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 {\bf  Predictable  Court Error and the Fundamentals of Property-Rule Protection }  \\



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October 3, 2004 \\



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Eric Rasmusen \\



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{\it Abstract}



In the standard typology of Calabresi \& Melamed (1972), if a right has property-rule protection, its owner can use the power of the state to protect the right by punishing a violator; but if a right has liability-rule protection, its owner can  only use the power of the state to  receive compensation when the right is violated. Calabresi \& Melamed say  that property-rule protection is more efficient than liability-rule   protection (a) when the parties involved can bargain with each other at low cost and (b) when it is hard for a court to accurately value the right.    I argue that  the real problem is  predictable court error.    The inability of   the court to value the right accurately may or may not  create risk if liability-rule protection is used, and private bargaining may or may not help in such a situation,  but those problems are not unduly severe if court error is unpredictable. If the court error is predictable, however, and the parties can predict that the court valuation of the right will be too low, the resulting temptation to violate the right creates severe efficiency problems.



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\noindent

 \hspace*{20pt} Indiana University Foundation Professor, Department of Business Economics and Public Policy, Kelley School of Business, Indiana University, BU 456, 1309 E.  10th Street, Bloomington, Indiana, 47405-1701. Office: (812) 855-9219.  Fax: 812-855-3344 Erasmuse@indiana.edu.//http://www.rasmusen.org.  \\

  http://www.rasmusen.org/papers/property-rasmusen.pdf.



\noindent I thank  xxx.



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\noindent

 {\bf 1.  Introduction}



Henry Smith (2004) has recently written a paper on why property is protected by property rules. This is not tautologous, for in law and economics Guido Calabresi \&   Melamed (1964) defined ``property rule protection'' of a person's right as the person being able  to stop   the right from being taken away involuntarily, whereas ``liability rule protection''  only entitled the person to compensation for loss of the right.  Real estate ownership has property rule protection, while  a contract   only has liability rule protection. Smith's article asks why property has that particular protection rule.



  The advantage of liability rule protection is that its transaction costs are low. Consider the example of breach of contract.   Suppose John Doe has paid Richard Roe \$100   for tickets to a concert.   Roe then decides he values the tickets at \$150, and he  fails to deliver them. Doe has a right to the tickets, and Roe has violated that right.



If Doe's right to the tickets is protected by a  property rule, he can go to court and force Roe to give him the tickets.



If Doe's right to the tickets is protected by a  liability rule, he can go to court and force Roe to give him  money equal to the value of the tickets.  The court will need to determine that value, and one common rule is to use the market value, which might or might not be greater than \$100.



 In the common law,  most  contract rights are   protected  by liability rules. If, however, Roe had already delivered the tickets, and he  then took them  back from Doe, the common law protects Doe by a property rule: Roe has committed theft, and must return the tickets.  We could imagine a regime which uses the opposite rules: that if Doe hasn't delivered the tickets yet and fails, he must deliver them; but if he has, and steals them, he must pay compensation for his theft.   Calabresi \& Melamed  and Smith  inquire into  which regime is better.



 Transaction costs are a major consideration. When Doe takes the right away from Roe, he does not need to bargain with Roe first: he just takes it, and pays compensation at the court-awarded price. To be sure, if the parties actually go to court, that is an additional transaction cost, but  if they can predict what the court will do, they do not need to incur that cost.  In fact, property-rule protection also has court costs in the background:   Doe can still take the  right away from Roe, but  Roe can go to court and make Doe give it back.  Predicting that, Doe does not take the right away in the first place. Thus, under a property rule if Doe has a greater desire for the tickets than Roe does he must contact him and haggle over a price.



The disadvantage of the liability rule,  as Calabresi and Melamed note, is that the court must measure the compensation Doe pays Roe.  If this is easy to measure, then Doe and Roe do not need to go to court to predict what the court will do; Roe simply pays the amount to Doe, and both haggling and court costs are avoided.  If it is hard to measure, then Doe and Roe might disagree as to what will happen in court and actually go to court to resolve that disagreement, incurring a large cost. Moreover, they may discover at the end of the process that  Doe actually values the  right more than Roe, so the   transfer was inefficient. In the example, it might happen that the court determines that the market value of the tickets is \$170, not the \$130 Roe thought it was and more than the \$150   at which Roe values them, and so Roe would regret having violated Doe's right.



  Calabresi and Melamed's conclusion is that a liability rule should be used when transaction costs are high and measurement costs are low, and a property rule should be used when transaction costs are low and measurement costs are high.



Smith says  in his article that



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From Calabresi and Melamed’s article on, the conventional wisdom among law-and- economics scholars had long been that property rules are superior when transaction costs are low.  But such scholars also noted with approval the tendency towards giving damages in the case of large-scale nuisances like pollution.  This initially favourable but limited view of liability rules has gathered steam, and over the years most of those theorizing about entitlement protection have come to conclude that liability rules are more or less generally preferable to property rules in achieving efficient allocation of resources. Property rules find relatively few defenders among legal economists, which is all the more surprising since property rules abound in the law.  If anything, the law treats property rule protection as the norm and liability rule protection as the exception -- the opposite of what the bulk of recent economic commentary would lead one to expect. (p. 2, footnotes omitted)



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In his supporting footnotes, Smith cites Ian Ayres \& Eric Talley (1995), who argue that   that liability rules  aid in bargaining; Louis Kaplow \& Steven Shavell (1996)  and  A. Mitchell Polinsky  (1979);   James  Krier \& Stewart   Schwab (1995) who survey the legal literature from 1975 to 1986; Ronen Avraham (forthcoming),  Ian Ayres \& Paul Goldbart   (2001) and  Madeline Morris (1993) as evidence that liability rules have been gaining favor.



Smith goes on to summarize his argument as follows.



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First, in what I will call the argument from ``delegation'', I will show that property rules are naturally paired with the rights to exclude typical of property law -- or more precisely, what I will call the ``exclusion'' strategy for delineating rights -- and that property rules gain from the savings in information costs made possible by rights to exclude as opposed to more tailored use rights. Second, and consistently with the information-cost point, exclusion and property rules will allow less room for opportunism on the part of potential takers of entitlements. Third, on the owner’s side, exclusion and property rules obviate wasteful self-help.



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          I agree with  Smith  that opportunism   would be  a particularly severe problem for the right    the law calls ``property'' if liability rules were used to protect it, and that opportunism and self-help would create inefficiency.   My reasoning will be different from Smith's, however. I will focus on the nature of the uncertainty over the value of the right.  Calabresi and Melamed said that it was a high degree of court uncertainty over the value of the right that would make liability rules inefficient. I will argue that it is not the amount of  possible court error that matters so much as its predictability.  That the court might drastically overvalue or undervalue the object creates risk, but does not mean that inefficient transfers will take place-- just that the taker may end up either lucky or unlucky in how much he must pay.  And there is no incentive for the original holder of the right to invest in self-help, because he knows that courts  compensate rights holders adequately on average, if not in every particular case. 



    That the court error is predictable, however, is much worse. Then, on occasions when it is known that the court will undervalue the right, the potential taker knows he can take cheaply, below the value of the  right to the  original holder.  Indeed, he might even take  when nobody but the orignal holder values the right, in order to sell it back at a profit. This incentive for taking which is predictably undercompensated will, as a second step, lead the original holder to invest in  costly self-help.  





In the present paper's model, therefore, the problem with poor measurement of the right will not be that it leads to litigation    because the rights-holder and the rights-violator come up with differing measurement or differing estimates of what the court will do and will therefore not settle out of court. Rather,  even though both of them may be able to perfectly predict what the court will do, the problem is that when they both know the court will undervalue the right, the rights-violator will be emboldened to seize it.





 



Smith does point out the importance of undercompensation, using the example of an asset use unknown to the court but known to the rights-holder and the taker (p. 60-71). This is a form of predictable error, which will lead to opportunistic taking and to self-help. Smith argues that the problem is situations in which the taker and rights-holder are better at acquiring information than   the courts. He  uses  the distinction between ``risk'' and ``uncertainty'' from Frank  Knight's    1921  {\it  	Risk, Uncertainty, and Profit}, in which Knight argues that bayesian modelling (to use the modern term) is inappropriate in situations where decisionmakers have   poor information, because they cannot form prior beliefs. That, I think,  is a wrong turn.  I will use a standard, bayesian model, but one in which the courts are legally constrained from using their knowledge of equilibrium behavior. Also, I see the problem not as the private parties being better informed than the court, but that they can predict the court's error. 





   If predictable court error is what raises problems for  the efficiency of liability rules, we can say something about when liability rules are most useful. 

  This  kind of opening for  opportunism is not present in all situations. It will arise chiefly when the following  four criteria are met:\\

\\

(i)  the value of the right is hard to measure (Calabresi and Melamed's reason), \\(ii)the rights violation is intentional, \\

 (iii) there exist many possible violators, \\

(iv) the violator and right-holder are not constrained by norms or reputation. \\  





\bigskip



\noindent 

 {\bf 2. The Model}



  Suppose  someone (``the owner'') is considering investing at cost $C$ in a good whose benefit to him is $V$, but whose benefit to each of $N$ potential ``takers'' is $Y_i, i = 1,...N$. 

Let us  use the convention that  Taker 1 has the highest value, taker 2 the next highest, and so forth, so $Y_1 > Y_2>...>Y_N$,    assuming for simplicity that there are  no ties. We will limit most of our discussion to the interaction between just the owner and Taker 1. Taker 1's value might be either greater or less than the owners: $Y_1>V$ and $Y_1<V$ will be both of interest to us. 



 



Property-rule protection  would   require that if  Taker 1 takes the  good, he must return it on pain of   a large penalty of $P>Y_1$. Thus, if he wants the good, he must engage in a transaction with the owner, inducing the owner to transfer the right.  





Liability-rule protection would  require that if Taker 1 takes the good, he must pay   the owner  damages   $D$ equal   to    the value of the good to the investor  as estimated by the court.  This is just an estimate, however, so the penalty is $D = f(V)$. If the court's estimate is  perfect, then $f(V)=V$; if it is an unbiased estimate then $f$ is a stochastic function $f(V) = V + \epsilon$, where $\epsilon$ follows some probability distribution with mean zero,     and $E(f(V)) =V$. If the taker does not pay the damages, he  must  pay the large penalty $P >Y_1$. 



 I have described this a little differently than the usual style. Often a property rule is described as one in which it is simply forbidden to take the good, on pain of penalty $P>Y_1$, whereas a liability rule allows someone to take the good if he pays $D$. That formulation obscures what happens if the taker does violate a property rule or refuses to pay the damages he owes under a liability rule. The penalty $P$ is not  the remedy under either rule-- it is the penalty which enforces the remedy. 



It is not quite correct to say, as is commonly done, that liability rules have the disadvantage of court costs whereas property rules do not. Liability rules require court costs only if the taker refuses to comply with the law by paying the damages a court would assess. Often this does require litigation, of course, but litigation is not a necessary feature of the rule. Litigation arises when the damages award the  court  would make  is not common knowledge, so the owner and the taker have to discuss  what the court would award and perhaps, if they disagree, actually go to court and find out. If, however, both sides know what the court would do, there will be no court costs from a liability rule. 



On the other hand, a property rule also requires litigation, and in the same circumstance: if the taker refuses to comply with the remedy the law provides the owner. The owner does not get the remedy of the return of his goods automatically: he needs to petition a court and prove to the court that the goods are his and not the taker's. The only difference is that property rule protection does not require the court to estimate a value, only to establish who has the right to the good. 







 



\bigskip

 \noindent {\bf 2a. Unpredictable Error }



First, consider what happens if the estimate is unbiased-- or if the parties cannot predict the direction of the court's bias, which amounts to the same thing from their point of view.



 If the owner invests in the good and is protected by a property rule, Taker 1 will not try to take it, since he would just have to return it anyway. He will  buy the good if $Y_1>V$ and transaction costs are low enough. 





If the  owner  in the good and is protected by a  liability rule, and Taker 1 takes it, he will have to pay damages of $f(V)+\epsilon$, an amount unknown to him with mean value $V$. Thus, he has to pay a random price. If he is risk-neutral, he will take the good if $Y_1>V$ and not otherwise, which is   the efficient allocation. If the owner is also risk-neutral, this arrangement is   efficient overall;  if the owner is risk averse, then it  creates the inefficiency of  artificial risk for the owner, who might end up with damages either greater or less than $V$. 



  If Taker 1 is risk-averse, then he, too, is concerned about the riskiness of the damages, and he might refrain from taking the good. Instead, if the transaction cost is low enough, he will buy it. 



Regardless of risk aversion, this situation does not  give rise to any opportunism. The good is only transferred if  it should be. 





  Note, too, that  aside from the risk, the owner is quite happy under the liability rule. He is fully compensated, in expectation, by the damages, even though they are uncertain. Thus, there is no reason for him to use self-help to  try to prevent the taking or to re-take the good.  



Note that this is a case in which the court is less accurate than the parties in its estimate of the value of the good, yet the court's disadvantage does not give rise to any inefficiency beyond risk. Indeed, if the parties are risk neutral, there is no need for the court to incur the high cost of accurate measurement at all: the court can make a quick guess as to the value of $V$, and if that is an unbiased, unpredictable estimate, we still would have Taker 1 taking the good only if $Y_1>V$. 



 



 If we thought more carefully about the litigation process,   unpredictable court error could introduce inefficiency through a secondary channel: reducing the probability of settlement out of court. 



 







Note that if the problem is that the taker and the owner have  differing estimates, so that out-of-court settlement fails, then probably bargaining over purchase fails too. Uncertainty of that kind is thus as bad for the efficiency of property rule protection as for liability rule protection.  



 \bigskip

 \noindent {\bf 2b.  Predictable Error: No Binding Agreements}



Now  us assume that liability rule damages are an imperfect but unbiased estimate of $V$. Most important, let us assume that all the players know the value of $D$ in advance.



This means that if $D<V$, which will happen at least occasionally,  the takers can predict that  the court will underestimate the damage and they will only have to pay a low penalty for taking the good.



Consider first the case in which the owner and the takers cannot make binding agreements with each other. Suppose that  $D < Y_1$.   Taker 1 will take the good.  If $Y_1 <V$,   this outcome will be Kaldor-Hicks inefficient.



If, in addition, $D <   C$, the owner will not invest in the good in thefirst place, and   outcome will be pareto inefficient-- nobody is better off than under property-rule protection. 



 Thus, property rule protection is needed to attain efficiency in intentional injuries. And, indeed, these  are most of what are protected by property rules-- breach of contract being a prominent exception.



 Breach of contract, however, does not fit this model very well. There is only one ``taker'' involved, the party that performs second,  and the  party that must perform first  can choose the identity of the potential taker, selecting him for a good reputation   Moreover, when breach damages are hard to calculate, courts {\it do} use property rule protection and order specific performance.



 What about another kind of predictable error-- error over who owns the right? That kind of court error has serious consequences for efficiency, but it is just as bad under liability rules as under property rules. Under either kind of rule, the court must decide who owns the right and is owed the remedy (of damages or return of the good). If Taker 1 can predict that the court will mistakenly think he owns the good, rather than the owner, he will of course  take the good.  Anticipating this, the owner will not invest in it in the first place. 



\bigskip 

 \noindent 

 {\bf 2c.  Predictable Error:   Binding Agreements Enforced by Liability Rule Protection}



Second, consider what happens if contracts can be made costlessly, and if contracts are enforced by the standard liability rule protection. The very court error that causes the problem will continue to bedevil us. Suppose that there is only one taker to fear, because  $ Y_2 < D <  Y_1$ (if there are more credible threats, another problem will arise, discussed below). The owner could pay the taker an amount $M = Y_1$  in exchange for not taking the good. But what if the taker breaches and takes the good? The court will measure the damage to be $D$ and require the taker to pay that amount, which he will be happy to do. Thus, a standard contract will not solve the problem even if transactions costs are zero.



\bigskip 

 \noindent 

{\bf 2d.  Predictable Error:   Binding Agreements Enforced by  Property Rule Protection}



Third, suppose that contracts have property-rule protection and so the enemy will keep his agreement.



  If the taker does not yet exist when the owner must decide whether to invest in the good, the owner will choose not invest. If he does, he will end up paying not just $C$, but $C+Y_1$, since the taker  will demand the full benefit to refrain from taking the good.



Suppose the taker  does exist when the  owner is deciding whether to invest, and that $ Y_2 < D <  Y_1$, so only Taker 1 is relevant. Then the outcome will be efficient. The owner will pay Taker 1 some amount in $[0, xxx]$, Taker 1 will agree not to take the good, and the owner will invest in it. 



 If  $  Y_3<  D <  Y_2$, there is the additional complication that    two takers are credible threats. There is a joint bargaining problem. If they are all present before the cabin is built, maybe there is no problem, though.



 This has established two things.



First: liability-rule protection cannot provide full compensation when there is predictable court error.



Second: liability-rule protection results in inefficiency as a result, under ordinary conditions in which Coasean bargaining fails to work.





\bigskip 

 \noindent {\it So Why Is Liability Rule Protection Ever Used? }



When is liability rule protection used?  



Unintentional torts. (but not intentional)



Breach of contract.



Regulatory offenses for which fines are paid. These fines are like liquidated damages.  Think of parking fines. 





\bigskip 

 \noindent {\it An Objection: Rationality of the Court}



 An objection to this analysis is that we have assumed that the court does make an error. In the model, if the court sees an enemy has burned down the cabin and seems willing to pay $D$, should the court not be worried that its original $D$ is an underestimate, and be willing to raise it?



 A jury will not have that much sophistication.



 A judge cannot be trusted with that much discretion. If he is allowed to depart from the evidence, he can abuse his position.



 \bigskip



\noindent {\bf 5. Concluding Remarks}

 



 I have argued that the problem with liability rule protection as compared to property rule protection  is not that it requires court costs or that courts  make unpredictable mistakes  when  they estimate damages. Rather, it is that courts make predictable mistakes, and takers violate rights in anticipation of unduly low  awards by the courts. Even if court error would be unbiased if courts measured the value of every right in existence, if it is predictable which rights would be undervalued by the courts, those are exactly the rights that will be violated.  Property rule protection does not have this problem, because the courts do no more than determine who owns the right, and by forcing return of the right, the rule does not allow a violator to take advantage of court error. 











\newpage



 \noindent {\bf References}



  Avraham, Ronan (forthcoming) ``Modular Liability Rules,''  {\it  International Review of Law  and Economics} (forthcoming).



   Ayres, Ian \& Paul Goldbart (2001) ``Optimal Delegation and Decoupling in the Design of Liability Rules,'' {\it Michigan Law Review}, 100: 1 (2001).

 

 







 Ayres, Ian \& Eric Talley (1995) ``Solomonic Bargaining: Dividing a Legal

Entitlement

to Facilitate

Coasean Trade,'' {\it Yale L.J.} 104: 1027 (1995).





Calabresi, Guido  \& A. Douglas Melamed (1972) ``Property Rules, Liability Rules, and Inalienability: One View of the Cathedral,''  {\it Harvard Law Review}, 85: 1089 (1972).



 



Friedman, David {\it Law's Order}, http://www.daviddfriedman.com/laws_order/index.shtml, chapter 5. 



 Heller, Michael (1998)  ``The Tragedy of the Anticommons,'' {\it Harvard Law Review}, 

111, 621.



 Kaplow,  Louis \& Steven Shavell, ``Property Rules Versus Liability Rules: An Economic Analysis,'' {\it Harvard Law Review}, 109: 713 (1996).





Knight, Frank H.  (1921) {\it  	Risk, Uncertainty, and Profit} Boston: Hart, Schaffner \& Marx; Houghton Mifflin Company (1921). Http: //www.econlib.org/library/Knight/knRUP.html





 Krier, James E. \& Stewart J. Schwab (1995) ``Property Rules and Liability Rules: The Cathedral in Another Light,'' {\it New York University Law Review}, 70:   440   (1995).



Lemley, Mark (2004) ``Property, Intellectual Property and Free Riding,'' Stanford working paper, http://ssrn.com/abstract=582602.



Levmore, Saul (1995) ``Love It or Leave It: Property Rules, Liability Rules, and Exclusivity of Remedies in Partnership and Marriage,''  {\it  Law and Contemporary Problems}, 58: 221-2 (Spring 1995).





  Morris, Madeline (1993) ``The Structure of Entitlements,''  

{\it Cornell Law Review},  78:  822  (1993).



 Polinsky, A. Mitchell (1979)  ``Controlling Externalities and Protecting

Entitlements:

Property

Right, Liability Rule, and Tax-Subsidy Approaches,''  {\it  Journal of  Legal Studies}, 8: 1 (1979).



 

 



 

Rachlinski, Jeffrey, Chris Guthrie \& Andrew Wistrich (2004)  ``Can Judges Ignore Inadmissible Information?  The Difficulty of Deliberately Disregarding,''



Rasmusen, Eric  (1995) ``Predictable and Unpredictable Error in Tort Awards: The Effect of Plaintiff Self Selection and Signalling,''  {\it International Review of Law and Economics},   15: 323-345  (September 1995).



 Smith, Henry E. (2004) ``Property and Property Rules,'' (May 3, 2004). American Law & Economics Association Annual Meetings. American Law & Economics Association 14th Annual Meeting.  Working Paper 43. http://law.bepress.com/alea/14th/art43





 



 









	 

	



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 Notres. 



Midkiff is 467 US 229.



Heller articl arguing for private takings.  M. Heller, Harvard Law Rev.

111, 621 (1998)

The Tragedy of the Anticommons.



 Think about the advantage of government agency regulation instead of tort, for

when there is predictable error. The government prosecutor will see the

predictable error, but has less incentive (in crim cases, though-- he still has

incentive to win more cases. A problem.) But we don't allow private

prosecutions, which would allow hold-up for ransom to not carry out the prison

sentence.  FDA rules as Frum looks at

Sharks A-Circling

Trial lawyers are hungry for yet more billions; a vilified Bush-administration

lawyer stands in their way.









   The difference between property and liability rules is not that the liability

rule needs a court and the property rule does not. Both need courts and

litigation to establish ownership. It is not even that liabiltiy rules require

the court to think about the remedy more, because in criminal law, the court

needs to establish a sentence.





Also, if the court just enjoins return of the

object,damages still need to be figured out for the interim period,lest this be

a free form of borrowing.



   The difference is that the liabiltiy rule also requires the court to

establish the value *of the object*.



 The property rule gets round predictable error by criminal penalties-penalties

meant to be in excess of actual benefit to the criminal to deter crime.





Criminal penalties are sometiems liability,s oeteims prpoerty rules. With theft:

you give back the goods, adn go to jail. For speeding: you pay  a fine, but you

cna speed if you pay the fine. Well, actually the fine goes up. But you don't

"give back" the goods. THe same for assault.Well, again, Stlger's multiple

offenses. But the first offense fotn seems just like liquidated damages,

staturoty damages.



Levmore 1995 love it or leave it. Property rules are invoked at the end of

relationships, liability ruels for continuing ones.



 Really,the disintion is between 1. Fixed peanlty, 2. variable penalty,

depending on mesaured damages, and 3. restoration, no penalty. Crim law vs.

civil law. We could imagine civil law with a fixed penalty. The measurement

error problem then is we would get more passing over the line.



No: Go back to criminal vs. civil.



 OVERESTIMATION OF VALUE: DOes this matter? Not for property. For Tort, it

does-- people will take too much care. BUt event that is mitigated by the fact

that so many tort interactions are anonymous-- car accidents, for example. I do

not drive more carefully behind a car with a child because I think courts

overestimate damages to children, because I don';t know the child is in there. I

*do* take too much care when I am a doctor treating a child, perhaps-- but can

at least make the child pay more for treatment, reducing the amount of the

interactoin.



   OVERESTIMATION OF PROBABILITY OF TAKING THE RIGHT.



How *could* a property rule be used in tort?  It would have to be criminalized--

imposing a heavy fine for violating the right. Claerly that would not work.



A property rule *could* be used in contract. That's specific performance.



 



Thought: what if error is unpredictable?  Won't property be mistakenly seized by those who underestiate its value? A hard porblem--maybe just note it. 



Remember teh cost of defence against takings. 



We could have a liability rule together with a big punitive transfer against anybody who tried to escape detection, or a multiple to account for it. And we could say that if you couldn't pay the fine, you would go to jail. So that is not he essence ofthe situation. 



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