of Contract Remedies 289 This formula concerns the promisor’s actual commitment to perform. Consider his ideally efficient commitment. Assume that the contract only affects the parties to it; so, efficiency requires maximizing the sum of their payoffs. In notation, N + N denotes py px the sum of the net benefits to Xavier and Yvonne from performance, and N N + bx by denotes the sum of the net benefits to Xavier and Yvonne from breach. Efficiency re- quires Xavier to follow this decision rule: Ú N + N N Q perform + N py by px bx N + . breach Q ... N + N N px bx by py As mentioned above, contract law frequently awards “expectation damages” as compensation for breach. Awarding perfect expectation damages restores the promisee to the position that he or she would have enjoyed if the promisor had performed. In no- tation, perfect expectation damages equal the difference in Yvonne’s net benefits be- Substitute this value for N tween performance and breach: = in Xavier’s L . N - L py by decision rule, and it is identical to the decision rule for efficiency. (Prove it for yourself.) We h ave e s t a b l i s h e d t h e f o l l ow i n g p r o p o s i t i o n : When a contract only affects the parties to it, liability for perfect expectation damages gives the promisor efficient incentives to perform or breach. What should be the remedy for breaking enforceable promises? This is the sec- ond fundamental question of contract law. The preceding proposition, which eluded contact theorists for decades, suggests an answer: expectation damages. This is the right answer to cause people who make promises to take the efficient level of com- mitment to keeping them. It is also the right answer to compensate fully the victims of breach. In fact, expectation damages are the most common remedy for breach of contract in the United States. Perfect expectation damages are apparently the legal ideal, but the actual remedy often differs from the perfect one. Damages below the perfect level cause the promisor to breach too often, and damages above the perfect level cause the promisor to perform too often, as explained in the next chapter. UESTION Q 8.7: Assume that the high costs of performing cause the promisor to breach a contract and pay perfect expectation damages to the promisee. Wo u l d t h e p r o m i s e e h ave p r e f e r r e d t h a t t h e p r o m i s o r p e r f o r m ? Explain the gain in total payoffs from allowing the promisor Q UESTION 8.8: to breach and pay expectation damages when performing is inefficient. A. Precaution Against Breach In the Waffle Shop contract, Xavier has good luck and performs, or else he has bad luck and breaches. Viewed realistically, however, Xavier can affect his luck. To increase the probability of getting a building permit on time, he can hire a lawyer, meet with the restive neighbors, and telephone politicians. We call these acts “promisor’s precaution

305 290 CHAPTER 8 Economic Theory of Contract Law An against breach” because they reduce the probability of breach, rather like the injurer’s precaution reduces the probability of an accident as discussed in Chapter 6. The preceding section proved that when a contract only affects the parties to it, liability for perfect expectation damages gives the promisor efficient incentives to perform or breach. The same proposition is true for the promisor’s incentives to take precaution against breach. , liability for When a contract only affects the parties to it perfect expectation damages gives the promisor efficient incentives to take precau- tion against breach. B. Reliance Now our focus shifts to the choices of the promisee, specifically to her reliance on the contract. In Figure 8.3, Yvonne can decide whether to contract, but after con- tracting she cannot affect her payoffs. This is a simplifying assumption. Viewed more realistically, Yvonne can increase her gain from performance or reduce her loss from breach. She can increase her gain from performance by ordering more food in ad- vance, accepting more dining reservations, and leasing more parking spaces for her guests. Alternatively, she can reduce her loss from breach by the opposite—order less food in advance, accept fewer dining reservations, and leasing fewer parking spaces for her guests. In general, reliance is a change in the promisee’s position induced by the promise. The change increases the benefit of performance and the cost of breach, which makes the contract riskier. Recall the rich uncle’s promise to give his nephew a trip around the world. The trip is more valuable to the nephew if he purchases the necessary items in advance—luggage, snowshoes, a pith helmet, and so on. But he must sell them at a loss if his uncle breaches his promise. Are Yvonne’s actual incentives for reliance efficient? Not if she receives perfect expectation damages for breach. When Yvonne receives perfect expectation damages, reliance increases her benefits from performance, and her reliance also increases Xavier’s costs of breach. With perfect expectation damages, Yvonne bears none of the risk of breach, and Xavier bears all of it. Pe r f e c t ex p e c t a t i o n d a m age s t h u s c a u s e Yvonne to overrely relative to the efficient reliance . In notation, when Xavier has good luck and performs, Yvonne’s reliance y N (y) N = N in creases her net benefit according to the function . When gpy gpy gpy N Xavier has bad luck and breaches, Yvonne’s reliance creases her net benefit y de bby (y) N = N . When Xavier breaches, Yvonne receives according to the function bby bby L w compensation equal to his liability . Let y denote the price of reliance . The ex- bx y pected value of the contract to Yvonne thus equals . y w - ) L + (1 - p ) N ) ( y ) + p ( N y ( bby gpy bx y Perfect expectation damages equal the difference in Yvonne’s net benefits between per- L - N = L N (y) (y) in the formance and breach: . Substitute this value for bby bx gpy bx expected value of the contract to Yvonne and it reduces to ) ( . y y w - N gpy y

306 IV. Economic Interpretation of Contracts 291 y The risk of loss has disappeared from this expression. When Yvonne chooses to max- imize this expression, she only considers her increase in net benefits from performance, not the increase in Xavier’s liability from breach. We h ave s h ow n t h a t l i a b i l i t y f o r p e r f e c t ex p e c t a t i o n d a m a g e s g ive s e ffi c i e n t i n - centives to the promisor to take precautions against breach, but the promisee has no incentive to restrain her reliance. This proposition should look familiar to you, be- cause you encountered its equivalent in Chapter 6 on torts: A rule of strict liability with perfect compensation for accidents gives efficient incentives to the injurer to take precaution, but the victim has no incentive to take precaution. Perfect damages have the same effect in contracts and torts: The injurer internalizes the harm and the victim externalizes it. This is only one of the remarkable symmetries hidden in lia- bility law. The simple answer to the second question of contract law—What should be the remedy for breaking enforceable promises?—is “perfect expectation damages.” This remedy is perfect for the promisor’s incentives, but imperfect for the promisee’s in- centives. Contract law has developed various doctrines to modify expectation dam- ages and reduce overreliance on contracts. The next chapter analyzes some of these doctrines. Q UESTION 8.9: Explain why compensating the victim of breach for expec- tation damages causes efficient performance and breach, whereas compensat- ing the victim of breach for excessive reliance may cause inefficient performance and breach. IV. Economic Interpretation of Contracts Enforcing a contract frequently involves interpreting it, which often poses conun- drums. A contract says, “Exceptions are allowed,” when the parties meant to say, “Exceptions are not allowed.” Should the court interpret the contract according to its plain meaning or the intent behind the words? The contract says “Two exceptions are al- lowed,” but the parties would have allowed a third exception if they had thought of it. Should the court interpret the contract to allow a third exception? When uncle promised to pay for his nephew’s trip around the world, did the promise mean business class or economy class airfare? When a child signs an unfavorable contract, should the court re- place the actual terms with terms favorable to the child? Instead of immersing ourselves in these conundrums—that’s for a law school class on contracts—we will elaborate some economic principles for interpreting contracts. Perfect Contracts According to the Coase Theorem, given zero transaction costs, rational parties will allocate legal entitlements efficiently. This proposition ap- plies to contracts. When transaction costs are zero, the contract is a perfect instrument for exchange. Every contingency is anticipated; every risk is internalized; all relevant

307 292 CHAPTER 8 Economic Theory of Contract Law An information is communicated; no gaps remain for courts to fill; no one needs the court’s protection from deceit or abuse; nothing can go wrong. Perfect contracts pose no co nundrums of interpretation. The parties need the state to enforce a perfect contract according to its plain meaning, but nothing more is required. Why contemplate such an absurdity? Because perfect contracts connect law to eco- nomics. In microeconomics, students learn the theory of perfect competition and then use departures from it to analyze actual markets, such as oligopolistic markets. By this approach, microeconomics sorts different kinds of market imperfections according to their causes. We will use the theories of market imperfections that students learn in mi- croeconomics to analyze contract imperfections. Unlike perfect contracts, real contracts allocate risks imperfectly. Suppose that Mr. McGuire signs a contract with the Wabash Construction Company to build a house for his family. Floor plan, construction materials, style of carpets, landscaping, compliance with zoning codes—all of this and more is specified, as well as the price to be paid and the date for completing the house. Now imagine some of the things that can go wrong. Mr. McGuire might die, and his family might no longer want the house. The court may make the estate of Mr. McGuire pay for the house after his death, thus enforcing the contract as written. Or zoning officials in the local government might reject the construction plan. The court may decide that the contract is void because law forbids its construction. Here the court fills a gap in the contract by supplying terms of its own that do not contradict the contract’s explicit terms. Or Mr. McGuire might discover that the contract calls for Wabash to install grossly inadequate pipes. The court may decide that Wabash, the builder, must install adequate pipes, in spite of what the contract says. Here the court sets aside explicit terms in the contract and re- places them with its own terms. We d e s c r i b e d t h r e e p o s s i b l e r e s p o n s e s o f c o u r t s t o c o n t r a c t i m p e r f e c t i o n s : ( i ) e n - force the explicit terms as if the contract were perfect; (ii) fill a gap in the contract without contradicting its explicit terms; or (iii) replace the contract’s explicit terms. Courts should usually tolerate contract imperfections and enforce the terms as written, just as officials should usually tolerate market imperfection and allow business to pro- ceed without regulation. Tolerance is usually required because the state cannot fix most imperfections in private transactions, just as it cannot fix most imperfections in marriages. When courts attempt to improve on a contract’s explicit terms, two instru- ments are available to them: default rules to fill gaps and mandatory rules to replace explicit terms. A. Default Rules Gaps in contracts may be inadvertent. The construction contract may not mention the possibility of zoning officials rejecting the construction plan because neither Mr. McGuire nor Wabash thought about this possibility. Alternatively, gaps may be de- liberate. The construction contract may not mention the possibility of zoning officials rejecting the construction plan because Mr. McGuire and Wabash both believed that

308 IV. Economic Interpretation of Contracts 293 this possibility was remote. Remote risks do not justify the cost of negotiating and drafting terms to allocate them. Or a deliberate gap may be left in a contract for psy- chological reasons, as when a couple promises to marry and remains silent about divid- ing property in the event of divorce. Consider the calculations that might lead rational parties to leave gaps deliberately Ex ante risks” refer to the risks of future losses faced by the parties when in contracts. “ they negotiate a contract. “ losses” refer to losses that actually materialize after Ex post making the contract. In general, the parties to a contract must choose between allocat- risks and allocating ex post losses. The parties expect to save transaction ing ex ante costs by leaving gaps in contracts whenever the actual cost of negotiating explicit terms expected exceeds the expected cost of filling a gap. The cost of filling a gap in the con- tract equals the probability that the loss materializes multiplied by the subsequent cost of allocating it. The following rule summarizes these facts: minimizing transaction costs of contracts leave gap, * its probability Q allocating a risk 7 allocating a loss allocating a risk * its probability Q fill gap. ... allocating a loss When a court imputes terms to fill a gap in a contract, the implicit terms apply default, by which means “in the absence of explicit terms to the contrary.” The par- ties are free to alter default terms by mutual consent. If the parties allocate the risk explicitly, the court enforces the explicit terms even though they contradict the de- fault terms that the court would have used to fill a gap. Thus, the court might enforce a term in the construction contract that requires the McGuires to pay compensation to Wabash if zoning officials prevent construction, even though the court would have voided the contract if it did not mention zoning disapproval and zoning officials pre- vented construction. Courts supply default terms to contracts by following rules. These “default rules” can be efficient or inefficient. How much harm can inefficient default rules do? That depends on the cost of transacting around them. When a default rule is inefficient, the parties can gain by replacing it with explicit terms that are efficient, but they have to bear the transaction costs of negotiating the explicit terms. Conversely, when default rules are efficient, the parties cannot gain by replacing the default rule with explicit terms. When the courts supply efficient default rules, the parties save the cost of nego- tiating explicit terms. The fewer the terms requiring negotiation, the cheaper is the con- tracting process. In general, all parties to a contract can benefit when lawmakers replace inefficient default terms with efficient default terms, and the size of the benefits depends on the cost of transacting around the default rule. Economic analysis offers a simple rule for courts to follow in order to identify effi- Impute the terms to the contract that the parties would have agreed to if cient rules: 7 they had bargained over all the relevant risk. This is the method of filling gaps by a 7 See David Charny, Hypothetical Bargains: The Normative Structure of Contract Interpretation, 89 M ICH . L. R EV . 1815 (1991).

309 294 CHAPTER 8 Economic Theory of Contract Law An . The actual bargain consists in the terms negotiated by the parties. hypothetical bargain The hypothetical bargain consists in the terms the parties would have reached if they had filled the gaps in the contract by negotiation. For maximum gain, the parties would have reached an efficient bargain. To discover the hypothetical bargain, the court must establish the most efficient form of cooperation. (The court may or may not have to ad- 8 just prices in the contract. )When courts fill gaps by imputing terms of the hypotheti- cal bargain, the parties receive their preferred contract from the court. Further negotiations between them cannot improve it. Q UESTION “Default rules save transaction costs in direct proportion 8.10: to their efficiency.” Explain this proposition. Q 8.11: Suppose that Wabash completes the house one month UESTION later than promised. Inclement weather, which was no one’s fault, caused the tardiness. Explain how the court might compute efficient damages. Q UESTION 8.12: Doctors who form a partnership may say nothing in the partnership agreement concerning its future dissolution. The parties may de- liberately avoid discussing dissolution for fear of breeding distrust. Provide some other examples of gaps left in contracts for strategic reasons. B. Mandatory Rules Besides gaps, imperfect contracts sometimes contain explicit terms that courts set aside. The court may disregard a consumer’s waiver of the right to sue for injuries caused by a defective product, or the court may substitute its own terms for the actual terms in a contract made by a child. Unlike default terms, these terms are mandatory. The parties to a contract cannot waive or remove or replace mandatory terms by mutual agreement. By imposing mandatory terms, the law regulates the contract. The economic the- ory of contract regulation resembles the economic theory of market regulation. Textbooks in microeconomics usually describe a perfectly competitive economy that requires no regulation and subsequently describe imperfections that may require 8 When the efficient risk-bearer actually foresaw a risk, or ought to have foreseen a risk, the court should presume that the negotiated price included compensation for bearing the risk. Whether someone actually foresaw a risk is a question of fact, and whether someone ought to have foreseen a risk is a question of good business practices. Sometimes, however, neither party to a contract foresees a risk and neither party ought to have foreseen it. Allocating an unforeseen loss can dramatically change the cost of the contract to one of the parties, so the court may also need to alter the price by applying the Nash bargaining solution (splitting the surplus) as explained in Chapter 4. Allocating risk and adjusting prices put such great demands on courts that they should seldom make the attempt.

310 IV. Economic Interpretation of Contracts 295 regulation, such as an electric company’s monopoly in supplying power to households in a town. Similarly, we described a perfect contract that requires no regulation and now we describe imperfect contracts that require mandatory rules. Categories of mar- ket failure often found in microeconomics can be used to categorize legal doctrines that impose mandatory rules. A brief sketch of those categories prepares for their detailed discussion in the next chapter. Our review of microeconomics in Chapter 2 identified Individual Rationality three assumptions about rational choice by individuals. First, a rational decision-maker can rank outcomes in order from least preferred to most preferred. In order to rank out- comes, decision makers must have stable preferences. If the promisor’s preferences are incompetent and cannot sufficiently unstable or disorderly, then he or she is legally conclude an enforceable contract. For example, children and the insane are legally in- competent. Second, the rational decision makers’ opportunities are moderately constrained so that they can achieve some, but not all, of their objectives. Dire constraints destroy free- dom of action. Two major contract doctrines excuse promise breaking on the ground . If the beneficiary of the promise extracted it by that the promisor faced dire constraints duress threats, then promise breaking is excused by reason of . For example, in a famous movie the “godfather” of a criminal syndicate makes contract offers that “cannot be re- fused” because the victim signs the contract with a gun held to his head. No court would enforce such a contract. Similarly, if a promise is extracted from a desperate promisor, the court may ex- cuse nonperformance on the ground of necessity. For example, suppose a surgeon runs out of gas on a lonely desert road where she might perish. A passerby offers to sell her five liters of gas for $50,000. Even if the surgeon accepts the offer, the court will not enforce her promise to pay. The court will not enforce the promise because it was given out of necessity. duress and necessity both apply when the promisor is in dire circum- Notice that stances, but the cause is different. The cause of necessity is usually the promisor’s bad judgment, bad luck, or a third person. For example, the surgeon may have run out of gas in the desert because she did not check the gas gauge, a hidden defect caused the gas gauge to fail, or her enemy secretly punctured the gas tank. In contrast, the cause of duress is usually the promisee. For example, the godfather held the gun to the promisor’s head. Thus, duress can be regarded as necessity caused by the promisee. In these examples, the dire constraint preceded the promise. Sometimes a dire con- straint the promise. A dire constraint that follows a promise can prevent the follows promisor from performing. For example, a surgeon may promise to operate and then break her hand before the scheduled operation. If a promise is made in good faith and fate intervenes to make performance impossible, then promise breaking may be ex- cused by reason of impossibility. For example, a manufacturer may be excused from fulfilling his contracts because his factory burned down. In general, the impossibility doctrine applies to unlikely events that prevent performance. In the next chapter we dis- cuss the optimal allocation of the risk of such events.

311 296 CHAPTER 8 Economic Theory of Contract Law An Web Note 8.2 Much research has been done recently on deviations from individual rational- ity. See our website for a discussion of some of that literature as it applies to the theory of contracts. Spillovers Sometimes transaction costs prevent people from participating in negotiations that affect them. An electric utility generates power by a dirty process such as burning soft coal, and the smoke harms the neighbors. The contracts between the buyers of electricity and the electric utility affect its neighbors. Although contracts contract law. In most often have external effects, the legal remedy seldom involves cases, the plaintiff in a suit for breach of contract must be the person to whom the promise was made (the promisee) or the person to whom the promisee’s rights were transferred (the transferee). People affected by a contract who are not parties to it—“third parties”—cannot find relief in contract law except under special circumstances. Instead of suing for relief under contract law, third parties must usually seek relief under the law of torts, property, crimes, or regulations. If a private contract to purchase goods from a polluting manufacturer causes more pollution, the public victims must sue un- der nuisance law or under an environmental regulation, not contract law. Sometimes contract law protects third parties by refusing to enforce a contract be- tween the first and second party. The courts may refuse to enforce such a contract when it derogates public policy. An example is the promise of a victim of a crime to reward a policeman for solving it. A policeman’s job is to catch criminals. Allowing victims to pay rewards for this service might distort police efforts. Rewards would make the po- lice focus on crimes whose solution recovers valuable assets that victims will pay to get back, such as stolen cars. The police might neglect crimes where deterrence is urgently needed and the victim has nothing economic to recover, such as rape. Some important kinds of business contracts are unenforceable for reasons of pub- lic policy. Companies often wish to make contracts not to compete with each other. Agreements not to compete enable cartels to exploit buyers by charging monopoly prices. Courts in England and America were reluctant to enforce nineteenth-century contracts to create cartels. Such contracts derogated public policies aiming to foster competition. Subsequent antitrust statutes outlawed cartels in the United States and the nations of Western Europe. For example, contracts to create a cartel are void in Europe by the law of the European Union (European Union Treaty, Section 85, paragraph 2). These are examples where the law will not enforce a contract whose performance is illegal or derogates public policy. Many examples of the opposite also exist—cases where the law will enforce a contract whose performance is illegal or derogates public policy. Thus, a married man may be liable for inducing a woman to rely on his promise of marriage, even though the law prohibits him from marrying without first obtaining a divorce. Similarly, a company that fails to supply a good as promised may be liable even though producing the good is impossible without violating an environmental regulation. Economic analysis suggests when the law should enforce or not enforce a contract whose performance violates law or public policy. Liability should rest with the party

312 IV. Economic Interpretation of Contracts 297 who knew, or had reason to know, that performance is illegal or derogates public pol- icy. Liability should rest with the informed party because he knew that he should not make the contract. Asymmetric Information Sometimes one or more of the parties to a contract lacks essential information about it. Several doctrines in contract law excuse promise breaking on the ground that the promise resulted from bad information. If the benefici- ary of the promise extracted it by lies, then breaking the promise is excused by reason fraud . For example, the seller of the “sure method to kill grasshoppers” defrauded of the farmer. Fraud violates the duty not to misinform the other party to a contract. Besides this negative duty, parties sometimes have the positive duty to disclose in- formation. In most sales contracts, a seller must warn the buyer about hidden dangers associated with the use of the product, even though this information may cause the buyer not to buy it. For example, the manufacturer of a drug must warn the user about side effects. In these circumstances, common law finds a duty to disclose. In the civil law tradition, your contract may be void because you did not supply the information culpa in contrahendo . that you should have. Civil law calls this doctrine Sometimes disguised defects lower the value of a good without making it danger- ous or unfit for use. Common law apparently contains no general duty to disclose such disguised defects. Common law does not require a used-car dealer to disclose the faults in a car offered for sale (only a duty not to lie about those faults). The law is different 9 for new goods, including new cars. People often trade because they have different expectations about whether the price of a good will rise of fall, as in stock markets. In such circumstances, at least one of the parties is misinformed. If people make contracts premised upon misinformation that they gathered for themselves, then the fact that the contract is based on misinformation does not excuse them from their contractual duties. For example, a stock trader who promises to supply 100 shares of Exxon in six months at a predetermined price cannot escape his obligation just because the price of the stock rose when he expected it to fall. Most of the preceding examples concern a misinformed party and a well-informed both party. Another possibility is that parties are misinformed. This is the basis of a le- gal excuse for breaking a promise known as frustration of purpose . English law provides some famous examples known as the Coronation Cases. In the early years of the twenti- eth century, rooms in buildings situated along certain London streets were rented in ad- vance for the day on which the new king’s coronation parade would pass by. However, the heir to the throne became ill, and the coronation was postponed. Postponing the pa- rade made the rental agreement worthless to the renter. Some owners of the rented rooms tried to collect the rent anyway. The courts refused to enforce the contracts on the ground that the change in circumstances frustrated the purpose of the contracts. 9 For new goods, the law in most states in the United States imputes a “warranty of fitness,” which is a guar- antee that the court reads into the contract, even though the actual contract did not explicitly contain such a guarantee. According to the implied warranty of fitness, the seller of a new good promises that it is fit to use for its intended purposes. The seller of a new car breaches this warranty and must return the purchase price if a fault in the car’s design prevents its use for transportation.” See UCC Sections 2-314 and 2-315.

313 298 CHAPTER 8 Economic Theory of Contract Law An Ye t a n o t h e r p o s s i b i l i t y i s t h a t b o t h p a r t i e s p r e m i s e t h e c o n t r a c t u p o n d i f f e r e n t m i s - information. If promises are exchanged on the basis of contradictory, but reasonable, conceptions of what is promised, then the contract is said to rest upon what is called a mutual mistake. To illustrate using our Example 2, the seller genuinely believed that he was negotiating to sell his rusty Chevrolet in the backyard, and the buyer genuinely be- lieved that she was negotiating to purchase the immaculate Cadillac in the driveway. Like frustration of purpose, mutual mistake justifies the court’s setting the contract aside. In our example, the court might order the buyer to return the car keys, and the seller to return the money. Competitive markets contain enough buyers and sellers that each per- Monopoly son has many alternative trading partners. In contrast, oligopoly limits the available trading partners to a small number, and monopoly limits the available trading partners to a single seller. When trading partners are limited, bargains can be very one-sided. Under the bargain theory, the courts enforced bargained promises and did not ask if the terms are fair. Consequently, the common law historically contains weak protection against exploitation by monopolies. Instead of common law, statutes supply most pro- tections against monopolies. In recent years, however, a new common law doctrine has evolved that allows judges to scrutinize the substantive terms of contracts. When a contract seems so unfair that its enforcement would violate the conscience of the judge, it may be set aside ac- cording to the doctrine of unconscionability. For example, assume a consumer signs a contract allowing a furniture seller to repossess all the furniture in her house if she misses one monthly payment on a single item of furniture. The court may find the re- possession term “unconscionable” and refuse to enforce it. We discuss this elusive doc- trine in the next chapter. The civil law tradition contains a concept—“lesion”—similar to unconscionability. “Lesion” refers to a contract that is too unequal to have legal force. Ta b l e 8 . 1 a s s o c i a t e s t h e l e a d i n g d o c t r i n e s f o r r eg u l a t i n g c o n t r a c t s w i t h t h e m a r ke t failure that they attempt to correct. Given low transaction costs, rational people will make contracts that approach perfection. A perfect contract has no gaps for courts to fill or market failures to regulate. If a contract approaches perfection, the court should simply enforce its terms. As transaction costs increase, however, people leave gaps in TABLE 8.1 Rationality, Transaction Costs, and Regulatory Doctrines of Contract Law Assumption If Violated, Contract Doctrine Individual Rationality Incompetency; incapacity; coercion; duress; necessity; impossibility Spillovers Unenforceability of contracts derogating public policy or statutory duty Information Fraud; failure to disclose; frustration of purpose; mutual mistake Monopoly Necessity; unconscionability or lesion

314 V. Relational Contracts: The Economics of the Long-Run 299 contracts. Courts should fill the gaps with efficient default terms. Transaction costs can also cause externalities, misinformation, or monopolies. Serious imperfections can cause markets to fail and create a need to regulate contracts. The farther the facts de- part from the ideal of perfect rationality and zero transaction costs, the stronger the case for judges’ regulating the terms of the contract. V. R e l a t i o n a l C o n t r a c t s : T h e E c o n o m i c s o f t h e L o n g - R u n If you break your promise to come to family dinner on Sunday evening, your mother can punish you in a thousand small ways. The same is true in repeated business transactions, where the preferred remedy for a broken promise is some form of retalia- tion, but not a lawsuit. To secure cooperation in long-run relations, the parties often rely upon informal devices, rather than enforceable rules. An overbearing partner may be brought back into line by a warning rather than a lawsuit. Or a businessman who over- steps the ethical boundaries of his profession may be chastened by gossip and ostracism. The most common problems of contracting are nonpayment of bills, late delivery, and poor performance. For nonpayment, a typical retaliation is suspension of supply; for late delivery, it is delayed payment; and for poor performance, it is partial payment. These informal devices usually operate within enduring relationships. Contracts often create relationships. In addition, contracts create legal duties that are not part of the contract. For example, when a customer opens a checking account with a U.S. bank, she signs a contract called a “depository agreement,” which creates a “fiduciary relationship.” This relationship imposes many duties upon the bank that are not stated in the depository agreement. As another illustration, a “franchisee” (local investor) may sign a contract with the “franchisor” (parent corporation) to operate a local fast-food restaurant. The franchise relationship creates many legal duties that the contract does not mention. Economists have studied how enduring relationships affect behavior. We will explain some of their central conclusions by repeating the agency game. A. Repeated Game In the agency game, the principal (first player) invests by placing some funds un- der the control of the agent (second player). To depict cooperation in an enduring rela- tionship, assume that the agency game in Figure 8.1 is repeated indefinitely, thus transforming a “one-shot game” into a “repeated game.” In any round of the repeated game in which the principal invests, the agent enjoys an immediate advantage from ap- propriating. An enforceable promise can solve this problem, as depicted in Figure 8.2. But suppose the promise is unenforceable for some reason—breach is unprovable, tri- als are too expensive, or courts are corrupt. To solve the problem without law, the prin- cipal can retaliate in subsequent rounds of the game. Figure 8.4 illustrates an effective strategy for the principal to deter appropriation by retaliating against it. Assume that the agent appropriates in round n of the game. The agent receives a payoff of 1 in round n. However, the principal retaliates by not invest- ing in round and in The agent receives a payoff of zero in rounds + n 2. + 1 n 1 + n n 2. + Thus, the strategy of appropriation yields a total payoff to the agent equal to and n through n 1 in rounds 2. + These facts are summarized in the first row of Figure 8.4.

315 300 An Economic Theory of Contract Law CHAPTER 8 +5 n +4 n +3 n +2 n +1 n n +6 n –1 n round FIGURE 8.4 Strategy of Payoffs to second player 0 appropriate ... ... 1 0 0 0 1 second player (agent) when first player .5 .5 cooperate .5 .5 ... .5 ... .5 (principal) plays tit for tat. Alternatively, assume that the agent could follow the strategy of cooperating in each round of the game. When the agent cooperates, the principal responds by invest- , ing. The agent’s payoffs in rounds thus equal .5, .5, and .5. The n and 2 + n n + 1, strategy of cooperating yields a total payoff to the agent equal to 1.5 in rounds n 10 These facts are summarized in the second row of Figure 8.4. through n + 2. is higher from co- n Figure 8.4 shows that the agent’s payoff in rounds through + n 2 operating than appropriating. This will be true for any three rounds of the game, provided that the principal continues playing the same strategy. For example, the total payoff to the agent who appropriates in rounds through equals 1, whereas the total payoff 3 + 5 + n n for cooperating equals 1.5. The agent thus benefits in the long run from cooperating rather than appropriating. The principal’s strategy of retaliation can teach this lesson to the agent. If the agent follows the strategy of appropriating in round n, he or she will probably learn a lesson by receiving zero payoff in rounds and . After learning the lesson, the 1 n + n 2 + agent will probably switch to the strategy of cooperating in round . + 3 n We have described a strategy in which the principal repays the agent’s cooperation by investing, and the principal retaliates against the agent’s appropriation by not invest- 11 ing. Rewarding cooperation and punishing appropriation has been called “tit for tat.” When the principal plays the strategy of tit for tat, the agent maximizes payoff by co- operating. What about the principal? Does he or she maximize payoff by playing tit for tat? Experimental evidence indicates that tit for tat comes very close to maximizing the principal’s payoff in a variety of circumstances, and these empirical findings are gener- 12 Thus, the strategy of tit for tat is an efficient equilibrium to ally supported by theory. 13 a repeated agency game. 10 Figure 8.4 assumes no discounting for time. Strictly speaking, payoffs should be discounted to present value from the date of receipt. 11 (1984). , T HE E VOLUTION OF R. A OOPERATION XELROD C 12 Id. 13 Maskin and Fudenberg have proved that in any game in which (1) players maximize the discounted sum of single period utilities, (2) the discount rate is not too high, and (3) the players can observe the past history of moves in the game, any pair of payoffs that Pareto-dominate the minimax can arise as average equilibrium payoffs of the repeated game. This theorem, however, still leaves unexplained why the probability of a Pareto-efficient solution is as high as empirical studies suggest it to be. See Drew Fudenberg & Eric Maskin, CONOMETRICA The Folk Theorem in Repeated Games with Discounting, or With Incomplete Information, 54 E 533 (1986). If the players are willing to settle for a strategy that is very close to the self-interested maximum, but a little short of it, the endgame problem can be solved and the players will cooperate. In general, see A S IXIT & B ARRY N ALEBUFF , T HINKING S VINASH : T HE C OMPETITIVE E DGE IN B USINESS , P OLITICS , TRATEGICALLY AND E VERYDAY L IFE (1991), and D REW F UDENBERG & J EAN T IROLE , G AME T HEORY (1991). Exceptional games without cooperative solutions need not concern us here. See Glenn W. Harrison & Jack Hirshleifer, An Experimental Evaluation of Weakest Link/Best Shot Models of Public Goods, 97 J. P OL . E CON .201 (1989) and Jack Hirshleifer & Juan Carlos Martinez Coll, What Strategies Can Support the Evolutionary Emergence ONFLICT R ESOLUTION 367 (1988). of Cooperation?, 32 J. C

316 V. Relational Contracts: The Economics of the Long-Run 301 Long-run relationships require commitment, which can facilitate economic coop- eration without state protection. Traditional forms of commitment include friendship, kinship, ethnicity, and religion. They often dominate economic life in communities with weak state protection of contracts. Business communities with weak state protec- tion include international merchants, businesses in countries with weak or corrupt governments, businesses caught in civil wars, and foraging tribes that remain unsub- ordinated to states. Our model predicts, correctly, that traditional forms of commit- ment will flourish in these circumstances and decline if the state imposed effective contract law. Similarly, traditional forms of commitment often dominate economic life in com- munities that face the state’s hostility. Businesses facing state hostility include organ- ized crime and some private businesses in socialist states. Our model predicts, correctly, that traditional forms of commitment should flourish in these circumstances. Long-run relations can arise from commitments to institutions. For example, Japanese employees show a high level of commitment to the corporation, as evidenced by low rates of labor mobility. Our theory predicts correctly that long-run relationships will cause Japanese corporations to rely less on enforceable contracts as compared to American or European corporations. Long-run relations in the Japanese economy cre- ate more order and less law than in other countries. B. Endgame Problem Even long-run relationships end eventually. Near their end, business relationships often deteriorate. To see why, return to our example of tit for tat as depicted in Figure 8.4. Recall that when the agent appropriates, the principal retaliates by not investing last for several rounds. However, the principal has no power to retaliate on the round of the game. Thus, the final round of the agency game has the same logic as a one-shot agency game. To illustrate, assume that the repeated game in Figure 8.4 has an end and both par- ties know it. To be concrete, assume that both parties know the game will end after round The agent does not fear retaliation for appropriating in round be- + n 3, + n 3. 3, the cause the agent knows that there will not be any more rounds. In round + n agent will receive a payoff of 1 from appropriating and a payoff of .5 from cooperating. n Consequently, the agent maximizes his or her payoff in round by appropriating. 3 + Knowing this, the principal will refuse to invest in round Thus the players can- 3. + n The last round in a repeated agency game has the same n + 3. not cooperate in round logic as a one-shot game. Consequently, the players in the agency game cannot cooper- ate in the last round without enforceable contracts. every round of the game. To see Wo r s e s t i l l , t h e p l a y e r s c o u l d fa i l t o c o o p e r a t e i n why, consider the strict logic of the situation. The principal follows the strategy of tit for tat, which rewards cooperation by subsequent investing and punishes appropria- tion by not investing in subsequent rounds. However, the principal will not invest in the last round, which is round Consequently, the principal cannot use round 3. + n n 2. + 3 + n to reward cooperation or punish appropriation by the agent in round

317 302 An Economic Theory of Contract Law CHAPTER 8 Knowing this fact, the agent can appropriate in round without fearing retalia- 2 + n tion in round Knowing this, the principal will refuse to invest in round 3. + n 2. + n + 1 and so forth back to the first round. In n The same logic now applies to round general, the demonstration that the players cannot cooperate in any given round leads to the conclusion that they cannot cooperate in the preceding round. If strictly rational parties know the round in which the repeated agency game ends, then the whole game unwinds, and the players fail to cooperate in any round. The phrase “the endgame problem” describes the unwinding of cooperation as a repeated game approaches its final round. Eastern Europe provides a dramatic example of the endgame problem af- ter 1989 when communism collapsed and central planning ended, as discussed in the accompanying box. People in long-run relationships develop social norms to coordinate their behav- ior without bargaining, which businessmen call “customs in trade.” Lisa Bernstein discovered a peculiar fact: Customs in trade often contradict the explicit provisions 14 of written contracts. In the Memphis textile exchange, the seller weighs the cotton to ensure that he ships the amount specified in the contract. The contract stipulates that the buyer must also weigh the cotton when accepting delivery from the seller so that the buyer will not have cause for complaint later. The custom, however, is for the buyer to accept the weight as stated by the seller, thus saving the bother of weighing it a second time. The Endgame Problem of Eastern Europe in 1989 The disintegration of communist governments in Eastern Europe accelerated dramatically in 1989. Central planning failed irreparably, and markets rapidly replaced central planning as the organizing economic principle. Unfortunately, production declined throughout Eastern Europe at this time. Why did the shift to markets immediately produce economic decline rather than economic growth? The “endgame problem” provides the key. Under communism, much production occurred through long-run relations. For example, a truck driver would haul goods for “free” as a “favor” to his friend who operated a gas station, and the gas-station operator would supply petrol for the trucker when supplies ran short. The demise of communism massively disrupted political life, which caused people to doubt the persistence of their long-run economic relationships. With the end of relationships in sight, cooperation failed. For example, the trucker lost confi- dence that the gas-station operator could continue to supply petrol (the gas-station operator might lose her job), so the trucker stopped hauling the gas-station operator’s goods for free. The failure of cooperation caused production to decline all over Eastern Europe after 1989. This situation could be corrected by effective legal protection for property and contracts. Some Eastern European states have made the correction. In other states, however, entrepreneurs still enjoy higher profits from stealing property (especially state property) than from producing goods. 14 Lisa Bernstein, Private Commercial Law in the Cotton Industry: Creating Cooperation Through Rules, . 1724 (2001). EV ICH . L. R 99 M Norms, and Institutions,

318 V. Relational Contracts: The Economics of the Long-Run 303 This contradiction between the written contract and the custom is easy to under- stand. The custom arises from buyers and sellers in long-run relationships who trust each other. As long as the relationship remains firm, the parties have little need for the contract. The contract, however, is written for deteriorating relationships. When the parties cannot rely on their relationship, they turn to the written contract. We have a long-run custom in trade and an endgame contract. This fact complicates using customs in trade to interpret contracts. Assume that the seller purports to deliver a ton of cotton to the buyer. The buyer accepts delivery without weighing the cotton. Later the buyer discovers that the cotton weighs less than a ton. The buyer stops dealing with the seller and sues the seller for “short-weighting.” The seller defends in court by saying that the contract obligated the buyer to weigh the cotton on delivery, which the buyer did not do. Having failed to complain when the cotton was de- livered, the buyer is precluded by contract from complaining later. The seller replies that, contrary to what the contract says, the custom in trade is for the buyer not to weight the cotton when it is delivered. Should the court follow the explicit terms of the contract and decide for the seller, or should the court set the the contract aside and decide for the buyer? Presumably the court should recognize that the parties wrote the contract for the dissolution of a relationship, which is what has occurred, so the court should enforce the written contract. So far we have discussed commitment to enduring relationships. However, most business relationships are tentative: They can persist indefinitely or end unexpect- edly as circumstances change. With tentative relationships in the agency game, the players often follow the strategy tit for tat: The principal retaliates against the agent’s appropriation by dissolving the relationship. This strategy by principals presents agents with a choice between two alternatives. The first strategy is for the agent to cooperate, in which case the relationship continues, and the agent receives a payoff of .5 in each round. The second strategy is to appropriate, thus provoking the first player to dissolve the relationship. By following the second strategy, the agent receives a payoff of 1.0 in the few rounds when he or she finds a principle to invest, and a payoff of zero in the other rounds when the search for a partner is un- successful. In brief, the agent chooses between cooperating and receiving a modest payoff in most rounds of the game or appropriating and receiving a large payoff in a few rounds of the game. Notice that these two strategies in the agency game correspond to familiar facts about business. Some businesses try to make modest profits on many transactions. These businesses focus on long-run relationships with repeat customers. Other businesses try to make large profits on few transactions. These businesses focus on attracting new cus- tomers for one-time sales. In a competitive equilibrium, both strategies must earn the same payoff. In other words, the strategy of cooperating in long-run relationships must yield the same payoff as the strategy of appropriating in one-shot relationships. This account corresponds to the dynamics of real markets. To illustrate, consider the market for trial lawyers. Most trial lawyers realistically assess their clients’ prospects at trial and use this assessment as the basis for a settlement out of court. These lawyers cor- respond to cooperators in the agency game who attract repeat customers and maintain long-run relationships with their clients. However, some lawyers provide unrealistically

319 304 CHAPTER 8 Economic Theory of Contract Law An optimistic assessments of their clients’ prospects at trial and use these assessments to in- duce their clients to engage in costly litigation. These lawyers correspond to appropria- tors in the agency game who attract relatively few repeat customers and maintain short-run relationships with most clients. The proportion of lawyers of each type adjusts in response to the profitability of the two strategies. If the bar finds ways to reduce the profitability of trials relative to settlements, then more lawyers will try to settle cases, and fewer lawyers will provoke trials. Businesses must expect the unexpected. Accommodating unforeseen changes re- quires flexible business relationships, not rigid rules. Formal rules do not tightly control very much business behavior. In a business relationship as in a marriage, enforcing the rights of the parties differs from repairing their relationship. When businesses in endur- ing relationships come to court, the judges sometimes adopt a different style of adjudi- cation by, say, requiring the parties to attempt mediation before proceeding to trial. Web Note 8.3 For more on relational contracts, see our website. How to Exchange Hostages Medieval kings used to guarantee the peace among themselves by exchanging hostages. Ask yourself this question: Suppose that a king wants to exchange hostages with another monarch to guarantee the peace. Assume that the king likes diamonds as much as he likes his children. That is, he values a diamond ring just as much as—neither more nor less than—he values his own son. Which would make a better hostage: the king’s diamond ring or his son? The better hostage is the one that deters both the hostage-giver and the hostage-taker from starting a war. By assumption, the king values the diamond ring and his son equally; the fear of losing the ring by starting a war equals the fear of losing his son. They are equally good deterrents against the hostage-giver’s starting a war. However, they are not equally good deterrents against the hostage- starting a war. The hostage-taker would presum- taker’s ably like to have the diamond ring but presumably places little intrinsic value on having the son of the neighboring king. The hostage-taker, therefore, is more inclined to start a war and keep the hostage if he holds the diamond ring rather than the king’s son. That is why the king’s son is a better hostage than the diamond ring. In general, a good hostage is something that the hostage-giver values highly and the hostage-taker values little. Asymmetrical valuation makes a good hostage. (See Oliver Williamson, Credible Commitments: Using Hostages to Support Exchange, 83 A M . E CON . R EV . 519 (1983).) Q UESTION 8.13: What sorts of things can corporations give as hostages in long-run contractual relations? Does hostage giving in long-run relationships serve the same or a different function as consideration in a short-run contract?

320 Suggested Readings 305 “Please, It’s My Turn to Pay.” Assume that two computer companies consider merging. To discuss the possible merger, the CEOs decide to have dinner together twice a week for two months. Each can pay for his own meal, or they can take turns paying the whole bill. If each pays for his own meal, neither of them has an incentive to overeat. Conversely, if they take turns paying the bill, then each of them has an incentive to order very expensive items when the other one is paying. “Each- pays-for-his-own-meal” is apparently the better practice. On further consideration, however, this is a mistake. The risk of overeating is trivial compared to the risk of a bad merger. A merger will require trust between them. They might try to establish trust in the small matter of lunch before going to the large matter of merging. “Take-turns- paying-the-whole-check” is a better practice for building trust. If you find out that someone over- orders whenever you pay for lunch, do you really want to merge your company with his? Conclusion Let us summarize our theoretical conclusions. Figure 8.1 describes a problem of cooperation: The principal will not invest unless the agent has an incentive to cooperate. Figure 8.2 depicts a legal solution to the problem. The legal solution is to make an enforceable contract. By enforcing promises, contract law enables people to make credible commitments to cooperate with each other. They maximize the gain from cooperation when law creates efficient incentives for performance and reliance. The law can also reduce the cost of negotiating contracts by supplying efficient default terms, and correct some market failures by supplying mandatory terms. The legal solution to cooperation presupposes an effective state to enforce contracts. The machinery of state law is expensive in the best circumstances and ineffective in the worst circumstances. Figure 8.4 depicts a nonlegal solution to the problem of cooperation: Form an enduring relationship, which enables the principal to retaliate when the agent appropriates. Long-run relationships succeed in repeated transactions of small value and fail in one-shot transactions of large value. Suggested Readings Opting Out of the Legal System: Extralegal Contractual Relations in the Bernstein, Lisa, 21 J. L Diamond Industry, EGAL S . 115 (1992). TUD TA N . 211 EV . L. R The Limits of Cognition and the Limits of Contract, 47 S Eisenberg, Melvin A., (1995). . 741 (1982). EV . L. R ARV 95 H The Bargain Principle and Its Limits, , ———

321 306 Economic Theory of Contract Law An CHAPTER 8 Hermalin, Benjamin E., Avery W. Katz, & Richard Craswell, The Law and Economics of , in A. M Contracts OLINSKY HAVELL , EDS ., H ANDBOOK OF L AW A N D ITCHELL & S TEVEN S P CONOMICS E , v. 1 (2007). , Economic Analysis of Contract Law After Three Decades: Success or Failure? Posner, Eric A., 112 Y ALEL L. J. 829 (2003). See also the responses to Posner’s article: Ian Ayres, Valuing Modern Contract Scholarship, 112 Y L. J. 881 (2003), and Richard Craswell, ALE In That 112 Case What Is the Question?: Economics and the Demands of Contract Theory, Y ALE L. J. 903 (2003). REEDOM OF HE REBILCOCK IMITS OF F , M C ONTRACT (1993). ICHAEL J., T L T

322 To p i c s i n t h e E c o n o m i c s of Contract Law 9 chapter, we explained that a theory of contracts must answer two NTHEPRECEDING questions: “What promises should be enforced?” and “What should be the remedy for breaking an enforceable promise?” We summarized the economic theory devel- I oped to answer these questions. Cooperation is productive: It creates value and typically benefits both parties. Enforcing promises enables people to make their commitments credible. Courts should enforce promises when the parties want enforceability in order to make a credible commitment to cooperate. Enforcement ideally induces optimal performance and reliance at low transaction costs. Optimal performance and reliance maximize the expected value of cooperation to both parties. This economic theory allowed us to develop a framework for analyzing contracts in the preceding chapter. In this chapter we add texture and detail to the economic framework. In the first part of this chapter we focus on remedies for breach of contract. The best remedy for breach secures optimal commitment to the contract, which causes efficient formation, performance, and reliance. Explicit terms in a contract may require interpretation, gaps may require filling, and inefficient or unfair terms may require regulation. We developed a general theory in the preceding chapter for optimal interpretation, gap-filling, and regulation of con- tracts. According to this theory, legal doctrines should perfect contracts by minimizing transaction costs and correcting market failures. We analyze the relevant legal doctrines in detail in the second part of this chapter. I. Remedies as Incentives When a party to a contract fails to perform as promised, the victim may ask the court for a remedy. Remedies fall into three general types: party-designed remedies, court-imposed damages, and specific performance. First, the contract may stipulate a remedy. The contract stipulates a remedy when it contains explicit terms prescribing what to do if someone breaches. For example, a construction contract may stipulate that the builder will pay $200 per day for late completion of a building. Instead of stipulat- ing a specific remedy, the contract may stipulate a remedial process. For example, the contract may specify that disputes between the parties will be arbitrated by the International Chamber of Commerce, which has its own rules about remedies. Because negotiating and drafting are costly, an efficient contract will not explicitly cover every contingency. In fact, most contracts do not specify remedies for breach. When the contract omits a remedy, the court must supply one. Second, the courts may 307

323 308 CHAPTER 9 opics in the Economics of Contract Law T supply a remedy in the form of damages. And third, the courts may order the breaching party to specifically perform the contractual promise. Damages and specific performance are the two general types of court-designed remedies for breach of contract. Different legal systems in different countries disagree about the preferred remedy. In common law countries and in France, courts say that damages are the preferred remedy, whereas German and most other European courts say that specific performance is the preferred remedy. The difference between alterna- tive legal traditions, however, is greater in theory than in practice. In practice, each le- gal system prescribes damages as the remedy in some circumstances and specific performance as the remedy in other circumstances. Furthermore, the prescriptions largely overlap in many different legal systems. Presumably, the prescriptions overlap because different systems of law respond to the same economic logic. Common law and civil law traditions both tend to specify the efficient remedy for breach of contract. The Uniform Commercial Code, Restatements of Contracts, and Statute of Frauds In the civil law countries, which include the nations of continental Europe, committees of schol- ars have formulated contract law into codes that legislatures enacted. In common law countries, which include the United States, judges have formulated contract law in deciding cases. This con- trast, however, can be overstated. Americans have actually codified much of the common law of Uniform Commercial Code , the American Law contracts in three important documents: the Restatements of Contracts , and statutes revising the old English Statute of Frauds . Institute’s The National Conference of Commissioners on Uniform State Laws was founded in the 1890s to unify common law in the American states. The Conference and the American Law Institute (described below) adopted the in 1952, extensively re- Uniform Commercial Code vised it in 1956, and have periodically revised portions of the code since then. Forty-nine states (all but Louisiana, which has a civil law tradition) have adopted the Uniform . It consists of nine articles covering all aspects of commercial transactions. Commercial Code For example, Article 1 sets out the general provisions of the code; Article 2 covers the sale of goods (services are not covered); and Article 9 covers secured transactions. The Restatements of the law are a project of the American Law Institute, a private group of judges, lawyers, and law professors founded in 1923, whose purpose “is to state clearly and precisely in the light of the decisions the principles and rules of the common law.” The Institute’s first project was the , which was published in 1932 and Restatement of Contracts subsequently revised in 1979. The ALI has also sought to restate the common law in property, contracts, torts, and other subjects. The Statute of Frauds (“An Act for Prevention of Frauds and Perjuries”) was passed by the English Parliament in 1677. The purpose of the act was to prevent fraud in the proof of contracts, deeds to land, trusts, and wills. To guarantee a trustworthy record, the statute re- quired a signed writing in certain contractual transactions, possibly supplemented by wit- nesses. The requirement of a written record for contracts whose value exceeds a certain minimum has become the most important feature in the modern revisions of the statute, which every American state has adopted.

324 I. Remedies as Incentives 309 A. Alternative Remedies Different remedies create different incentives for the parties to a contract. We will develop models to compare the incentive effects of different remedies on investment in performance and reliance. Before turning to their incentive effects, however, we must use economics to distinguish the different forms of remedies given by courts. 1. Expectation Damages Damages for breach of contract compensate the promisee for the injury caused by the nonperforming promisor. In a contract setting, the term “injury” has several different meanings. First, the promisee is worse off than if the contract had been performed. Performance provides a baseline for computing the injury. Using this baseline, the courts award damages that place the victim of breach in the position he or she would have been in if the other party had performed. The promisee expects to gain from performance. Consequently, the common law tradition refers to damages based on the value of expected performance as “expectation 1 damages.” The civil law tradition refers to these damages as “positive damages” ( ) because the damages replace income that would have accrued in the lucrum cessans future. If expectation damages or positive damages achieve their purpose, the potential victim of breach is equally well off whether there is performance, on the one hand, or breach and the payment of damages, on the other hand. We say that perfect expectation between performance and breach. damages leave potential victims indifferent We will illustrate expectation damages by three examples: Seller’s Breach. O T icket Agency offers opera tickets at the Example 1: price p . p . K Ticket Agency offers equivalent opera tickets at the lower price O K Consumer orders x p and promises to pay tickets from K at the contract price K K when he picks up the tickets on the day of the performance. Close to the day of t