Solomonic bargaining: dividing a legal entitlement to facilitate Coasean trade.

• Author: Ayres, Ian

1. INTRODUCTION

   It is a common argument in law and economics that divided ownership can create or exacerbate strategic behavior. For instance, when several persons own the land designated for a proposed stadium, individual sellers may "hold out" for a disproportionate share of the gains from trade.(1) Alternatively, when building a public library would benefit multiple residents, individual buyers may "free ride" on the willingness of others to pay for its construction.

   2 Such transaction costs of collective action fall under a variety of analytic rubrics, including the "tragedy of the commons" and the theory of "public goods."(3) Nonetheless, each example of market failure shares a common attribute: The division of a single legal entitlement, or of rivalrous entitlements,(4) among joint sellers or joint buyers may prevent socially efficient transactions, particularly when the parties possess private information about their preferences.(5)

   This Article explores a different way of dividing an entitlement. Rather than analyzing divisions among buyers or among sellers, we consider the effects of splitting an entitlement between the two groups. Our core insight is Solomonic in character: Dividing a legal entitlement between rivalrous users can facilitate efficient trade.(6) More specifically, we show that when two parties have private information about how much they value an entitlement, endowing each party with a partial claim to the entitlement can reduce the incentive to behave strategically during bargaining, thereby enhancing economic efficiency.

   Private information is a particularly pernicious form of transaction cost, especially in legal contexts where, for procedural or other reasons, parties must negotiate within "thin" markets.(7) In such contexts, self-interested bargainers have a strong incentive to misrepresent their private valuations so as to capture a larger share of the bargaining "pie." These incentives often lead to predictable opportunistic strategies: Sellers tend to overstate the value they place on the bargained-for item, while buyers tend to understate their desire to purchase it. As a result of such strategic behavior, the parties may fail to detect and exploit a mutually beneficial trade, and even when they can it is usually after considerable and costly delay.

   In this Article, we argue that divided entitlements can facilitate trade by inducing claim holders to reveal more information than they would under an undivided entitlement regime. Owners of divided, or "Solomonic," entitlements must bargain more forthrightly than owners of undivided entitlements, because the entitlement division obscures the titular boundary between buyer" and "seller." More precisely, endowing each bargainer with a share of the underlying entitlement creates the possibility of two different types of Coasean trade: A bargainer might buy the other party's claim, or, alternatively, she might sell her own. During negotiation, each party is likely to be uncertain about whether she will ultimately emerge as a seller or a buyer. This strategic "identity crisis" can strongly mitigate each party's incentive to misrepresent her respective valuation; each party must balance countervailing interests in shading up her valuation, as one would qua seller, and shading down her valuation, as one would qua buyer. This form of rational ambivalence, we argue, can lead the bargainers to represent their valuations more truthfully.(8)

   To illustrate this identity crisis with a traditional type of property division, consider a negotiation between Smith and Jones about who should develop Blackacre as a mall. Assume it is commonly known that Blackacre's most valuable use is as a mall, and that either Smith or Jones is the most efficient developer. But assume also that the parties' private valuations make it unclear who is the more efficient developer. Blackacre is divided so that Smith owns Blackacre in fee simple, subject to an executory interest in Jones that becomes possessory if Blackacre is ever used for any purpose other than a horse buggy factory. Because of the low demand for horse buggies, Blackacre's value as a buggy factory is negligible. Under these circumstances, the mall might only be built if one of the parties agrees to sell her estate in the land to the other.(9) Imagine what would go through Smith's mind in considering how much to offer to purchase Jones' interest. Smith, as a buyer, would want to offer a low price, but the possibility that Smith could become a seller complicates Smith's decision. If Smith offers too low a price, Jones is liable to turn the tables by suggesting that Smith should sell her own claim. In essence, Jones would be saying: "Where did you get that price? If that's all you think Blackacre is worth, I'll buy your claim." Thus, when ownership is so divided, a party's explicit or implicit representation about the entitlement's value might be used by the other side to propose the other type of transaction.(10)

   This example illustrates how a particular type of division can facilitate efficient trade. Throughout this Article, we compare bargaining in the shadow of an absolute, undivided entitlement to bargaining in the shadow of a number of such Solomonic divisions.(11) Our analysis, however, revolves around two broad axes of division. The first axis represents the degree of protection accorded a given entitlement, and the second axis represents the explicit ownership structure of the entitlement.

   With respect to the first axis of division, the law may effect a Solomonic division through the degree to which it protects one's ownership interest in the underlying entitlement. Our discussion of this axis centers predominantly on the distinction-first analyzed by Calabresi and Melamed(12)--between "liability rules" (i.e., remedies at law) and "property rules" (i.e., equitable relief). Protecting an "owner" of an entitlement with a liability rule is a type of Solomonic division, because a liability rule endows "nonowners" with an option to take the entitlement nonconsensually and pay the damage amount."(13) Property protection, on the other hand, does not represent a division, since the nonowner lacks power to appropriate the underlying entitlement nonconsensually.

   We show that liability rules possess an "information-forcing" quality that property rules do not.(14) Under a liability rule regime, a nominal entitlement owner has an incentive to reveal truthfully whether her valuation is above or below the damage amount. We demonstrate that the entitlement owner's choice between two different kinds of Coasean transactions acts as a credible signal whether she has a relatively high or relatively low valuation. This credible signal of valuation decreases the aggregate amount of private information by "partitioning" the entitlement holders into two discrete sets, thereby facilitating more efficient trade. In contrast, property rule protections render such credible signaling impossible.(15)

   Our argument that liability rules can catalyze consensual trade challenges various common wisdoms in law and economics. Many scholars have argued that clear property rights are appropriate when transaction costs are low, because property rights encourage people to bargain. For example, Judge Posner has captured the common wisdom by asserting that in "low-transaction-cost settings . . . the law should require the parties to transact in the market; it can do this by making the present owner's property right absolute (or nearly so), so that anyone who thinks the property is worth more has to negotiate with the owner."(16) These scholars often assert that property rules are "market- encouraging,"(17) while liability rules are "market-mimicking."(18) few strands of the law-and-economics literature-particularly the literature on efficient breach of contract-have allowed for parties to bargain in the shadow of liability rules as well as in the shadow of property rules,(19) we are the first to show that liability rules may induce both more contracting and more efficient contracting than property rules.

   Viewing liability rules as market catalysts, rather than substitutes, can also lead to other contradictions of the accepted wisdom in law and economics. For instance, the common assertion that liability rules are market-mimicking has led numerous scholars to conclude that the best liability rules are the ones that carefully "tailor" the damage amount to the plaintiff's valuation.(20) Only in this way, many argue, can a court replicate the terms for which parties would have bargained had they been able to negotiate.(21) Because Calabresi and Melamed were so successful in showing that tailored liability rules are appropriate when parties do not have an opportunity to contract, subsequent scholars have overlooked the possibility that untailored rules-which fix damages at one size to fit all plaintiffs regardless of plaintiffs' actual valuation--may promote trade when contracting is possible. And, in fact, we find that when parties have the opportunity to contract, untailored liability rules can be more effective in channeling bargainers toward consensual trade, where the parties tailor the terms of trade themselves. Indeed, tailoring legal rules to give parties private information about the consequences of nonconsensual taking can severely undermine the incentives to trade consensually.(22) When dividing entitlements to facilitate trade, courts should therefore avoid tailoring that creates additional informational asymmetries that amplify strategic behavior. Untailored liability rules represent a largely missing category of entitlement protection that may facilitate trade without the judicial costs of tailoring.(23)

   The second axis of division we analyze is the actual ownership structure of an entitlement, focusing explicitly on the benefits of ownership that is "fractional" in nature. Following Professor Ellickson's analysis...