Property rights and liability rules: the ex ante view of the Cathedral.

• Author: Bebchuk, Lucian Arye

1. INTRODUCTION: ALTERNATIVE VIEWS OF THE CATHEDRAL

   This Article aims to contribute to the study of how the law should allocate and protect entitlements in the presence of externalities. In their classic article published thirty years ago, Calabresi and Melamed studied such questions and offered what they labeled "one view of the Cathedral." (1) I seek to add to the inquiry started by Calabresi and Melamed by offering an ex ante perspective and analyzing how allocations of entitlements affect parties' ex ante actions and investments.

   Suppose that an upstream Factory would benefit from an activity that would pollute a river and harm an activity conducted by a downstream Resort. In this as in many other cases, the respective rights of the parties must be determined. Does Factory have the right to engage in the polluting activity, or does Resort have the right to water free of pollution? If Resort is entitled to unpolluted water, should it be protected by a property right or by a liability rule? (2)

   Calabresi and Melamed, and the subsequent extensive literature on the subject, (3) have primarily conducted what I will label an "ex post analysis." I use this term to refer to an analysis that takes as given the payoffs that parties would have with and without externality-producing actions. In the above example, an ex post analysis would take as given both the presence of Factory and Resort and their potential costs and benefits from their respective activities. Taking these elements of the situation as given, the analysis would examine which entitlement allocations would lead to the efficient level, if any, of pollution-producing activity on the part of Factory.

   The common starting point for an ex post analysis is the Coasean insight that, in cases in which the relevant parties can easily bargain ex post, the allocation of entitlements will matter little in terms of efficiency. (4) As long as parties can bargain around legal rules, the ex post outcome will be always efficient. Given that bargaining is subject to transaction costs and imperfect information, however, such ex post efficiency cannot be guaranteed. The ex post analysis therefore examines which allocation of entitlements would most likely facilitate the efficient outcome in a world where such obstacles to bargaining exist.

   This Article focuses on how ex ante decisions are affected by allocations of entitlements. By ex ante decisions I mean throughout this Article those decisions that (i) take place before decisions whether to undertake externality-producing actions are made, and (ii) influence the parties' potential payoffs with or without these externality-producing actions. Thus, in the considered example, the ex post payoffs of Factory and Resort with and without pollution might be a product of their ex ante decisions whether to locate along the river in the first place and, if so, how close to the river to locate; what scope of activities to develop; what products or services to provide; how many workers to hire and how much to invest in their human capital; and so forth. Such ex ante decisions are ubiquitous, of course, and they critically affect the ex post structure of cases the law must address. (5)

   To study the ex ante dimension of the Cathedral in isolation from the ex post problems extensively studied in prior work, I will put aside these problems by assuming that ex post bargaining between the parties is easy. It is worth stressing, however, that I have no doubt that ex post considerations are important for legal decisionmaking in the externalities context. To analyze the ex ante effects, however, it will be useful to abstract from the ex post problems, and to this end I will focus in this Article on situations in which ex post bargaining is easy.

   In examining the ex ante effects of alternative rules, my analysis builds on the large economic literature analyzing "incomplete contracts." (6) This literature has sought to analyze how the potential division of surplus in later renegotiations might affect earlier investments. Although this literature has focused on contexts that differ from the harmful-externalities context on which I focus, its analytical approach has been useful for carrying out my analysis.

   It is worthwhile highlighting at the outset some general differences between an ex ante and an ex post analysis. From an ex post perspective, the distribution of ex post value between the parties has no relevance for efficiency. To be sure, writers carrying an ex post analysis have differed on whether the distributive consequences of alternative rules have some importance by themselves, independent of the goal of efficiency. Such writers have nevertheless generally shared the view that ex post distribution is irrelevant from the perspective of efficiency itself.

   As the analysis of this Article demonstrates, however, once ex ante effects are taken into account, the ex post division of value might have considerable efficiency implications. Different divisions of ex post value lead to different ex ante actions and investments. As a result, a given rule's effects on the ex post division of the total pie have an important effect on the overall ex ante efficiency of the rule.

   Relatedly, the introduction of ex ante effects also makes the choice of legal rule important in cases in which ex post bargaining is easy. The standard ex post analysis assumes that, when the parties can easily bargain ex post, the choice of legal rule has little or no relevance for efficiency. In such cases, ex post bargaining can be expected to produce an efficient outcome regardless of the initial allocation of entitlements. For this reason, prior work has commonly focused on cases in which ex post bargaining is difficult or even impossible.

   As the analysis of this Article will show, however, once we take ex ante effects into account, the choice of rule might have important efficiency implications even when ex post bargaining is easy. By affecting the bargaining positions of each party in ex post bargaining, the choice of rule will affect the ex post division of value. This ex post division of value, in turn, will affect ex ante incentives and thereby ex ante efficiency.

   My analysis therefore begins by examining how various alternative rules affect bargaining between parties and, in turn, the ex post division of value. To illustrate these effects, note that, in the considered example, Factory would generally fare better if it had a property right to pollute rather than if Resort had a property right to enjoin Factory's pollution. Suppose that Factory and Resort can freely bargain with one another, and suppose also that pollution would be efficient because the value to Factory of the pollution-causing activity exceeds the harm it imposes on Resort. Given easy ex post bargaining, both rules would result in polluting by Factory. The rules would differ, however, in the distribution of value between Factory and Resort that they would produce.

   If Factory had the property right, it could keep the full value of its pollution-producing activities to itself. By contrast, if Resort had the property right, Factory would not be able to capture fully the value of its pollution-producing activity. Resort would be able to extract some of this value in exchange for consenting to Factory's pollution. (7)

   After identifying the distributive effects of alternative rules, the analysis will examine how these different ex post distributions of value affect parties' ex ante investments. Consider the incentives for Factory to invest ex ante in enhancing the value it can derive from its activities. If Resort had a property right to enjoin Factory, Factory would invest too little ex ante, because Resort's property right would enable Resort to extract part of the value created by this investment. Because Factory can anticipate this need to share the value of its activity with Resort, it would not have incentives to invest optimally. In contrast, if Factory were granted a property right to pollute, Factory would not have to share with Resort any part of the value produced by Factory's ex ante investment. Thus, granting a property right to Factory would encourage it to invest ex ante. Indeed, for reasons to become clear later, if Factory were granted a property right, it would even tend to invest excessively.

   Now suppose that Resort were granted an entitlement to a pollution-free river but with the weaker protection of a liability rule. In this case, Factory would still have an incentive to invest. Under this liability rule, if Factory were to operate, Factory would pay Resort the (court-estimated) harm that pollution would inflict on Resort. As a result, Factory would retain the excess of the value of its activity over this harm, and Factory would thus fully capture any incremental increase in the value produced by its ex ante investment. Consequently, Factory would have an incentive to invest at the efficient level.

   Consider also the effects of the allocation of entitlements on Resort's incentives to invest ex ante in enhancing the value of its activities. If Resort were granted a property right to pollution-free water, Resort would have incentives to invest, and indeed might even invest excessively. Providing Resort with the entitlement protected only by a liability rule would not solve this problem of excessive investment. Indeed, as the analysis will show, liability rule protection would lead Resort to make investments that would be excessive to a degree even greater than under a property-right rule.

   In addition to ex ante investments in enhancing the values of the parties' respective activities, the analysis will also examine Factory's and Resort's ex ante investments in reducing the harm that would result in the event of conflicting use. Factory and Resort, for example, could make investments to eliminate or reduce their reliance on the river in case a conflicting use problem...