Fractured Markets and Legal Institutions

• Author: Herbert Hovenkamp
• Position: Ben V. & Dorothy Willie Professor of Law, University of Iowa
• Pages: 617-661

Fractured Markets and Legal Institutions Herbert Hovenkamp  I. INTRODUCTION ............................................................................. 618 II. THE COSTS OF RESOURCE MOVEMENT ......................................... 621 A. R ELATIVE D EADWEIGHT L OSS .................................................. 624 B. T HE C HOICE OF AN I NITIAL P OSITION AND THE V ALUE OF P LANNING ............................................................................... 625 III. COASEAN MARKETS ....................................................................... 627 A. I DENTIFYING THE E FFICIENT O UTCOME .................................... 627 B. M ICROMARKETS : F UNCTIONALITY AND F RACTURE .................... 629 C. T HE C OUNTEREXAMPLE OF A UTOMOBILE A CCIDENTS ............... 631 D. K EEPING C ONTRACT AND B EHAVIORAL E XPECTATIONS W ITHIN A PPROPRIATE B OUNDS ............................................................. 634 IV. COASEAN MARKETS WITH MANY PLAYERS ..................................... 636 A. T HE P UBLIC G OODS C HARACTER OF M ANY -P LAYER C OASEAN M ARKETS ................................................................................ 639 B. E XCESSIVE C YCLING OR E XCESSIVE S TABILITY ? .......................... 643 C. F RACTURED M ARKETS AND THE O PTIMAL S OURCE OF R EGULATION ........................................................................... 645 D. EX ANTE AND EX POST D ECISION M AKING : E FFICIENCY AND THE L ONG R UN .............................................................................. 646 V. MANAGING FRACTURE THROUGH DEFAULT RULES ...................... 648 A. D EFAULT R ULES FOR D IFFERENT L EGAL I NSTITUTIONS .............. 651 1. The Selection of a Default Rule ................................... 651 2. Choosing Between Default and Absolute Rules .......... 654 3. Minimum Coalition to Reverse a Default .................... 655 B. D EFAULT R ULES IN T RADITIONAL M ARKETS : C OMMERCIAL VS . N ONCOMMERCIAL ................................................................... 656 C. D EFAULT R ULES FOR C OASEAN M ARKETS ................................. 657  Ben V. & Dorothy Willie Professor, University of Iowa. 618 IOWA LAW REVIEW [Vol. 100:617 VI. “STACKING” LEGAL INSTITUTIONS TO MINIMIZE FRACTURE: “ONE WAY” DEFAULTS ............................................................................ 658 VII. CONCLUSION: THE DESIGN OF MARKETS ...................................... 660 I. INTRODUCTION How should the legal system address conflicts that occur in very small environments? The conflicts come in many kinds, including a nuisance dispute between neighbors, an impending collision between two moving vehicles, a joint decision between spouses about whether or on what terms to continue their marriage, or a disagreement between managers and shareholders within a firm. The literature often refers to these small environments as “markets.” Considering them in that way, however, averts our attention from larger environments that should be included in the inquiry but that often do not function well as private markets. The term “institutions” is better, because it encompasses environments in which people have both market (exchange-based) and non-market interactions. Further, institutions are human creations, while environments need not be. One way to think of the problem is as “market fracture,” or the cost of breaking the arenas in which people interact into excessively small pieces. Focusing on the larger rather than the smaller arena can enable an increase in social wealth or welfare but may also require greater state oversight. In the process it may also require us to abandon the language of markets or constrain its use, particularly in situations where instability (cycling) or behavioral issues are prominent. In these settings the “market” is often little more than an unhelpful metaphor. People’s options often narrow as their commitment to a course of action becomes deeper or more specific. One good example is marriage. While the market for getting married is large and competitive, depending on the size of the community, the market for divorce is a bilateral monopoly: you can get a divorce only from the one you are with. This partly explains why most divorces are more costly than most weddings. But if we assumed that the divorce rate is excessive and something should be done about it, the fix might require state intervention in the marriage market. That is, it may be preferable to fix this problem earlier rather than later. Alternatively, employers and prospective employees may bargain over jobs in a competitive market. Post-hiring promotion or termination issues are negotiated in a much smaller institution, however, which may also be a bilateral monopoly in some cases. Similarly, when a farmer in early spring makes a decision about what to plant, the “market” she faces includes the full range of products she is capable 2015] FRACTURED MARKETS AND LEGAL INSTITUTIONS 619 of growing on her land and with her existing equipment. Once she has planted beans, however, the market she faces is typically reduced to that product, although it may be salable over a large geographic range. After the beans have been delivered to a particular store, the market for them may consist only of the subset of people who shop there. Each further stage in the process fractures the market further and leaves people with a smaller range of choices, provided that the costs of reversing the decision are greater than the payoffs from switching. To the extent reversal is costly, making a decision earlier saves more resources than making it later. Indeed, the prospective farmer faces her largest range of choices before she has settled on farming as a career at all. At that time even her purchase of land and equipment is one of many options. In addition, the decisions to enter farming, to grow beans in a particular year, or to sell them to a particular store may have been mistakes. If so, they are corrected more cheaply earlier rather than later. In The Problem of Social Cost , Ronald Coase identified the costs of bargaining as the main impediment to the free and efficient flow of resources. 1 As a result, Coase argued throughout his career that transaction costs make a legal system important to social ordering. 2 Coase wrote about several common law disputes among neighbors whose economic activities conflicted with one another. One of them was Sturges v. Bridgman , a 19th-century British nuisance case between the two occupants of a duplex building sharing a party wall. 3 Octavius Sturges was a London pediatrician who specialized in childrens’ respiratory diseases, such as pneumonia. Frederick Horatio Bridgman was a confectioner to Queen Victoria, whose process for making sweets required him to use a mechanical mortar and pestle to pulverize substances such as chocolate. 4 The nuisance dispute arose when Sturges complained that Bridgman’s machine, with its repetitive pounding, made it impossible for Sturges to use his stethoscope to diagnose patients. Coase argued that if high transaction costs did not interfere, private bargaining would provide a solution to the problem of conflicting uses, which he characterized as “efficient.” By that he meant that the right to continue would be given to the person who valued it most. 5 For example, if the pediatrician valued the right to relative silence at £100, while the confectioner valued the right to conduct his business at £60, the efficient solution would preserve the pediatrician’s £100 value over the confectioner’s £60 value. If no 1. R.H. Coase, The Problem of Social Cost , 3 J.L. & ECON. 1, 15 (1960). 2 . See, e.g. , R.H. Coase, Professor, Univ. Chi. Law Sch., The Institutional Structure of Production, Prize Lecture for the Alfred Nobel Memorial Prize in Economic Sciences (Dec. 9, 1991), in 82 AM. ECON. REV. 713 (1992). 3. See generally Sturges v. Bridgman, LR 11 Ch.D. 852 (1879). 4. For more on the players and the facts in Sturges v. Bridgman , see generally A.W. Brian Simpson, Coase v. Pigou Reexamined , 25 J. LEGAL STUD. 53, 54–58 (1996). 5. Coase, supra note 1, at 16. 620 IOWA LAW REVIEW [Vol. 100:617 one else was affected, then this outcome made society as a whole wealthier as well. Alternative solutions might preserve the ability of both parties to operate, however, generating a social value of £160. Coase did not consider these, because the tiny market he considered was too small to include them. He was concerned with transaction costs, and on his assumptions the only parties who could transact were Sturges and Bridgman. This tiny microcosm was the appropriate institution for analysis because Sturges and Bridgman were locked together by virtue of their own previous investments. Stepping back to an earlier point in time and considering a broader range of alternatives was not economically feasible if the payoff to extraction was less than the payoff to staying inside their tiny market and reaching an agreement. The greater benefit from stepping back does not result from eliminating or internalizing an externality. The problem is not that looking at the smaller environment ignores an uncompensated injury that one person imposes on another, but rather that the larger environment prevents certain injuries from arising in the first place. Neither does it have anything to do with transaction costs: the parties might be able to bargain costlessly to a maximizing solution within their current environment but would still be unable to achieve the gains that the larger environment permits. These costs of reversal are sometimes transaction costs, but often they are simply a cost of moving resources. For example, the farmer who realizes too late that planting beans was a mistake may have to plow up the bean field, prepare the soil a second time, and plant spinach or some other crop. Assuming she does the work herself, however, most of these costs would not...