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Electronic copy available at: http://ssrn.com/abstract=2403839
1
COASEAN KEEP-AWAY:
VOLUNTARY
TRANSACTION COSTS
Jordan M. Barry,* John William Hatfield,
**
& Scott Duke Kominers†
Abstract
The Coase Theorem predicts that, if there are no
transaction costs, parties will always contract their way to an
efficient outcome. Thus, no matter which legal rules society
chooses, “Coasean bargains” will lead to efficient results.
There are always some transaction costs. However,
transaction costs are often thought to be low when there are no
structural impediments to negotiation, such as large numbers of
parties or barriers to communication. When these obstacles are
not present, it is commonly assumed that the parties will achieve
an efficient result through Coasean bargaining. We show that this
assumption is incorrect.
* Associate Professor and Herzog Endowed Scholar, University of San Diego
School of Law. **
Associate Professor, McCombs School of Business, University of Texas at
Austin. † Junior Fellow, Harvard Society of Fellows; Associate, Department of
Economics, Harvard University; Associate, Harvard Business School; Research
Scientist, Harvard Program for Evolutionary Dynamics; Associate, Center for
Research on Computation and Society, Harvard School of Engineering and
Applied Sciences. We thank Emily Keifer, Phoebe Allardice, Andres Almazan,
Gary S. Becker, Giuseppe Dari-Mattiacci, Noah Feldman, Lee Anne Fennel,
Jerry Green, Zachary J. Gubler, James J. Heckman, Dale Jorgenson, Louis
Kaplow, Elizabeth Pollman, J.J. Prescott, Alvin E. Roth, Elaine Scarry, Amartya
Sen, Steven M. Shavell, and E. Glen Weyl as well as attendees at the National
Business Law Scholars Conference, the Southern California Junior Faculty
Workshop, and the University of San Diego faculty colloquium for their helpful
thoughts and comments. This project was generously supported by a summer
research grant from the University of San Diego School of Law. Kominers
gratefully acknowledges the support of the National Science Foundation (Grant
CCF-1216095), the Harvard Milton Fund, a Yahoo! Key Scientific Challenges
Program Fellowship, a Terence M. Considine Fellowship in Law and Economics
funded by the John M. Olin Center at Harvard Law School, the American
Mathematical Society, and the Simons Foundation.
Electronic copy available at: http://ssrn.com/abstract=2403839
2
In particular, we demonstrate that transaction costs can be
high, even when there are no structural impediments to
bargaining, because the parties themselves may intentionally
create transaction costs. Intuitively, an individual may prefer the
Coasean bargain that is struck when certain parties are excluded
from negotiations. Accordingly, that individual will wish to create
transaction costs that keep those parties—potentially including
herself—away from the negotiating table. We show that there are
many contexts in which the parties will choose to create these
“voluntary transaction costs,” including environmental litigation,
multilateral treaty negotiations, and creditor-debtor relationships.
Because of the prevalence of voluntary transaction costs,
Coasean logic applies to a significantly smaller class of cases than
has previously been recognized. This renders law very important:
Legal rules provide the starting point for the parties' negotiation;
we find that when the parties’ starting point is closer to the
efficient result, they are more likely to achieve an efficient outcome
through Coasean bargaining. This insight favors reasonable use
rules and other legal rules that attempt to assign entitlements in an
efficient manner. We also find that liability remedies are more
likely to encourage efficient outcomes than injunctive remedies
are.
I. INTRODUCTION ...........................................................................3
II. BACKGROUND ON THE COASE THEOREM ....................................8 III. VOLUNTARY TRANSACTION COSTS ..........................................15
A. The Private Value of Transaction Costs for Others .............17 B. The Private Value of Transaction Costs for Oneself ............24 C. Voluntary Transaction Costs and Inefficiency .....................28
IV. IMPLICATIONS FOR CHOOSING LEGAL RULES ...........................43 A. Structuring Legal Rights ......................................................44
1. Legal Rules That Always Produce Efficiency .................. 44 2. The Value of a More Efficient Starting Point ................... 47
B. The Importance of Legal Remedies ......................................57 1. Remedies in Low- and High- Transaction Cost
Environments .................................................................... 58 2. Injunctive Remedies vs. Liability Remedies .................... 60
C. Distributional Consequences ...............................................65
V. CONCLUSION ............................................................................66
3
I. INTRODUCTION
Legal scholars have cited Ronald Coase’s The Problem of
Social Cost more than they have cited any other scholarly work.1
In that article, Coase put forth what has become known as the
“Coase Theorem.”2 The Coase Theorem says, essentially, that if
there are no transaction costs, individuals will always organize
their behavior in a way that maximizes their combined well-being.
The logic is straightforward: If Ronald has the legal right to do
something, and George values that right more than Ronald, George
can purchase the right from Ronald. When there are no transaction
costs—that is, nothing impedes people from making and enforcing
contracts—people will make contracts that transfer legal rights to
the individuals who will use them most productively. These
contracts, known as “Coasean bargains,” always produce an
efficient outcome no matter how society initially assigns legal
rights.3 Thus, legal rules will have no effect on individuals’
behavior or their total wealth; they can only affect the way in
which wealth is distributed.4
Coase constructed the Coase Theorem as a reductio ad
absurdum to highlight how important transaction costs are: If one
accepts the premise that transaction costs are negligible, it follows
that legal rules do not affect behavior. Coase thought that this
1 See Fred R. Shapiro & Michelle Pearse, The Most Cited Law Review Articles
of All Time, 110 U. MICH. L. REV. 1483, 1489 (2012) (listing The Problem of
Social Cost as having 5,157 citations in law reviews alone, over 40% more
citations than the next-most-cited article). 2 The use of the term “Coase Theorem” to describe the insight of The Problem of
Social Cost is usually attributed to George Stigler. Coase himself never stated a
formal theorem; this has become increasingly problematic as the field of
economics has become more technical and mathematically precise. See R.H.
Coase, The Problem of Social Cost, 3 J.L. & ECON. 1 (1960); GEORGE STIGLER,
THE THEORY OF PRICE (1966). In our Companion Paper, we formalize the
Coase Theorem and formally prove our results. See Companion Paper, infra
note 11, passim. 3 See, e.g., Thomas W. Merrill & David M. Schizer, The Shale Oil and Gas
Revolution, Hydraulic Fracturing, and Water Contamination: A Regulatory
Strategy, 98 U. MINN. L. REV. 145, 210-11 (2013); Melissa B. Jacoby & Edward
J. Janger, Ice Cube Bonds: Allocating the Cost of Process in Chapter 11
Bankruptcy, 123 YALE L.J. 862 (2014). 4 This is a slight oversimplification. Legal rules change transfer payments and,
in certain specific circumstances, can affect final behaviors as well. See, e.g.,
Guido Calabresi & A. Douglas Melamed, Property Rules, Liability Rules, and
Inalienability: One View of the Cathedral, 85 HARV. L. REV. 1089, 1095-96
(1972). We address this issue more formally in Part II. See footnote 19, infra,
and accompanying text.
4
conclusion was clearly incorrect. Accordingly, the premise—that
transaction costs are negligible—must be false.5
As Coase himself recognized, real-world agreements
always involve some transaction costs, so the Coase Theorem
never applies directly. Nonetheless, it is widely agreed that the
Coase Theorem’s predictions generally persist when transaction
costs are low.6 Transaction costs are often thought to be low when
there are no structural impediments to negotiation, such as very
large numbers of parties or laws that make it difficult to form or
enforce contracts.7
5 See, e.g., Robert C. Ellickson, The Case for Coase and Against “Coaseanism”,
99 YALE L.J. 611 (1989). 6 See, e.g., Ian Ayres & Robert Gertner, Strategic Contractual Inefficiency and
the Optimal Choice of Legal Rules, 101 YALE L.J. 729, 761-62 (1992); Richard
R.W. Brooks, The Relative Burden of Determining Property Rules and Liability
Rules: Broken Elevators in the Cathedral, 97 NW. U. L. REV. 267, 270 n.11
(2002) (“[E]fficiency is always achieved when transaction costs are sufficiently
small . . . .”); Adam Chase, The Efficiency Benefits of “Green Taxes”: A Tribute
to Senator John Heinz, 11 UCLA J. ENV’L L. & POL’Y 1, 7 (1992) (“When
transaction costs are negligible, . . . parties will eventually contract with one
another so that they optimize the allocation of [rights].”); Lee Anne Fennell, The
Problem of Resource Access, 126 HARV. L. REV. 1471, 1499 (2013) (“It is
standard to assume that in a low transaction cost world, property and markets are
all we need.”); George S. Geis, Empirically Assessing Hadley v. Baxendale, 32
FLORIDA ST. U. L. REV. 897, 909 n.62 (noting that “if transaction costs are
[sufficiently] small” then “everyone [will] contract[] around inefficient
defaults”); Pierre Schlag, Coase Minus the Coase Theorem—Some Problems
with Chicago Transaction Cost Analysis, 99 IOWA L. REV. 175, 205 n.96 (2013)
(“When transaction costs are sufficiently negligible [the Coase Theorem’s
predictions will hold].”); David Schleicher, City Unplanning, 122 YALE L.J.
1670, 1682 (2013) (“The assignment of [a] right should not matter if transaction
costs are low, as Coasean bargaining . . . should ensure that we get to the
optimal [result].”); Christopher Jon Sprigman et al., What’s a Name Worth?:
Experimental Tests of the Value of Attribution in Intellectual Property, 93 B.U.
L. REV. 1389, 1421 (2013) (“[W]hen transaction costs are small, default rules
should have no effect.”); Todd J. Zywicki, A Unanimity-Reinforcing Model of
Efficiency in the Common Law: An Institutional Comparison of Common Law
and Legislative Solutions to Large-Number Externality Problems, 46 CASE W.
RESERVE L. REV. 961, 999-1000 (1996). 7 See, e.g., Omri Ben-Shahar, Damages for Unlicensed Use, 78 U. CHI. L. REV.
7, 27-28 (2011) (arguing that transaction costs are low between parties who have
already entered into a licensing agreement); Ariel L. Bendor, Prior Restraint,
Incommensurability, and the Constitutionalism of Means, 68 FORDHAM L. REV.
289, 325-26 (1999) (“[I]n the field of intellectual property, transaction costs are
generally low[, i]n part [because] the intellectual property interest in a given
work tends to be found in the hands of one person or a limited number of
people.”); Kenneth W. Dam, Some Economic Considerations in the Intellectual
Property Protection of Software, 24 J. LEG. STUD. 321, 365 (1995) (arguing that
transaction costs will be low in the software industry because the parties are
5
businesses, there are many possible transaction structures, and the universe of
potential contracting parties is limited and knowable); Alan Devlin, Restricting
Experimental Use, 32 HARV. J.L. & PUB. POL’Y 599, 638-40 (2009) (arguing
that transaction costs will be low for patent licensing agreements because
negotiations are “between a small number of easily identifiable parties over a
discrete topic”); Alan Grant & Emily Grant, The Bride, the Groom, and the
Court: A One-Ring Circus, 35 CAPITAL U. L. REV. 743, 753 (2007) (arguing that
transaction costs will be low between parties getting engaged because there are
only two, easily identified parties); Henry Hansmann & Reinier Kraakman,
Toward Unlimited Shareholder Liability for Corporate Torts, 100 YALE L.J.
1879, 1893-94 (1991) (noting that corporate shareholders may easily be able to
create complex agreements when there are relatively few shareholders); Trotter
Hardy, Property (and Copyright) in Cyberspace, 1996 U. CHI. LEGAL F. 217,
219-237 (arguing that transaction costs are low in cyberspace because it is easy
for the parties to communicate); Keith Hylton, Duty in Tort Law: An Economic
Approach, 75 FORDHAM L. REV. 1501, 1513-14 (2006) (arguing that transaction
costs are low in the trespass context); Eugene Kontorovitch, Liability Rules for
Constitutional Rights: The Case of Mass Detentions, 56 STAN. L. REV. 755, 769-
70 (2004) (arguing that well-functioning markets make transaction costs low for
purchases of corporate stock); Eugene Kontorovitch, The Constitution in Two
Dimensions: A Transaction Cost Analysis of Constitutional Remedies, 91 VA. L.
REV. 1135, 1165-66 (2005) (arguing that transaction costs of quartering soldiers
are low in peacetime, but not in wartime, because there are well-functioning
rental and construction markets); Robert Merges, Intellectual Property Rights
and Bargaining Breakdown: The Case of Blocking Patents, 62 TENN. L. REV.
75, 76-78 (1994) (arguing that transaction costs are low with respect to patents
licensing, as “(1) there are only two parties to the transaction, and they can
easily identify each other; [and] (2) the costs of a transaction between the parties
are otherwise low”); Thomas W. Merrill, Trespass, Nuisance, and the Costs of
Determining Property Rights, 14 J. LEGAL STUD. 13, 13-15 (1985) (arguing that
transaction costs are likely to be low in the context of trespass because there are
only two parties and they are generally identifiable); Maureen A. O’Rourke,
Rethinking Remedies at the Intersection of Intellectual Property and Contract:
Toward a Unified Body of Law, 82 IOWA L. REV. 1137, 1148, 1185-86 (1997)
(arguing that transaction costs are typically low with respect to copyright and
trademark licensing transactions, as “there are few parties to the transaction” and
contracting rules are not onerous); Alan Schwartz, A Contract Theory Approach
to Business Bankruptcy, 107 YALE L.J. 1807, 1819-20 (1998) (arguing that
transaction costs are low in renegotiations of commercial sales of goods because
there are few parties and the legal requirements to modify a contract are not
onerous); David E. Van Zandt, An Alternative Theory of Practical Reason in
Judicial Decisions, 65 TULANE L. REV. 775, 821 n.202 (1991) (concluding that
transaction costs are likely to be low in landlord-tenant negotiations because
there are only two parties); Developments in the Law of Cyberspace, Internet
Regulation Through Architectural Modification: The Property Rule Structure of
Code Solutions, 112 HARV. L. REV. 1634, 1636 & n. 13 (1999) (arguing that
“transaction costs are extremely low” in cyberspace because the medium
facilitates communication and the recording of data); Aaron T. Dozeman,
Salinger and eBay: When Equitable Considerations Undermine Exclusivity, 21
DEPAUL J. ART, TECH. & INTELLECTUAL PROPERTY L. 323, 346-50 (2011)
(arguing that transaction costs are low in negotiations to use copyrighted works
because they only involve two parties); Daniel Kearney, Network Effects and the
Emerging Doctrine of Cybertrespass, 23 YALE L. & POL’Y REV. 313, 338-39
(2005) (arguing that “transaction costs are likely to be low” in online
6
In this Article, we show that transaction costs can be high
even when there are no structural impediments to negotiation.
Individuals will frequently wish to create transaction costs, even
when those transaction costs prevent the formation of an efficient
Coasean bargain. Because these intentionally manufactured
transaction costs are created by choice, and are not an unavoidable
consequence of the circumstances in which the parties find
themselves, we term them voluntary transaction costs.
Intuitively, an individual may prefer that some transaction
costs exist because the parties will strike different deals depending
on who is seated at the metaphorical negotiating table. An
individual may prefer the deal that will be struck if certain parties
are excluded from negotiations over the deal that is struck when
those parties participate. In such instances, that individual will
wish to create transaction costs that keep those parties away from
the negotiating table.
To take a simple example, an investor who owns a plot of
pristine woodlands might wish to sell the land to a developer who
wants to build on that land. A conservationist might prefer that the
land remain in its natural state. If she can, she will create
transaction costs that prevent the investor and the developer from
coming to the negotiating table and striking a deal.8
Moreover, in many instances an individual may wish to
create transaction costs in order to keep herself away from the
negotiating table. In her absence, the remaining parties at the table
will often reach an agreement that closely resembles the agreement
that they would have made if she had participated in the
negotiations. However, by not participating in the deal, the absent
individual can avoid having to contribute any of her own resources
to support it. In essence, creating transaction costs can allow an
individual to hitch a free ride on the labors of others. This can
leave her better off than if she had participated in the negotiations.
interactions, even when there are many parties, because many interactions are
automated and it is easy for parties to communicate). 8 This general scenario is quite common; for example, a similar dynamic is
currently playing out with respect to a half-billion-dollar construction project in
San Diego. See notes 81-97, infra, and accompanying text.
7
For example, suppose that several nations convene a
meeting to organize a peacekeeping action. An individual country
may decline to participate, even if it favors the mission and wants
it to succeed: By declining to participate, it can avoid having to
contribute its own resources to the project. So long as that
country’s contributions are not essential, the mission will still go
forward. Not participating may enable the country to reap the
same benefits as it would if it participated, but at a lower cost.9
As we demonstrate, there are a large number of
circumstances in which parties will wish to create voluntary
transaction costs. The prevalence of voluntary transaction costs
means that the Coase Theorem’s prediction—that people will
negotiate their way to an efficient outcome—applies in many
fewer scenarios than has previously been appreciated. In short,
Coase was more insightful than perhaps even he realized.
We demonstrate that, when voluntary transaction costs are
possible, the parties will typically achieve an efficient outcome
under certain legal regimes, but not others. This makes the choice
of legal regime increasingly important.
We explore two aspects of legal regimes that strongly
affect the likelihood of an efficient outcome. The first is how the
legal system initially assigns legal rights among actors. We
identify some circumstances in which assigning legal rights to
particular parties always encourages efficient Coasean bargains.
More generally, we find that the parties’ likelihood of striking an
efficient Coasean bargain depends on how the legal system
initially assigns legal rights among the parties: The more efficient
that initial assignment is, the more likely the parties are to strike an
efficient Coasean bargain. This favors reasonable use rules and
other legal rules that attempt to allocate rights in a way that
resembles the efficient outcome.
The second key feature is the remedy available when a
legal right is violated. In some instances, a protected party has the
9 This dynamic applies to many other actions that require international
coordination, including pollution reduction and trade sanctions. See notes 109-
115, infra, and accompanying text; see also Avinash Dixit & Mancur Olson,
Does Voluntary Participation Undermine the Coase Theorem, 76 J. PUB. ECON.
309 (2000).
8
right to injunctive relief—that is, she can secure a court order that
effectively forbids the illegal action. In other instances, the law
merely provides a liability remedy; the protected party’s only
recourse is to collect damages from the party acting unlawfully.10
Our analysis suggests that liability remedies foster efficient
Coasean bargains in a larger set of circumstances than injunctive
remedies do. With respect to both legal rules and remedies, we
find trade-offs between the likelihood that a particular legal regime
will foster an efficient result and the amount of information that
courts and legislators must have to implement that regime.
This Article proceeds as follows. Part II provides general
background on the Coase Theorem and how it is commonly
understood. Part III uses a series of simple examples to illustrate
how voluntary transaction costs affect the Coase Theorem’s
predictions. Specifically, it shows when and why parties will want
to manufacture transaction costs for themselves and others, even
when doing so creates inefficiencies. It also identifies real-world
scenarios that are likely to exhibit dynamics that resemble our
stylized examples. Part IV explores how the initial choice of legal
rules and remedies can affect final outcomes, and the implications
that this has for designing legal regimes. Throughout the paper,
we include citations to a companion paper that contains formal
proofs of our results.11
Part V concludes.
II. BACKGROUND ON THE COASE THEOREM
To understand the Coase Theorem, it is helpful to first
define two concepts. First, a particular state of the world is
efficient if it maximizes the combined welfare of all parties.12
An
example helps illustrate this.
Suppose that Ronald has $2000 in cash and a car that he
values at $1000. Suppose further that George has $2000 in cash,
10
We use “injunctive remedies” and “liability remedies” to refer to what much
of the literature refers to as “property rules” and “liability rules.” See Calabresi
& Melamed, supra note 4, at 1092 (starting this practice). We do so in order to
sharpen the distinction between legal rules, which establish what actions are
lawful, and the remedies available when those rules are violated. 11
See Jordan M. Barry et al., Voluntary Transaction Costs and the Coase
Theorem, available at scottkom.com/article [hereinafter Companion Paper]. 12
More precisely, if it maximizes the combined utility of the parties. See HAL
R. VARIAN, INTERMEDIATE MICROECONOMICS 54-55 (4th ed. 1996)
9
and that George values Ronald’s car at $2000. This state of the
world is not efficient. If George were to buy Ronald’s car for
$1500, both Ronald and George would be better off—Ronald
would go from having $3000 worth of utility to $3500,13
and
George’s utility would increase from $2000 to $250014
—raising
their combined utility. Thus, the state of the world in which
Ronald owns the car is inefficient, because Ronald and George’s
combined utility is higher when George buys the car from Ronald.
Similarly, the state of the world in which George buys the
car is efficient, as there is no way to reallocate resources between
Ronald and George in a way that increases their combined utility.
It is possible to make either Ronald or George better off by moving
money between them—in other words, increasing or decreasing
the price that George pays Ronald for the car—but the combined
utility of Ronald and George will remain the same.
Second, we must define a transaction cost. Scholars have
used this term to encompass a wide range of phenomena, but, at its
broadest, it includes anything that impedes a transaction.15
This
would include, for example, the time it takes the parties to
negotiate a deal, the time it takes to locate the relevant interested
parties, and the cost of enforcing an agreement.16
It has also been
applied to circumstances that complicate the bargaining process,
such as when the parties have asymmetric information17
or parties
must coordinate their efforts to achieve a common goal.18
13
Ronald started with $2000 in cash and a car he valued at $1000, giving him a
total of $3000 of value. Now he has $3500 in cash, making him $500 better off. 14
George originally had $2000 in cash. He now has $500 in cash and a car that
he values at $2000, making him $500 better off. 15
See, e.g., Calabresi & Melamed, supra note 4, at 1094-95. 16
See, e.g., Tun-Jen Chiang, The Reciprocity of Search, 66 VANDERBILT L. REV.
1, 21-22 (2013) (discussing circumstances in which it may be difficult to
determine whether a party has breached an agreement). 17
See, e.g., Ian Ayres & Eric Talley, Solomonic Bargaining: Dividing a Legal
Entitlement to Facilitate Coasean Trade, 104 YALE L.J. 1027, 1035 (1995)
(“This Article focuses on a specific type of transaction cost: private
information.”); Calabresi & Melamed, supra note 4, at 1094-95 (defining
transaction costs to include imperfect knowledge). 18
See, e.g., James E. Krier & Stewart J. Schwab, The Cathedral at Twenty-Five:
Citations and Impressions, 106 YALE L.J. 2121, 2135 (1997) Kevin Werbach,
Supercommons: Toward a Unified Theory of Wireless Communication, 82 TEX.
L. REV. 863, 953 n.385 (2004).
10
We are now able to state the Coase Theorem: If there are
no transaction costs, and legal rights are clear, then no matter
which legal rules society adopts, the parties will reach an efficient
result.19
This does not mean that legal rules do not matter, because
they will have distributional effects—that is, legal rules can make
particular parties better or worse off than they would be
otherwise—but the choice of legal rules will not affect efficiency.20
The intuition behind the Coase Theorem is as follows: If
society chooses legal rules that are not efficient, then, by
definition, there are other ways of allocating rights among the
parties that would make them better off as a group.21
If the parties
can make themselves better off as a group, then they can make
transfers between themselves so that each individual member of
the group is better off.22
In other words, if the parties can strike a
deal that grows the economic pie, everyone can have a bigger slice.
Thus, in any inefficient state of the world, it is in every party’s
interest to move to an efficient state. And, because there are no
transaction costs—that is, there is nothing to impede the parties
from making any deal that is in their interests—the parties will
make and implement an agreement to move the world to an
efficient state. These efficiency-creating agreements are
commonly referred to as Coasean bargains.23
One of Coase’s classic examples24
illustrating his theorem
involves a railroad track that runs next to a wheat field. 25
The
19
The version of the Coase Theorem we state here depends on the presence of a
numeraire good (money) that all parties value equally, as well as an assumption
that parties can borrow this good, i.e., that the parties are not credit-constrained.
Without these assumptions the Coase Theorem guarantees that the world will
reach a Pareto efficient result, but not necessarily one that maximizes the
combined utility of all parties. See, e.g., PAUL MILGROM & JOHN ROBERTS,
ECONOMICS, ORGANIZATION AND MANAGEMENT (1992). We suppress these
technical issues for clarity and ease of exposition: Throughout this Article, we
assume that the difference in the monetary value that each actor assigns to
different outcomes is finite and independent of the actor’s wealth, and that all
actors have access to enough cash to support any relevant Coasean bargain. 20
RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 63-64 (8th ed. 2011). 21
Id. at 7. 22
This follows from the assumptions made in footnote 19, supra. 23
See sources cited in note 3, supra. 24
See Coase, supra note 2, at 29-34. Our example differs slightly from Coase’s.
We return to variations on this example throughout this Article. 25
We revisit variations on this basic theme throughout this Article. See Parts
III.A-C, IV.A-B, infra.
11
railroad’s locomotive shoots off sparks. If these sparks hit the
wheat, the field will burst into flame, which is extremely costly
(that is, inefficient). There are two possible solutions: (1) the
railroad can refrain from running its locomotive, or (2) the
farmer—let’s call her Alice—can plant her wheat far enough back
from the train track to ensure that sparks will not land on her wheat
and ignite it. 26
Assume that there are no transaction costs.
First, assume that the law gives farmers the right to not
have sparks on their land; in other words, assume that farmers have
the right to prevent railroads from running any locomotives that
shoot sparks onto their land. Suppose that running the train is
worth $500 to the railroad and that Alice will lose $1000 if she has
to plant back from the track. In these circumstances, the railroad
will not run the train and Alice will plant near the track. This is
efficient, so the parties have no incentive to strike a different
deal.27
Now suppose that we change the legal rule, so that
railroads have the right to shoot sparks off of their locomotives.
This would be inefficient, as the railroad would be willing to forgo
running the train in exchange for a payment of $500 or more, and
Alice would be willing to pay up to $1000 to be able to plant wheat
closer to the track. In this scenario, Alice and the railroad have an
incentive to strike a deal in which Alice pays the railroad not to run
the train so that she can plant closer to the track. As long as Alice
pays the railroad more than $500 but less than $1000,28
both
26
It is often tempting to see one party as the victim of the other’s behavior, but
this is frequently counterproductive. Externalities in the Coasean sense are
inherently symmetric: If the farmer has the right to have no sparks on his land,
then the railroad does not have the right to emit sparks from its locomotive.
Giving the farmer the legal right harms the railroad and vice versa. The right to
engage in an activity is equivalent, from an economic perspective, to a right to
be free from harm. See ROBERT H. FRANK, THE DARWIN ECONOMY 90-95
(2011). 27
Recall that the benefit that the railroad would receive from running the train is
less than the harm that Alice would suffer from planting farther back from the
track. Accordingly, changing the status quo will not produce net gains. 28
Equivalent arrangements are possible in which both parties make payments;
for example, Alice could pay the railroad $3000 and the railroad could pay Alice
$2200. For simplicity and clarity of exposition, all of the cash payments
described in this example and throughout this paper are net payments.
12
parties will be strictly better off.29
We assume here, and
throughout the paper generally, that the parties at the table split
their joint gains evenly. We adopt this assumption merely to
simplify our exposition; we note that it is not necessary for our
analysis. Thus, Alice pays the railroad $750, leaving both her and
the railroad $250 better off than they would be if the railroad ran
its train past Alice’s field.30
Observe that in both of the cases discussed above, the
railroad did not run its train and Alice planted wheat right up to the
railroad track. Even though the legal rule was different, the parties
reached the same efficient result in both scenarios. The legal rule
in these scenarios is much like the car in the prior example—an
item that some parties value more than others, and which the
parties can trade among themselves. Note also that the choice of
legal rule does have distributional effects—the railroad is $750
better off in the second scenario than the first,31
and Alice is $750
better off in the first scenario than the second.32
Now suppose that the facts are exactly as described above,
except that the railroad reaps a benefit of $2000 when it runs its
train instead of $500. If the law protects farmers from having
sparks on their land, Alice would be willing to plant further back
from the track, as long as she was paid $1000 or more to do so.33
At the same time, the railroad would be willing to pay up to $2000
to be able to run its train.34
Once again, Alice and the railroad will
have an incentive to strike a deal. So long as the railroad pays
Alice more than $1000 and less than $2000 to plant her crops
further back from the track, both Alice and the railroad will be
better off. Assuming once again that Alice and the railroad split
29
Alice pays less than $1000 for a benefit worth $1000. The railroad loses a
benefit of $500 but receives more than $500 in cash. Thus, both parties are
better off. 30
The parties’ transaction creates $500 of joint gains. Each party gets half of
that: Alice pays $750 and receives $1000 in benefits; the railroad gets $750 and
loses $500 in benefits. 31
In both scenarios, the railroad does not run the train, but in the second
scenario it receives a $750 payment from Alice. 32
In both scenarios, Alice plants wheat up to the track, but in the first she makes
a $750 payment to the railroad. 33
Planting back from the track would cost Alice $1000 in forgone wheat, so she
must receive a cash payment of at least this amount to surrender her right. 34
Running the train gives the railroad a $2000 benefit, so the railroad is willing
to pay up to $2000 cash to acquire the right to run the train.
13
the gains from the transaction, the railroad will pay Alice $1500,
leaving both parties $500 better off.35
If the law gives railroads the right to shoot sparks off of
their locomotives, the railroad will run the train and Alice will
plant away from the track. This is an efficient outcome, so the
parties will not have any incentive to strike further deals.36
Once again, in both of these cases, Alice plants back from
the track and the railroad runs its train. This is an efficient result
because the cost to Alice of planting away from the track ($1000)
is less than the benefit to the railroad from running the train
($2000). There are distributional consequences to the choice of
legal rule, however; Alice is $1500 better off in the first scenario
compared to the second,37
and the railroad is $1500 better off in
the second scenario compared to the first.38
All of these examples assume that there are zero transaction
costs (as does the Coase Theorem itself). Because nothing
impedes Alice and the railroad from making deals, they can easily
and completely circumvent any inefficient legal rule and reach an
efficient result.
Assuming that there are no transaction costs is a
tremendous assumption. In reality, there are always some
transaction costs39
—for example, it will always take at least a
small amount of time to work out a deal40
—but, when transaction
costs are low, the basic logic of the Coase Theorem still applies.41
On the other hand, when parties face large transaction costs, the
legal rule—and not the relative benefits of different activities—
35
The parties’ bargain creates $1000 in net benefits. The railroad pays $1500
and gets a benefit of $2000 from running the train. Alice gets $1500 and loses
$1000 in forgone wheat. Thus, each party nets $500, one half of the gains
produced. 36
The railroad would lose $2000 if it lost the right to run its train, while Alice
would only gain half of that from being able to plant wheat closer to the track.
Thus, there are no gains to be had from trade. 37
In both scenarios, Alice does not plant wheat up to the track, but in the first
she receives a $1500 payment from the railroad. 38
In both scenarios, the railroad runs the train, but in the second it does not
make a $1500 payment to Alice. 39
See, e.g., POSNER, supra note 20, at 65. 40
Id. 41
Id.
14
may determine how parties behave.42
In such cases, legal rules
may control whether the parties reach an efficient outcome, as well
as how value is distributed among the various parties.
When assessing the magnitude of transaction costs standing
in the way of an agreement, commentators have generally focused
on structural features of the negotiations. For instance, scholars
have frequently considered the number of parties,43
how easily the
parties can communicate with each other,44
whether the parties
have the same information,45
whether the agreement being
negotiated has simple terms,46
and how easy it is for a party to
enforce an agreement after it is made.47
When these transaction
costs, which we term “structural transaction costs,” are low,
42
For example, suppose again that running the train produces benefits of $500
for the railroad, and that if the train does not run $1000 of additional wheat can
be planted near the track. However, assume that $1000 in lost profit is spread
among 200 farmers whose fields border the train track, each of whom loses $5.
The choice of legal rule is likely to be important, because it will probably be
very difficult to coordinate the 200 farmers to act together and raise enough
money to pay off the railroad not to run its train. Similarly, if the railroad gets a
benefit of $2000 from running the train, it will be costly for the railroad to track
down all of the farmers and make a deal with each one to plant wheat farther
back from the track. Parties also may not reach a deal if they have a strained or
contentious relationship (which can often happen after protracted litigation).
See Ward Farnsworth, Do Parties to Nuisance Cases Bargain After Judgment?
A Glimpse Inside the Cathedral, 66 U. CHI. L. REV. 373 (1999) (examining 20
nuisance cases that produced injunctions and finding that parties did not bargain
after any of them). 43
Commentators often assume that transaction costs are likely to be low when
there are few parties involved, and high when there are many parties involved.
See, e.g., POSNER, supra note 20, at 77; Zywicki, supra note 6, at 961-62.
However, bilateral monopolies can encourage strategic behavior, which is itself
a transaction cost. See POSNER, supra note 20, at 77-78. 44
See, e.g., Hardy, supra note 7; Mark A. Lemley, Shrinkwraps in Cyberspace,
35 JURIMETRICS 311, 323 (1995). This might be violated if, for example, the
parties do not speak the same language, either literally or figuratively. See, e.g.,
William Hubbard, The Competitive Advantage of Weak Patents, 54 BOSTON
COLLEGE L. REV. 1909, 1948 (2013). 45
The greater the extent to which the parties have asymmetric information, the
higher that transaction costs are usually expected to be. See, e.g., Ayres &
Talley, supra note 17, at 1035; Calabresi & Melamed, supra note 4, at 1094-95. 46
The logic is that agreements with more complicated terms take more time and
effort to negotiate and draft. Thus, these agreements involve larger transaction
costs. See, e.g., Devlin, supra note 7, at 638-40; Hansmann & Kraakman, supra
note 7, at 1893-94. 47
If it is relatively simple for a party to determine whether the agreement has
been honored and to be made whole for any damages she suffers as a result of
her counterparty’s non-compliance, transaction costs are expected to be lower.
To the extent that more costly monitoring actions are necessary, transaction
costs are expected to be higher. See, e.g., Hylton, supra note 7, at 1513-14.
15
commentators have often accepted the Coase Theorem’s
predictions.48
Structural transaction costs are undeniably important; large
structural transaction costs can prevent the parties from making
agreements. However, structural transaction costs are not the only
impediment to bargaining. As we demonstrate in Part III, even
when there are no structural transaction costs, in many instances
the parties themselves will intentionally generate transaction costs.
Thus, the zero-transaction-cost assumption is an even more
herculean assumption than is commonly recognized.
III. VOLUNTARY TRANSACTION COSTS
The Coase Theorem, and the basic logic underlying it, have
generally been explored and understood through a few famous
examples.49
These examples are designed to have low transaction
costs, and they generally resemble the examples described in Part
II. They involve exactly two parties. The parties’ identities
vary— a farmer and a railroad;50
a doctor and a confectioner;51
a
48
See, e.g., sources cited in footnote 7, supra. 49
There is also a second category of examples, designed to show how the logic
of the Coase Theorem breaks down when transaction costs are high. These
examples typically feature a large number of parties who are difficult to
coordinate. Common examples include motorists disturbing patients by honking
their horns as they drive by a hospital; traffic congestion; and overfishing of
global fisheries. However, the most common version involves a factory
emitting pollution that affects a large number of homeowners. See, e.g.,
POSNER, supra note 20, at 78-79; Jodi Beggs, The Coase Theorem, ABOUT.COM
(last visited Jan. 13, 2004) (providing a more modern spin by discussing a wind
farm whose turbines produce noise that bothers nearby households). Because
there are so many homeowners, organizing them into a unified group that can
jointly take action is assumed to be impossible. If the factory has the right to
pollute, but doing so is not efficient, the residents will not be able to coordinate
and collectively buy off the factory. Conversely, if each resident has the right to
prevent the factory from polluting, the factory will not be able to arrange a
purchase of that right from each resident. Thus, in these examples, Coasean
bargains are deemed impossible, and the legal rule controls the outcome. Cf.
Alan Schwartz & Joel Watson, The Law and Economics of Costly Contracting,
20 J.L. ECON. & ORG. 2, 3 (2004) (noting that “contracting and renegotiation
costs are . . . commonly assumed to be either very high or very low” and
“explor[ing] the middle ground”). 50
See, e.g., Robert C. Ellickson, Of Coase and Cattle: Dispute Resolution
Among Neighbors in Shasta County, 38 STAN. L. REV. 638 (1986). 51
See Sturges v. Bridgman, LR 11 Ch D 852 (1879).
16
farmer and a rancher;52
etc.53
—but they are almost always
neighbors who must resolve a question of conflicting rights.54
Does the confectioner have the right to use his kitchen as he sees
fit, even though it makes the doctor’s examination room noisy, or
does the doctor have the right to quiet in his examination room,
even though it means the confectioner cannot use his kitchen?55
These examples are useful, but they are not representative
of the broad class of problems to which the logic of the Coase
Theorem is often applied. In particular, they do not consider
scenarios in which there are more than two parties. In such
circumstances, parties will often have incentives to create
transaction costs.56
These voluntary transaction costs confound the
mechanism underlying the Coase Theorem, rendering its logic
applicable to a smaller class of circumstances than has previously
been recognized.
We begin by demonstrating why parties might wish to
create transaction costs for others, before turning to scenarios in
which they may wish to create transaction costs for themselves.57
52
See, e.g., Graciela Kuechle, & Diego Rios, The Coase Theorem Reconsidered:
The Role of Alternative Activities, 32 INT’L REV. L. & ECON. 129, 129-30
(2012). 53
See, e.g., Coase, supra note 2, at 8 (discussing a building that obstructed
currents of air, impairing a windmill’s operation); id. (discussing a building that
cast a shadow on a nearby hotel’s sunbathing area); id. at 37 (giving an example
involving one neighbor whose rabbits eat another neighbor’s crops). 54
See Calabresi & Melamed, supra note 4, at 1101 (describing parties in an
example illustrating the Coase Theorem as “inevitably neighbors”); Ellickson,
supra note 50. 55
See Coase, supra note 2, at 2. 56
In the two-party case, voluntary transaction costs should not arise because it is
in neither party’s interest to create them. See Companion Paper, supra note 11,
at thm 1. 57
For ease of exposition, we generally restrict our focus going forward to a
particular class of transaction costs that are easy to understand and model. In
the examples that follow, and for much of the remainder of this Article, we use
the term transaction costs to refer to costs that a party must pay to make any deal
at all; they are, quite literally, the cost of engaging in a transaction. Cf.
Farnsworth, supra note 42 (considering the transactional barriers created by
unhappiness about bargaining over a particular topic, or with a particular party).
Our definition fits comfortably within the heart of the definition of transaction
costs usually used in the literature, though that definition encompasses other
phenomena as well. See footnote 15, supra, and accompanying text. Moreover,
we note that our definition captures more of these other phenomena than might
initially be apparent. For example, a party may be able to eliminate the problem
of asymmetric information by conducting her own costly investigations.
17
We illustrate both of these dynamics by revisiting, and tweaking
slightly, our example from Part II.58
A. The Private Value of Transaction Costs for Others
There are many instances in which one or more individuals
will wish to create transaction costs for other parties. For example,
this dynamic arises whenever the following two criteria are met59
:
First, there is at least one “dispensable party”—a party whose
participation in the Coasean bargain is not necessary to achieve an
efficient result. Second, there is a dispensable party whose
preferred outcome is an inefficient one. More precisely, the
dispensable party prefers the Coasean bargain that would arise if
certain individuals (the “opposition”60
) did not participate in the
bargaining process over the efficient Coasean bargain that would
arise if everyone participated.61
To see why parties often wish to create transaction costs for
others, it is helpful to consider two separate possibilities. First,
suppose that the parties strike a Coasean bargain under which the
dispensable party does not receive any cash payments.62
By
assumption, there is some other Coasean bargain that (1) the
dispensable party would like better, and (2) would arise if the
opposition were excluded from the negotiating process.63
Accordingly, the dispensable party will wish to create transaction
costs that keep the opposition away from the bargaining table and
bring about her preferred outcome.
Similarly, coordination costs are essentially the time, effort, and other resources
required to assemble and organize collective action. One must commit those
resources in order to achieve the desired deal; thus, there is a cost to engaging in
such transactions as well. 58
Throughout this Article, we ignore mixed-strategy equilibria for two reasons:
First, it simplifies our analysis. Second, we primarily focus on the efficiency of
various outcomes. Our examples involve unique efficient outcomes; thus,
mixed-strategy equilibria are inefficient. 59
These conditions are sufficient, but not necessary. See footnotes 148-149,
infra, and accompanying text (discussing a scenario that does not satisfy these
conditions and in which parties wish to create transaction costs for others). 60
Cf. FRANK, supra note 26, at 90-95. 61
See Companion Paper, supra note 11, at § 2.1. 62
Again, the relevant measure is net payments. See note 28, supra. 63
See text accompanying note 61, supra.
18
On the other hand,64
suppose that the parties strike a
Coasean bargain that gives the dispensable party a cash payment.65
In this scenario, the opposition has an incentive to exclude the
dispensable party from the bargaining table66
: By definition, the
dispensable party is not needed to achieve efficiency.67
Therefore,
the remaining parties can still produce the efficient result in her
absence. This means that the size of the economic pie will remain
the same if the dispensable party is excluded from the bargaining
table. However, if the dispensable party is excluded from the
bargaining process, she will no longer receive any payments.68
In
other words, the opposition can take the payments that would have
gone to the dispensable party and divide them among themselves
instead. Consequently, the opposition wants to create transaction
costs that keep the dispensable party away from the bargaining
table.69
An example helps illustrate these points. Consider once
again a railroad whose track runs next to farmer Alice’s wheat
fields. The railroad’s locomotive emits sparks, and if these sparks
land in Alice’s wheat fields, the fields will ignite, which is
extremely costly. As before, we assume that there are only two
ways to avoid this problem: (1) the railroad can refrain from
running its train, at a cost to the railroad of $500, or (2) Alice can
plant her wheat far enough back from the track to ensure that errant
sparks will not ignite her fields, at a cost to her of $1000.
We now depart from our previous example by adding a
new person, Zelda. Zelda is a conservationist who owns
undeveloped, forested land that also abuts the train track. The
64
Note that, between the first and the second case, we cover all possibilities; the
parties’ Coasean bargain must either (1) provide for expected cash payments to
the dispensable party, or (2) not provide such payments. 65
In other words, assume that the cash payments that she receives from the other
parties to the Coasean bargain are larger than the cash payments that she must
make to other parties pursuant to the Coasean bargain. 66
More precisely, it is not just the opposition who has this incentive. Every
other party to the Coasean bargain will also wish to exclude the dispensable
party and capture some of the cash payments that the dispensable party would
have received. 67
See text accompanying note 61, supra. 68
See Companion Paper, supra note 11, at 4 n.5. 69
The precise incentives of each of the remaining parties to exclude the
dispensable party depend on how the payments that would have gone to the
dispensable party are divided among the remaining parties.
19
sparks emitted by the locomotive ignite dry brush on Zelda’s land.
However, from Zelda’s perspective, these sparks are a positive; the
regular train schedule produces many small fires that help clear
away dead underbrush and prevent large and dangerous forest fires
from developing on her property.70
If the train does not run, Zelda
can accomplish the same result by doing controlled burns on her
land, at a cost to her of $200.71
Thus, unlike Alice, Zelda reaps a
$200 benefit when the locomotive runs.72
Suppose that the law gives the railroad the right to emit
sparks. If there are no transaction costs, Alice and the railroad will
make a Coasean bargain in which Alice pays the railroad not to run
its train. This would produce an efficient result—not running the
train costs the railroad $500 and Zelda $200, but it provides Alice
a $1000 benefit.73
However, even if there are no structural transaction costs,
one or more of the parties will always have an incentive to
manufacture transaction costs. The dynamic that we describe
below applies regardless of how the parties divide up the gains
from bargaining; however, it is easiest to understand in the context
of a specific numerical example. We therefore assume, as before,
that the parties divide the gains produced by their Coasean bargain
evenly among themselves.74
Accordingly, Alice will pay $600 to
the railroad and $300 to Zelda, totaling $900, and will be able to
grow an additional $1000 worth of wheat. This leaves each party
$100 better off than they were before they struck their Coasean
bargain.75
70
Cf. U.S. FOREST SERV., MANAGING WILDLAND FIRES: PRESCRIBED FIRE,
available at fs.fed.us/fire/management/rx.html, last visited Feb. 23, 2014
(describing how, without periodic fires, certain ecosystems can become
unhealthy for flora and fauna and dangerous for people). 71
Cf. id. (describing how the U.S. Forest Service engages in prescribed fires to
ensure that certain lands do not go too long without a fire). 72
Many other similar examples can easily be constructed. For instance, Zelda
could be a bed-and-breakfast owner whose guests like to see the train go by. 73
The total cost of not running the train is $700 ($500 to the railroad and $200
to Zelda), which is $300 less than the $1000 benefit to Alice. 74
See text accompanying notes 29 and 30, supra. 75
The parties’ transaction produces $300 net gains, so splitting those gains
means giving each party a $100 benefit: Alice pays a total of $900 and receives
$1000 more wheat. Zelda receives $300 and loses a $200 benefit. The railroad
receives $600 and loses a $500 benefit.
20
Consider the Coasean bargain that would be struck without
Zelda’s participation, however. These circumstances are
essentially identical to those of an example discussed in Part II:
Alice and the railroad will split the $500 joint gains that they
receive from the transaction, leaving each $250 better off.76
Thus,
both Alice and the railroad are $150 better off if Zelda is excluded
from the Coasean bargain. Accordingly, they would each be
willing to pay up to $150 to create transaction costs that prevent
Zelda from participating in the bargaining process.
It is worth emphasizing that this dynamic does not depend
on the precise way that the parties divide the surplus: Zelda’s
participation is not necessary to achieve an efficient result. Thus,
if the Coasean bargain provides for any payment to Zelda, either
Alice, the railroad, or both are better off when Zelda is excluded
from the bargaining process. Hence, either or both Alice and the
railroad will create transaction costs for Zelda if possible.
The only circumstance under which neither Alice nor the
railroad will want to create transaction costs that keep Zelda away
is when Zelda does not receive any cash payments. However, in
such circumstances, Zelda will want to create transaction costs that
prevent Alice and the railroad from negotiating with each other: If
Alice and the railroad cannot negotiate, the railroad will run its
train. This will give Zelda $200 more in benefits that she receives
if Alice and the railroad negotiate a deal that does not provide
Zelda with a cash payment.77
Putting this all together, it will always be the case that
either (1) Alice and the railroad have an incentive to keep Zelda
away from the negotiating table, or (2) Zelda will have an
incentive to keep Alice and the railroad from negotiating with each
other.78
Even if there are no structural transaction costs, overall
76
See footnote 30, supra, and accompanying text. 77
If the railroad does not run the train and Zelda gets no cash payment, she nets
zero. If the railroad runs the train, Zelda gets a $200 benefit. 78
This situation has some similarities with, but is distinguishable from, the
problem of the empty core, which is well documented in the context of the
Coase Theorem. See, e.g., Yakar Kannai, "The Core and Balancedness", in 1
HANDBOOK OF GAME THEORY WITH ECONOMIC APPLICATIONS, 355–395
(Robert J. Aumann & Sergiu Hart, eds., 1992); Olga N. Bondareva, Some
Applications of Linear Programming Methods to the Theory of Cooperative
Games, 10 PROBLEMY KYBERNETIKI 119 (1963); Lloyd S. Shapley, On
Balanced Sets and Cores, 14 NAVAL RESEARCH LOGISTICS Q. 453 (1967); see
21
transaction costs may still be large because the parties will create
voluntary transaction costs if they can.
It is not difficult to come up with a bevy of real-world
scenarios in which an individual prefers to exclude other parties
with opposing interests. For instance, at auctions, bidders often
wish to exclude other would-be bidders in order to keep sale prices
lower.79
Similarly, producers are typically happy to increase their
market power by preventing competitors from having access to
their customers.80
More interestingly, the chief goal of many lawsuits is to
impose transaction costs on parties who are attempting to bring
about a result that the plaintiff does not like. These lawsuits’
purpose is to make it harder for the defendants to strike certain
bargains. Often, these lawsuits challenge the procedure through
which the defendants made the deal in question.81
Even when
also Varouj A. Aivazian & Jeffrey L. Callen, The Coase Theorem and the Empty
Core, 24 J.L. & ECON. 175 (1981); Ronald H. Coase, The Coase Theorem and
the Empty Core: A Comment, 24 J.L. & ECON. 183 (1981); Varouj A. Aivazian
& Jeffrey L. Callen, The Core, Transaction Costs, and the Coase Theorem,
CONST’L POL. ECON. (2003). 79
See, e.g., Robert C. Marshall & Michael J. Meurer, Bidder Collusion and
Antitrust Law: Refining the Analysis of Price Fixing to Account for the Special
Features of Auction Markets, 72 ANTITRUST L.J. 1 (2004); Katherine Sawyer,
Mobile Investor to Plead Guilty in Foreclosure Auction Bid-Rigging Scheme,
TIMES-PICAYUNE, Apr. 30, 2012, available at blog.al.com/live/2012/04/
mobile_investor_to_plead_guilt.html. 80
Agreements among competitors to divide territory geographically is illegal
under the Sherman Act. See, e.g., U.S. DEP’T OF JUSTICE, ANTITRUST
RESOURCE MANUAL § 8. 81
For example, environmental groups sometimes bring lawsuits to halt proposed
construction projects on the grounds that the developer has not undertaken
certain procedural steps, such as conducting legally mandated studies or
allowing sufficient opportunity for public comment. Similarly, parties
sometimes challenge the validity of new regulations issued by a government
agency on the ground that the agency did not follow the proper procedure, such
as giving notice to the public and allowing an appropriate amount of time for the
public to submit comments. See, e.g., Electronic Privacy Information Center v.
Dep’t of Homeland Security, 653 F.3d 1 (D.C. Cir. 2011) (ruling that the
Department of Homeland Security violated the Administrative Procedures Act
when it decided to screen airline passengers through advanced imaging
technology instead of magnetometers and remanding for further proceedings);
Lucia Graves, Groups Against Keystone XL Oil Pipeline Sue to Block
Construction, HUFFINGTONPOST.COM, Dec. 5, 2011, huffingtonpost.com/
2011/10/05/groups-sue-to-block-construction-of-keystone-xl_n_996075.html;
Suzanne Stevens, Environmental Groups Expand Lawsuit to Block Tesoro Oil
Terminal, SUSTAINABLE BUS. OREGON, Nov. 19, 2013, available at
sustainablebusinessoregon.com/articles/2013/11/environmental-groups-expand-
22
these suits succeed, the defendants can usually still proceed with
their deal, so long as they first engage in the required steps. In
some instances, the added cost and delay is sufficient to prevent
the project altogether.82
Other times, the plaintiff is able to extract
concessions from the defendants in exchange for dropping its
suit.83
This dynamic resembles the scenario in which
conservationist Zelda attempts to create transaction costs that keep
farmer Alice and the railroad from striking a deal.84
The parallels are easiest to see in the context of a specific
example. One of the biggest current issues in San Diego politics is
a $525 million proposed expansion of the city’s waterfront
convention center.85
In October, 2013, San Diego port and city
officials (the “San Diego officials”) received a necessary approval
for the project from the California Coastal Commission (the
“CCC”).86
The San Diego Navy Broadway Complex Coalition
(“SDNBCC”) then filed suit in an attempt to block the expansion
project from going forward.87
The SDNBCC’s legal challenge is
based on alleged procedural failings in the CCC’s approval
process.88
The SDNBCC opposes the expansion because it
lawsuit.html; Ty West, Lawsuit Filed to Block Northern Beltline Permit,
BIRMINGHAM BUS. J., Oct. 25, 2013, available at bizjournals.com/birmingham/
news/2013/10/25/northern-beltline-lawsuit-filed.html. 82
Cf. Lucian Arye Bebchuk et al., The Powerful Antitakeover Force of
Staggered Boards: Theory, Evidence, and Policy, 54 STAN. L. REV. 887, 904
927-29 (2002) (finding that, when anti-takeover devices extend the time
required to acquire a company to over one year, acquisitions do not happen);
Jordan M. Barry & John William Hatfield, Pills and Partisans: Understanding
Takeover Defenses, 160 U. PENN. L. REV. 633 (2012) (exploring the
implications of this dynamic). 83
See, e.g., MAYER BROWN, U.S. ENVIRONMENTAL LAWS INCREASINGLY LEAD
TO LITIGATION CONCERNING THE SITING AND OPERATION OF RENEWABLE
ENERGY PROJECTS (2010), available at mayerbrown.com/files/Publication/. 84
See Part III.A, supra. 85
See, e.g., Padma Nagappan, Convention Center Expansion Plans Mired in
Controversy, DAILY TRANSCRIPT, Aug. 30, 2012; James R. Riffel, Filner,
DeMaio Debate Convention Center Expansion Financing, KPBS.ORG, Oct. 3,
2012, kpbs.org/news/2012/oct/03/filner-demaio-debate-convention-center-
expansion-f/. 86
Lori Weisberg, Commission OKs Convention Expansion, SAN DIEGO UNION-
TRIBUNE, Oct. 10, 2013, available at utsandiego.com/news/2013/Oct/10/coastal-
commission-convention-expansion-plan-bay/. 87
Roger Showley, Convention Center Lawsuit Filed, SAN DIEGO UNION-
TRIBUNE, Nov. 25, 2013, available at
utsandiego.com/news/2013/nov/25/convention-center-expansion-lawsuit/. 88
See id. (identifying challenges to the approval process, including the failure to
consider alternative projects, according insufficient opportunity for public
comment, the CCC’s failure to issue a recommendation in a specific form at a
23
believes that the expansion will reduce the public’s access to the
San Diego Bay and have adverse effects on the environment.89
This example tracks our farmer/conservationist example
well.90
The SDNBCC resembles conservationist Zelda, the CCC
resembles the railroad, and the San Diego officials resemble farmer
Alice. Left to their own devices, the San Diego officials and the
CCC would proceed with the expansion project,91
just as Alice and
the railroad would reach an agreement not to run the train.92
The
SDNBCC, like Zelda, prefers the outcome when the parties do not
bargain93
over the bargain that will otherwise occur.94
Accordingly, the SDNBCC filed its lawsuit and created transaction
costs for the other parties. And, by creating those transaction
costs, the SDNBCC may be able to extract concessions from the
other parties95
—essentially equivalent to cash payments in our
stylized example.96
Many other real-world examples also fit this
general mold.97
Finally, note that the other parties’ incentives to exclude a
dispensable party stem from the cash payments that the
dispensable party receives. The larger those payments are, the
more incentive the other parties have to kick out the dispensable
party and divide up the payments that would have gone to her.
particular time, and some CCC members’ failure to disclose communications in
a timely fashion). 89
See Weisberg, supra note 86. 90
In analogizing to the farmer/conservationist example discussed above, we do
not mean to imply that the proposed expansion is efficient. We take no position
on that issue. 91
See Weisberg, supra note 86 (discussing the negotiations between the CCC
and San Diego officials). 92
See footnotes 30 and 76, supra, and accompanying text. 93
That is, the legal default rule. See footnote 217, supra, and accompanying
text. 94
See footnote 77, supra, and accompanying text. 95
For example, SDNBCC would likely prefer a prior proposal, which included a
large pedestrian bridge into the expansion. This option was rejected on the
grounds that it would be too costly, but that decision could potentially be
reversed. See Weisberg, supra note 86. 96
See Part III.A, supra. 97
A similar story could be told about the same project with respect to organized
labor instead of SDNBCC. Labor groups originally opposed the project and
threatened litigation, but changed their position after reaching an agreement with
the project’s contractor. See Lori Weisberg, Convention Center Labor Pact
Ignites Controversy, SAN DIEGO UNION-TRIBUNE, Nov. 12, 2012, available at
utsandiego.com/news/2012/Nov/12/convention-center-labor-pact-ignites-
controversy/.
24
Note also that the dispensable party is likely to receive larger
payments when the parties at the table divide up the gains from
their agreement more equitably.98
Hence, the incentives to exclude
dispensable parties from negotiations altogether become stronger
as the parties at the bargaining table allocate the benefits of the
transaction among themselves in a more egalitarian manner.
B. The Private Value of Transaction Costs for Oneself
There are also scenarios in which it is in a party’s best
interest to create transaction costs that keep her from participating
in any Coasean bargain. Consider once more our prior example
with a railroad that borders farmland. However, unlike our
previous example, suppose that there are now two farmers, Alice
and Bob, whose wheat fields abut the train tracks. As before, not
running the train will cost the railroad $500, and it will cost Alice
and Bob $1000 each to plant their crops away from the tracks.
Assume that the law gives the railroad the right to emit
sparks from its locomotive. In the absence of any agreement, the
farmers will be forced to plant back from the tracks. However, the
Coase Theorem predicts that, as long as there are no transaction
costs, this will not happen: Because planting back from the tracks
costs Alice and Bob more than it would cost the railroad not to run
the train, Alice and Bob should pay the railroad not to run the train.
Assuming once more that the parties evenly divide the gains
produced by their agreement,99
Alice and Bob each pay the
railroad $500,100
leaving each party $500 better off than she would
be in the absence of an agreement.101
So far, having three actors in our example instead of two
has not had much effect. The basic transaction is the same: The
farmer buys off the railroad, just as in our original example.102
The
98
The dispensable party is receiving cash payments, even though her
participation is not necessary to achieve efficiency; thus, she is receiving a share
of the gains, even though she did nothing to create those gains. 99
See text accompanying notes 29 and 30, supra. 100
The exact split is not important to our conclusions; it simply facilitates and
clarifies the analysis somewhat. 101
The railroad loses $500 by not running the train, but receives $1000 cash
from the farmers, for a net profit of $500. Alice and Bob each pay $500, but
earn $1000 in additional profit from growing additional wheat. 102
See footnotes 28-30, supra, and accompanying text.
25
only difference is that now there are two farmers who team up to
buy off the railroad instead of one farmer acting alone.
Now suppose that Bob faces high transaction costs: In
order to be party to any agreement, Bob must pay $2000. The
most that Bob can hope to benefit under a Coasean bargain is
$1500, the net value produced from not running the train.103
Because that is less than the $2000 cost that Bob must incur to
make any agreement, it is never in Bob’s interest to participate in
any transaction. Bob should never come to the negotiating table.
Taking Bob out of the picture leaves just Alice and the
railroad. Because Alice’s gains from planting additional wheat
($1000) exceed the benefit that the railroad receives from running
the train ($500), Alice should still buy off the railroad without
Bob’s involvement: As long as Alice pays the railroad more than
$500 and less than $1000 not to run the train, both she and the
railroad will be better off.104
Three things are worth noting here. First, even without
Bob’s involvement, the parties have resolved the legal entitlements
question in the same way; the train does not run in either scenario.
Second, even though Bob has not participated in the
negotiation, he still benefits from its results: By not running its
train, the railroad protects both Alice’s and Bob’s fields from
sparks and enables them both to plant more wheat; the same track
and the same trains run (or do not run) by both farms. Thus, Bob
will still pocket $1000 in profits from growing wheat near the
track. Bob’s lack of involvement in the negotiation has not made
the bargaining outcome any less favorable to him.
Third, by not participating in the agreement, Bob has
avoided having to make any payments to the railroad. This leaves
Bob $500 better off than he was in the previous example, in which
he grew the same amount of wheat but paid $500 to the railroad.
103
If he receives any more than $1500, at least one of the other parties to the
agreement must be paying out more money than she receives in benefits from
the transaction. Accordingly, that party would be better off rejecting the
Coasean bargain. 104
Applying the same criteria as in our prior example, we would expect Alice to
pay the railroad $750, leaving both her and the railroad with a gain of $250 from
the transaction.
26
Thus, the $2000 transaction costs that Bob faced have left
him $500 better off. And, although Bob benefits from these
transaction costs, Alice and the railroad suffer. Since Bob now
keeps $1000 of the gains created by the transaction, Alice and the
railroad have only $500 in gains left to split between them.
Because Bob is better off with the $2000 transaction costs
than without them, he prefers when they are present. Moreover, if
they are not present, Bob will have a strong incentive to
manufacture them, and would happily pay up to $500 to do so.105
The phenomenon of individuals intentionally making
themselves unavailable will be familiar to most people who have
been tasked with rounding up volunteers to serve on an office
committee, or who have tried to get roommates to help clean up
the common areas of an apartment.106
This dynamic also applies to
fundraising for public goods, such as parks or fireworks
displays;107
indeed, the difficulty of collecting voluntary
contributions for public goods is one of the chief economic
justifications for empowering governments to levy and collect
taxes.108
It is worth noting that this same dynamic can also affect
negotiations between governments. For example, countries often
enter into multilateral treaties as a way to take coordinated action
toward a common goal. For instance, environmental treaties, in
which signatories commit to taking coordinated action to reduce
pollution, often fit this mold.109
These treaties generally require
taking actions that are economically costly.110
From the
105
On the other hand, Alice and the railroad would be willing to pay up to $500
to eliminate Bob’s transaction costs. 106
All of these problems are essentially free-rider problems. See MANCUR
OLSON, THE LOGIC OF COLLECTIVE ACTION (1965). 107
See id. 108
See VARIAN, supra note 12, at 605-26. 109
See, e.g., UNITED NATIONS, FRAMEWORK CONVENTION ON CLIMATE
CHANGE, KYOTO PROTOCOL (1997), available at unfccc.int/kyoto_protocol/
items/2830.php. (reducing emissions); UNITED NATIONS, MONTREAL PROTOCOL
ON SUBSTANCES THAT DEPLETE THE OZONE LAYER (1997), available at
ozone.unep.org/new_site/en/ (phasing out production of ozone-depleting
substances); UNITED NATIONS, PROTOCOL ON FURTHER REDUCTION OF SULPHUR
EMISSIONS (1994), available at unece.org/env/lrtap/fsulf_h1.html (reducing
emissions to combat acid rain). 110
See FRANK, supra note 26, at 177 (“Firms don’t pollute because they derive
pleasure from doing so. They do it because removing pollution costs money.”).
27
perspective of an individual country, it may be advantageous to
refrain from joining the treaty; doing so may enable that country to
avoid incurring costs, even as it reaps the benefits from the other
signatories’ actions.111
Many other international compacts also
exhibit this dynamic, such as those establishing trade sanctions,112
sovereign debt bailouts,113
contributions to international
peacekeeping forces,114
or banking transparency.115
This dynamic can also arise within a country that has a
federalist form of government. Consider a beneficial infrastructure
project that will be located in a particular city. That city is
contained within a county, which is contained within a state, which
is contained with the nation. Each level of government has an
interest in the project being completed. However, each has a
limited amount of funds at its disposal. Thus, each governmental
entity would prefer that the others fund the project. Accordingly,
each government may endeavor to keep itself away from the
negotiating table in order to force the other governments to commit
the necessary funds.
The dynamic explored throughout this Subpart is, in many
ways, the flipside of the dynamic underlying our analysis in Part
III.A. Here, Bob is a dispensable party—his participation is not
needed to reach the efficient outcome—just like Zelda was there.
The difference between Bob and Zelda is that Zelda preferred an
inefficient outcome; thus, she would not contribute cash payments
to the Coasean bargain, and the other parties were happy to
exclude her. Bob, in contrast, prefers the efficient outcome.
Accordingly, he is theoretically willing to make cash payments to
bring it about. But, if he can avoid coming to the table, he can
avoid spending his own money and free-ride off of Alice’s
contributions. Consequently, Bob wishes to exclude himself.
111
See Dixit & Olson, supra note 9 (illustrating this dynamic). 112
Cf. Howard LaFranchi, What Do Iran Sanctions Cost You?, CHRISTIAN
SCIENCE MONITOR, Apr. 5, 2012 (discussing the cost to U.S. citizens of
imposing sanctions on Iran). 113
See Jack Ewing, Germany Resists Europe’s Pleas to Spend More, N.Y.
TIMES, Jan. 8, 2012. 114
See David Bosco, The Price of Peace, FOREIGN POLICY, May 29, 2013. 115
See ORGANISATION FOR ECONOMIC COOPERATION & DEVELOPMENT,
CONVENTION ON MUTUAL ASSISTANCE IN TAX MATTERS (2011), available at
oecd.org/tax/exchange-of-tax-information/.
28
Combining the results of Parts III.A and III.B, we see that
when there are dispensable parties, individuals will generally want
to create transaction costs. If a dispensable party favors an
inefficient result, the other parties will wish to create transaction
costs for her.116
If a dispensable party favors an efficient result,
then she will wish to create transaction costs for herself.117
The combined effect of these two dynamics is that parties
will frequently have incentives to create transaction costs. As we
demonstrate below, this has important consequences.
C. Voluntary Transaction Costs and Inefficiency
The possibility that parties may voluntarily create
transaction costs imposes significant additional limitations on the
circumstances in which the Coase Theorem’s predictions apply.118
Consequently, even when there are no structural transaction costs,
voluntary transaction costs may prevent the parties from
contracting their way to an efficient result. In these circumstances,
legal rules may determine whether the parties reach an efficient
outcome.
In our previous examples illustrating voluntary transaction
costs, the parties generally reached an efficient result, regardless of
the legal rule.119
In Part III.A, no matter the legal rule, excluding
the dispensable parties from negotiations did not endanger the
efficient result.120
Nor did the legal rule affect efficiency in Part
III.B; Alice and the railroad negotiated an efficient result even
when Bob opted out of negotiations.121
In both instances, the key
116
By the same token, the dispensable party will be willing to pay to eliminate
transaction costs that keep her away from the table. 117
Similarly, the other parties to the Coasean bargain will be willing to pay to
eliminate transaction costs that keep the dispensable party away from the table. 118
Shades of this point have been made in the literature. See Calabresi &
Melamed, supra note 4 (stating that zero-transaction-cost assumption must
imply full knowledge of reservation prices to address freeloading); Dixit &
Olson, supra note 9 (considering the free-rider dynamic in a specific context). 119
This is not quite accurate. In the farmer/conservationist example explored in
Part II.A, if Zelda creates transaction costs that prevent the other parties from
coming to the table, the parties do not achieve an efficient result. 120
See note 76, supra, and accompanying text. 121
See note 104, supra, and accompanying text.
29
predictions of the Coase Theorem persisted. Legal rules, and the
addition of new transaction costs, had only distributional effects.122
However, this is not always the case. There are instances
in which creating transaction costs produces net benefits for the
party creating them, but shrinks the size of the economic pie
overall. Voluntary transaction costs can create inefficiencies just
like any other transaction cost can.
We first illustrate this point with a scenario in which parties
have incentives to impose transaction costs on themselves. We
once again assume that railroad tracks run next to the wheat fields
of two farmers, Alice and Bob. The tracks are parallel to each
other, so that one track (the “near track”) is closer to the farmers’
fields and the other track (the “far track”) is farther away. The
railroad can run trains, which emit sparks, on either or both tracks.
If the trains run, the farmers must plant back from the tracks to
prevent errant sparks from igniting their fields. The farmers must
plant further back from the tracks, and incur greater opportunity
costs from forgone wheat, if a train runs on the near track than if a
train runs on the far track.
Assume that, if the railroad runs trains on both tracks, Bob
and Alice must each forgo planting $1000 of wheat. If trains only
run on the far track, Alice and Bob can plant most of the way to the
tracks, letting each of them earn $650 more from growing wheat
than they could if trains ran on both tracks. Further assume that
running trains on both tracks gives the railroad $800 in benefits,
and that running trains on only one track gives the railroad $400 in
benefits.123
Table 1, below, summarizes these results.124
122
See notes 76 and 105, supra, and accompanying text. 123
Equivalently, the railroad gets $400 for each track on which it runs trains. 124
We assume that the railroad does not choose to run a train on only the near
track; i.e., it is a good neighbor. But cf. Daniel B. Kelly, Strategic Spillovers,
111 COL. L. REV. 1641 (2011) (arguing that parties sometimes intentionally take
actions that produce negative externalities in order to extract payments from the
negatively affected individual in exchange for abating the harmful activity).
30
TABLE 1
Value
to Alice
Value
to Bob
Value to
Railroad
No Trains Run $1000 $1000 $0
Trains Run on
Far Track Only $650 $650 $400
Trains Run on
Both Tracks $0 $0 $800
As in our previous example, the efficient result is for the
railroad not to run any trains; doing so creates $2000 of value for
the parties to divide amongst themselves.125
This is more than both
the $1700 of value created by only running trains on the far track
and the $800 of value created from running trains on both tracks.126
But, if Bob has the ability to impose transaction costs on himself,
the result that the parties achieve will depend on the legal rule.
Consider first what happens if the farmers are legally
entitled to not have sparks on their land. In this circumstance,
there is no agreement to be struck: Alice and Bob would demand
that the railroad pay them a combined total of at least $700 before
they would allow the railroad to run trains on the far track, but the
railroad would not be willing to pay more than $400 for that
right.127
Similarly, Alice and Bob will only allow the railroad to
run trains on both tracks if they receive a payment of at least
$2000. That amount is far more than the $800 that the railroad
might be willing to pay them for that right. Accordingly, the
parties will achieve an efficient result. All of the surplus will
125
This can be seen by adding the values in the top row of Table 1.
Equivalently, this is the sum of the $1000 that Alice and Bob each receive from
planting additional wheat and the $0 value that the railroad receives from not
running any trains. 126
See Table 1, supra. 127
See Table 1, supra.
31
accrue to Bob and Alice, and Bob will not choose to create
transaction costs.128
Next, consider what happens if the law gives the railroad
the right to run trains on the far track only. It is in Alice and Bob’s
joint best interests to induce the railroad not to run any trains;
doing so will enable them to earn $700 more in profits.129
Not
running the train on the far track costs the railroad $400. Thus,
there is the potential for the farmers and the railroad to make an
agreement that leaves each party better off.
But this agreement is only possible if both Alice and Bob
participate in negotiations. The railroad reaps a $400 benefit from
running the train on the far track, so it will not agree to cease doing
so unless it receives a cash payment of at least $400.130
Each
individual farmer reaps only $350 in benefits from the train not
running; accordingly, neither individual farmer will be willing to
pay the railroad enough to induce the railroad to stop running the
train.
Thus, if Bob creates transaction costs, Alice and the
railroad will not strike any further agreements. The railroad will
run the train on the far track, and Bob will get $650.
On the other hand, if Bob chooses to participate in the
negotiations, he and Alice can jointly induce the railroad not to run
any trains, creating additional surplus. Assuming, as previously,131
that the parties divide this surplus evenly among themselves, Alice
and Bob will each pay the railroad $250 not to run the train.132
In
this scenario, Bob pays out $250 to the railroad, but gets to plant
an additional $350 worth of wheat, leaving him with $750 of
value.133
As this is more than the $650 of value that he receives
when he does not participate in negotiations, Bob will prefer to
participate.
128
More precisely, if Bob can create transaction costs at no cost to himself, he
will be indifferent between creating them and not. In either event, there is no
deal to be struck even in the absence of transaction costs, so the effect is the
same. 129
See Table 1, supra. 130
See Table 1, supra. 131
See text accompanying notes 29 and 30, supra. 132
Each of Alice and Bob pays $250 for a $350 benefit. The railroad loses a
$400 benefit but receives $500 in payments. 133
See Table 1, supra.
32
Thus, when the law gives the railroad the right to run trains
on the far track only, Bob will choose not to create transaction
costs and will instead choose to join Alice in negotiating with the
railroad. In fact, Bob might now be willing to pay up to $300 to
eliminate transaction costs that keep him away from the
negotiating table.134
This legal rule will result in the railroad not
running the train, the efficient result.
Finally, suppose that the law permits the railroad to run
trains on both tracks. Under this rule, the parties will never reach
an agreement under which the railroad does not run any trains.135
Striking a Coasean bargain in which the farmers pay the railroad
not to run any trains creates $1200 of value.136
As discussed
above, this agreement is only possible if all three parties come to
the table.137
Since we assume that the parties evenly divide up the
surplus that their bargaining creates, Bob and Alice will each net
$400,138
as will the railroad.139
Alternatively, if Bob faces high transaction costs that
prevent him from participating in the agreement, Alice will be left
to negotiate with the railroad on her own. In that case, Alice will
pay the railroad not to run trains on the near track, as that lets Alice
plant an additional $650 of wheat but only costs the railroad
$400.140
But Alice will not be willing to pay the railroad not to run
any trains: Such an agreement would allow Alice to plant $350
more wheat than if trains only run on the far track. However, she
must pay the railroad an additional $400 not to run any trains.
Thus, if Bob is removed from the negotiating table, Alice and the
134
There is potentially $300 of surplus to be gained from having the railroad run
no trains instead of running trains on the far track only. See Table 1, supra. As
shown below, this surplus will not be realized unless Bob participates in the
agreement. Thus, Bob might potentially be willing to pay up to $300 to be
involved in the agreement. 135
More specifically, the parties will never reach such an agreement if Bob is
rational and Alice and the railroad play subgame-perfect strategies. See
Companion Paper, supra note 11, at § 2.1. 136
Without a bargain, the railroad will run trains on both tracks, creating $800 of
value. With a bargain, no trains will run, producing $2000 of value, an increase
of $1200. See Table 1, supra. 137
See text accompanying notes 130-131, supra. 138
This corresponds to each paying the railroad $600 not to run the train. 139
The railroad will receive $1200 and will forgo the $800 benefit it would
receive from running its train, leaving it $400 better off as well. 140
See Table 1, supra.
33
railroad will reach an agreement under which the railroad will run
trains on the far track only.
Accordingly, if Bob faces prohibitive transaction costs that
prevent him from participating in an agreement, he will be able to
grow $650 worth of wheat. This is less than the $1000 worth of
wheat that he is able to grow when he participates in the
agreement. However, when he does not participate in the
agreement, Bob does not have to make any payments to the
railroad. This means that his $650 in additional wheat is all profit,
making Bob $250 better off than he is when he teams up with
Alice to negotiate with the railroad. Bob would therefore be
willing to pay up to $250 to create transaction costs—even though
his leaving the table costs Alice and the railroad a combined total
of $550 and leads to an inefficient outcome.141
Table 2 summarizes these results. When voluntary
transaction costs are possible, the legal rule affects Bob’s choice
and the efficiency of the final outcome. Thus, when there are
voluntary transaction costs, the choice of legal rule becomes
crucial; the Coase Theorem and its underlying logic simply do not
apply.
141
As noted above, if Bob comes to the table, each party gets $400 of the gains
created by the Coasean bargain. Thus, Alice and the railroad receive $800
surplus between them. If Bob leaves the table, Alice and the railroad will split
$250 in surplus between them. Accordingly, Bob’s leaving the table costs Alice
and the railroad a combined total of $550, more than twice the amount that Bob
gains by opting out of the agreement.
34
TABLE 2
Railroad’s
Legal Right
Voluntary
Transaction
Costs?
Ultimate
Result
Efficient
Result?
Can Run
Trains on
Both Tracks
Bob Will Pay
to Create
Train Runs
on Far Track No
Can Run
Trains on Far
Track Only
Bob Will Pay
to Remove No Trains Run Yes
Cannot Run
Trains on
Either Track
Bob Is
Indifferent142
No Trains Run Yes
We emphasize that this result—that, when the law gives the
railroad the right to run trains on both tracks, it is not in each
party’s best interests to come to the table and strike an efficient
Coasean bargain—holds no matter how the parties divide up the
gains from their agreement.
To see this, suppose that both of the farmers and the
railroad each has the ability to create transaction costs that keep
themselves away from the negotiating table. In any scenario in
which all three parties come to the table and reach an efficient
agreement, the farmers must compensate the railroad for the value
it loses by not running any trains. That means the railroad must
receive cash payments from the farmers totaling at least $800.143
This means that at least one of the farmers must make a cash
payment of $400 or more;144
for simplicity, assume that that farmer
is Bob.145
The parties’ Coasean bargain enables Bob to plant an
142
See discussion in footnote 128, supra. 143
See Table 1, supra. 144
If both farmers were making cash payments of less than $400, then the sum
of both farmers’ payments would be less than $800. A payment of that size is
not large enough to induce the railroad not to run any trains. 145
This assumption produces no loss of generality; Bob and Alice are identically
situated, so the analysis is the same if Alice pays at least $400 instead of Bob.
35
additional $1000 of wheat, and requires him to make a payment of
at least $400. Thus, Bob gets, at most, $600 in net value from the
parties’ Coasean bargain.146
Consider instead what happens if Bob does not come to the
negotiating table. Without Bob, Alice will still want to negotiate
with the railroad: running trains on the near track costs Alice $650
in forgone wheat, but only gives the railroad $400 in benefits. It is
therefore in both Alice’s and the railroad’s interests to make an
agreement under which Alice pays the railroad between $400 and
$650 not to run any trains on the near track. Because the near
track runs next to both Alice’s farm and Bob’s farm, this
agreement will also allow Bob to plant $650 of additional wheat.
This is less than the $1000 in wheat that Bob can plant when no
trains run. However, this $650 is all profit for Bob; he does not
need to make any cash payments to secure it. Thus, Bob is better
off creating transaction costs that keep him away from the table.
Accordingly, it is never in all parties’ best interests to come
to the negotiating table. But, when the law gives the railroad the
right to run trains on both tracks, the parties can only achieve an
efficient result when they all participate in negotiations. Thus,
when parties have the ability to create large transaction costs for
themselves, the parties will never achieve an efficient result under
this legal regime.147
This Subpart’s analysis has been built around scenarios in
which individuals want to keep themselves away from the
negotiating table. Similar dynamics apply to scenarios in which
individuals want to keep other parties away from the negotiating
table.
For example, consider again the farmer/conservationist
scenario described in Part III.A, supra. Once again, we assume
that running the train creates benefits of $500 for the railroad and
$200 for conservationist Zelda, and creates costs of $1000 for
farmer Alice. Further suppose that there is a hill on the edge of
Zelda’s property that is prone to occasional, small mudslides.
146
Bob gets $1000 of extra wheat and must pay at least $400; thus, he nets at
most $600. 147
This assumes that the parties have an injunctive remedy. See Part IV.B,
infra.
36
When these mudslides happen, mud lands on farmer Alice’s
property and destroys $10 worth of wheat. If she chooses, Zelda
can stop these mudslides, thereby ending the destruction of Alice’s
wheat, at a cost of $5.148
If Zelda is excluded from negotiations, she will not stop the
mudslides, which is inefficient. However, the potential value lost
to this inefficiency ($5) is smaller than the cash payment that Zelda
receives from the other parties if she participates in the Coasean
bargain (≈$300).149
Accordingly, it is still in Alice’s and the
railroad’s interests to exclude Zelda from negotiations, even
though doing so results in inefficiency.
Both the two-farmer and the farmer/conservationist
examples described above share an important feature. In each
instance, there are three possible outcomes: The legal default
outcome and two alternatives. The legal default is the least
efficient outcome;150
both alternatives—the “efficient outcome”151
and the “intermediate outcome”152
—are more efficient than the
legal default.153
Moreover, the efficiency gains from moving from
the legal default to the intermediate outcome are larger than the
incremental gains from moving from the intermediate outcome to
the efficient outcome.154
Thus, creating transaction costs will often
benefit a party if doing so helps her to secure a larger share of the
gains produced by moving to the intermediate outcome—even if
148
For example, Zelda could build a wall to reinforce the hill or catch the mud
before it lands on Alice’s property. 149
Fixing the mudslide problem saves $10 of wheat at a cost of $5, producing $5
in net gains. Zelda receives a $300 payment when the parties split the gains
from their agreement; see note 75, supra, and accompanying text. 150
In the two-farmer example, the legal default is trains running on both tracks.
In the farmer/conservationist example, the default is running the train and not
fixing the mudslide-prone hill. 151
In the two-farmer example, the efficient outcome is no trains running. In the
farmer/conservationist example, the efficient outcome is no trains running and
fixing the mudslide-prone hill. 152
In the two-farmer example, the intermediate outcome is trains running on the
far track. In the farmer/conservationist example, the efficient outcome is no
trains running and not fixing the mudslide-prone hill. 153
See Table 1 and footnote 149 and accompanying text, supra. 154
In the two-farmer example, moving from the legal default to the intermediate
outcome produces $900 of value; moving from the intermediate outcome to the
efficient outcome produces $300 of value. See Table 1, supra. In the
farmer/conservationist example, moving from the legal default to the
intermediate outcome produces $300 of value; moving from the intermediate
outcome to the efficient outcome produces $5 of value.
37
those transaction costs prevents an efficient Coasean bargain.155
In
such circumstances, the parties achieve most of the potential social
gains (the intermediate outcome) but fall short of the full social
gains available (the efficient outcome).156
For our purposes, the key point is that these circumstances
are likely to arise with great frequency: Parties often have multiple
ways in which they can accomplish a particular goal, and they
generally select the most cost-effective options first.157
Thus, the
dynamic described above—in which the efficiency gained by
moving to an intermediate outcome exceeds the incremental
efficiency gained by moving from an intermediate outcome to the
efficient outcome—is likely to occur frequently. In other words,
the first steps toward the efficient result will often produce the
largest net benefits.158
Accordingly, parties may often wish to
create voluntary transaction costs.
For example, voluntary transaction costs play a critical role
in the behavior of creditors when a borrower suffers a financial
decline. This topic has been the subject of considerable recent
attention from scholars, practitioners, and journalists.159
155
See notes 141 and 149, supra, and accompanying text. 156
This dynamic is distinct from the problem of the empty core. See, e.g., Yakar
Kannai, "The Core and Balancedness", in 1 HANDBOOK OF GAME THEORY WITH
ECONOMIC APPLICATIONS, 355–395 (Robert J. Aumann & Sergiu Hart, eds.,
1992); Olga N. Bondareva, Some Applications of Linear Programming Methods
to the Theory of Cooperative Games, 10 PROBLEMY KYBERNETIKI 119 (1963);
Lloyd S. Shapley, On Balanced Sets and Cores, 14 NAVAL RESEARCH
LOGISTICS Q. 453 (1967); see also Varouj A. Aivazian & Jeffrey L. Callen, The
Coase Theorem and the Empty Core, 24 J.L. & ECON. 175 (1981); Ronald H.
Coase, The Coase Theorem and the Empty Core: A Comment, 24 J.L. & ECON.
183 (1981); Varouj A. Aivazian & Jeffrey L. Callen, The Core, Transaction
Costs, and the Coase Theorem, CONST’L POL. ECON. (2003). 157
This principle is sometimes called the low-hanging-fruit principle. The
analogy is to fruit-pickers harvesting the most easily accessible fruit first before
going after fruit that is harder to access. See ROBERT H. FRANK & BEN S.
BERNANKE, PRINCIPLES OF MICROECONOMICS 46-47 (2d ed. 2004). 158
Formally, this will not always be the case. There are circumstances in which
this dynamic may not hold, such as when the returns from an activity are
convex. However, it is generally believed (and assumed) that such scenarios are
relatively rare. See id. 159
See, e.g., Henry T.C. Hu & Bernard Black, Debt, Equity and Hybrid
Decoupling: Governance and Systemic Risk Implications, 14 EUR. FIN. MGMT
663 (2008); Theresa Einhorn, 28th Annual Review of Developments in Business
Financing: Current Trends in the Corporate Debt Market and Credit
Derivatives, 2010 AM. BAR ASSOC. SEC. BUS. L. 1, available at
haynesboone.com/files/Publication/; Daniel Gross, The Scary Rise of the
“Empty Creditor”, MONEYBOX, SLATE.COM, Apr. 21, 2009; Dante Altieri
38
Historically, when homeowners or profitable businesses have
found themselves overextended and unable to pay their debts, they
have negotiated agreements with their creditors.160
These
agreements generally provide for the debt to be repaid over a
longer period of time than originally contemplated,161
and they
often reduce the total amount of debt outstanding.162
For their part,
creditors generally agree to receive less than they are legally
entitled to receive because, by doing so, they ultimately receive
more money than they would if they strictly enforced the original
terms of their loans: In the case of the homeowner, she would
likely abandon the house, leaving the creditor with an asset she
would have to liquidate, which could be a difficult, costly, and
lengthy process.163
With respect to the business, if the creditors
stand on their rights they will force a profitable company out of
business, ultimately resulting in the creditors receiving less money
than if they had agreed to a reduction or a restructuring of debt.
These scenarios are classic Coasean bargains: The
creditors have a legal right to certain payments at certain times.
The creditors and the borrower come to the table and work out an
agreement. Pursuant to that agreement, the creditors relinquish
some of their legal rights. This produces significant gains for the
Marinucci, Empty-Creditor Syndrome and Vivisepulture: Preventing Credit-
Default-Swap Holders from Pushing Companies into Premature Graves by
Refusing to Negotiate Restructurings, Comment, 62 CASE W.L. REV. 1285,
(2012); András Danas, Do Empty Creditors Matter? Evidence from Distressed
Exchange Offers, wpweb2.tepper.cmu.edu/wfa/wfasecure/upload/
2012_PA_952361_202294_910787.pdf; SUMIT AGARWAL ET AL., FED. RES.
BANK OF CHICAGO, THE ROLE OF SECURITIZATION IN MORTGAGE
RENEGOTIATION, Working Paper 2011-02, available at chicagofed.org/
digital_assets/publications/working_papers/2011/wp2011_02.pdf; Tomasz
Piskorski et al., Securitization and Distressed Loan Renegotiation: Evidence
from the Subprime Mortgage Crisis, 97 J. FIN. ECON. 369 (2010); Eric A. Posner
& Luigi Zingales, A Loan Modification Approach to the Housing Crisis, 11 AM.
L. & ECON. REV. 575 (2009); Christopher Mayer, Housing, Subprime
Mortgages, and Securitization: How Did We Go Wrong and What Can We
Learn So This Doesn’t Happen Again?, Testimony in front of the U.S. Financial
Crisis Inquiry Commission (2010); Samuel Kruger, The Effect of Mortgage
Securitization on Foreclosure and Modification, available at
scholar.harvard.edu/skruger/ions/effect-mortgage-securitization-foreclosure-
and-modification (last visited Feb. 24, 2014). 160
See BETHANY MCLEAN & JOE NOCERA, ALL THE DEVILS ARE HERE: THE
HIDDEN HISTORY OF THE FINANCIAL CRISIS 308 (2010) 161
Id. 162
Id. 163
Jacoby & Janger, supra note 3, at 894.
39
borrower that exceed the losses to the creditors.164
The agreement
grows the size of the economic pie, ultimately allowing the
creditors to receive more money than they would have received if
they insisted on enforcing the letter of their agreements.165
That said, it is not necessary for every creditor to relinquish
some of its rights; it is only necessary that the buyer’s debt be
restructured in a way that allows it to stay in business and keep
earning profits. An individual creditor receives the most money
when she refrains from restructuring the debt that she holds while
the other creditors restructure theirs. Thus, if a creditor can
prevent herself from coming to the table, she can avoid having to
make concessions, benefiting herself at the expense of the debtor
and the other creditors. In recent years, creditors’ increasing use of
two particular investment techniques—both of which have the
effect of keeping creditors away from the negotiating table when
the borrower wants to restructure its debt—has drawn a
considerable amount of attention.
First, creditors have increasingly purchased large amounts
of credit default swaps on the debt that they are owed. 166
Credit
default swaps resemble insurance policies; the holder of a credit
default swap is entitled to receive a payment from a third party if
the borrower in question does not meet all of its obligations under
a particular debt instrument.167
These credit default swaps do not change the value of
arranging a loan modification for the distressed debtor; they
164
See id. at 892-93. 165
See id. 166
In several recent instances, creditors have acquired credit default swaps that
were as large as the debt they held or even larger. See, e.g., Einhorn, supra note
159 (discussing similar situations involving General Motors, YRC Worldwide,
and Gannett Co.); Martin Hutchinson, Ban Credit Default Swaps? These
Corporate Bankruptcies Show We Should, MONEY MORNING, Apr. 23, 2009,
moneymorning.com/2009/04/23/ban-credit-default-swaps/ (discussing similar
situations at AbitibiBowater Inc. and General Growth Properties Inc.); Adam
Reiser, An Economic Analysis and Legal Framework for Credit Default Swap
Regulation, 14 N.C. BANKING INST. 101, 120-21 (2009), available at
law.unc.edu/documents/journals/ncbank/balancesheet/ (discussing a similar
situation involving Tower Automotive); Loren Steffy, Some Bondholders Bank
on Bankruptcy, HOUSTON CHRON., Jul. 21, 2009, chron.com/business/steffy/
article/Some-bondholders-bank-on-bankruptcy-1622890.php (discussing similar
situations involving Six Flags). 167
See FRANK PARTNOY, INFECTIOUS GREED 372-73 (2009).
40
merely change which parties reap gains and bears costs from a
modification.168
However, they do increase the number of parties
who have a stake in the debtor’s solvency; by entering into a credit
default swap, the creditor essentially distributes part of her interest
in the debt to her counterparty.169
This means that more parties
must be brought to the negotiating table to resolve the issues
pertaining to that creditor’s debt.170
In other words, by entering
into credit default swaps, the creditor can raise the transaction
costs of modifying the debt that she holds.171
This can make it
hard for her to come to the table, leaving the other creditors to
make larger sacrifices.172
Second, creditors have increasingly divided their interests
among a larger number of parties, making it more difficult and
unwieldy for them to participate in a deal. The most visible
example of this in recent years is the securitization of residential
mortgages.173
Historically, these mortgages were held by the bank
that made the loan.174
If a homeowner became unable to pay, she
could go to that bank directly and try to negotiate a
modification.175
Securitized mortgages, in contrast, are packaged
168
Every payment that the creditor receives from her counterparty is an equal
benefit to the creditor and cost to the counterparty, and vice versa. 169
Taken to its extreme, a creditor can divest herself of any economic interest in
a debtor. Such creditors are sometimes referred to as empty creditors, because
they retain legal rights to payments from the debtor but have emptied out their
economic interest. See, e.g., Hu & Black, supra note 159, at 709; Gross, supra
note 159; see also Jordan M. Barry et al., On Derivatives Markets and Social
Welfare: A Theory of Empty Voting and Hidden Ownership, 99 VA. L. REV.
1103 (2013) (discussing decoupling strategies more generally). 170
For example, suppose that a creditor has a claim to $1 million in payments
from the borrower, then enters into credit default swaps on $100,000 of that debt
with nine counterparties. Before the creditor entered into those transactions,
assembling all of the people with an interest in that $1,000,000 payment being
made simply meant bringing the creditor to the table. After those transactions,
accomplishing the same result required bringing in the creditor and all nine
counterparties. 171
This is especially true when she enters into credit default swaps with multiple
different counterparties. 172
To be sure, there are other reasons why creditors might wish to purchase
credit default swaps on the debt they owe. For example, there are regulatory and
risk-management benefits. See PARTNOY, supra note 167, at 374-77; IVO
WELCH, CORPORATE FINANCE 129-30 (2d ed. 2011). Credit default swaps can
also reduce the frequency of socially inefficient strategic defaults by borrowers.
See Patrick Bolton & Martin Oehmke, Credit Default Swaps and the Empty
Creditor Problem, 24 REV. FIN. STUD. 2617 (2011). 173
See MCLEAN & NOCERA, supra note 160, at 308. 174
Id. 175
Id.
41
together in large quantities, made into bonds or other securities,
and sold off to various investors in pieces.176
Often, these various
securities have differing cash flow rights.177
Both the number of
holders and their varied interests substantially complicate
restructuring negotiations.178
This encourages individuals to
restructure their other debts instead of their mortgages, which can
redound to the benefit of the mortgage lender.179
Staying away from debt renegotiations is often good for
individual lenders, but it is quite costly for society more
generally.180
When it is unclear whether a business will be able to
continue operations, employees—especially those with the best
outside options—start to leave.181
Customers may abandon a
company if they are worried about its ability to support a product
over the long-term.182
Suppliers demand higher prices and greater
contractual protections.183
All of these effects can produce a
downward spiral that can sink an otherwise viable business.184
Thus, it is better to renegotiate a company’s outstanding debts
sooner rather than later.185
Yet in a number of large and high-
profile examples—including AIG,186
Chrysler,187
General
176
See GERALD P. DWYER, FED. RES. BANK OF ATLANTA, THE FINANCIAL
SYSTEM AFTER THE CRISIS: STRUCTURED FINANCE AND CREDIT RATING
AGENCIES (2010), available at frb.atlanta.org. 177
Many mortgage-backed securities were broken into tranches. Payments on
the mortgages underlying the securities went to the holders of the most senior
tranches first. Only once those investors were paid in full would the holders of
the next-most-senior tranch receive any money, and so on and so forth. Id. 178
See Piskorski et al., supra note 159, at 370-73. 179
For example, approximately 37 million Americans currently have
outstanding student loan debt, and over 50 million U.S. households have
outstanding credit card debt. See AM. STUDENT ASSISTANCE, STUDENT LOAN
DEBT STATISTICS, available at asa.org/policy/resources/stats/, last visited Feb.
24, 2014; Tim Chen, American Household Credit Card Debt Statistics: 2013,
NERDWALLET.COM, last visited Feb. 24, 2014. 180
See In re Gen. Motors Corp., 407 B.R, 463, 493 (Bankr. S.D.N.Y. 2009)
(“This is hardly the first time that this Court has seen creditors risk doomsday
consequences to increase their incremental recoveries . . . .”). 181
See Donald C. Hambrick & Richard A. D’Aveni, Top Team Deterioration As
Part of the Downward Spiral of Large Corporate Bankruptcies, 38 MGT. SCI.
1445 (1992). 182
Jacoby & Janger, supra note 3, at 894. 183
Id. 184
Hambrick & D’Aveni, supra note 181. 185
See, e.g., Gross, supra note 159. 186
See, e.g., id.; Marinucci, supra note 159, at 1301-02. 187
See Neil King Jr. & Jeffrey McCracken, Chrysler Chapter 11 Is Imminent,
WALL ST. J., Apr. 30, 2009, online.wasj.com/article/
SB124102375931669205.html.
42
Motors,188
Six Flags,189
and others190
—the distribution of the
economic interest in a sizable bloc of outstanding debt
significantly complicated and lengthened the negotiating process
and cast the outcome of that process into doubt.191
Similarly, renegotiating mortgages in the wake of an
unexpected economic downturn can create significant value for
both borrowers and lenders.192
Foreclosures can also harm other
homeowners in the same neighborhood by lowering housing
values.193
Moreover, declining housing values can further fuel the
economic downturn.194
Studies have found that securitized loans
are significantly more likely to be foreclosed upon than similar
loans held by a single lender,195
and some have argued that the
188
Einhorn, supra note 159, at 19. 189
See Credit Default Swaps and Bankruptcy: No Empty Threat, PAYMENT-
TIMES BLOG, payment-times.com/wordpress/2009/06/credit-default-swaps-and-
bankruptcy-no-empty-threat/ (last visited Aug. 18, 2013); Gross, supra note 159;
Michael S. Rosenwald, Plagued by Death, Six Flags Faces Its Own Wild Ride,
WASH. POST, Apr. 13, 2009, washingtonpost.com/wp-
dyn/content/article/2009/04/12/AR2009041202152.html; Steffy, supra note 166. 190
See, e.g., Einhorn, supra note 159 (discussing YRC Worldwide and Gannett);
Henny Sender, Hedge-Fund Lending to Distressed Firms Makes for Gray Rules
and Rough Play, WALL ST. J., Jul. 18, 2005,
online.wsj.com/article/1,,SB112164567837987920,00.html (discussing the case
of Tower Automotive); Danas, supra note 159 (“Anecdotal evidence suggests
that corporations such as AbitibiBotwater, General Motors, Harrah's
Entertainment, McClatchy, and Unisys had difficulties in reducing their debt
because of CDS [credit default swap] holders.”). 191
See Danas, supra note 159 (finding that the creditors of companies with
credit default swaps on their debt are more than 50% less likely to participate in
voluntary restructurings). But see Mascia Bedendo et al., In- and Out-of-Court
Debt Restructuring in the Presence of Credit Default Swaps,
www2.warwick.ac.uk/fac/soc/wbs/subjects/finance/fof2012/programme/empty_
cds.pdf (not finding any effect of credit default swaps on voluntary
restructurings). 192
See Patrick Bolton & Howard Rosenthal, Political Intervention in Debt
Contracts, 110 J. POL. ECON. 1103 (2002); Randall S. Kroszner, Is It Better to
Forgive Than to Receive? An Empirical Analysis of the Impact of Debt
Repudiation (2003); Tomasz Piskorski & Alexei Tchistyi, Stochastic House
Appreciation and Optimal Mortgage Lending (2008); see also Piskorski et al.,
supra note 159 (describing the evidence from these studies as “compelling”). 193
Danas, supra note 159; Posner & Zingales, supra note 159. 194
See Danas, supra note 159. 195
See AGARWAL ET AL., supra note 159 (finding that bank-held loans are 26-
36% more likely to be renegotiated than comparable securitized mortgages);
Piskorski et al., supra note 159, at 374 (finding that seriously delinquent
securitized loans are between 13% and 32% more likely to be foreclosed upon
than seriously delinquent loans held by banks); Kruger, supra note 159, at 1
(finding that securitization increases the probability of foreclosure by 35% and
decreases the probability of loan modification by 69%); see also Posner &
43
difficulties of renegotiating securitized loans significantly
exacerbated the 2007-2008 financial crisis and the great
recession.196
Thus voluntary transaction costs, and the efficiency
problems that they can create, are of great real-world importance.
We now turn to some of the implications that voluntary transaction
costs have for the selection and design of legal rules.
IV. IMPLICATIONS FOR CHOOSING LEGAL RULES
As Part III demonstrated, when parties have the ability to
create transaction costs, the Coase Theorem generally will not
apply.197
Thus, we cannot necessarily expect that parties will reach
an efficient result on their own.198
Accordingly, different legal
rules can produce very different outcomes. Having established the
importance of legal rules when voluntary transaction costs are
possible, we now explore the effects of different legal rules on the
parties’ negotiations in greater detail. We then consider the effects
of the remedies that the law provides when those rules are
violated.199
Zingales, supra note 159 (arguing that unnecessary foreclosures in the wake of
the financial crisis could destroy hundreds of billions of dollars of value);
Mayer, supra note 159. But see MANUEL ADELINO ET AL., WHY DON’T
LENDERS RENEGOTIATE MORE HOME MORTGAGES? REDEFAULTS, SELF-CURES,
AND SECURITIZATION, FED. RES. BANK OF BOSTON PUBLIC POLICY DISCUSSION
PAPER NO. 09-4 (arguing that securitization does not reduce renegotiations);
MANUEL ADELINO ET AL., RENEGOTIATING HOME MORTGAGES: EVIDENCE FROM
THE SUBPRIME CRISIS, FED. RES. BANK OF BOSTON PUBLIC POLICY DISCUSSION
PAPER NO. 09-4 (similar); FOOTE ET AL., REDUCING FORECLOSURES: NO EASY
ANSWERS, NBER MACROECONOMICS ANNUAL 24, 89 (2009) (similar). 196
See, e.g., Edward L. Glaeser, Debating the Securitization of Mortgages,
ECONOMIX, NYTIMES.COM, July 27, 2010 (providing an overview of the debate
on this issue); Kruger, supra note 159, at 1-2 (finding that securitization led to
500,000 additional foreclosures during the financial crisis). 197
See Part III.C, supra. 198
See Coase, supra note 2. 199
We explore these issues through examples like that in Part III.B, supra, in
which actors have incentives to keep themselves away from the table. Similar
examples can be constructed for instances in which parties want to keep other
individuals away from the table.
44
A. Structuring Legal Rights
We begin by considering who legal rules should protect,
and to what degree.200
The answers to both questions can
significantly affect whether the parties achieve an efficient result.
1. Legal Rules That Always Produce Efficiency
As a preliminary matter, when policymakers know that a
particular course of action for each party will produce an efficient
result, they can easily guarantee an efficient outcome: They can
enact a legal rule that requires each party to take that efficiency-
creating course of action. We term such a rule a “fully specified
efficient rule.”201
A fully specified efficient rule always guarantees
that the parties will achieve an efficient outcome.202
To understand the logic behind this result, suppose that a
party—let’s call her Alice—is considering deviating from her
legally mandated action. Suppose that the new action Alice is
contemplating produces an inefficient outcome.203
Because the
new outcome is inefficient, Alice’s action must make someone
worse off.204
Each of the parties made worse off by Alice’s new
behavior—the “damaged parties”—has the legal right to insist that
Alice fulfill her legal obligations. To keep each of the damaged
parties from standing on his rights and blocking her new behavior,
Alice must pay each damaged party enough to fully compensate
him for the losses that her new behavior inflicts upon him.
However, because Alice’s legally mandated action produces an
efficient outcome, moving to an inefficient outcome shrinks the
economic pie. Thus, the aggregate gains to Alice and any parties
who benefit from her new action will be smaller than the damaged
parties’ aggregate losses. Accordingly, the beneficiaries of Alice’s
new action will not be willing to pay the damaged parties enough
200
In doing so, we supplement extensive literature on this topic. See, e.g., Krier
& Schwab, supra note 18, at 447-49 (discussing the literature as of 1997). 201
Cf. A. MITCHELL POLINSKY, AN INTRODUCTION TO LAW AND ECONOMICS 31-
33 (4th ed. 2011) (discussing fully specified contracts). 202
A fully specified efficient rule also has other benefits, such as avoiding any
transaction costs that would otherwise be incurred in bringing about an efficient
result. See Coase, supra note 2, at 19. 203
If the new action does not produce an inefficient result, then the parties still
achieve an efficient outcome and there is no issue. 204
If no one is worse off, then the combined utility of the parties must have
grown or stayed the same, in which case the new outcome is not inefficient.
45
to fully compensate them, and at least one damaged party will
always choose to stop Alice from changing her behavior.
Note also that, when there is a fully specified efficient rule,
it is not worthwhile to keep the “opposition”205
away from the
table. If actor Alice wishes to change her own behavior, she must
secure the consent of the opposition in order to do so, and this can
only be done through a negotiated agreement. Conversely, if the
opposition is considering a change in its behavior, it must secure
Alice’s consent. Alice will only give her consent if the opposition
fully compensates her for any losses she would suffer. Thus, she
has no interest in keeping the opposition away from the negotiating
table.
While the fully specified efficient rule is a useful
theoretical construct, it is unlikely that policymakers could enact
many such rules in practice. To implement a fully specified
efficient rule, policymakers must be able to determine the efficient
outcome in advance, as well as a behavior by each party that brings
about that outcome.206
Acquiring and processing the necessary
information to make these determinations will often prove
prohibitively difficult.
In certain circumstances, there are more practicable legal
rules that also promise efficiency. One subset in particular is
worth highlighting. Sometimes, an activity benefits only one
individual but harms many other parties.207
We term this a “one-
against-many” scenario. The classic one-against-many scenario
involves a factory that produces pollution that harms many
homeowners.208
Both of our recurring examples are one-against-
many scenarios: In the farmer/conservationist example, not
205
See footnote 60, supra, and accompanying text. 206
Moreover, the underlying economic facts can change over time, making this
task even more difficult. 207
Equivalently, an activity can harm only one individual but benefit many
others. For example, consider a factory that produces pollution that harms many
surrounding homeowners. If the factory operates, that harms many shareholders
but benefits only the factory (ignoring the issue of public shareholders,
employees, and so forth). If the behavior is framed as the right to cease the
factory’s production, that harms only the factory and benefits many
homeowners. But both scenarios are exactly identical. See FRANK, supra note
26, at 90-95. 208
For a modern spin, see Beggs, supra note 49 (discussing a wind farm whose
turbines produce noise that bothers nearby households).
46
running the train benefited only the farmer, and hurt both the
railroad and the conservationist.209
Similarly, in the two-farmer
example, running the train benefitted only the railroad, and hurt
both farmers.210
When there is a one-against-many scenario, a legal rule that
enables each member of the many to stop the one from engaging in
activity (a “many-privileging rule”) ensures that none of the parties
wishes to create transaction costs. By discouraging voluntary
transaction costs, many-privileging rules can encourage efficiency.
To appreciate why this is so, it is helpful to examine this dynamic
through the lens of our recurring two-farmer example.
Assume that the law imposes a many-privileging rule—that
is, it gives farmers the right to keep sparks off of their lands. First,
consider the railroad’s incentives. It wishes to run trains on the
railroad track. Every individual farmer has the right to stop the
railroad from doing so. The railroad must therefore reach an
agreement with every farmer if it wishes to run trains. That means
the railroad will not want to keep any farmers away from the table.
Nor does the railroad wish to keep itself away from the table. It is
the only party who is willing to pay the farmers to allow trains to
run; if it does not arrange a deal with the farmers, there will be no
deal.211
Therefore, the railroad does not wish to create transaction
costs.
Next, consider the farmers’ incentives. Each farmer has the
power to prevent the trains from running if she so chooses. Each
farmer can refuse any deal that is not in her interest; accordingly, if
the trains run, each farmer must have struck a deal that made her
better off than she would have been if no trains ran. That means
that each farmer has no reason to keep herself away from the
table.212
Moreover, each farmer can only strike a deal with the
railroad if the railroad and all the other farmers come to the table
as well.213
Consequently, neither farmer wishes to create
209
See notes 70-72, supra, and accompanying text. 210
See Table 1, supra. 211
In other words, there is no one that the railroad can hope to free-ride off of. 212
But see notes 215216, infra, and accompanying text. 213
It is clear why the railroad must come to the table for the farmer to strike a
deal with it. Moreover, the railroad only wants to strike a deal if doing so allows
the railroad to run the train. This can only happen if the railroad can strike a
deal with every farmer, which is only possible if all farmers come to the table.
47
transaction costs that keep the other farmer away from the table,
either. This analysis applies with the same force if there are two
farmers, three farmers, or a hundred farmers.214
In a one-against-many scenario, imposing a many-
privileging legal rule guarantees that no party will want to create
transaction costs. It is worth noting that we established this result
without making any assumptions about which outcome was
efficient; a many-privileging legal rule encourages the parties to
reach an efficient result regardless of which outcome is efficient.
That said, we must note that many-privileging legal rules
also have a serious drawback. A many-privileging legal rule can
create the perfect conditions for a hold-out problem, in which each
member of the many attempts to hold out on giving his consent in
order to extract as much of the gains from the efficient bargain as
possible.215
This sort of strategic behavior—often considered a
transaction cost216
—can prevent the parties from reaching an
efficient Coasean bargain. This suggests a trade-off between
voluntary and structural transaction costs in one-against-many
scenarios.
2. The Value of a More Efficient Starting Point
The Coase Theorem recognizes that legal entitlements are
not final judgments. They are merely default rules that the parties
can alter through private agreement if they so choose. Legal
entitlements are not the last word, but instead the beginning of the
conversation.217
When voluntary transaction costs are possible, the
starting point for negotiations can be extremely important. The
smaller the gap between the parties’ starting point and the efficient
outcome, the better the parties’ prospects are of traversing that gap.
214
Cf. William Yardley, Turbines Too Loud? Here, Take $5,000, N.Y. TIMES,
July 31, 2010 (discussing how a wind farm is paying local residents $5,000 to
waive their right to complain about noise produced by the wind turbines). 215
We note that this is not a problem if protected parties are only entitled to a
liability remedy instead of an injunctive remedy. See Part IV.B.2, infra. 216
See, e.g., Fennell, supra note 4, at 1486-87 (discussing the classification
issue). 217
See, e.g., Jerry Kang, Information Privacy in Cyberspace Transactions, 50
STAN. L. REV. 1193, 1250-51 (1998) (“[E]ven if transaction costs are not large
enough to transform default rules into immutable ones, the default rule still
matters because ‘it determines who will bargain and at what cost.’”); Parts IV.A-
B, infra.
48
To see the intuition behind this result, recall our prior
discussion of when parties chose to create transaction costs, even
though doing so produced inefficient outcomes.218
In the examples
we examined, the first steps toward the efficient result produced
the largest net benefits. This is likely to be a common scenario; the
worse one’s starting point, the easier it is to make large
improvements.219
At the same time, larger bargains are likely to
entail larger transfer payments, which increases the incentives for a
potential payer to create transaction costs to keep herself away
from the table. Even if those transaction costs prevent an efficient
bargain, the other parties who come to the table are still likely to
strike some deal—and that deal will produce large benefits without
a cash payment from the absent party.
It is helpful to illustrate these points by modifying our
familiar two-farmer example. Once again, assume that there are
two wheat farmers, Alice and Bob, whose farms abut parallel
railroad tracks, and who must leave ground fallow next to the
tracks to prevent sparks from passing trains from lighting their
fields on fire. In this example, however, we assume that there are
four railroad tracks, which we will number 1 to 4, with track 4
being the closest to the farmers’ fields and track 1 being the
farthest. There are two railroads—the Reading Railroad and the
Short Line Railroad220
—that send trains down these tracks.221
Like
Bob, the Short Line Railroad has the option to create transaction
costs that will prevent it from being party to any transaction
between the railroads and the farmers.
Both railroads have the same access to all four tracks.222
Each can run trains on all four tracks, the furthest three tracks, the
furthest two tracks, the furthest track, or run no trains at all.223
Running trains on more tracks increases the benefits to the
railroads, but requires the farmers to forgo planting more wheat.
218
See Part III.C, supra. 219
This is an application of the low-hanging-fruit principle. See FRANK &
BERNANKE, supra note 157, at 46-47. 220
We do not consider the incentives of the B&O and Pennsylvania Railroads. 221
Presumably, they are not sending trains down the tracks at the same time. 222
For example, this scenario could arise if the government owned the tracks
and made them available to all railroads, or if a private third party owned the
tracks and leased them out for use by others. 223
Again, we assume that the railroads are good neighbors. See note 124, supra,
and sources cited therein.
49
For simplicity, we number these various options based on the
closest track to the farmers’ fields on which trains run—which also
corresponds to the number of tracks on which trains run.224
Table 3, below, shows the benefits that running trains on
various tracks accords to the farmers and the railroads, and the net
surplus that each scenario creates.
TABLE 3225
Closest Track
on Which
Trains Run
Value to
Farmers
Value to
Railroads
Total
Value
4 $0 $3800 $3800
3 $1800 $3200 $5000
2 $2700 $2700 $5400
1 $3200 $1800 $5000
No Trains Run $3800 $0 $3800
This table groups the consequences of running trains on
varied numbers of tracks for both farmers as a group and for both
railroads as a group. This approach makes sense for two reasons:
First, note that because the same railroad tracks abut both farms,
any locomotive going by one farm at a particular distance from the
field will go by the other farm at the same distance. Thus, each
farmer will have the same amount of sparks thrown onto his or her
land. The railroads’ situation is equivalent; if Alice and Bob plant
far enough back from the train tracks that the Reading Railroad can
safely run trains on a particular track, the Short Line Railroad can
also safely run trains on that same track.
224
For example, recall that track 4 is the closest to the farmers’ fields. If trains
run on track 4, then they are also running on tracks 1, 2, and 3. Thus, there are
also trains running on 4 tracks. 225
Note that the symmetry inherent in Table 3 is not necessary to any of the
results of this Subpart. Structuring the table this way merely simplifies the
exposition.
50
Second, we assume that Alice and Bob have similar fields,
so that they receive the same benefit from planting wheat closer to
the track, and that the two railroads have similar cost structures and
opportunities, so that they receive the same benefits from running
trains on particular tracks. We therefore assume that the value to
each individual farmer in each scenario in Table 3 is one half of
the total shown for both farmers, and the value that each railroad
receives from running a given number of trains is one half of the
total shown for both railroads.
Examining the rightmost column of Table 3 makes clear
that the efficient outcome is to run trains on tracks 1 and 2 only;
doing so creates more value than any other option. Running trains
on one additional or one fewer track are the next most efficient
options. The least efficient option is running trains on all four
tracks or not running any trains at all. Note also that as the
outcome becomes farther from the efficient outcome, the loss of
value relative to the efficient outcome becomes much larger.
We now demonstrate that the parties will not reach the
efficient outcome if the legal default rule enables railroads to run
trains on all four tracks, or forbids them from running any trains at
all.
We first consider what happens if the law accords the
railroads the right to run trains on all four tracks.226
The question
then becomes whether the farmers will strike a bargain with the
railroads in which the farmers pay the railroads to run trains on
fewer tracks and, if so, how many fewer tracks.
There are two cases to consider. In the first scenario, Bob
chooses not to create transaction costs that keep him out of the
negotiations. Combined, Alice and Bob should strike a deal with
the railroads to run trains on tracks 1 and 2 only;227
this maximizes
the joint value that all the parties receive.228
The railroads would
be willing do so in exchange for any amount that exceeds $1100,
and Alice and Bob stand to gain $2700 combined.
226
This is equivalent to a legal rule that grants railroads an absolute right to emit
sparks from their locomotives. 227
This gives Alice and Bob combined benefits of $2700, but only costs the
railroads $1100. 228
See Table 3, supra.
51
Assuming, as previously, that the parties split the gains
created evenly among themselves,229
each farmer should contribute
$950 to defray the railroads’ costs of installation. This would
leave each railroad $400 better off than it was when it ran trains on
all four tracks.230
Meanwhile, each farmer would earn an
additional $1350 from growing additional wheat. After paying
$950 to the railroads, each farmer would be $400 better off as well.
In the second scenario, Bob chooses to create transaction
costs that prevent him from negotiating with the railroads. This
means that Alice is the only one negotiating with the railroads.
Alice gets $900 of value from having no trains run on track 4, and
running trains on track 4 is only worth $600 to the railroads. Thus,
Alice and the railroads will reach a contract under which the
railroads do not run trains on track 4. If trains stop running on
track 3, Alice benefits by $450. However, running trains on track
3 is worth $500 to the railroads. Alice therefore will not be willing
to pay the railroads enough to induce them to stop running trains
on track 3. Accordingly, if Bob stays away from the negotiating
table, Alice will pay the railroads not to run trains on track 4.
This result is less efficient than the first scenario. Running
trains on tracks 1, 2, and 3 creates $5000 of value, while only
running trains on tracks 1 and 2 creates $5400 of value.231
However, the value is divided very differently in the two scenarios.
In the first scenario, Alice and the two railroads have a $300
increase in value to divvy up between themselves. Bob, on the
other hand, captures the remaining $900 of value himself: The
railroads not running trains on track 4 allows Bob to grow $900
more wheat, and he does not need to pay the railroads anything.
This means that Bob does much better under this scenario than
under the previous one.
Because Bob makes much more profit in scenario two than
scenario one, he will choose to create transaction costs in order to
bring that scenario into effect. Accordingly, a legal rule that gives
railroads the legal right to run trains on all four tracks will produce
229
See text accompanying notes 29 and 30, supra. 230
Each railroad gets $950 cash; simultaneously, running trains on 2 tracks
instead of all 4 costs each railroad $550 of value. Thus, the agreement gives
each railroad $400 in net benefits. 231
See Table 3, supra.
52
scenario two above and result in trains running on tracks 1, 2, and
3 instead of only on tracks 1 and 2—an inefficient result.
We now turn to the opposite extreme—a legal rule that
prevents trains from running on any tracks.232
This corresponds to
the bottom row of Table 3, in which no trains run. This produces
$3800 of value for the farmers, but none for the railroads.
Similarly to the previous example, the railroads may be
able to pay the farmers in exchange for the farmers allowing trains
to run on certain tracks. The Short Line Railroad, like Bob, has the
ability to create transaction costs that prevent it from being party to
any agreement. Thus, as before, there are two cases to consider.
In the first case, the Short Line Railroad does not create
transaction costs and both railroads negotiate with both farmers.
With all parties at the table, the parties should be expected to reach
an efficient result. As noted previously, that corresponds to trains
running on tracks 1 and 2 only.
Compared to the situation in which no trains run, running
trains on tracks 1 and 2 creates an additional $1600 of value.
Assuming that the parties again divide that surplus among
themselves evenly,233
this corresponds to the railroads paying each
farmer $950 to allow trains to run on tracks 1 and 2 instead of
insisting that no trains run. This will require the farmers to plant
farther back from the train track, which will cost each farmer $550
in forgone wheat. However, after the payment from the railroads
is accounted for, each farmer is $400 better off. Similarly, each
railroad will earn $1350 from running trains on tracks 1 and 2.
After subtracting out the $950 each railroad must pay the farmers,
each railroad is $400 richer.
Alternatively, the Short Line Railroad could instead choose
to create transaction costs that prevent it from being party to any
negotiations with Alice and Bob. If that happens, the Reading
Railroad will still be negotiating with the farmers. Reading
Railroad will be willing to pay the farmers enough to allow it to
run trains on track 1. Reading would earn $900 from running
232
This is equivalent to a legal rule that grants the farmers an absolute right to
not have sparks cast onto their land. 233
See text accompanying notes 29 and 30, supra.
53
trains on that track, and the farmers would only lose $600 worth of
wheat production. This shift creates $300 of surplus for the two
farmers and Reading to allocate among themselves.
Allowing trains to run on track 2 as well would cost the
farmers an additional $500 in lost wheat production, but would
only benefit Reading Railroad by $450. Accordingly, if the Short
Line Railroad does not come to the negotiating table, the Reading
Railroad will not be willing to pay the farmers enough to allow it
to run trains on track 2.
Overall, this scenario produces a less efficient result than
when Short Line participates in the negotiations. By not striking
an agreement that would let the railroads run trains on track 2, the
parties are leaving $400 of potential gains from trade on the table.
Nonetheless, Short Line Railroad prefers this second
scenario. Compared to when no trains run, the first scenario gives
Short Line $400 in additional value. The second scenario, in
contrast, makes Short Line $900 better off, because it does not
need to make any payments to the farmers. Thus, Short Line
prefers the second scenario. Accordingly, a legal rule that forbids
railroads from running trains on any of the tracks will lead to trains
running on track 1 only. This is an inefficient outcome.
In this example, initial legal default rules that are too far
from the efficient result in either direction produce inefficient
outcomes. However, as long as the legal default rule is at least an
intermediate outcome—that is, the legal default rule is close
enough to the efficient result—the parties reach an efficient
outcome. The logic underlying this effect is the same as in Table
2234
: The parties that can create transaction costs must participate
in the agreement to produce an efficient outcome. Alice alone will
never be willing to pay the railroads enough to stop running trains
on track 3.235
Thus, if the law allows the railroads to run trains on
tracks 1, 2, and 3, Bob can only improve on that outcome by
teaming up with Alice to buy off the railroads and increase the size
of the pie. The same logic applies to the Short Line Railroad if the
law only permits the railroads to run trains on track 4. Table 4,
below, summarizes these results.
234
See Table 2, supra. 235
See note 130, supra, and accompanying text.
54
TABLE 4
Closest Track
on Which
Law Allows
Trains to Run
Parties
Receiving
Payments
Voluntary
Transaction
Costs?
Closest
Track on
Which
Trains Run
Efficient
Result?
4 Railroads
Bob Will
Pay to
Create
3 No
3 Railroads
Bob Will
Pay to
Remove
2 Yes
2
Neither
Indifferent 2 Yes
1 Farmers
Short Line
Will Pay to
Remove
2 Yes
No
Trains
Run
Farmers
Short Line
Will Pay to
Create
1 No
The analysis above naturally raises the question of when
and how the legal default is likely to approximate the efficient
outcome. One such way is to define legal rights by implicitly or
explicitly weighing costs and benefits. For example, there are a
number of instances in which the common law gives parties the
right to engage in a particular activity so long as their behavior is
reasonable.236
These “reasonable use” rules roughly correspond to
236
Ideally, such rules should consider all costs and benefits, including those that
accrue to parties outside of the litigation. It is unclear to what extent courts
incorporate such factors.
55
courts weighing the costs and benefits of the proposed activity and
ruling accordingly.237
Many of the areas governed by reasonable use rules are
areas for which voluntary transaction costs are relevant.238
Nuisance law, for example, protects landowners against substantial
and unreasonable interference with their use and enjoyment of
their land.239
Landowners have typically brought nuisance cases
against neighbors engaging in activities that produce significant
amounts of noise, dust, smoke, odors, or vibrations.240
These types
of behaviors are likely to affect multiple neighbors of the offending
party. However, in many cases they will not affect so many other
landowners as to render a negotiated transaction prohibitively
difficult.241
Indeed, nuisance cases provide the fact patterns for
some of the most famous examples illustrating the Coase
Theorem.242
To take another example from property law, landowners in
most states have the right to modify their land to reasonably alter
or divert the natural flow of water across their properties.243
Such
237
This is, of course, an oversimplification, but it is a useful high-level view.
See, e.g., JOHN W. JOHNSON, UNITED STATES WATER LAW: AN INTRODUCTION
90 (2008) (describing how courts decide whether an action is reasonable by
weighing the value of the action against the damages caused to others’ property
from the action in question, as compared to the damages that would result from
alternative actions). 238
To be clear, we do not argue that state legislatures or common law courts
imposed these rules based on some intuitive understanding of voluntary
transaction costs. These rules can be derived based on other principles, such as
conceptions of justice or natural law. See, e.g., Swett v. Cutts, 50 N.H. 439, 444
(1870) (stating that the right of a riparian owner is “a natural right . . . to partake
in the enjoyment of the common bounty of Providence, as in the cases of light
and air”). They can also be derived based on other efficiency arguments; since
all real-world transactions involve transaction costs, an efficient legal rule that
obviates the need for further negotiations among the parties will enhance
efficiency. See Coase, supra note 2, at 19. 239
See, e.g., San Diego Gas & Electric Co. v. Superior Court, 920 P.2d 669, 696
(Cal. 1996); JOSEPH SINGER, PROPERTY LAW: RULES, POLICIES, AND PRACTICES
307 (3d ed. 2002). 240
In re Chicago Flood Litigation, 680 N.E.2d 265, 278 (Ill. 1997); SINGER,
supra note 239, at 306 (also listing attracting insects among the actions giving
rise to causes of action for nuisance). 241
Such scenarios often constitute public nuisances instead of private ones. See
RESTATEMENT (SECOND) OF TORTS § 821B(1). 242
See sources cited in notes 50-53, supra. 243
See JOHNSON, supra note 237, at 90-91 (describing reasonable use rules and
their prevalence, and noting that states that purport to follow other rules
effectively follow reasonable use rules in practice).
56
diversions will often affect multiple identifiable neighbors, who
could plausibly negotiate an agreement. Similarly, in states with
riparian water law systems, landowners whose properties adjoin
waterways may take water for all reasonable uses, so long as they
do not unreasonably interfere with others’ uses of water from the
waterway.244
The possibility of voluntary transaction costs
provides additional support for these reasonable use rules and
suggests that such rules could prove beneficial in additional
circumstances.245
A drawback of reasonable use rules is that they require
courts and parties to have more information than more bright-line
rules do. This can make bright-line rules more attractive in certain
instances.
For example, if a railroad has an absolute right to emit
sparks, the railroad knows what its legal rights are and can act
accordingly. On the other hand, if the railroad has the right to emit
sparks only if it does not unreasonably interfere with the farmer’s
right to use its property, it may not be clear to the railroad what its
legal rights are. At the very least, the railroad will have to estimate
the likely effects of its spark emission activity on the farmer.246
Similarly, courts will have to weigh the costs and benefits to the
railroads and farmers against each other. This may prove
challenging, and the court may err.
However, we note that a legal default rule that does not
exactly match the efficient outcome may still provide significant
benefits.247
Returning to our two-farmer, two-railroad example
above, a perfectly conceived and implemented reasonable use rule
244
Id. at 36-37. 245
To be clear, we do not argue that state legislatures or common law courts
imposed these rules based on some intuitive understanding of voluntary
transaction costs. These rules can be derived based on other principles, such as
conceptions of justice or natural law. See, e.g., Swett v. Cutts, 50 N.H. 439, 444
(1870) (stating that the right of a riparian owner is “a natural right . . . to partake
in the enjoyment of the common bounty of Providence, as in the cases of light
and air”). They can also be derived based on other efficiency arguments; since
all real-world transactions involve transaction costs, an efficient legal rule that
obviates the need for further negotiations among the parties will enhance
efficiency. See Coase, supra note 2, at 19. 246
Unclear rights may also increase the frequency of litigation, which is costly.
See POSNER, supra note 20, at 791. 247
This point also helps ameliorate the concern raised in note 236, supra.
57
would result in trains running on tracks 1 and 2 only.248
But if
courts overweigh the interests of the farmers or the railroads, this
might not happen, and the actual legal rule might permit trains to
run on tracks 1, 2, and 3, or only on track 1. In either instance, the
legal rule will be close to efficient, and the parties will be able to
close the remaining gap.249
On the other hand, assigning an
absolute right to either the farmers or the railroads does not
produce an efficient result.250
This same logic applies to statutes that create bright-line
rules. Legislatures are often better equipped than courts to make
large-scale societal judgments regarding the costs and benefits of
particular activities.251
A legal rule that draws a bright line—even
an arbitrary one—will have the same benefits as a reasonable use
rule, so long as that bright line is close to the efficient outcome.252
B. The Importance of Legal Remedies
In all of the examples we have analyzed so far, we have
assumed that legally protected parties can prevent any behavior
that violates the law if they so choose. However, the remedies that
the law provides to protected parties have strong effects on both
whether the parties will strike a deal and the type of deal that the
parties will strike.253
We first discuss the differing ways in which
remedies affect the parties’ decisions when transaction costs are
low and when they are high. We then consider the relative merits
of injunctive remedies and liability remedies, the two most
common types of remedies that U.S. laws provide.
248
See Table 3, supra. 249
See Table 4, supra. 250
See Table 4, supra. 251
POSNER, supra note 20, at 715-16. 252
A more efficient legal default rule is also preferable if no bargaining takes
place. This is particularly important if parties are able to create transaction costs
that prevent all bargaining. See Part III.A, supra. 253
In doing so, we supplement extensive literature on this topic. See, e.g.,
Brooks, supra note 6; Louis Kaplow & Steven Shavell, Property Rules Versus
Liability Rules: An Economic Analysis, 109 HARV. L. REV. 713 (1996); A.
Mitchell Polinsky, Resolving Nuisance Disputes: The Simple Economics of
Injunctive and Damage Remedies, 32 STAN. L. REV. 1075, 1088-92 (1980);
Ayres & Talley, supra note 17; Louis Kaplow & Steven Shavell, Do Liability
Rules Facilitate Bargaining? A Reply to Ayres and Talley, 105 YALE L.J. 221
(1995); Ian Ayres & Eric Talley, Distinguishing Between Consensual and
Nonconsensual Advantages of Liability Rules, 105 YALE L.J. 235 (1995).
58
1. Remedies in Low- and High- Transaction Cost
Environments
Remedies are important in both low- and high-transaction
cost environments, but they have different effects in each
circumstance.254
When there are large transaction costs, so that
Coasean bargaining is impossible, legal remedies determine what
consequences the parties will reap from various competing courses
of action. This affects what decisions the parties will make, and
can either prevent or facilitate the achievement of an efficient
result. In contrast, when there are no transaction costs, the parties
can always strike a Coasean bargain that produces efficiency,
regardless of what remedies the law provides. However, the legal
remedies available still shape the agreements that the parties will
make.255
These points are best illustrated through example.
Consider another farmer and railroad scenario. Assume that
running the train is worth $1000 to the railroad, and that the farmer
will lose $500 if he plants further back from the track. Since the
farmer’s loss from planting back from the track is smaller than the
$1000 gain the railroad gets from running the train, it is efficient
for the train to run. Assume that farmers have the legal right to not
have any sparks cast onto their fields.
First, suppose that transaction costs are high, so that the
parties cannot negotiate. Even though farmers have the legal right
to not have any sparks cast onto their fields, that does not
necessarily mean that the railroad will not run the train; the answer
to that question depends on the consequences that the railroad will
suffer if it violates the law.256
If running the train will incur a
penalty that exceeds the $1000 benefit to the railroad of running
the train,257
a rational railroad will not run the train.258
Conversely,
254
See also Giuseppe Dari-Mattiaci, Endogenous Transaction Costs (exploring
the extent to which different legal remedies create transaction costs). 255
This dynamic is often referred to as bargaining in the shadow of the law.
See, e.g., Robert H. Mnookin & Lewis Kornhauser, Bargaining in the Shadow of
the Law: The Case of Divorce, 88 YALE L.J. 950, 968 (1979). 256
The cost of violating the law may extend beyond the legally mandated
punishment. There may be bad publicity, or political costs, associated with such
violations as well, and these costs should be included in the railroad’s calculus
as well. For simplicity, we assume throughout this paper that the only relevant
consequences are the legally mandated punishments. 257
Or, equivalently, the $1000 opportunity cost of not running the train.
59
if the punishment for running the train is a fine of $500, a rational
railroad will run its train and pay the fine; from the railroad’s
perspective, it would not make sense to forgo $1000 from running
its train solely to avoid paying a $500 fine. Thus, when transaction
costs are high, the legal remedy can determine the actions the
parties will take, which can prevent or enable an efficient result.
On the other hand, if there are no transaction costs, then
regardless of what remedy the law provides, the railroad and
farmer can strike a deal in which the railroad pays the farmer to
plant further back from the track. The size of the payment to the
farmer could be anywhere between $500 and $1000. In general, it
is difficult to predict precisely where in this range the parties will
strike their agreement. However, legal rules can channel the
parties towards particular outcomes.
For example, many statutes entitle parties to fixed damage
awards for violations of particular rights.259
Suppose that the
farmer’s jurisdiction has a statute that entitles the farmer to an
$800 payment from any railroad that throws sparks onto her
property, and that this is the farmer’s only remedy. In such a
situation, the railroad will be unwilling to pay the farmer more than
$800.260
Similarly, the farmer should not accept a payment of less
than $800.261
In such circumstances, the parties seem likely to
transact at a price of approximately $800.262
Thus, regardless of
258
We assume there are no intermediate options. 259
See, e.g., 17 U.S.C. § 504(c) (2012) (setting statutory minimum damages of
$750, and maximum damages of $30,000, for copyright infringement); 15
U.S.C. § 1117(c) (2012) (setting statutory minimum damages of $1000, and
maximum damages of $200,000, for using counterfeit trademarks); 18 U.S.C. §
2520(c)(2)(B) (setting statutory damages for intercepting electronic
communications of $100 per day, up to $10,000 total). 260
Suppose the railroad agreed to pay the farmer $900 to allow it to run its train.
If the railroad did not pay the farmer and simply ran the train, it would only owe
$800 in damages. This would leave the railroad better off than under its deal
with the farmer. Thus, the railroad should never agree to such a deal. 261
Suppose the farmer and the railroad do not reach an agreement. The railroad
will be better off if it runs its train and pays the $800 penalty than if it does not
run the train and loses $1000 of value. Thus, the railroad is likely to run its train
and pay the farmer the $800 penalty. Knowing this, the farmer will be reluctant
to part with her legal right for less than $800. 262
In reality, there are always costs to enforcing legal rights. Since striking a
deal allows the parties to avoid incurring these costs (in exchange for incurring
the costs of deal-making), the set of possible outcomes would generally extend
to some range around and including an $800 payment. For example, suppose
that enforcing a legal right by lawsuit requires each party to incur $50 of legal
60
the size of transaction costs, legal remedies remain important,
though their effects vary in each instance.
2. Injunctive Remedies vs. Liability Remedies
U.S. laws provide considerable variation in the legal
remedies that they accord to parties who suffer various wrongs, but
injunctive remedies and liability remedies are the most common.263
A party entitled to an injunctive remedy can secure a court
order commanding the other party to cease its unlawful
behavior.264
A party who violates such an order may be held in
contempt of court, which can be punished through heavy fine or
imprisonment.265
In all of the examples we analyzed in previous
subparts, we assumed that legally protected parties could prevent
any behavior that violates the legal rule if they so choose. This is
equivalent to assuming that aggrieved parties are entitled to an
injunctive remedy.
Liability remedies, in contrast, only entitle the damaged
party to recover monetary damages from the party violating the
law.266
In most instances, the wronged party is entitled to recover
the amount of damages caused by the violator’s wrongful
actions—such rules are termed compensatory liability rules, as
they exactly compensate the wronged party for the harm they
suffered—but this is not a necessary feature of liability rules and
there are many counterexamples.267
Liability remedies facilitate an efficient result in more
circumstances than injunctive remedies do. Given a legal rule, any
result that can be achieved via injunctive remedies can also be
costs. If the railroad illegally runs its train and the farmer files suit, the total cost
to the railroad will be $850 and the farmer will net $750 cash. Assuming that
negotiating a deal is costless, the parties could plausibly strike a deal at any
price between $750 and $850 in this instance. See POSNER, supra note 20, at
791. 263
See Calabresi & Melamed, supra note 4, at 1092. 264
Id. 265
Id. 266
Id. 267
Perhaps the most well-known is the damages rule for antitrust violations,
which allows wronged parties to recover three times the damages that they
suffer, but there are many examples. See, e.g., 15 U.S.C. § 1117(b) (2012)
(trademark violations involving counterfeit marks); 35 U.S.C. § 284 (2012)
(authorizing courts to award treble damages in patent infringement cases).
61
achieved via liability remedies. The key intuition is that a liability
remedy that provides for a large enough damages payment will
always prevent a party from acting in a way that triggers her
liability. In other words, sufficiently large liability remedies
produce the same effects as injunctive remedies. The reverse is not
true; thus, there are certain instances in which liability remedies
can produce efficient results that injunctive remedies cannot.268
However, neither injunctive nor common liability remedies
guarantee that the parties will reach an efficient result.
To see how liability remedies can promote efficiency when
injunctive remedies do not, we revisit the two-farmer, two-
railroad-track example that we considered in Part III.C. The
railroad can run trains on both tracks, the track farther from the
farmers’ property, or neither track.269
The closer that the railroad
runs trains to the farmers’ property, the farther back the farmers
must plant their wheat from the track.
The payoffs for the parties under different circumstances
are shown in Table 5, below.
TABLE 5
Value
to Alice
Value
to Bob
Value to
Railroad
No Trains Run $1000 $1000 $0
Trains Run on
Far Track Only $650 $650 $400
Trains Run on
Both Tracks $0 $0 $800
Suppose that all three parties have the ability to create
transaction costs that keep themselves away from the negotiating
table. In addition, suppose that Alice has a hill on the edge of her 268
For the remainder of this Subpart, we only consider liability rules that are
compensatory. 269
Again, we assume that the railroad is a good neighbor. See note 124, supra,
and sources cited therein.
62
property that is prone to mudslides. If she chooses, Alice can
redirect these mudslides so that they spill onto the near track,
rendering it impassible. Suppose that the law gives the railroad the
right to run trains on both tracks, and that it is illegal for Alice to
redirect the mudslides to block the near track.
If the railroad’s legal right is backed by an injunctive
remedy, Alice will not be able to block the near track. If she
attempts to do so, she is violating the law, and the railroad can
secure an injunction that forces her to stop. This scenario is
therefore exactly identical to the scenario analyzed in Part III.C: In
both scenarios, the same parties have the same choices and the
same payoffs. There, as here, the efficient result is for no trains to
run.270
In both scenarios, both farmers and the railroad must come
to the negotiating table for the parties to achieve an efficient
result.271
Because this situation is identical to the scenario
analyzed in Part III.C, it produces the same result; there is never an
efficient outcome because it is never in the interests of both
farmers to come to the negotiating table.
Now suppose instead that the law only provides the railroad
with a compensatory liability remedy. In other words, if Alice
blocks the near track, the railroad cannot unblock the track; it can
only recover damages from Alice in an amount equal to the benefit
that the railroad would have received if the near track had not been
blocked. It is now possible for the parties to achieve an efficient
result.272
Consider again a scenario in which all parties come to the
table. Suppose that the farmers pay the railroad a total of $900 not
to run the train, $600 of which comes from Alice and $300 of
which comes from Bob. This produces an efficient result; the
question is whether all parties are acting in their interests by
coming to the table.
270
This produces $2000 of value, which is more than the $1700 produced when
trains run on the far track only and the $800 produced when trains run on both
tracks. See Table 5, supra. 271
In both scenarios, inducing the railroad not to run trains on the far track
requires a payment of $400, but each farmer only benefits by $350 from that
train not running. Thus, an efficient deal with the railroad is only possible if
both farmers come to the table. See Part III.C, supra. 272
We note that it is not certain, however. See Companion Paper, supra note 11,
at 6.
63
The railroad is better off coming to the table. If the railroad
does not come to the table, it will not be party to any agreement.273
Alice will then block the near track.274
The railroad will run trains
on the far track and collect damages from Alice, which will
compensate the railroad for the value it loses from not running
trains on the near track. The end result is that the railroad will only
receive $800 of value, which is $100 less than the $900 it receives
pursuant to the parties’ agreement.275
Similarly, for a farmer to evaluate whether coming to the
table makes her better off, she must know what will happen if she
does not come to the table. Bob currently gets $700 of value.276
If
he leaves the table, the best outcome that he can hope for is that
Alice will stop the railroad from running trains on the near track.277
This will give Bob only $650 of net value.278
Thus, Bob is better
off staying at the table.
But what of Alice? Currently, she receives $400 of value.
One might think that, by leaving the table, she could force Bob to
negotiate with the railroad alone. Bob would then pay the railroad
not to run trains on the near track, giving Alice $650 of value.279
Indeed, that could happen—but it is not the only possibility.
Because of the liability remedy, Alice cannot truly leave
negotiations. Even when Alice leaves the table, she still has the
ability to change the railroad’s behavior: she can block the near
track and pay the railroad for its losses. Bob could plausibly
decide not to strike any deal with the railroad if he thinks that,
when push comes to shove, Alice will block the near track. And,
given that Bob does not negotiate with the railroad, it is in Alice’s
interest to block the near track, as this enables her to plant $650 of
wheat at a cost of only $400.
273
See Companion Paper, supra note 11, at 4 n.5. 274
Blocking the near track enables Alice to plant $650 in additional wheat.
These gains exceed the $400 damages payment she must make to the railroad. 275
See Table 5, supra. 276
He grows $1000 worth of wheat and pays the railroad $300. 277
See note 130, supra, and accompanying text. Alice may accomplish this
either by negotiating a deal with the railroad or by blocking the near track. 278
See Table 5, supra. 279
Bob and Alice have the same payoffs; see note 130, supra, and
accompanying text.
64
That scenario nets Alice only $250, which is less than the
$400 she receives when both Bob and Alice come to the
negotiating table.280
So, if this scenario is likely—and this
scenario is perfectly plausible, as it entails everyone acting in her
best interest—then Alice is better off coming to the negotiating
table. Thus, under a liability rule, an efficient result is possible,
though generally not guaranteed.
A few additional points deserve mention. First, the
assumption that only Alice can block the near track merely
clarifies the analysis; it is not necessary to our result. The
behaviors described above are also equilibrium behaviors when
both Alice and Bob have the ability to block the near track.281
It is
also worth noting that the real world is often asymmetric. Even
when an action affects multiple parties in the same way, some of
those parties may naturally be in a better position than others to
block that action.
For example, consider a scenario in which a beekeeper’s
bees pollinate a local orchard’s apple trees but also sting a local
rancher’s cattle.282
Suppose that the rancher has the right to restrict
the number of bees in the beekeeper’s hives, and that right is
enforced by a liability remedy. In this scenario, the beekeeper, and
not the farmer, is naturally in a position to violate the rancher’s
right and pay him damages, even though both the farmer and the
beekeeper benefit from the beekeeper having more bees.283
280
Under the proposed agreement, Alice pays $600 to the railroad and gets to
grow an additional $1000 worth of wheat. 281
Those behaviors are not the only equilibrium behaviors. For example, Alice
could pay $300 and Bob could pay $600. This would be an equilibrium so long
as Bob thought that, if he refused to come to the table, Alice would not negotiate
with the railroad, leaving him to block the track. 282
This is essentially a combination of two famous Coasean examples. See
Elodie Bertrand, What do Cattle and Bees Tell Us About the Coase Theorem?,
Communication to the 13th Conference of the Charles Gide Association, Paris,
May 27-29, 2010, available at colloquegide2010.univ-paris1.fr/IMG/pdf/
Bertrand.pdf. 283
Similarly, consider the famous Coasean example involving a rancher who
neighbors a farmer, and who wishes to allow his cattle to graze on the farmer’s
lands. See id. The rancher’s cattle may wander across the neighboring farmer’s
property to other farmers’ lands, but it may be much easier for the first farmer to
build a fence that restrains the cattle, particularly if there are only a handful of
bridges or other chokepoints through which the cattle can cross onto the first
farmer’s property.
65
Moreover, liability remedies themselves are fundamentally
asymmetric. An individual who deviates from the behavior
required by the legal rule is required to pay damages to those
parties who are hurt by her actions. However, that same individual
is not entitled to receive a payment from those parties who benefit
from her actions.
Theoretically, liability remedies could be fully symmetric.
Such remedies would give all parties incentives to exercise their
decision-making rights in an efficient manner, regardless of the
legal rule. Essentially, there would no longer be positive or
negative externalities—actors would experience all of the positive
or negative consequences of their actions, which would lead them
to act in an efficient manner.284
Yet, despite the theoretical
advantages of fully symmetric liability rules, such rules have never
been seriously considered because of the administrative challenges
they pose.
Similarly, courts must have more information to administer
a liability remedy than an injunctive remedy.285
A liability remedy
requires courts to calculate how much damage a protected party
suffered from a violation of the law. In contrast, a court does not
need to determine the amount of damages caused to apply
injunctive relief; the court must merely decide whether a particular
action violates the legal rule.286
Moreover, enforcing a liability
remedy requires less information than enforcing a reasonable use
rule,287
but is less likely to bring about an efficient result.288
C. Distributional Consequences
Throughout this Article, we have emphasized how various
legal rules and legal remedies affect the likelihood that the parties
284
POSNER, supra note 20, at 3-4. 285
Note also that enforcing a liability remedy requires less information than
enforcing a reasonable use rule. The reasonable use rule requires a court to
weigh the benefits of an activity against its costs, while a liability rule only
requires a court to evaluate the negative consequences of an activity. 286
See, e.g., Calabresi & Melamed, supra note 4; David McGowan, Website
Access: The Case for Consent, 35 LOY. U. CHI. L.J. 341, 342-43 (2003)
(arguing that injunctive remedies are preferable when bargaining is possible
because judicial cost-benefit analysis is imperfect). 287
The reasonable use rule requires a court to weigh the benefits of an activity
against its costs, while a liability rule only requires a court to evaluate the
negative consequences of an activity. 288
See Part III.A.2, supra.
66
achieve an efficient result. However, this is only half of the story.
As Coase recognized, the choices among legal rules and remedies
have distributional consequences. This is true irrespective of
whether these choices have efficiency consequences. Legally
protected parties may be able to secure cash payments from other
parties that they otherwise would not receive.289
Liability rules can
restrict the prices at which parties are willing to transact.290
This
can be a boon or a bane to individual parties, depending on the
specifics of a given situation.
Because the distributional consequences of these choices
are so context-specific, they are not conducive to analysis in the
abstract. We merely note that, depending on the specific
circumstances of a particular situation and one’s policy
preferences, one might prefer one legal rule or remedy over
another based on its distributional effects, even though that rule or
remedy is less likely to produce an efficient result.
V. CONCLUSION
In essence, the Coase Theorem makes an appeal to reason:
If only everyone could get together at one big table and talk things
out, they would always reach efficient results. Coase devised his
famous theorem to highlight the difficulties involved in bringing
everyone together and negotiating an agreement—that is, the
structural transaction costs that parties face. Our analysis
demonstrates that there are additional difficulties inherent in
Coase’s hypothetical: In many instances, there will be parties who
will not want to let everyone come to the table, and those parties
will erect obstacles to prevent that from happening.
Consequently, the design of legal rules is very important,
even when structural transaction costs are low. There is a trade-off
between the likelihood that a legal rule or remedy will produce
efficient results and the information that courts or legislators must
have to implement it. Fully specified efficient rules guarantee
efficiency, but require the strongest assumptions about the
information available to policymakers.291
Defining legal rights in
ways that track the efficient outcome is likely to encourage
289
See, e.g., notes 31-32, supra, and accompanying text. 290
See Part III.B.1, supra. 291
See Part IV.A, supra.
67
efficiency, but requires hard factual determinations. Similarly,
liability remedies are more likely to promote efficiency than
injunctive remedies, but are more difficult for courts to enforce.
Regardless of the legal regime, it is crucial to recognize
that transaction costs are not merely a feature of the parties’
environment. The parties themselves can—and will—create them
on their own. Thus, Coase’s point that transaction costs are
ubiquitous and important was even more far-reaching than has
generally been recognized—in short, Coase was more right than
perhaps even he knew.
