A clear view of 'The Cathedral': the dominance of property rules.

AuthorEpstein, Richard A.
PositionProperty Rules, Liability Rules, and Inalienability: A Twenty-Five Year Retrospective
  1. Introduction: Two Kinds of Rules, Two Kinds of Risks

    In their 1972 article, Guido Calabresi and A. Douglas Melamed introduced the now standard distinction between property rules and liability rules.(1) A property right gives an individual the right to keep an entitlement unless and until he chooses to part with it voluntarily.(2) Property rights are, in this sense, made absolute because the ownership of some asset confers sole and exclusive power on a given individual to determine whether to retain or part with an asset on whatever terms he sees fit. In contrast, a liability rule denies the holder of the asset the power to exclude others or, indeed, to keep the asset for himself. Rather, under the standard definition he is helpless to resist the efforts by some other individual to take that thing upon payment of its fair value, as objectively determined by some neutral party.(3)

    Calabresi and Melamed would have made a major contribution if they had simply pointed out how these remedial choices recur in widely divergent substantive settings. Yet their article became enormously influential by pinpointing the key economic consequence that flows from these alternative specifications of remedial protection for any entitlement. Because property rules give one person the sole and absolute power over the use and disposition of a given thing, it follows that its owner may hold out for as much as he pleases before selling the thing in question. In contrast, by limiting the owner's protection to a liability rule, that holdout power is lost, and in its stead the owner of the thing receives some right to compensation for the thing that has been taken away from him against his will.

    It is one thing to articulate a distinction, it is another to determine how it should be used. Although their work was pathbreaking in many ways, Calabresi and Melamed nonetheless failed to address systematically the challenge of deciding whether legal protection via a property or a liability rule should be conferred to holders of particular sorts of assets, or why. It is to that question that I shall address myself here. I shall lay out my cards clearly at the beginning. In a world in which transaction costs were zero, where all disputes could be costlessly resolved, the choice between liability rules and property rules would be of little or no importance -- just another application of the ubiquitous Coase Theorem.(4) On the one hand, the holdout danger from a property rule would be of no consequence because the two parties could exchange an infinite number of offers within an infinitesimal period of time; in essence, that is what a world of zero transaction costs would entail. On the other hand, a liability rule would have no serious downside either. Armed with our zero transaction costs assumption, any dispute on valuation could be resolved both accurately and instantly. In both cases, each asset would end up in the hands of the party who valued it most with no institutional drag, so that the choice of institutional arrangements would be of little or no consequence to the overall situation.

    It is an open question, however, whether one can even understand what a world of zero transaction costs means, given the violence it does to our ordinary understanding of the importance of time. Be that as it may, our world is not one in which transaction costs are zero. Rather, they are positive and large, so that the choice between the two rules is certain to have major consequences for the overall operation of any legal system. Given this fact, it becomes clear that each legal system will have to choose some legal rule that minimizes the transactional imperfections that occur in securing the transfer of assets from one person to another. The standard practice in virtually all legal systems assumes the dominance of property rules over liability rules, except under those circumstances where some serious holdout problem is created because circumstances limit each side to a single trading partner. In these cases of necessity, the holdout problem could prove enormous, so that the strong protection of a property rule is relaxed. One person may be allowed to take the property of another upon payment of compensation, but only in a constrained institutional setting that limits the cases in which that right can be exercised and supervises the payment of compensation for it.

    The reason for this allocation of power is as follows. In most situations, the owner of a particular asset may choose from a large number of potential trading partners. In those settings, the holdout advantage conferred by a liability rule is relatively small, for a potential buyer can play one seller off against another until a competitive price is reached. At this point, the exchange will usually occur without explicit legal intervention on terms that leave both parties satisfied with the outcome, taking into account both the market and subjective components of value that may inhere in specific assets. To inject liability rules into this setting, however, requires some level of state intervention in each and every transaction to set the appropriate value for the parties. The risk of undercompensation in such situations is pervasive given the inability to determine with accuracy the losses, both economic and subjective, that follow when individuals find that someone else has plucked away from them assets that they need for the operation of their own business. The problems here are acute under the current law of eminent domain, in which the levels of compensation generated systematically ignore all elements of subjective loss and consequential damages brought on by deliberate government action.(5) Do we allow one business to take some key equipment from the other in the dark of night if it is willing to pay full compensation? Do we allow one person to take the wedding ring of another simply by paying its market value? Over time, the inefficiencies of a liability system cascade until the security of possession and the security of exchange needed for complex commercial life and a satisfying personal one are no longer available.

    These valuation difficulties help explain why liability rules, when used, always take the direction of a "call" -- that is, an option that allows some person the right to take a thing in time of need. To be sure, markets themselves invent all sorts of different kinds of options, including "puts," which allow holders of a specific asset to sell it to another person for some predetermined price.(6) Those arrangements are common enough in financial markets, but they are rarely encountered in the world of legally created remedies.

    The reason seems clear. A liability rule is typically adopted to counter the monopoly position of the holder of the asset. The holder of cash has no monopoly position at all, so it is very hard to believe that by allowing the present holder of some specific asset to designate the person who must take it off his hands, we advance any conceivable measure of social welfare. The potential recipients are numerous, and there is no reason to believe that if the holder of the asset is allowed to cash out safely from the transaction, he will foist the asset off on a party, arbitrarily chosen, that can make better use of it than he. Puts, therefore, are never imposed as a matter of law on strangers but are the outgrowth of consensual transactions over organized markets. As between strangers, liability rules, however sharply constrained, always take the form of calls. The person who has the cash can dictate that some asset be moved in his direction, where there is every reason to believe that he can make at least some intelligent use of it, perhaps better than his incumbent.

    Owing to these dangers, liability rules are limited to those circumstances in which property rules work badly, namely, cases where the holdout power implicit in a property rule becomes so large that useful transactions may be blocked by a wide range of strategic behaviors. These holdout situations arise when the resource currently commanded by A is needed by B, such that each can deal only with the other for the useful exchange to take place. In such settings, A may value the thing at 10 and B may value it at 1000, such that it is clear that a mutually beneficial voluntary exchange could take place at any sum between 11 and 999, but the exact point between the two extremes cannot be determined in the abstract, so that the parties labor under strong incentives to hold out for the largest fraction of the gain. At this point, even if the bargain is made, much of the surplus (equal to 1000 minus 10, or 990) could be dissipated in achieving it. Alternatively, the bargaining process itself could break down. Aware of these future possibilities, the parties could easily take excessive precautions to avoid ever finding themselves in a holdout situation.(7)

    Often, the parties will know that these risks might occur. Tenants to a lease can introduce terms that ease the problems on renewal. Marriage contracts could include provisions for property division on divorce. Where these contract rules are made, they normally ought to be respected because the parties have the best knowledge of their future situation and can assess the competing risks better than the legal system, but in many cases the holdout problem is thrust upon people without their consent and against their will. To prevent the bargaining from breaking down in these contexts, the law could tell one person that he is entitled to take the property of another upon payment of just compensation, namely, an amount that equals the return he could have gotten for that asset in a competitive situation in which that holdout potential is lost. Yet even here, the law will, whenever possible, impose a layer of independent review that indicates what property may be taken and how much compensation should be paid for it.

    Stated formally...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT