Do liability rules facilitate bargaining? A reply to Ayres and Talley.

• Author: Kaplow, Louis
• Position: Response to Ian Ayres and Eric Talley, Yale Law Journal, vol. 104, p. 1027, 1994

In a recent article, Ian Ayres and Eric Talley revisit the question of the relative superiority of property versus liability rules,(1) a topic that was introduced to legal academia in its economically oriented form by Calabresi and Melamed two decades ago.(2) Ayres and Talley focus on the context in which bargaining is feasible, such as when one neighbor disturbs another (in contrast to situations in which bargaining is infeasible, such as when industrial pollution harms many disorganized victims). In this case, the Coase Theorem(3) informs us that when bargaining functions perfectly, the efficient result will be achieved regardless of the legal rule. When bargaining is imperfect due to the possibility of strategic behavior, however, it is understood that the efficient result might not be reached under either property or liability rules.(4)

The primary argument advanced in Ayres and Talley's article is that, when bargaining is imperfect, "liability rules possess an `information-forcing' quality" that "may induce both more contracting and more efficient contracting than property rules."(5) We question their analysis on the following grounds:

* The information-forcing argument they offer in support of their thesis is incomplete and may be upset by countervailing factors.

* A priori reasoning suggests that the opposite of their thesis is likely to be true in the context that they examine.

* Their numerical example turns out to illustrate the opposite of their thesis.

* Variations of their numerical example also illustrate the opposite of their thesis.

We begin by outlining the theory concerning the choice between property and liability rules and how it depends upon bargaining. We next state Ayres and Talley's thesis and the argument they offer to support it. Then we explain each of the four points listed above. Finally, we note that Ayres and Talley's response to this Comment advances a new argument that has little to do with the argument in their article. We conclude by commenting on how bargaining bears on the choice between property and liability rules in the context Ayres and Talley examine.

1. BARGAINING AND THE CHOICE BETWEEN PROPERTY AND LIABILITY RULES FOR THE CONTROL OF HARMFUL EXTERNALITIES

   Ayres and Talley consider the familiar context in which an injurer (say, a factory) may cause harm to a victim (say, a neighbor who would be bothered by noise from the factory). It is efficient for the injurer to harm the victim if and only if the benefit from the harm-causing activity exceeds the harm to the victim.

   Adopting the now familiar framework of Calabresi and Melamed,(6) Ayres and Talley compare a liability rule-in which the injurer is free to harm the victim, upon payment of damages--to property rules--for example, a property rule allowing victims to enjoin any harm-causing activity. (To focus on their main argument, they assume that there are no complications such as victims' incentives, risk aversion, litigation costs, and so on. We will adhere to the same assumptions here.(7))

   Because Ayres and Talley's thesis concerns bargaining under legal rules, it is useful to distinguish the following three cases.

   1. Bargaining Is Impossible

      When bargaining is impossible, a liability rule will result in efficient behavior if the damages injurers must pay equal the harm their acts produce, for injurers will then take action if and only if the value of their activity exceeds the harm it causes. By contrast, a property rule protecting victims will prevent some efficient activity, while a property rule freely permitting injurers to cause harm will allow some inefficient activity to occur. As a consequence, the liability rule is superior to the use of property rules.

      The preceding argument assumes that damages equal harm, which is known to the parties and the court. Often, however, courts will not be able to assess harm accurately.(8) In this situation, it can be demonstrated that a liability rule with damages set equal to average harm remains superior to property rules.(9)

   2. Bargaining Is Perfect

      When bargaining is perfect, we know from the Coase Theorem that efficient behavior will result regardless of the legal rule. For example, under a property rule protecting victims, injurers will bribe victims to permit harm whenever that is efficient. Under a liability rule where damages are mistakenly set below actual harm, victims will bribe injurers to desist whenever that is efficient. Because perfect bargaining results in efficiency, the level of social welfare under property rules is the same as under liability rules.

   3. Bargaining Is Imperfect Due to Asymmetric Information

      When each party's own valuation is not known by the other, each party will have incentives to misrepresent its valuation in bargaining, hoping to extract more of the bargaining surplus from the other party. Parties may therefore demand too much or offer too little, with the result that efficient bargains may not be reached. In this case, one cannot say unambiguously whether property rules or liability rules will be superior.(10) We offer, however, two related conjectures for the simple world that Ayres and Talley examine:

      (1) When bargaining is imperfect, the liability rule will tend to produce greater total welfare than property rules (but the advantage of the liability rule will be less than when bargaining is impossible).

      (2) When bargaining is imperfect, the use of property rules will lead to greater bargaining-related welfare gains than does the liability rule.

      Why do we suspect these claims to be true? Consider the "race" between property rules and liability rules. If the race is run without bargaining, the liability rule will win, as we explained in Section I.A. If the race is run with perfect bargaining, there will be a tie, as we explained in Section I.B. Hence, under perfect bargaining, property rules necessarily lead to greater bargaining-related welfare gains than does the liability rule. Under imperfect bargaining, our a priori guess (but it is only a guess) is therefore that property rules lead to greater bargaining-related welfare gains; that is, we suspect that under imperfect bargaining, some but not all of the initial efficiency disadvantage that exists under property rules is nullified through bargaining.

      To illustrate, suppose that, in the absence of bargaining, welfare is $90 under the liability rule but is only $70 under a property rule. Under perfect bargaining, assume that welfare under both types of rule is $100. Then, the liability rule gains only $10 due to bargaining, whereas the property rule gains $30. Under imperfect bargaining--in which, say, half of all efficient agreements are consummated--the liability rule's bargaining-related gains are $5, whereas the property rule's bargaining-related gains are $15.

2. AYRES AND TALLEY'S THESIS: LIABILITY RULES FACILITATE BARGAINING

   We now turn to Ayres and Talley's argument, that liability rules have an information-forcing effect that facilitates bargaining. We take their thesis to be that, as a result of the information-forcing effect, bargaining tends to raise social welfare by a greater amount under liability rules than under property rules: The combination of the number of agreements made as a consequence of bargaining, and the improvement that each of these agreements brings about, raises social welfare more when a liability rule is in place than when a property rule is in place.

   To avoid possible confusion below, we note that Ayres and Talley's thesis is not that welfare is higher under liability rules without regard to how much welfare rises as a consequence of bargaining--that is, without regard to either the number of agreements or how much each agreement raises welfare. The subject of Ayres and Talley's thesis is whether liability rules "[f]acilitate Coasean [t]rade,"(11) not whether liability rules might be better than property rules for reasons having nothing to do with bargaining.(12) One would not say, for example, that liability rules facilitate bargaining in a case such as the following: Welfare is $60 under a liability rule both with and without bargaining--that is, all bargains fail, so welfare is not at all increased by bargaining--and welfare is $59 under a property rule with bargaining but $50 without bargaining--so welfare is increased, by $9, as a result of bargaining.

   As a final observation, we note that, although Ayres and Talley do not assert that liability rules always facilitate bargaining...