• The Coase Theorem

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favors the less productive use, then the owner of the land with the more productive use will be able to muster a side payment that will induce the owner of the less productive use to desist or modify that use. If contracting were costless, the neighbors would contract for modifications in their respective activities until they reached the point at which further gains would not induce additional modifications in the use of either property.

A simple numerical example illustrates the argument. Suppose there are two neighboring landowners, a factory and a laundry. The factory uses a production process that emits soot. The soot penetrates into the laundry, so that the more soot the factory emits, the more difficult it is for the laundry to produce clean clothing. Assume the problem can only be controlled by the factory installing various types of soot arrestors. The more effective the arrestor, the more expensive it is to install and operate. But the more effective the arrestor, the cleaner the clothing produced by the laundry, which increases its sales and its profits. The schedule of costs and profits looks like this:

Under Coase’s thought experiment, it doesn’t matter whether the law says the factory has a right to emit as much soot as it likes, or if it says that the laundry has a right to be free of soot, or if it prescribes some intermediate position. If contracting is costless, the parties will trade away their rights in return for side payments until they reach the outcome that maximizes their joint wellbeing. Obviously, neither of the extreme results—complete freedom to

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emit soot or complete prohibition on emitting soot—represents a stable solution. If the entitlement goes to the factory, the laundry will be willing to make side payments to the factory if it will install arrestors. At least for the less expensive arrestors, the laundry gains more in profits than it would cost to install arrestors. Conversely, if the entitlement goes to the laundry, the factory will be willing to pay the laundry to let the factory emit some soot. At least for the most expensive arrestors, the costs to the factory exceed the profits lost by the laundry. The proposals will go back and forth, but with zero transaction costs, the bargaining will continue until the parties settle on four pounds of soot. At this level, the joint wealth of the factory and laundry is maximized at $400, and neither party can make an offer to the other that will make both of them better off. For example, if the laundry tries to convince the factory to reduce emissions to two pounds, this will increase the laundry’s profits by $900 ($2700 – $1800) but will cost the factory $1100 (by increasing its cost from $1400 to $2500). No deal. Similarly, if the factory tries to convince the laundry to let it increase emissions to six pounds, this will save the factory $500 (by reducing the cost from $1400 to $900), but the laundry will lose $1200 in profits ($1800–$600). Again, no deal.

What are the lessons to be drawn from this thought experiment? Coase did not believe that contracting is costless. To the contrary, he thought it always consumes significant resources. So, what’s the point?

One point often drawn from Coase—the so-called reciprocity of causation—sits rather uneasily with property law. Coase was at great pains to point out that there would be no use conflict if either party were absent. So when there is a conflict between cattle and crops, confectioners and doctors, or factories and laundries, Coase thought it is incorrect to say that the cattle, the confectioner, or the factory causes harm to the crops, the doctor, or the laundry, respectively. Without the crops, the doctor, or the laundry there would be no conflict. The economic question is which activity is more valuable if we cannot have both, and in a zero-transaction-cost

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world the opportunity cost will be reflected in the size of the payment that would be offered by the one who lacks the entitlement.

Coase’s agnosticism about causation does not accord with widespread moral intuitions. The owners of damaged noses do not cause punches in the sense that the owners of overactive fists do. And when we get to questions of murder and rape in criminal law, Coasean causal agnosticism is a nonstarter. With respect to property, too, causal agnosticism does not square with the structure of entitlements. When someone owns Blackacre, the exclusion strategy protects the owner against an open-ended set of invasions, ranging from intrusions by persons and large objects to interferences with use from unusual odors and sounds. When the conflict between cattle and crops, or confectioners and doctors, or factories and laundries arises, we are not writing on a blank slate. The owner has a presumptive right against such invasions. In high-transaction- cost settings, we may sometimes have to overcome these transaction costs in the interest of mutual accommodation and maximizing the value of resources—think of airplane overflights. But the basic structure of entitlements is inconsistent with Coasean causal agnosticism in important respects. Whatever the exact source and justification of our moral intuitions against force and theft, the basic structure of property entitlements sounding in exclusion makes the system easy to understand and use, among all the far-flung parties who are expected to respect owners’ rights.3 In other words, there are transaction-cost reasons—as Coase would be the first to appreciate—for not treating causation in resource disputes as symmetric.

Notwithstanding these reservations about the conception of property implicit in Coase’s article, his emphasis on the importance of transaction costs and the possibility of exchange of rights offers

3.See Th omas W. Merrill & Henry E. Smith, The Morality of Property, 48 Wm. & Mary L. Rev. 1849 (2007).

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valuable lessons for courts and lawyers. One lesson is that if high transaction costs make contracting impossible, then perhaps the law should mimic the result the parties would agree on if they could contract. If we assume that all parties are rational maximizers, that is, that they always want more of whatever it is they value, and if we assume that all values can be expressed in terms of money, then this suggests that the law should try to achieve the result that maximizes the joint wealth of the affected parties measured by their willingness to pay. Obviously, these are debatable assumptions. Irrationality is not uncommon. Many would strenuously insist that all values cannot be cashed out in dollars. And setting the entitlement (to emit or prevent emissions) will have distributive consequences in that having the initial entitlement will make that party better off. But the Coase theorem is widely cited by those who think that efficiency is an important value in the design of legal institutions, and the thought experiment seems to provide intuitive support for the importance of trying to achieve efficient results.

A second lesson is that lawyers should think about possible contractual solutions to externality problems when they are feasible. Litigation and regulation are not the only or even usually the best solutions to problems about access over neighboring property or regulating spillovers. Neighbors can negotiate contracts to modify their property rights by easements or can enter into contracts governing the use of land that run with the land. (Many problems are solved by more informal understandings, including norms of live and let live.) These “Coasean bargains” may provide a better solution than litigation or public regulation.

A third possible lesson is that the law should be designed so as to facilitate contractual solutions to externality problems. Here, two lines of inquiry have emerged in response to Coase. The first and less-developed line of inquiry picks up on his suggestion that the initial delimitation of rights must be clearly established to permit market transactions to transfer and recombine rights. This perhaps suggests that bright line rules will facilitate contractual

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exchanges of rights.4 But this conclusion, if correct, is in considerable tension with first point above about the desirability of having the law mimic the outcome the parties would reach if transaction costs were zero, which seems to require highly discretionary entitlement rules. It may be that the law can either encourage ex ante bargains or can provide an ex post substitute for bargains, but cannot easily do both.

The second line of inquiry, which has consumed a tremendous amount of intellectual energy, asks whether entitlements should be exchanged only with the consent of the parties or should be allowed to be taken by one party on payment of a judicially determined price. This is the famous distinction introduced by Calabresi and Melamed between “property rules” and “liability rules.”5 An entitlement protected by a property rule must be purchased through a voluntary exchange of rights. An entitlement protected by a liability rule can be taken unilaterally in return for a payment of just compensation, as when the government uses its power of eminent domain to acquire property (see Chapter 9).

Commentators, including Calabresi and Melamed, initially assumed that property rules should prevail in low-transaction-cost settings where Coasean bargains are possible. Coasean bargains assure efficiency; at least the affected parties who agree to the exchange must be better off, or else they would not enter into the agreement. And requiring the consent of all the owners protects subjective values in circumstances where owners place a higher value on their property than the market does. In high- transaction-cost settings, however, it was thought to be preferable to switch to liability rules. Because the party forcing the exchange

4.See Th omas W. Merrill, Trespass, Nuisance, and the Costs of Determining Property Rights, 14 J. Legal Stud. 13 (1985).

5.Guido Calabresi & A. Douglas Melamed, Property Rules, Liability Rules, and Inalienability: One View of the Cathedral, 85 Harv. L. Rev. 1089 (1972).

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must pay just compensation, which is usually set at fair market value, the party forcing the exchange will do so only if the new use is more valuable than the present market value. Thus, compelled exchanges (liability rules) were thought to promote efficient solutions in the presence of high transaction costs—in the sense of maximizing market-measured wealth. Of course, compelled exchanges are not necessarily efficient in the broader sense that asks whether the welfare of the parties is enhanced, because such exchanges will sometimes result in a sacrifice in subjective values not captured by markets. For liability rules to begin to reflect subjective values, they need to be more complicated than simply a judicial estimate based on market prices, but perhaps because such schemes would add to administrative costs we rarely see them in practice.

The Calabresi and Melamed analysis, building on Coase, tends to view the problem of externalities ex post, after a particular problem of access or a spillover has developed. From this perspective, high transaction costs can appear to be ubiquitous. Even if there are only two parties, once they are locked in a dispute they stand in a bilateral monopoly relationship that may lead to bargaining breakdown. The ex post perspective therefore tends toward the conclusion that liability rules are always superior to property rules on efficiency grounds.

More recently, scholars have shifted from the ex post to the ex ante perspective, asking what incentives these different modes of protection create for future behavior. Here, the case tends to shift back toward property rules, or, according to some, more elaborately tailored liability rules designed to tweak incentives. Because property rules protect subjective values that are not reflected in the market’s valuation of property, they protect reliance interests and encourage investment. Property rules are also relatively simple for duty-holders to interpret (keep off, or else) and for courts to administer. And property rule protection creates an incentive for owners to generate new information about the uses to which their property