BOUNDED RATIONALITY AND THE THEORY OF PROPERTY.

• Author: Bar-Gill, Oren

INTRODUCTION 1021 I. PROPERTY AND TIME 1024 A. One-Period Model 1025 B. Multiple Period: Recurring Takings 1026 II. THE CONVENTIONAL JUSTIFICATION, AND ITS FAILURE 1028 A. The Multiple-Takers Problem 1028 B. Framework of Analysis 1029 C. Efficiency With Multiple Takers 1030 D. The (Inconsequential) Limits of Efficiency 1030 E. Beyond Coase 1032 F. Taking Stock 1033 III. BOUNDED RATIONALITY 1033 A. The Inefficiency of Liability Rules 1034 B. The Efficiency of Property Rules 1036 C. More Irrationality? 1038 IV. EXTENSIONS AND OBJECTIONS 1039 A. High Transaction Cost 1039 B. Nondurable Assets 1042 C. Ex Ante Efficiency 1043 1. Investments in Taking and Anti-Taking Technologies 1043 2. Investments in Improving Assets 1044 3. Entry and Exit Decisions 1045 4. Taking Stock 1046 D. Nonconsequentialist Theories 1046 CONCLUSION 1046 APPENDIX 1048 INTRODUCTION

Property rights are commonly enforced by property rules, which are characterized by injunctive relief for the right holder and harsh sanctions for the infringer. Indeed, any theory of property must explain and justify the link between property rights and property rules. In this Article, we argue that the conventional justification fails. This failure can be attributed to the standard assumption that parties are perfectly rational. When the rationality assumption is relaxed, a novel justification emerges for the dominance of property rules. Bounded rationality provides the hitherto underappreciated foundation for the theory of property.

Consider the following example: After hours of hard work at the library, you leave your laptop on the table and step outside for a well-deserved break. Working at a nearby table, I lift my head and see the laptop. I walk over, pick it up, and place it in my backpack. I have taken your laptop without your consent. What are the legal consequences? If I am caught, I will be forced to return the laptop to you. I might also be prosecuted for theft and subjected to a criminal sanction. Your property right to the laptop is protected by a "property rule." Such a rule, characterized by injunctive relief and harsh sanctions, provides you, the right holder, with strong protection. (1) The alternative mode of protection, "liability rule protection," is much weaker. It requires only that the perpetrator, the taker, pay compensatory damages to the right holder. (2) While prevalent in other legal contexts, liability rules are seldom used to protect property rights in tangible personal property. I, the thief, cannot keep your laptop and just pay some damages that a court thinks sufficiently compensate you, the laptop's owner. (3)

Property rule protection is inexorably linked with the very notion of property. Injunctive relief and specific performance, through which property rules are characteristically implemented, have a long association with common-law property rights. (4) Many view the right to exclude as the defining characteristic of property. (5) And injunctive relief, the quintessential property rule remedy, is seen as the natural way to enforce the right to exclude. (6) Modern property scholarship similarly associates property rights with property rule protection. (7) The economic literature on property rights assumes, without question, that these rights must be protected by property rules. Indeed, an entire literature on trade and exchange in a market economy presumes that entitlements can only change hands if the original right holder consents--namely, that the penalty for involuntary transfer is prohibitively harsh. (8) Calabresi and Melamed, in their seminal contribution, succinctly summarized the foundational relationship between property rights and property rules: "[M]uch of what is generally called private property can be viewed as an entitlement which is protected by a property rule." (9) It is no happenstance that property rules and property rights share an adjective.

A theory of property must, therefore, explain the key role of property rule protection. Why the harsh penalty for the laptop thief? Why can I not take your laptop and pay compensatory damages? The standard answers, we argue, are unsatisfactory. Conventional wisdom justifies the dominance of property rules by arguing that strong property rights--namely, property rights protected by property rules--are the backbone of the market system, that property rules are necessary for efficient exchange, and that the market system would crumble if we replace strong property rights with weaker liability rule protection. We challenge this conventional wisdom. We show that efficiency generally obtains in a liability rule regime as long as we maintain the standard rationality assumption (which underlies the conventional argument).

We then develop our new, bounded rationality theory of property. We show that when the conventional rationality assumption is replaced with a more realistic bounded rationality assumption, the concerns about liability rules resurface. In a liability rule regime, consecutive rounds of takings, or threats to take, are inevitable, and efficiency depends on the parties' ability to anticipate these future interactions and account for them when buying and selling property. Liability rules impose unrealistic demands on boundedly rational parties who struggle to anticipate the future implications of present actions and cannot think more than a few steps ahead. Thus, liability rules are efficient in an ideal world populated by perfectly rational parties, but not in the real world. Property rules do not require such a high level of sophistication. They support efficient exchange between boundedly rational, as well as perfectly rational, parties. Robustness to bounded rationality proves to be a foundational difference between property rules and liability rules. And so, bounded rationality becomes a key element of property theory.

Before proceeding further, a methodological note is in order: ours is a consequentialist theory of property. Since property rules are fundamental building blocks of our market economy, it seems important to develop, and defend, such a consequentialist, efficiency-oriented theory. This is not meant to exclude or undermine nonconsequentialist arguments (e.g., autonomy-based arguments) for the dominance of property rules.

The remainder of this Article is organized as follows. Part I sets the stage by uncovering the essential link between property and time. Many assets are durable; they exist and produce value over time. This essential feature of property triggers the concern about recurring takings in a liability rule regime--a concern which underlies the conventional justification for property rules as well as our bounded rationality theory of property. Part II presents the conventional justification for property rules, under the standard rational choice assumptions, and shows why this justification fails. Part III relaxes the perfect rationality assumption and develops our novel bounded rationality theory of property. Part IV considers several extensions and objections. It explores the effects of transaction costs on the relative efficiency of property rules and liability rules. It confronts the objection that not all assets are durable. It discusses the implications of property rules (as compared to liability rules) for ex ante efficiency, as opposed to ex post exchange efficiency. And it engages, albeit briefly, with nonconsequentialist theories of property.

1. PROPERTY AND TIME

   The quintessential objects of property theory are assets whose value stretches over multiple periods of time. Land and real estate last for many years, if not indefinitely. Personal property, like a car or a laptop computer, produce value for long periods of time. Intangible property--the object of intellectual property rights--exists over spans of years, which are, sometimes, defined by law. (10) Time, in the sense of asset durability, is a defining feature of property. And a convincing theory of property should account for the role of time. Indeed, the conventional argument for property rule protection is based, in large part, on the alleged failure of liability rules to support the efficient allocation of assets over time.

   Property rules constitute the backbone of the market system and guide interactions between many parties over many time periods. Accordingly, both the conventional justification for property rule protection and our novel, bounded rationality justification are based on a multiperiod model of repeat interactions among multiple actors. In this Part, we set the stage for this multiperiod analysis. We begin, in Section LA, by developing some basic intuitions using a simple, one-period model. This unrealistic, single-period analysis serves to highlight the importance of time--of the multiple periods that measure the life span and value of property. Then, in Section I.B, we turn to the multiperiod model. The challenge for liability rules--both under the conventional approach and in our bounded rationality theory--begins with a concern about recurring takings. Over multiple periods, an asset that is protected by a liability rule might be the subject of recurring takings. We identify three distinct scenarios where recurring takings may threaten the efficiency of liability rules and thus provide a theoretical foundation for the dominance of property rules. (11)

   1. One-Period Model

      Consider a simple one-period model. At the beginning of the single period, the asset is held by Owner. Taker then appears and threatens to take the asset from Owner. Owner values the asset at $100. Assume that, in any negotiations between Owner and Taker, Owner has all the bargaining power. (12) Further, assume that such negotiations are not hindered by transaction costs ("TCs"). Indeed, if we think of the choice between property rules and liability rules as determining the ground rules for the market system, and if we think that the market facilitates low-cost...