Fractured Markets and Legal Institutions

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

617

Fractured Markets and Legal Institutions

Herbert Hovenkamp

I. INTRODUCTION ............................................................................. 618

II. THE COSTS OF RESOURCE MOVEMENT ......................................... 621

A. RELATIVE DEADWEIGHT LOSS .................................................. 624

B. THE CHOICE OF AN INITIAL POSITION AND THE VALUE OF

PLANNING ............................................................................... 625

III. COASEAN MARKETS ....................................................................... 627

A. IDENTIFYING THE EFFICIENT OUTCOME .................................... 627

B. MICROMARKETS: FUNCTIONALITY AND FRACTURE .................... 629

C. THE COUNTEREXAMPLE OF AUTOMOBILE ACCIDENTS ............... 631

D. KEEPING CONTRACT AND BEHAVIORAL EXPECTATIONS WITHIN

APPROPRIATE BOUNDS ............................................................. 634

IV. COASEAN MARKETS WITH MANY PLAYERS ..................................... 636

A. THE PUBLIC GOODS CHARACTER OF MANY-PLAYER COASEAN

MARKETS ................................................................................ 639

B. EXCESSIVE CYCLING OR EXCESSIVE STABILITY? .......................... 643

C. FRACTURED MARKETS AND THE OPTIMAL SOURCE OF

REGULATION ........................................................................... 645

D. EX ANTE AND EX POST DECISION MAKING: EFFICIENCY AND THE

LONG RUN .............................................................................. 646

V. MANAGING FRACTURE THROUGH DEFAULT RULES ...................... 648

A. DEFAULT RULES FOR DIFFERENT LEGAL INSTITUTIONS .............. 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. DEFAULT RULES IN TRADITIONAL MARKETS: COMMERCIAL VS.

NONCOMMERCIAL ................................................................... 656

C. DEFAULT RULES FOR COASEAN MARKETS ................................. 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 chocol ate.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 Econ omic 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.