The Oxford Handbook of Law and Economics 9780199684267, 9780199684205, 9780199684250, 9780198803737, 019968426X

Citation preview

 

T h e Ox f o r d H a n d b o o k o f

L AW A N D E C ON OM IC S

 

 

The Oxford Handbook of

LAW AND ECONOMICS Volume 2: Private and Commercial Law Edited by

FRANCESCO PARISI

1

 

3 Great Clarendon Street, Oxford, ox2 6dp, United Kingdom Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © Oxford University Press 2017 Chapter 11 © Yochai Benkler The moral rights of the author‌have been asserted Impression: 1 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number: 2017935284 ISBN 978–0–19–968426–7 (Volume 1) ISBN 978–0–19–968420–5 (Volume 2) ISBN 978–0–19–968425–0 (Volume 3) ISBN 978–0–19–880373–7 (Set) Printed and bound by CPI Group (UK) Ltd, Croydon, CR0 4YY Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work.

 

Contents

List of Figures  List of Tables  List of Contributors 

vii ix xi

PA RT I   P R I VAT E  L AW 1. Economics of Contract Law  Douglas Baird

3

2. (In)Efficient Breach of Contract Daniel Markovits and Alan Schwartz

20

3. Economics of Tort Law  Jennifer Arlen

41

4. Estimating Pain-​and-​Suffering Damages  Ronen Avraham

96

5. Medical Malpractice  Ronen Avraham and Max M. Schanzenbach

120

6. Economics of Property Law  Henry E. Smith

148

7. Commons and Anticommons  Michael Heller

178

8. Economics of Intellectual Property Law  Robert P. Merges

200

9. Trademarks and Unfair Competition  Clarisa Long

220

10. Law and Economics of Information  Tim Wu

239

 

vi   Contents

11. Open-​Access and Information Commons  Yochai Benkler

256

12. Family and Household Economics  Amy Wax

280

13. Economics of Remedies  Ariel Porat

308

PA RT I I   C OR P OR AT E , C OM M E RC IA L , A N D E N V I RON M E N TA L  L AW 14. The Economic Nature of the Corporation  Lynn Stout

337

15. Market for Corporate Law Redux Roberta Romano

358

16. Law and Economics of Agency and Partnership  George M. Cohen

399

17. Banking and Financial Regulation  Steven L. Schwarcz

423

18. Economics of Bankruptcy  Michelle J. White

447

19. Law and Economics of Insurance  Daniel Schwarcz and Peter Siegelman

481

20. Environmental Law and Economics Michael A. Livermore and Richard L. Revesz

509

Author Index  Subject Index 

543 557

 

List of Figures



7.1 The standard solution to commons tragedy 

181



7.2 Revealing the hidden half of the ownership spectrum 

181



7.3 Ordinary use as the end point 

186



7.4 The trilogy of ownership 

186



7.5 The familiar split in ownership 

187



7.6 The new spectrum of use 

188



7.7 Goldilocks’ quest for the optimum 

188



7.8 An ownership puzzle 

189



7.9 The full spectrum of ownership 

189

7.10 The full spectrum of property, revealed 

190

7.11 Value symmetry in an anticommons and a commons 

191

7.12 Substitutes versus complements 

191

18.1 The insurance effect of bankruptcy 

464

 

 

List of Tables

11.1 Types of Open Access Commons by Governance and Provisioning Model 276 13.1 Allocating and Protecting Entitlements

310

19.1 Types of Insurance Policies with Identified Features 

499

 

 

List of Contributors

Jennifer Arlen, New York University School of Law Ronen Avraham, The University of Texas at Austin Douglas Baird, University of Chicago Law School Yochai Benkler, Harvard Law School George M. Cohen, University of Virginia Michael Heller, Columbia Law School Michael A. Livermore, University of Virginia School of Law Clarisa Long, Columbia Law School Daniel Markovits, Yale Law School Robert P. Merges, UC Berkeley School of Law Ariel Porat, Tel Aviv University Richard L. Revesz, New York University School of Law Roberta Romano, Yale Law School Max M. Schanzenbach, Northwestern Pritzker School of Law Daniel Schwarcz, University of Minnesota Law School Steven L. Schwarcz, Duke University School of Law Alan Schwartz, Yale Law School Peter Siegelman, University of Connecticut Law School Henry E. Smith, Harvard Law School Lynn Stout, Cornell Law School Amy Wax, University of Pennsylvania Law School Michelle P. White, University of California, San Diego Tim Wu, Columbia Law School

 

 

Pa rt I

P R I VAT E  L AW

 

 

Chapter 1

EC ONOM I C S OF C ONTRAC T  L AW Douglas Baird

Before law and economics entered the scene, contracts scholarship had not advanced much beyond Fuller and Perdue’s exploration of contract damages in an article in the Yale Law Journal published in 1936. By Fuller and Perdue’s account, contract law must in the first instance confront competing theories of relief—​reliance, expectation, and restitution. The choice between them required a normative assessment of the protection an innocent party deserved—​compensation equal to the full benefit of the promise, restoration to where she had been before the promise was made, or recovery of any benefits she had bestowed upon the party who had broken the promise. Contracts thinkers such as Oliver Wendell Holmes and Samuel Williston showed that common law courts had decisively favored the first approach—​expectation damages. By the middle of the twentieth century, however, the conventional wisdom had become that the middle course—​ reliance damages—​was the most sensible and most consistent with notions of corrective justice. The first generation of law-​and-​economic scholars entered this debate in the early 1970s (Posner 1972; Barton 1972). For them, notions of corrective justice and intuitions about fairness were off the mark. What mattered was that those who contemplated breaking a promise took account of the costs their conduct imposed on others. Far from being morally objectionable, keeping a promise or breaking it might be good or bad depending upon the circumstances. The role of contract law was to ensure that the incentives were aligned to ensure that breach took place only when it made economic sense. These accounts both vindicated the classical contract thinkers, such as Holmes, and showed that contract law itself possessed an inner logic. Expectation damages remain at the center of the law and economics of contract, but they are more contested. The contemporary view of expectation damages, and indeed of most other contract doctrines, starts with the idea that in a regime of free contracting, contract law provides a starting place. If parties are free to fashion their own terms, the debate should not be so much on whether expectation damages provide parties with the

 

4   DOUGLAS BAIRD proper incentives when the time comes to perform or breach, but on whether they provide a good starting place for parties to negotiate with each other and otherwise navigate the forces at work throughout the contractual relationship. This introductory essay sketches out the debate in its most general terms. The chapters that follow analyze these questions in more detail.

1.1.  The Expectation Damages Principle The common law, as a general matter, awarded disappointed litigants money damages. In the case of a breach of contract, those who broke promises were neither forced to perform nor punished. Instead, disappointed promisees were entitled to what Oliver Wendell Holmes called, “a compensatory sum” (1897). “Breachers” had to put their contracting opposites in the same position they would have been in had the promise been kept. They could not escape with less, but they did not have to pay more. Richard Posner (1972) showed that there was a very simple and straightforward way of making sense of such a rule. Making promises legally enforceable allows parties to count on the other’s performance. They can invest in the relationship, knowing that either the promise will be kept or they will be left in the same economic position as if it had. Because they will be compensated in the event of a breach, they will make investments that they would otherwise recoup only if the promise were performed. You can spend the resources needed to build the custom machine for me, confident that you will not be out of pocket if I breach and you are left with a machine that no one else can use. In a competitive market, expectation damages are an excellent way to capture all the ways, direct and indirect, in which someone relies on the existence of a contract. At the same time, the law should not give innocent parties more than expectation damages. Circumstances can change. My costs of keeping a promise may become larger than the benefits it brings to you. Keeping the promise is no longer in our joint interest. A law of contracts should focus on maximizing our joint welfare at the time of performance. It should induce parties to keep their promises when, but only when it is socially optimal that they do so. A rule that requires me to pay a compensatory sum when I breach forces me to take account of the harm my breach has on you. When I breach, you are paid an amount that makes you indifferent to my performance. I shall breach only if it makes me better off without leaving you worse off. The law of contract forces me to take into account the costs of breaking my promises just as the law of tort forces me to take account of the costs of socially undesirable conduct. In both instances, the common law rules work to induce individuals to internalize the harm that their conduct imposes on others. When Holmes asserted that the law of contracts gave the bad man an option to perform or pay a compensatory sum, he took no position on whether keeping a promise was good or bad. Holmes (1897) saw himself as a pragmatist giving an account of law as it was. Whether keeping a promise was required as a moral or ethical matter was not

 

ECONOMICS OF CONTRACT LAW    5 relevant to the task at hand. In providing his explicitly economic justification for the common law of contract, Richard Posner went a step further. In his view, the ethical notion that it is good to keep promises is wrong-​headed. The rule of expectation damages is desirable precisely because it encourages breach when it is efficient. Society as a whole is better off if people keep promises only in those situations in which it is socially efficient that they do. This effort to use economics to explain contract law has come under fierce criticism (Schiffrin 2007). The idea that breaching a promise was affirmatively desirable was provocative and perhaps deliberately so. The idea of “efficient breach” cuts strongly against the moral intuition that promises should be kept. But it is possible—​perhaps even desirable—​to talk about Posner’s contribution without engaging this debate. Quite apart from the morality of breaking promises, it was a significant advance over previous accounts of contract to show that expectation damages sensibly realign incentives, and it is a long step toward understanding the foundations of contract law. But Posner’s account of expectation damages, like all great revolutionary ideas, is too simple to be completely right. His account of expectation damages focused entirely on the incentives of the breaching party at the time of performance. It neglects the need to ensure that both parties’ incentives are properly aligned throughout the contractual relationship. Most obviously, at the same time one sets damages on the breaching party, one also needs to look at how these damages, in turn, affect the nonbreaching party. Just as the breaching party must have the right set of incentives, so must the beneficiary of the promise. We want that person to engage in the optimal amount of reliance. We want that person to invest, but not overinvest, in the contractual relationship (Shavell 1980). Imagine that a homeowner contemplates adding a driveway and a garage to her house. She values the driveway and garage at one amount if she starts building the garage early so they are both done at the same time, but at a somewhat smaller amount if the sole owner delays building the garage. Neither is worth anything without the other. Once construction of the driveway starts, however, the condition of the underlying soil will be revealed, and there is a chance that building the driveway will be unexpectedly high. Because of the chance that the driveway will prove unexpectedly costly, the homeowner might wait to build the garage. She would rather lose the benefit of having the garage and the driveway done at the same time than take the risk that she would incur most of the cost of building the garage only to discover that soil conditions were such that the project was not worth doing. If this homeowner were to enter a contract with a third party willing to build the driveway, however, she might build the garage sooner. She still captures the benefit if the other party keeps the promise, and the other party is obliged to cover the costs of the garage if she does not. Expectation damages require the third party to pay damages sufficient to pay all of the money the homeowner spends on the garage, plus whatever value she would have enjoyed from having the driveway and the garage. She enjoys the benefit of getting things sooner rather than later, but faces none of the cost if the project is abandoned. The homeowner is under no obligation to hold off the construction of the garage because of the possibility that the other party will not perform. The effect

 

6   DOUGLAS BAIRD of expectation damages is that the beneficiary of a promise treats the third party’s performance as sure-​fire. She no longer has to take into account the possibility that building the driveway might be prohibitively expensive in deciding whether to get an early start on the garage. As a general matter, expectation damages give the innocent party an incentive to overrely on promises (Shavell 1980). In a competitive market, of course, the cost of this overreliance will not fall entirely on the driveway builder. Parties negotiate in the shadow of the legal rule. We should expect that promisor to command a price for the driveway contract that takes this possibility into account. But readjusting the price does not cure the underlying distortion. The homeowner will still have an incentive to build the garage too soon, and resources will be wasted. This is the problem of “overreliance.” Of course, if the parties could anticipate this risk, they would write a contract that obliged the homeowner to start building the garage only when doing so was efficient. But the builder of the driveway may not know enough to insist on such a clause. Not all forms of overreliance can be specified in detail, and, in any event, doing so is itself costly. More to the point, to the extent that a special contracts clause is necessary, expectation damages are no longer aligning the incentives of the parties. In the worst case, the expected costs of overreliance may keep parties from entering into a contract that is in their joint interest. The risk of overreliance, however, does not suggest that Fuller and Perdue’s alternatives to expectation damages were to be preferred. Merely capping damages at the homeowner’s reliance costs does not make the problem go away. Indeed, it makes it worse (Shavell 1980). The homeowner has an incentive to build the garage early even if doing so brings her no benefit at all. Assume that the homeowner receives no benefit from building the garage before the driveway. Under reliance damages, building the garage early is still worth doing because it provides a spur to the builder of the driveway. Building the garage increases the amount of the reliance damages that must be paid. The prospect of paying higher damages makes the other party more likely to perform. The builder may be better off completing the driveway after bad soil conditions are discovered, given the costs that have been sunk in building the garage. In a reliance-​based world, the innocent party is not indifferent between breach and performance. She prefers performance, and she is willing to spend resources to induce performance, even when it is socially wasteful. We could reshape the expectation-​damages rule and give the promisee only those reliance expenditures that were reasonable (Spier and Whinston 1995). If a sole owner would delay building the garage, then the promisee should not be able to recover those expenses if she built it early. But fine-​tuning expectation damages requires the court to solve the same kind of joint maximizing problem that makes Pigovian taxes virtually impossible to implement (Coase 1960). The larger point, however, goes beyond overreliance. The concept of expectation damages focuses on only one part of a complicated puzzle. As the rest of this chapter explores, the puzzle contains many other parts. Of these, one of the most important is the need to account for the possibility of renegotiation. The chapter next turns to this.

 

ECONOMICS OF CONTRACT LAW    7

1.2. Renegotiation When transaction costs are low enough, bargaining between the parties takes them to the Pareto frontier (Coase 1960). This now commonplace observation underscores an assumption embedded in the economic rationale for expectation damages. This rationale implicitly assumes that renegotiations between the parties after the fact are not possible. If they were, performance should go forward when and only when it is socially desirable regardless of the remedy for breach. Although renegotiations are far from costless, they are sometimes possible. A law-​and-​economics account of contract should consider them (Rogerson 1984). Return to the example of the garage and the driveway. Bad soil conditions are discovered, and it is no longer in the mutual interests of the parties for the driveway to be built, regardless of whether the homeowner has already built the garage. But as long as the costs of renegotiation are low enough, the driveway will not be built, even if the homeowner has a right to specific performance. Rather than building the driveway, the builder would reach some kind of bargain with the homeowner. In a world of expectation damages, the homeowner would insist on at least the amount that she values the completed garage and driveway (less costs saved as a result of the breach). But, given the unexpectedly high cost of the driveway, the builder would be willing to offer more than this. A bargain can be struck. As long as the costs are low enough, neither the builder nor the homeowner should walk away from the negotiating table. Rational parties do not leave money on the table. Again, there is not necessarily any advantage taking. The parties can take account of the bargaining game in the initial pricing of the contract. It might seem that, when renegotiation is possible, we should be indifferent between expectation damages and specific performance. But this is not so (Rogerson 1984). Renegotiation allows parties to reach the efficient outcome based on where things stand at the time of the renegotiation. The optimal rule needs to take into account the way the rule affects the behavior of the parties between the time of the contract and the time of the renegotiation. Rogerson (1984) shows the overreliance problem is lower in a specific performance regime than in one of expectation damages. With expectation damages, I build the garage whenever there is a benefit to me from having it early. You promise to build the driveway or put me in the same economic position I would have been in had the promise been kept. If you perform, I get the garage and the driveway. If you breach, I get an amount of money that puts me in the same position. Given that I can recapture the cost of building the garage if we fail to reach a deal as an element of my damages, I shall always receive it in any bargain that it is in my self-​interest to accept. By contrast, in a regime of specific performance, the cost of building the garage is not always something that I always recapture. To be sure, building the garage improves my bargaining position. Once the garage is built, my costs are sunk and the driveway may never be built. I value having the driveway more once I have already spent money

 

8   DOUGLAS BAIRD on the garage. But the amount by which my bargaining position improves is not necessarily enough to justify constructing the garage early. I would rather pocket the money you need to spend to buy your way out of the contract without spending any money on the garage. Building the garage early improves my bargaining position, but not necessarily enough to justify doing it. As renegotiation is possible, I shall tend to build the garage early more often in an expectation-​damages regime than in one of specific performance. Inducing each of the parties to behave optimally during the course of their performance is a complicated problem. Even if we focus simply on the problem of overreliance, expectation damages lose some of their luster. Moreover, overreliance is only part of a much larger problem. The problem of overreliance exists because the contract itself is not completely specified. If the parties were well informed and had time to negotiate, the contractor and the homeowner would bargain explicitly about the timing of the construction of the garage. The inability to specify everything with precision imposes costs that go well beyond the problem of overreliance. Just as the inability to spell out obligations completely may lead to overinvestment in the contractual relationship, it is equally possible that it can lead to underinvestment. Both buyer and seller might be better off if the seller invested more in the quality of the goods she was making, but if a judge has no way of telling whether the seller made the investment, she cannot impose a remedy. She cannot craft an order that obliges that party to perform if she does not know exactly what the person should do. Parties must write contracts taking account of the limits that judges face as best they can (Hart and Moore 1999). The challenge for contract law is not to design the optimal contract but rather to put in place a set of background rules that makes the parties’ task easier. The extent to which the law should allow renegotiation after performance begins and circumstances change is a question that exemplifies the difficulties contract law faces. Legal rules that facilitate renegotiation can make the parties better off, but, precisely because the renegotiations can be anticipated, they can also make the parties worse off. Parties can under-​or overinvest in the contractual relationship precisely because they know that the parties will later find themselves in a world in which the other will be better off renegotiating, rather than trying to compel performance. The value of imposing limits on their ability to renegotiate turns largely on the ability of the court to understand the dynamics of the original bargain. If the renegotiation arises as a result of changed circumstances, the law should facilitate it. On the other hand, if parties cannot spell out their obligations completely and a court is unable to tell whether parties have lived up to their obligations, parties are able to take advantage of the situation after the fact. A legal rule that limits the ability of the parties to renegotiate might make both better off before the fact. The canonical case is Alaska Packers (Threedy 2000). At the turn of the twentieth century, a group of hired laborers travels to a distant harbor in Alaska where they are to work for the salmon season for a packing company. There is a dispute,

 

ECONOMICS OF CONTRACT LAW    9 and the workers insist on a renegotiation of their initial contract. Once everyone returns to San Francisco, the workers try to enforce the new contract. The packer argues that contract law should refuse to allow renegotiated contracts under these circumstances. There were two possible stories. Under one, the nets turned out to be different from what the workers expected. As the workers were paid by the size of their catch, they were left worse off. The workers could assert that, even if the unusual nets were not the fault of the packer, the unexpected conditions justified the renegotiation. And if it were the packer’s fault, the breach would not only entitle the workers to refuse to perform without a new deal, but would indeed give them the right to sue the packer for damages once they returned. In either case, conditions have changed, and renegotiating the contract makes sense. Under the competing story, however, the packer provided the nets it was supposed to. The workers were simply taking advantage of the packer’s inability to bring up replacements owing to the shortness of the season. The parties themselves may know the true state of affairs, but as long as the court does not, each party has a chance to take advantage of the other. If the workers have no right to renegotiate, the packer can get away with providing subpar nets. But if there is a right to renegotiate, the workers can engage in advantage taking. Even if they were given the nets they were promised, the workers can force the packer to renegotiate. The court’s inability to tell whether the parties lived up to their promises keeps it from imposing a damage remedy that correctly aligns incentives. It is possible to write models in which the legal rule should be one that facilitates renegotiations, as well as ones in which parties are able to tie their hands in their original contract, and legal rules should limit the ability of parties to renegotiate. Many things, including the bargaining power of the parties, need to be taken into account (Choi and Triantis 2012). A general theory of the law governing reorganizations, if it exists at all, is yet undiscovered.

1.3.  The Limits of Expectation Damages Quite apart from the problem of overreliance and the possibility of renegotiation, there is considerable reason to doubt that the expectation-damages concept deserves the central place it has enjoyed in the law and economics of contract (Posner 2003). The canonical case in which expectation damages works arises when the promisor faces a change in circumstance. The performance of the promise was once in the joint interests of the parties but is no longer. A new opportunity has come along that allows me to put my human capital to a better use, and you can readily find someone else to take my place. Expectation damages, however, will ensure that I take advantage of this new opportunity only if a judge can calculate damages accurately, and there is considerable reason to doubt that she can.

 

10   DOUGLAS BAIRD The judge must assess accurately the costs you incurred as a result of my breach. These costs include the costs of delay and the costs of finding someone else to do the job, and they include any lowering of the quality of the performance when someone else does it. How well is a judge able to take all this into account? You may have bargained for my services for reasons that are important, but not readily transparent. If the court overestimates the harm you suffer from breach, I will perform even when everyone is better off if we parted company. If the court systematically underestimates the harm from my breach, I shall breach too often. A court could account for all these things in principle, but the case for expectation damages rests on the idea that courts are good at making this sort of calculation. Expectation damages are easiest to measure in the common case in which the market price of a fungible commodity changes after the contract is entered. But exactly here where expectation damages are easiest to measure is where the efficient-​breach argument has little traction. Disputes arising from these contracts rarely are litigated in common law courts. Contracts involving purely fungible commodities tend to arise in self-​regulated markets, such as the Chicago Board of Trade. More important, contract breaches involving corn or wheat are not likely to be ones where there is likely to be much social benefit from breach. If it is a fungible commodity, why do I need to break my contract to provide it to some new buyer? Presumably, this new buyer can find someone else willing to sell at the market price. Even if the entire supply were locked up, new buyers, if they are indeed the highest-​valued users, can go to those who already have goods under contract and acquire the rights from them. Such contracts are typically assignable. Even if not, when the old buyer acquires the goods, she should be willing to resell them to those who value them more. To be sure, there are the costs of two sales, but these may be less than the costs of the breach. Fungible goods are often stored with third parties. They are bought and sold without any change in the physical location. Breach may arise in these cases not because breach will put the goods to a higher-​ valued use, but because the breaching party believes that expectation damages, once the dust settles, will turn out to be undercompensatory. There are many common law doctrines—​such as limiting individuals to damages that are reasonably foreseeable and nonspeculative—​that make expectation damages less than completely compensatory. But even if courts turned out to provide, on average, damages that equaled expectation damages, expectation damages would still not provide the correct incentives if those who are considering breach could assess before the fact whether the judge would underestimate damages in their particular case. It does no good to have an unbiased judge if the parties can predict in advance when she will be too high and when too low. This opportunity for strategic behavior exists whenever the promisor knows more about the costs of breach than the judge does. The possibility that judges are not going to do a good job of assessing expectation damages—​particularly the possibility that they might systematically underestimate them—​naturally leads to the question of whether the common law’s ban on supercompensatory damages is at all sensible (Baird 2013).

 

ECONOMICS OF CONTRACT LAW    11 Let us assume I want my portrait painted and I know that artists are, as a group, unreliable. Timely performance is very important for me, but the judge is likely to underestimate how important it is. In such a case, it would be useful for me to be able to bargain for supercompensatory damages. I shall have to pay more in order to persuade someone to enter into such a contract, but it allows me to screen the painters. Only those most likely to perform on time will be willing to accept my contract. Even if renegotiation is costly and there is a possibility that the painter will perform even though her efforts are better spent elsewhere, there are offsetting benefits as the willingness to pay a penalty signals private information. There is, of course, the possibility that the penalty clause reflects advantage taking against an unsophisticated consumer, but it is not obvious that one needs a special rule governing damages as opposed to a general mechanism against unconscionability. Using supercompensatory damages as a screening mechanism is one of many reasons why parties might not opt for expectation damages. The ability to find such rationales for other damage measures leads one to doubt that the traditional law-​and-​economics explanation for expectation damages is compelling. Although expectation damages may induce parties to take account of the costs of breach—​and this is an eminently sensible role for a contract damages rule to play—​it is not the only possible role. To justify expectation damages, one needs to explain why, in the mine-​run of cases, it is more compelling compared with the others. If one accepts the idea that two sophisticated parties should be able to bargain for any measure of damages they find in their mutual interest, the case for expectation damages rests upon the idea that it is a sensible baseline from which parties can depart, rather than that it induces optimal decisions about breach and that this concern trumps everything else. To see if expectation damages are even a logical starting point, engage in the following thought experiment. At the outset, I tell you explicitly that there is a possibility that it may not be in our mutual self-​interest that I perform. But I also tell you that I do not want to be a bad person, and I have no intention of breaching any contract. Instead, what I want is an option built into the contract that gives me an option not to perform. There is a clause in the contract in which I have the right to cancel the contract in exchange for giving you a certain amount of money. If we negotiated this option, what is the option price upon which we would agree? (Scott and Triantis 2004). Once the remedy for breach of contract is money damages, it would seem that it should equal the price parties would agree upon for the right not to perform. The challenge of contract law is setting the presumptive price of that option. If we characterize the problem in that way, it is not at all obvious that the right way to price the option is to use expectation damages (Scott and Triantis 2004). As in the case of the painter, it could be much more, but it many other cases it could be much less. Placing the problem of contract damages inside a framework that promotes free contracting replicates a more general problem in the law and economics of contract. Contract law provides a backdrop. Identifying exactly what purpose this backdrop should serve has been a long-​ standing question in the law and economics of contract, and it is the focus of the next section.

 

12   DOUGLAS BAIRD

1.4. Default Terms At the same time it was wrestling with the question of expectation damages and whether it was in the mutual interests of the parties, economics was used to shed light on contract’s substantive rules. Contract law simply provided the parties with terms that advanced their mutual interest. In a world in which we are committed to free contracting, these terms, like expectation damages, should be the rule only until parties negotiating at arms’ length bargain for something else. Contracts are incomplete, and the law is needed to fill in the gaps. When parties enter into a deal with each other, there are many things left unspoken. It could be a warranty term, a delivery date, or questions about who bears the risk of loss when the goods are destroyed in transit. Merchants ordinarily do not have the time or the money to spell out every particular detail. In the 1970s, the literature talked about contract law as providing parties with a set of “off-​the-​rack terms” (Goetz and Scott 1977). Contract law is not a set of abstract principles but rather a set of premade contract terms. Contract law saves parties the costs of drafting a long contract every time they deal with one another. Contract law provides a set of off-​the-​rack terms. Like off-​the-​rack clothes, they do not necessarily fit perfectly, but they fit most people, most of the time. Tailoring contracts, like tailoring clothes, takes time and money. Like bespoke clothes, they are more costly. For the vast majority of people, however, ordinary terms will do. Most are content with the terms contract law gives them. You may be a special person. You may be especially large, extra tall, extra short, or extra whatever. The clothes you find on the rack do not fit you. You may want to get your clothes custom-​made. Similarly, if you are a contracting party, when your needs are special, you can get your own customized terms. The imperfections in expectation damages seem tolerable from this perspective. One need not make the argument that they serve everyone, only that they work for most. It is as good a baseline as anything else is. Even if the inability to opt out of expectation damages under current law does not make sense, it may still be a sensible off-​the-​rack rule. Expectation damages are not necessarily God-​given, but they do align incentives at the time of the breach decision, and this is important. They are what parties would bargain for most of the time. The account of the law and economics of contract as it emerged at the end of the 1970s put no special magic into much of contract law. The rules governing warranties, the risk of loss, and the like were simply sensible terms. For example, at common law and under the law merchant, manufacturers sell their goods with an implied warranty of merchantability. Unless the manufacturer disclaims, they come with the promise that they pass without objection in the trade under the contract description. If I am the shoemaker and you buy shoes from me, an implicit term of the bargain is that the shoes I give you pass without objection in the trade as “shoes,” and they are suitable for the purposes

 

ECONOMICS OF CONTRACT LAW    13 for which shoes are typically used. This feature of the law has been in place since the twelfth or thirteenth century. It is not controversial and it never has been controversial. Appropriately limited, the implied warranty of merchantability is a sensible off-​the-​ rack rule. If I make something and do not want to promise that it passes without objection in the trade under the contract description, I am the one who is doing something unusual. Hence, I should be the one who has to bargain for special terms. It is often said that the common law was a regime of caveat emptor. This is not true (Scheppele 1988). Caveat emptor was a doctrine that put sensible limits on the warranty of merchantability. It applied most often in contexts in which the seller was not a manufacturer. The seller had no more expertise than the buyer did. I have a ship with lots of different kinds of cargo, including exotic wood. I am an intermediary and I am selling you goods I have acquired from others. It would be odd if I were making warranties about qualities that you can judge much better than I can. You have expertise with respect to wood, and I do not. The other cases to which caveat emptor applied arose when the buyer’s obligation to inspect was more important than seller’s promises with respect to quality were. If I sell you a horse, you have a duty to inspect it. You are responsible for any defects that an inspection should have revealed. The cases worth litigating typically involved horses and other assets that were both valuable and subject to change. A seller is obliged to reveal latent defects, but not those a reasonable inspection would reveal. A different rule would inevitably lead to litigation over whether the horse became lame before or after the sale. Quite apart from providing specific terms, contract law also provides general rules of engagement (Baird 2013). There is a general duty of good faith, but there is no affirmative duty to disclose information. The most sensible trade-​off here is again not obvious. On the one hand, it does not make sense to force the buyer to engage in an endless game of twenty questions to find out what the seller knows, but neither does it make sense to force the parties to disclose information that may be costly to acquire. But even this background rule needs to be seen in light of the general prohibition on fraud and its corollary—​you must disclose information that once you have learned it makes previous statements misleading. Again, it is hard to argue that these particular background rules are inevitable, but it is quite easy to argue that they provide sensible rules of engagement. The value of contract law is not that it provides any particular set of terms, but that it provides some set of terms and that these, in the main, be sensible. When you enter into a contract, you should be confident that if you do not bargain for special terms, you will get a set of terms that make sense for most people most of the time. The common law of contracts provides a set of terms that gives the vast majority the right set of incentives. The iconic (and now rather dated) example deals with the person who wants to climb Mt. Everest and buys an ordinary camera and an ordinary roll of film to take her picture when she reaches the top. The camera and film prove defective. The seller is liable for damages, but how should these be calculated? The sensible allocation of damages should take into account not only the need to give the seller incentives to make sure the film is not defective but should also give the buyer an incentive to take precautions against the possibility of defects. It makes sense that a

 

14   DOUGLAS BAIRD photographer who will incur large damages in the event that the film proves defective take precautions, such as buying an especially reliable camera or bringing a back-​up, rather than imposing the entire risk on the seller, who is unable to take such precautions, or forcing the seller to bargain with each buyer to shift the risk back. Such a rule makes sense in a world in which we want sellers of cameras and film to be able to sell them to people cheaply. This rationale provides an explanation for the rule of Hadley v. Baxendale, the rule that limits consequential damages for those risks that are reasonably foreseeable. As the use of photographic film suggests, this account of contracts belongs to a different era (Posner 1972). Much has changed. Among other things, a new vocabulary has emerged. Law and economics switched from using the idea of “off-​the-​rack” terms to “default” terms in the 1980s. This new vocabulary came from the introduction of personal computers. Software could be configured in many different ways, but when first installed, the software came configured in a standard way. These were known as “default settings.” You could change them if you wanted, but they provided a decent starting place. Contract rules could be seen in the same way. Contract rules were like factory defaults in your word processing program. The literature replaced “off-​the-​rack terms” with “default terms.” The change in vocabulary brought with it a subtle change in the way people thought about the problem of contract law. The idea of “off-​the-​rack” clothes reinforced the idea that contract law was simply the standard contract that most people wanted because it sensibly allocated risk. The metaphor of “default” rules underscores the idea that the contract terms the law provides are simply a starting place. What most want might be a good starting place, but somewhere else might be as good or better. The starting place, for example, might be set to induce those with important information to reveal it during the course of contract negotiations. Parties might be better off if, rather than allocate risks optimally, the default rules put parties in a position that forced the disclosure of information (Ayres and Gertner 1989). Consider a variation on the facts of Peevyhouse (Baird, Gertner, and Picker 1994). A strip-​mining company approaches a couple who own a farm. It wants to acquire the right to strip mine the land. The couple requires that the company promise to restore the land once they have finished. Their subjective value is high. They put a much higher value on having the land restored than other farmers would. When the couple entered into the contract, they cared intensely not simply about damages in the event of breach or the incentives of the coal mining company, but also about the likelihood of breach, a question on which the company was much better informed than they were. A rule the holds the strip-​mining company liable for the entire cost of restoring the land—​regardless of whether the couple even thinks it worth that much—​may make sense. The prospect of facing that kind of damage award will force the coal mining company to disclose information, either explicitly or by opting out of the default rule and adding a clause limiting damages in the event of a breach. Rather than terms that fit parties most of the time, it might make more sense to choose rules that provide the best starting place for negotiations. As this example illustrates, a

 

ECONOMICS OF CONTRACT LAW    15 good starting place may focus on providing an incentive to those with information to reveal it. Alternatively, it might be one that provides terms that are suitable for the unsophisticated. Because sophisticated parties are better able to reshape contract terms, it makes sense to impose upon them the obligation to do it. One can take the analogy to default terms in computer programs a step further (Ayres 2012). Lawmakers should pay attention not only to the content of default terms but also to the rules that govern opting out of them. Just as it ordinarily takes multiple keystrokes to delete a file permanently, it may make sense to require parties to jump through special hoops when opting out of a particularly important default. Opting out of the right to litigate the dispute in court and instead agreeing to arbitration may require more steps and deliberation than a change in delivery date.

1.5.  Contract Terms as a Product Attribute It has become a commonplace that contract law in the first instance provides a set of terms that parties can use or not as they please. From this, it is only a short step to treat a contract term as just another product feature. A contract term that accompanies the sale of a computer is no different from its hard disk or its battery. It may be good or bad. Some buy a product after learning all its features; others buy knowing comparatively few. Whether a buyer knows the content of various contract terms may be no different from whether the buyer knows about other features of the product. This perspective sheds some light on how we might think about standardized contracts (Baird 2013). The typical contract we have today is, by and large, not negotiated. If I buy a piece of software, I will typically click and agree to certain terms. But it is most unlikely that I am going to read the terms. As a practical matter, I either take Microsoft’s or Apple’s terms sight unseen or do not buy their product. Courts still put forward legal tests that make the enforceability of standardized terms turn on whether the typical buyer is likely to have read them. It is hard to believe that the judges who write these opinions actually read fine print in the manner they ascribe to their hypothetically reasonable person. The rest of us certainly do not (Bakos, Marotta-​ Wurgler, and Trossen 2014). A coherent account of the law and economics of contract must confront the dynamics of the marketplace. In this respect, an account of contracts that focuses upon default terms that are merely starting places for further negotiation does not capture much of what is going on in many contracting environments. One suspects that if the legal terms were in fact important, at least some consumers would find out about them by reading product reviews or advertising rather than reading the contract. They would not negotiate, but neither would they buy products that contained terms they did not like. What matters is not whether every consumer knows about the hidden legal terms, but rather whether a sufficient number of sophisticated

 

16   DOUGLAS BAIRD people know about them to ensure that sellers have to offer good terms in order to gain sufficient business (Schwartz and Wilde 1979). Apple sells to Fortune 500 companies, as well as to ordinary consumers. To the extent Apple sells the same product with the same terms, it may have no ability to exploit consumers even if it were inclined to do so. Its need to attract both types of customers may allow the ignorant to free ride on the expertise of the sophisticated. This perspective reminds us that we should take seriously the idea that contract law can only do a limited amount of work. Those of an economic bent are more inclined than others are to think that markets will tend to be self-​policing. But regardless of how much people trust markets, they should be able to agree on where trouble, if it exists, is most likely to lie. Advantage taking is more probable in specialized markets that focus on the unsophisticated—​such as the market for payday loans or rent-​to-​own furniture—​than it is in mass markets in which large firms sell on the same terms to everyone (Baird 2013). For some, the consuming problem with respect to standardized contracts is the nightmare scenario in which you buy a product, take it out of the box, use it, and only several weeks later learn that the seventieth page of the fine-​print contract contains language to the effect saying that you owe the seller an extra $1000. Because the common law of contract is based on the arms’-​length bargain, there is no neat doctrinal response to this problem. The buyer became bound by all the terms of the contract when she accepted the goods. It was her responsibility to read the contract and to object to any terms not to her liking. It is worth noting, however, that this problem appears much more in the law school classroom than it does in mass consumer markets. Reputational forces matter. Moreover, rules against fraud offer more protection that contract law does. Any representations made in advertising or any places that represent the product as having particular features that the seller knows the product does not have is a form of common law fraud. It is punishable criminally. The egregious conduct that contracts professors fear may not be properly the province of contract law at all. When it arises, contract law is neither necessary nor appropriate. To the extent that we worry about hidden terms, it may make sense not to worry about the process of negotiation itself and instead mandate forms of protection—​such as the implied warranty of merchantability—​that ensure that unknown terms cannot work much of a surprise. If I sell you a product, it has to pass without objection to the trade under the contract description. One can mandate such a warranty in all contracts. Alternatively, one can keep it as a default rule, but require special hoops to jump through in the event that a seller wants to opt out (such as requiring such terms to be highlighted). But lawmakers need to be careful. Making many terms prominent ensures that none of them is prominent (Ben-​Shahar and Schneider 2011). Solving this problem requires going beyond thinking of contracts as a discrete document that normally emerges from arms’ length bargaining. The law must regulate the market as a whole. Economics has much to say about how markets as a whole should be regulated. There is no need to create an acoustical separation between the economic

 

ECONOMICS OF CONTRACT LAW    17 theory of such regulation and the law and economics of contract, but the more one focuses on this problem, the farther one is stepping away from Richard Posner’s original enterprise, which was to make sense of the core doctrines of the common law of contracts.

1.6.  Contract Law and Contract Theory Much of the challenge in exploring contract law is identifying what is distinctive about contract law. The law and economics of contract law needs to be located between two poles. As discussed in the last section, there is the challenge of regulating the market as a whole. Economics has much to say about regulation, but one can argue that this is distinct from the domain of the law and economics of contract. Regulation arguably stands apart from contract law proper. Contract law may be best conceived as an enterprise that focuses on the terms and conditions on which two individuals enter into a bargain with each other. At the other extreme are the bargains themselves. If two people want to contract with each other, they face many problems. It is very hard to spell out everything in detail. When things are left unsaid, there is the possibility of shirking by either side. All contracts are incomplete. It may be that you know what you should be doing, and I know what you should be doing, but it is going to be hard for any judge or indeed any third party arbiter to figure it out. It may also be that I simply do not have enough information to know how you should carry out the job. You have promised to mow my lawn and you have expertise about how to do the job that I do not have. For this and other reasons, I do not know enough to specify in the contract exactly how you should go about performing your job. You may cut corners and keep the promises you made to me without promising me everything that I would have demanded had I sufficient knowledge. Moral hazard and adverse selection problems are everywhere. Economics has much to say about how parties overcome agency and other problems in designing their contracts. But the problems of contract design are the province of contract theory. They are not the same as contract law. Contract theory has spawned its own robust literature (Bolton and Dewatripont 2004), but it is a literature that, as far as the law is concerned, has little to say about the content of contract law beyond a general mandate for courts to enforce contracts as written. Contract law is an enterprise distinct from contract theory. Rather than trying to understand contracts themselves, it focuses on the rules that tell a court that comes how to interpret them, it is the world in which parties find themselves when they start to write their contracts. Contract law is a set of ground rules. Largely, a sensible contract law merely provides parties that want to engage in trade with a starting place from which they can fashion their own bargain. But what makes some starting places better

 

18   DOUGLAS BAIRD than others? What are the stakes? What turns on this? For many years, advances in the law and economics of contracts have started with such questions. We may anticipate that this will continue.

References Ayres, Ian. 2012. “Regulating Opt-​Out: An Economic Theory of Altering Rules.” Yale Law Journal 121, pp. 2032–​2116. Ayres, Ian and Gertner, Robert H. 1989. “Filling in Gaps in Incomplete Contracts: An Economic Theory of Default Rules.” Yale Law Journal 99, pp. 87–​130. Baird, Douglas G. 2013. Reconstructing Contracts. Cambridge, MA: Harvard University Press. Baird, Douglas G., Gertner, Robert H., and Picker, Randal C. 1994. Game Theory and the Law. Cambridge, MA: Harvard University Press. Bakos, Yannis, Marotta-​Wergler, Florencia, and Trossen, David R. 2014. “Does Anyone Read the Fine Print? Testing a Law and Economics Approach to Standard Form Contracts.” Journal of Legal Studies 43, pp. 1–​35. Barton, John H. 1972. “The Economic Basis of Damages for Breach of Contract.” Journal of Legal Studies 1, pp. 277–​304. Ben-​ Shahar, Omri and Schneider, Carl E. 2011. “The Failure of Mandated Disclosure.” University of Pennsylvania Law Review 159, pp. 647–​749. Bolton, Patrick and Dewatripont, Mathias. 2004. Contract Theory. Cambridge, MA: MIT Press. Choi, Albert and Triantis, George. 2012. “The Effect of Bargaining Power on Contract Design.” Virginia Law Review 98, pp. 1665–​1743. Coase, R. H. 1960. “The Problem of Social Cost.” Journal of Law and Economics 3, pp. 1–​44. Fuller, L. L. and Perdue, William R. 1936. “The Reliance Interest in Contract Damages (Part I). Yale Law Journal 46, pp. 52–​96. Goetz, Charles J., and Scott, Robert E. 1977. “Liquidated Damages, Penalties and the Just Compensation Principle: Some Notes on an Enforcement Model and a Theory of Efficient Breach.” Columbia Law Review 77, pp. 554–​594. Hart, Oliver and Moore, John. 1999. “Foundations of Incomplete Contracts.” Review of Economic Studies 66, pp. 115–​138. Holmes, Oliver Wendell. 1897. “The Path of the Law.” Harvard Law Review 10, pp. 457–​478. Posner, Eric A. 2003. “Economic Analysis of Contract Law after Three Decades: Success or Failure.” Yale Law Journal 112, pp. 829–​880. Posner, Richard A. 1972. Economic Analysis of Law, Boston, MA: Little, Brown. Rogerson, William P. 1984. “Efficient Reliance and Damage Measures for Breach of Contract.” RAND Journal of Economics 15, pp. 39–​53. Scheppele, Kim L. 1988. Legal Secrets: Equality and Efficiency in the Common Law Chicago, IL: University of Chicago Press. Schiffrin, Seana Valentine. 2007. “The Divergence of Contract and Promise.” Harvard Law Review 120, pp. 708–​753. Schwartz, Alan and Wilde, Louis L. 1979. “Intervening in Markets on the Basis of Imperfect Information: A Legal and Economic Analysis.” University of Pennsylvania Law Review 127, pp. 630–​682. Scott, Robert E. and Triantis, George C. 2004. “Embedded Options and the Case against Compensation in Contract Law.” Columbia Law Review 104, pp. 1428–​1491.

 

ECONOMICS OF CONTRACT LAW    19 Shavell, Steven. 1980. “Damage Measures for Breach of Contract.” Bell Journal of Economics 11, pp. 466–​490. Spier, Kathryn E. and Whinston, Michael D. 1995. “On the Efficiency of Privately Stipulated Damages for Breach of Contract:  Entry Barriers, Reliance, and Renegotiation.” RAND Journal of Economics 26, pp. 180–​202. Threedy, Deborah L. 2000. “A Fish Story: Alaska Packers’ Association v. Domenico.” Utah Law Review 2000, pp. 185–​221.

 

Chapter 2

(IN) EFFICIE NT BRE AC H OF C ONTRAC T Daniel Markovits and Alan Schwartz

2.1. Introduction 2.1.1. The Law The common law of contracts vindicates promisees’ rights principally through the expectation remedy. Although the Restatement recognizes three distinct contractual interests—​expectation, reliance, and restitution—​it expressly privileges the expectation interest over the other two. The law, the Restatement observes, “[o]‌rdinarily … enforces the broken promise by protecting the expectation that the injured party had when he made the contract” (Restatement 1981, § 344 cmt. a). Courts thus respond to breach “by attempting to put [the promisee] in as good a position as he would have been in had the contract been performed”; that is, by “giv[ing] the injured party the ‘benefit of the bargain’ ” (Restatement 1981, § 344 cmt. a) The Uniform Commercial Code similarly recites that contract remedies are designed to put the aggrieved party “in as good a position as if the other party had fully performed” (UCC § 1-​305 [a]). Conventional contract law thus appears to vindicate contractual promises not directly but only through substitutionary means, by requiring the promisor to pay money damages that equal the benefit of the promisee’s lost bargain. As a consequence, promisees become indifferent, ex post, between performance and breach-​plus-​damages, transaction costs aside. An implication of contract law’s “benefit of the bargain damages” is that a promisor, after paying them, is free to realize gains made possible by diverting the promised performance to a higher-​valuing third party, or by not performing at all. In the current lexicon, contractual expectations conventionally thus receive liability rather than property rule protection (Calabresi and Melamed 1972). The rationale behind the law’s decision to accord limited protection to promisees has a name—​the “theory

 

(In)Efficient Breach of Contract    21 of efficient breach.” The theory has become sufficiently familiar to appear in textbooks intended for students (Ferriell 2009, 715–​17). It also is unpopular outside the lawyer-​ economist community.1

2.1.2. The Theory Restated Efficient breach theory should vanish because no breach is efficient. To see why, assume that contracting agents can contract in their self-​interest and that it is in the agents’ self-​ interest to choose efficient contract terms: that is, terms that maximize the expected surplus that the agents’ deal makes possible. Then define a breach of contract as an agent’s failure to take an action that the contract requires or her taking an action that the contract forbids.2 Under this definition, no breach is efficient because to breach would be not to take an action that the contract efficiently requires or to take an action that the contract efficiently forbids. It follows that the analyst’s or the court’s first-​order question is interpretative: what does the contract at issue require, permit, or forbid? We illustrate with the canonical case. Consider two contracts. Contract A lays out a single path to performance: The promisor must trade a specified good or service for a price. Contract B, which we call a dual-​performance contract, provides alternative paths to performance: The promisor must trade the good or service item or transfer a sum to the promisee that equals the gain the promisee would have realized from the trade. Let the promisor not trade the item, but transfer the sum instead. This would be a breach if the parties wrote contract A, but not if the parties wrote contract B. The promisor would breach even Contract B, however, if she failed both to trade and to transfer the sum. Neither the failure to trade nor the failure to transfer could be efficient breaches if the applicable contract terms were 1  An article by Roy Ryden Anderson (2015) asserts, “Unsurprisingly, most dispassionate contracts scholars have rejected the theory out of hand.” Professor Anderson summarizes the “now rather infamous theory of ‘efficient breach’—​a self-​indulgent proclamation that is noxious to even neoclassical contract law. The heretical supposition of an efficient breach is that the compensated promisee will be indifferent to the breach, the breaching promisor will be most pleased with herself, and the rest of us will somehow happily benefit … by having the performance of the breached contract wind up with someone who … values the performance more than does the promisee” (2015, 957). According to Professor Anderson, and others, efficient breach theory “since it first slithered into view … has been almost exclusively a creature of the academic literature and the law school classroom … because the idea is based on so many unrealistic and unprovable assumptions that run counter to the workday world, to life experience, and to the natural intuition of fair-​minded people” (2015, 957–​58 [footnotes within quotes omitted]). 2  The UCC does not define a breach, but §2-​106(2) defines conforming as actions that are “in accordance with the obligations under the contract.” It follows that a breach would be to take an action that is not in accordance with those obligations. Similarly, Restatement (Second) of Contracts §2(1) defines an enforceable promise as “a manifestation of intention to act or refrain from acting in a specified way, so made as to justify a promisee as understanding that a commitment has been made.” Hence, the failure to act, or not to refrain from acting, in the “specified way” would be a breach. In accordance with this inference, Restatement §235(2) provides that “When performance of a duty under a contract is due any non-​performance is a breach.”

 

22    DANIEL MARKOVITS AND ALAN SCHWARTZ efficient. Hence, to ask whether a breach is efficient is to ask the wrong question. Moreover, it is a question that courts generally know not to ask, as the law’s foundational commitment to freedom of contract entails that courts do not evaluate the efficiency of terms in business contracts. Finally, the right question is what did the contract require the promisor to do? Once again, this question does not distinctively concern remedies at all; rather, it concerns interpretation. Richard Posner (1972), the most prominent and effective early proponent of efficient breach theory, made the initial mistake. He assumed that parties always wrote Contract A, but he recognized that, in his examples, it would be ex post efficient for the promisor to pay off the promisee and sell the specified property item to another. That the parties wrote Contract A implied that nondelivery was a breach; that the promisor should not deliver thus was an efficient breach. But if it would be efficient, again on his examples, for the promisor to transfer rather than trade, the parties would have written Contract B. Of course, Contract A might actually be efficient, for example, when the promisee’s expectation is not monetizable. In almost every example of efficient breach the literature provides, this condition is not satisfied. The correct conclusion, then, is that the parties wrote Contract B, so that nondelivery alone would not be a breach. As should be apparent, Contract B tracks current law, under which an agent is free not to trade, but must then transfer the promisee’s expectation. The contract is attractive when parties can inform the court of the promisee’s gain: the value a buyer would have realized3 or the cost the seller would have incurred.4 When values and costs are verifiable, the Contract makes each party the residual claimant with respect to the breach decision.5 As an example, let the seller discover an opportunity to sell to a third party or to redeploy her resources to some entirely distinct purpose, rather than perform under the initial agreement. Contract B gives the seller efficient incentives to decide whether to take the opportunity because she would realize the gain but bear the cost—​the buyer’s expectation. Similarly, the Contract requires the buyer to internalize the gains and costs were he to perform elsewhere, or not perform. Therefore, under the contract (which reflects the law today), a promisor will choose the permitted action—​to transfer the specified property or to pay—​that produces the greater overall gain.

2.1.3. The Expectation Interest as a Default There is a well-​grounded view that parties have limited contractual control over remedies. For example, a court will not ask whether, all economic things considered, it was “reasonable” of the parties to contract to trade 200 widgets rather than 150 widgets, but a court will ask whether, all economic things considered, a party estimate of the profit the 3 

The law awards the buyer his value less the price. The law awards the seller the price less her cost. 5  An early elaboration of this rationale is Birmingham (1970, 273–​92). The first formal explanation is Shavell (1980). 4 

 

(In)Efficient Breach of Contract    23 promisee would realize from a deal was “reasonable,” if that estimate was instantiated in a liquidated damage clause. Furthermore, parties cannot require a court to enforce their promises specifically. On the other hand, much scope remains for parties to contract away from the standard expectation interest remedy. Parties thus have substantial discretion to liquidate damages, to under-​liquidate damages (Schwartz 2010; Stole 1992), to limit remedies (UCC §2-​7 19), to exclude consequential damages, and often successfully to request specific performance by setting out their need for the remedy in a contract’s whereas clauses.6 That this much contracting scope exists supports our claim, assumed in Section 1.2 and set out in more detail below, that parties actually choose expectation interest contracts such as Contract B when their contracts are silent regarding remedies. The remainder of this chapter expands the claims in Section 1 in more detail, considers moral and economic objections to Contract B, and analyzes contract doctrine to show that the law actually presupposes that parties write this Contract.

2.2.  Critiques of Efficient Breach of Contract Certain moral theorists, for some time and with increasing force, have adopted a strong line of attack against orthodox contract law. This attack rests on the premise that a promisor who refuses to trade commits a breach. The moralists, that is, make the same mistake that Posner made: they assume that parties write Contract A when parties actually write Contract B. On the moralists’ assumption, orthodox contract remedies price breach, and they set prices so low (at levels that enable breaching promisors to profit from their wrongs) as to encourage breaches of the very obligations that contract law purports to establish. This feature of the orthodox doctrine, these critics say, undermines the immanent normativity of contract obligation and causes contract law to diverge from the morality of promise in unattractive ways.7 Moral critics of orthodox contract also, and relatedly, attack other features of established law, for example the mitigation doctrine. This doctrine supports the expectation remedy by requiring promisees to respond to breach by taking steps to minimize their costs, and thus the promisor’s damages, from the promisor’s failure to trade. Critics of orthodox contract law charge that the doctrine authorizes a breaching promisor to draft her promisee involuntarily into the promisor’s service, specifically by requiring the promisee to exercise initiative in order to reduce the damages that breaching promisors owe (Shiffrin 2012).8 Supracompensatory remedies, 6  Parties cannot contract for penalties but, in symmetric information environments, they do not want penalties (see Schwartz 1990). When information is asymmetric and parties contract partly to induce efficient investment, penalties can be efficient, however. (See Edlin and Schwartz 2003.) 7  A variety of these claims appears in, for example, Friedman (1989); Shiffrin (2007; 2009). 8  Shiffrin’s (2012) concern is incorrect. Mitigation protects the promisee’s expectation at the lowest cost, an efficiency that is reflected in the price. Promisees do not need to be coerced to mitigate because

 

24    DANIEL MARKOVITS AND ALAN SCHWARTZ moral critics of orthodox contract say, would avoid all of these wrongs. A legal regime that responded to breach of contract by ordering specific performance, restitutionary disgorgement, or even punitive damages would truly sanction rather than merely price breach. Such a regime would thus support the internal norms of contract obligation and bring the law of contract into conformity with the morality of promise. A legal rule whose theoretical foundation appears shaky to many commentators sometimes is replaced, so it is unsurprising that the expectation interest’s critics have made real-​world progress; courts and other legal authorities have begun to adjust the law in response to their critiques. The Uniform Commercial Code liberalized the right to specific performance. Specific performance, however, sometimes is impractical: it takes too long to get. Specific performance also is impossible when the promisor has sold the property to a good faith purchaser. The disgorgement remedy ameliorates these difficulties, because it requires the promisor to transfer to the promisee the gain the promisor realized from redeploying her resources. The recently adopted Restatement of Restitution permits a court to replace the expectation remedy with disgorgement when the remedy is inadequate,9 and “gain based damages” are beginning to be awarded in England and Israel.10 American courts also increasingly exhibit distaste for restricting contract damages to the promisee’s loss when the promisor benefited from not performing the contract’s substantive terms (Restatement [Third] of Restitution and Unjust Enrichment, § 39[1]‌[2011]).11 Critics even argue that the promisee’s right to they realize mitigation gains. And they are not in fact coerced because they have assumed the duty to mitigate and memorialized this duty in the contract through the lower price. 9  A thoughtful analysis by the drafter appears in Kull (2001). A more recent thorough treatment, which summarizes newer cases and commentary, is Anderson (2015). 10  For England, see Cunnington (2008). For Israel, see Adras Building Material Ltd v Harlow & Jones Gmbh, (1995) 3 Restitution L Rev 235, 240, 242, 246, 249, 261, 268. Adras is criticized in Botterell (2010, 135–​60). 11  Traditionally, disgorgement remedies were awarded only in narrow classes of cases. For example, disgorgement might be awarded in cases in which the breaching party violated a fiduciary or quasi-​ fiduciary duty owed to the victim of the breach. See, e.g., Snepp v United States, 444 US 507, 515–​16 (1980) (awarding the CIA disgorgement of profits earned by a former agent in connection with a tell-​all book published without being vetted as required by his contract of employment with the CIA); X-​It Prods, LLC v Walter Kidde Portable Equip, Inc, 155 F Supp 2d 577, 658 (ED Va 2001) (observing that “equitable remedies” including disgorgement, may be awarded in cases of “wrongfully obtained profits in a variety of contexts, including breach of fiduciary obligation or breach of contract” but suggesting that the proper award of these remedies depends on a factual finding of “unclean hands”); Ajaxo Inc v E*Trade Grp, Inc, 37 Cal Rptr 3d 221, 248 (Cal Ct App 2005) (awarding a disgorgement remedy in connection with breach of a nondisclosure agreement governing trade secrets or proprietary confidential information). Another narrow class of cases, in which disgorgement remedies have historically been awarded, concerns breaches of contract to sell land, where courts, when they are unable to adopt the traditional specific performance remedy for technical reasons, have imposed constructive trusts on breaching sellers and required them to disgorge their gains from breach. See, e.g., Gassner v Lockett, 101 So 2d 33, 34 (Fla 1958) (imposing a constructive trust against a breaching seller where a new buyer’s recording of title prevented the court from ordering specific performance of the sale to the buyer against whom the seller breached). This use of disgorgement comports with our views. Insofar as the common law treats land as unique and makes contracts to sell land specifically enforceable, such contracts do not, properly interpreted, permit sellers to transfer rather than trade. Refusals to trade are, consequently, breaches, full stop.

 

(In)Efficient Breach of Contract    25 trade sometimes should be protected with the strongest remedy: punitive damages (see Shiffrin 2007).

2.3.  A Poorly Framed Dispute Sections 1 and 2 imply that the dispute between proponents and critics of efficient breach theory is poorly framed. This misframing gives considerable force to criticisms of a law that would permit breaches on payment of a price. The critics’ concerns are misplaced, however, because they suppose breaches to exist where there are no breaches. Critics and proponents of the theory incorrectly assume that some contract breaches are efficient but disagree over the morality of particular breaches. If no breach is efficient, however, there is no dispute: a truly breaching promisor is behaving both inefficiently and immorally. Using the example above, when parties write Contract A, the promisor’s failure to trade is an immoral and inefficient breach. When parties write Contract B, the failure to trade is neither. Hence, the only thing to argue about is which contract the parties wrote. Section 3 thus analyzes the two assumptions that underlie our claim that typical parties would and do write Contract B. The assumptions are (a) that renegotiation is infinitely costly; and (b) that contract creation costs are zero. Assumption (a) implies that parties cannot renegotiate ex post, so their choice of a contract is consequential; assumption (b) implies that parties are free to write whatever contract they like. To see why these assumptions matter, first let renegotiation costs be zero. The Coase Theorem teaches that if agents are informed, as in common contracting situations, agents bargain to the efficient allocation of property rights whenever the status quo allocation is suboptimal. To apply the Theorem here, let the law protect the expectation with a property rule—​specific performance—​and assume that trade would be inefficient: the promisor’s loss from trade would exceed the promisee’s gain. In this circumstance, parties would renegotiate to excuse the promisor from trading: that is, the parties would renegotiate to the result that a liability rule would have yielded on its own. Now let there be a liability rule and assume that trade would be efficient: the promisee’s gain from trade exceeds the promisor’s costs. In this circumstance, the promisor simply trades, which is the result that a property rule would have directed. And to summarize, in the ideal Coase Theorem environment that efficient breach theory assumes, efficient performance (and efficient nonperformance) occurs under every rule type. Therefore, though Recently, there has been a trend toward looking more favorably on disgorgement remedies in connection with ordinary breaches of contract. See EarthInfo, Inc v Hydrosphere Res Consultants, Inc, 900 P2d 113, 119–​20 (Colo 1995) (approving restitution for breach of contract where a defendant’s wrongdoing leads directly to her profits); see also Univ of Colo Found, Inc v Am Cyanamid Co, 342 F3d 1298, 1311 (Fed Cir 2003) (recognizing EarthInfo as stating Colorado law); Dastgheib v Genentech, Inc, 438 F Supp 2d 546, 552 (ED Pa 2006)(approving of disgorgement in EarthInfo type situations); and Daily v Gusto Records, Inc, No 3:94-​1090, 2000 US Dist LEXIS 22537, at *6 (MD Tenn Mar 31,( 2000) (endorsing the EarthInfo logic).

 

26    DANIEL MARKOVITS AND ALAN SCHWARTZ parties could write Contract B, they also could write Contract A, which would yield the same result. The theory, that is, cannot explain why parties would contract for any remedy in the feasible set rather than any other remedy. A similar analysis shows that the moral issue concerning efficient breach is not properly joined. Imagine that agents make Contract B. Under it, recall, the parties agree to alternative performances: either they will trade goods or services in exchange for a price or the promisor will make a monetary transfer to the promisee, equal to the gain the promisee would have realized from receiving the goods or services. If contractual promises are understood in this way, as involving a promise either to trade or to transfer, then, as suggested above, a seller who voluntarily transfers rather than trades does not in fact breach the contract. So called efficient breaches are not in fact breaches at all, and a court that requires the promisor to pay expectation damages provides not substitutionary but rather direct relief, specifically enforcing the transfer prong of the dual performance promise. Critics of efficient breach theory may object to this argument because, in their view, Contract B (or the expectation interest remedy that replicates it) is unfair. Under this Contract, critics worry, the promisor captures all of the gains from reallocating her resources to another use, but promisees are entitled to those gains. To see why this fairness objection is misplaced, realize first that parties contract because they anticipate that trading will produce net gains. They anticipate, that is, that buyers’ values of trade will exceed sellers’ costs, so that trade will produce joint surplus.12 But between the time of contract and the time of trade, a buyer’s valuation may fall, or a seller’s costs may rise. Accordingly, even as the parties anticipate gains from trade, it always remains possible that, as events transpire, the parties’ joint surplus will be maximized by not trading. This logic is of course available to the parties when they fix the terms of their contracts. Accordingly, a seller who retains the right to capture nontrading gains at performance time will pay for this right up front, at formation—​her payment will be memorialized in a lower price. The lower price, moreover, increases the difference between the buyer’s value and the contract price and hence the buyer’s expectation damages in the event that the seller opts to transfer rather than to trade. Thus, although the expectation remedy appears to allow the seller to capture the entire gains from “efficient breach,” this appearance deceives. The price mechanism gives buyers a share of all the gains from contracting, including of the nontrading gains associated with “efficient breach.” Put concisely, the buyer’s gain is invariant to the legal remedy.13 12 

For expositional purposes only, and without loss of generality, we refer to promisors as sellers and promisees as buyers. 13  It may help to state this result formally. Let the buyer have property rule protection. The price of the contracted for item, pPR, equals the seller’s costs, c. There are two cost components. The first, denoted (i), is production cost. The second is the bribe, b, the seller expects to pay to the buyer for permission to exit if transfer of the item would be inefficient. Let the probability of inefficient transfer be 0 < θ < 1. The bribe’s expected cost, denoted (ii), thus is θb, and pPR = (i) + (ii). The buyer would realize v from transfer plus the expected value of the bribe. His expectation under property rule protection thus is v + (ii) – p ​ PR = v + (ii) – ((i) + (ii)) = v – (​ i). Now let the buyer have liability rule protection. The seller need not pay a bribe so her costs fall by the bribe’s amount. Hence, pLR = (i). The buyer’s expectation

 

(In)Efficient Breach of Contract    27 On this view, the morality of promise therefore does not favor mandating trade or requiring sellers to disgorge their gains from diverting trade to higher-​valuing third parties. Indeed, a buyer who pays the lower price associated with the expectation remedy but subsequently insists on specific performance (or disgorgement of the nontrading gain produced by an “efficient breach”) claims a benefit that she has not paid for, and that she forswore in her contract (through its price term). One might even say that such a buyer acts in bad faith. The conventional disputes about the theory of efficient breach are therefore poorly framed, and the central issues the expectation remedy raises—​both economic and moral—​are not truly joined. Whereas these issues are framed (by all sides) as concerning the law’s choice of contract remedies, they in fact concern the parties’ choice of contract terms. And whereas the assessment of the expectation remedy is supposed (again, by all sides) to turn on substantive economic or moral arguments, it in fact turns on how best to interpret party intent.

2.4.  Efficient Breach Reconsidered: Would Parties Write Contract B? Parties sometimes explicitly adopt one or the other contract type, as when they contract specifically for trade,14 or when they incorporate a conventionally explicit dual performance “take-​or-​pay” clause. But many contracts give courts less direction on the interpretive question than one might hope; hence the confusion about the theory of efficient breach. How, then, should a court construe a contractual promise whose character is not obvious? Continuing with our illustration, when should a court decide which of Contracts A or B particular parties wrote? becomes v – pLR = v – (i). Therefore, the buyer’s expected gain is invariant to the legal rule. This result is proved for the general case in Markovits and Schwartz (2011, 1959–​1970). 14 

We defend the expectation remedy as a default, not as a mandatory rule. In most jurisdictions, however, current law is mandatory: courts do not enforce contracts for specific performance. See Yorio (1989), supplemented in Thel and Siegelman (2011, 233–​241). The proposed new UCC Article 2, in § 2-​7 16(1), recommends that courts should enforce specific performance terms in commercial contracts, but no states have adopted this Article, and it is about to be withdrawn. Thel and Seigelman (2011) make two claims regarding the disgorgement remedy: (a) it is awarded frequently, and (b) it is an efficient remedy when courts cannot fully protect the promisee’s expectation. The first claim restates the expectation remedy. Thus, market damages—​the difference between the contract price and the ex post market price—​are thought to protect the expectation. A promisor who sells to a third party at the ex post market price must pay market damages to the promisee. Because these damages equal her gain, Thel and Siegelman (2011) classify market damages as a disgorgement remedy. We use the more common classification of these damages here. These authors recognize elsewhere that parties may bargain for liability rule protection or property rule protection when free to do so. See Thel and Seigelman (2009).

 

28    DANIEL MARKOVITS AND ALAN SCHWARTZ Section 1.3 argued that courts should assume parties wrote Contract B because they could conveniently have written Contract A. Economic, moral, and doctrinal considerations reinforce this argument. Contracts that are silent about remedies should be read to make dual performance promises. Beginning with the economic argument, recall our assumptions of infinite renegotiation costs and zero contract-​writing costs. Both sets of costs actually are positive, and when this is so, the common-​law expectation remedy promotes efficiency. To see why, consider the renegotiation case, in which the seller could realize a nontrading gain, and so must decide whether to trade under the contract or not. The expectation remedy allows the seller unilateral discretion to choose, subject to an incentive regime that requires her to internalize the full social costs of her choice. (To observe this simply recapitulates the conventional theory of efficient breach.) Now suppose that the buyer is entitled to specific performance or, analogously, to disgorgement of any gains that the seller captures by declining to trade. It is one thing for the buyer to possess a legal right to these gains, however, and quite another for the buyer in fact to obtain them. Even under a specific performance regime, the seller can deprive her buyer of the nontrading gain, simply by trading. Accordingly, a seller and buyer contemplating nontrading gains will enter into an ex post renegotiation of their contract, in which the seller will purchase the right to exit by offering the buyer his expectation plus a portion of the nontrading gain.15 Renegotiations are costly in general, and there is every reason to suspect that property rule-​triggered renegotiations will be especially costly. When a promisor/​seller rejects trade, a specific performance remedy forces the parties into a bilateral monopoly. Bargaining in this game is zero sum: every dollar the seller pays to the buyer is a dollar that the seller must lose, and the seller’s incentive to resist payment is increasing in the size of the payment the buyer seeks. Moreover, no outside offers from third parties exist to narrow the bargaining space or discipline the parties’ conduct. Because the promisee/​ buyer has a higher ex post payoff under a property rule than under a liability rule, the seller bargains harder, and perhaps less ethically, to avoid paying him under the property rule. Hence, Contract A is more costly to enforce than Contract B is. Commonly used contracts, that is, are insufficiently state contingent and so produce ex post inefficient outcomes with positive probability. Parties ex ante thus have a choice between writing Contract A, which will have to be renegotiated if an inefficient state materializes, and Contract B, which permits unilateral promisor exit and so needs not be renegotiated if an inefficient state materializes. When the parties’ gross return is the same under either contract and renegotiation costs are positive, parties therefore prefer Contract B, which tracks current law. 15 

A restitutionary remedy that permits the promisee to choose between trade and promisor breach plus disgorgement of breach gains would also make the promisee the residual claimant. Moreover, such a remedy might avoid renegotiation costs by empowering the promisee to compel the promisor to “breach” and pay restitution. See Brooks (2006). We focus on the traditional expectation interest remedy because it is much the more common. In addition, as we have argued elsewhere, a promise with the power to compel “breach” and disgorgement is more naturally said to own the promisor, so that contract, as a distinctive form of legal ordering, falls from view. See Markovits and Schwartz (2011, 1992–​1993).

 

(In)Efficient Breach of Contract    29 This preference is strengthened when the zero contracting costs assumption is relaxed, because Contract B is less costly to write than Contract A is. Contract B conditions only on two states of the world—​when trade is efficient and when it is not—​and need not anticipate the parties’ ex post bargaining returns. Contract A must condition on the trade and no-​trade states but also on the state when disgorgement is needed because the promisor has sold the subject of sale, and Contract A also requires the parties to anticipate and so price the renegotiation result.16 Again, because the parties’ gross gain is the same under either contract and contracting costs are lower under Contract B, parties prefer Contract B.

2.5.  Revisting the Moral Issues When parties write Contract B, the promisee trades his right to property rule protection in return for a larger expected return.17 As a consequence, nothing in the nature of dual performance promises renders them any less solemn, and nothing in the nature of the expectation remedy renders the law’s enforcement of dual performance promises any less complete than the conventional morality of promise and contract recommends. Dual performance contracts, thus, are not formally distinctive:  they announce real obligations, which promisors really recognize, even (indeed just as intently) when they honor their promises’ transfer prongs as when they trade. The same holds for the law. When a court awards expectation damages in connection with Contract B—​the dual performance contract—​the court acknowledges rather than denies the contract’s promissory obligation; and, the expectation remedy provides direct rather than substitutionary relief, constituting specific performance of one of the dual performance promise’s two prongs. Indeed, nothing in the nature of dual performance promises precludes the law’s sanctioning true breaches, in which a promisor declines both to trade and to transfer, including even through punitive damages. Moreover, dual performance promises deploy the formal morality of promise in the service of distinctively appealing substantive arrangements. Parties to Contract B recognize that they are assuming genuinely promissory moral and legal obligations. Dual performance contracts prescribe conduct for both the trade and the no-​trade states. But as long as parties respect the constraints that these prescriptions create, they are as free to pursue their respective self-​interests within these promissory relations as they were without them, including when they initially negotiated their promissory engagements. Dual performance contracts reflect negotiated settlements, which simultaneously bind 16 

The contracting cost concern is considered in detail in Markovits and Schwartz (2011, 1973–​1974). Because the parties’ gross gain is the same under either contract, but total transaction costs are lower under Contract B, this contract maximizes net expected surplus. And because the transaction cost savings are reflected in a lower price, the buyer realizes his share of those savings. Hence, the buyer does better under Contract B than under Contract A. 17 

 

30    DANIEL MARKOVITS AND ALAN SCHWARTZ the parties to a real agreement and free the parties from any further legal need or duty to renegotiate, going forward. Unlike fiduciary engagements, which, by their nature, impose open-​ended obligations of general benevolence toward the other party and thus require continuing renegotiations, contracts, properly understood, limit the obligations they impose according to the terms of the initial agreements that the parties struck. Dual performance contracts, and the expectation remedy with which they are associated, enact this central feature of contract. The promisor may remain as self-​interested within her contract as she was without it, and may consult her private advantage in deciding whether to trade or to transfer, as long only as she also vindicates her promisee’s contractual expectations. By contrast, supracompensatory remedies impress contracting parties into obligations of fiduciary benevolence and ongoing readjustment in the administration of contracts, under which promisors’ acquire open-​ended duties to consult their promisees’ interests as they administer their contracts. Supracompensatory contractual remedies thus carry with them implicit instructions concerning how contracting parties must carry out the renegotiations that such remedies inevitably engender. A promisor who applied ruthless self-​interest to these negotiations would surely fall foul of the ideals in whose name the supracompensatory remedies are proposed: a breaching promisor who uses her bargaining power to retain any share of the surplus generated by the breach continues to profit from her own “wrong” just as surely as one who simply keeps the entire ex post surplus under the traditional expectation remedy. Proponents of supracompensatory remedies must therefore condemn such hard bargaining ex post, for the very same reason they (mistakenly) condemn the “opportunistic” efficient breach that they associate with current law. Honoring the ideals that underwrite the case for supracompensatory remedies thus requires parties to renegotiate in a manner that departs radically from the norms governing their initial negotiations. And this is the essence of a fiduciary relationship.18 18  This formulation suggests that the dispute between the conventional understanding of contract and critics who seek to remake contract on a fiduciary model might be characterized in another way, emphasizing doctrines concerning performance rather than remedies for breach. Arguments that favor supracompensatory remedies by invoking fiduciary-​like principles of other regard within the contract relation propose, in effect, to revise the duty of good faith in contract performance. The duty of good faith in performance—​imposed through one of the rare mandatory rules of contract law—​has conventionally been understood to require only that promisors refrain from using vulnerabilities that promisees incurred as a result of contracting to deprive the promisees of benefits that the contracts were intended to secure. See UCC (2011, § 1-​201) (limiting good faith to “honesty in fact and the observance of reasonable commercial standards of fair dealing”). The substantive content of the duty of good faith in performance is thus conventionally fixed according to the terms of the parties’ agreement. This renders it entirely consistent with good faith for a promisor single-​mindedly to pursue her self-​interest within the contract relation, as long as she accepts the contract as a side-​constraint. Therefore, it is not bad faith for a promisor to comply with Contract B by honoring its transfer rather than its trade prong. Critics of the expectation remedy thus misapply the duty of good faith, on its conventional understanding, because it cannot be bad faith to comply with a contract. Alternatively, the critics are implicitly rejecting the conventional understanding in favor of an alternative account, on which good faith requires not just respecting the promise but an open-​ended, fiduciary-​like regard for the other party. See Markovits (2014).

 

(In)Efficient Breach of Contract    31 Contract B thus not only is more efficient than Contract A—​the contract associated with supracompensatory remedies; Contract B also is more solicitous of contract law’s core moral values. Because the dual performance contract leaves the contracting parties in control of the substance of their obligations, and, in particular, because the Contract imposes only obligations the parties assumed ex ante, the Contract better respects freedom of contract. Dual performance contracts also work better than fiduciary contracts at fashioning contractual trust in a manner appropriate to the relations among traders who approach one another at arm’s length in open, cosmopolitan economies (as even the critics of the expectation remedy accept that traders typically do). Trading partners in such economies approach their exchanges not just with divergent interests; they may also have divergent conceptions of fairness and the general interest. A large part of contract law’s moral and political appeal lies in its capacity to support respectful exchange among persons who agree on little (or perhaps nothing) besides the terms of their exchange. In order to support exchange under such circumstances of pluralism, contract law must allow trading partners to cabin their obligations as narrowly as they wish, and thus to remain, in spite of their contracts, at arm’s length in respect of all matters that their agreements do not cover. By allowing such arms’ length exchange, moreover, contract law supports a valuable and distinctive form of interpersonal respect. Exchange partners appreciate each other’s universal humanity, recognizing each other in respect of the deliberative and intentional capacities that all persons share (whatever their interests) rather than in respect of more particular, and hence more contingent, substantive interests and concerns. Precisely because it cabins contractual enforcement according to the terms of the parties’ initial agreement, the expectation remedy supports broad-​based contracting that embodies this model of interpersonal respect. A contract law that imposed supracompensatory remedies and embraced a fiduciary ideal would cast its net more narrowly and replace this conception of respect with another.19

2.6.  Contract Doctrine Instantiates Dual Performance Obligations Recall once again that though parties contract in order to realize gains from trade, sophisticated parties know that trading may not generate gains in every future state and that sometimes surplus can be increased by not trading. The parties (who wish to maximize total surplus ex ante) thus have reason to plan for both the case in which trade is efficient ex post and the case in which not trading is efficient. In a transactions costly world, for reasons rehearsed earlier, the expected contractual surplus across both states

19 

See, generally, Markovits (2011); Markovits and Schwartz (2011).

 

32    DANIEL MARKOVITS AND ALAN SCHWARTZ is maximized by agreeing that when trade turns out to be inefficient ex post, the seller may divert performance as efficiency requires, as long as she makes a transfer equal to the buyer’s valuation of trade. Observe, further, that allowing the seller to retain the entire gains received ex post from refusing to trade does not entail that she acquires the entire expected value of the nontrading surplus ex ante. The contracting parties, after all, bargain ex ante over the whole expected contractual surplus, and a contract term that increases nontrading surplus ex post must also increase contractual surplus ex ante and thus (because the term cannot by itself alter the parties’ relative bargaining powers) also increase the buyer’s surplus ex ante. This result is achieved through the mechanism of the price; the contract price falls where a contract allows the seller to avoid inefficient trade by making a transfer equal to the buyer’s expectation. The lower price allows the buyer to share in both the trading and the nontrading gains from contracting. The lower price has another consequence. Because the buyer’s gains from contracting equal her value minus the price, the lower price just contemplated increases the buyer’s expectation interest. In this way, the lower price also increases the transfer that the seller must make in lieu of trading. The contract’s price term and transfer term are thus necessarily intertwined. Put differently, contracting parties (who can anticipate not just trade but also the possibility of not trading) necessarily choose the remedies associated with the prices that they set. The transfer prong of a dual performance contract is therefore just as real as the trade prong; it is memorialized in the contract through the price term (which, once again, fixes the gain to buyers not just from trade but from transfer, because the required transfer amount equals the value to them of trade, minus the price). A contract’s price term is thus an implied-​in-​fact liquidated damages clause that establishes the liquidated amount as an alternative performance. Ordinary contracts, rightly understood, are dual performance contracts. The positive law acknowledges and incorporates this insight. To be sure, the Restatement appears superficially to take another view. Section 361 thus recites, “Specific performance or an injunction may be granted to enforce a duty even though there is a provision for liquidated damages for breach of that duty” (Restatement 1981, § 361). The first comment to this section adds that “[m]‌erely by providing for liquidated damages, the parties are not taken to have fixed a price to be paid for the privilege not to perform,” so that “[s]uch a provision does not, therefore, preclude the granting of specific performance or an injunction if that relief would otherwise be granted” (Restatement 1981, § 361cmt a). If liquidated damages are substitutionary, as the Restatement apparently suggests, then the expectation remedy should be substitutionary as well. A better interpretation of the Restatement, however, recognizes that these remarks do not reject the dual performance hypothesis but rather underestimate how frequently parties contract in the alternative. Although section 361 instructs courts not to infer a party intention to price the refusal to perform the contract’s trade terms from the “mere” presence of a liquidated damage clause, parties plainly remain permitted to price this refusal. The comment goes on to say, “there is no reason why parties may not fix such a

 

(In)Efficient Breach of Contract    33 price [at which a promisor may replace trade with transfer] if they so choose.” Further, the comment instructs courts to deny an injunction to enforce a contract’s trade terms whenever “a contract contains a provision for the payment of such a price as a true alternative performance” (Restatement (Second) of Contracts 1981, § 361 cmt b [emphasis added]). Moreover, courts applying the Restatement are receptive to the possibility that a contract might incorporate an alternative promise. Although courts will specifically enforce trade despite an express transfer term where the transfer is “intended to be mere security for the performance of the principle [sic] obligation,” they also insist that “where the sum specified may be substituted for the performance of the act at the election of the person by whom the money is to be paid, or the act done, equity will deny specific performance” (Duckwall v Rees, 86 NE2d 460, 462 [Ind App 1949] [en banc]). Courts following this reasoning deny specific performance of the trade terms to a promisee whose promisor complied with a liquidated damages clause. See, e.g., Davis v Isenstein, 100 NE 940 (Ill 1913); O’Shield v Lakeside Bank, 781 NE2d 1114 (Ill App Ct 2002); Moss & Raley v Wren, 120 SW 847 (Tex 1909). Pomeroy’s (1897) treatise on Specific Performance of Contracts thus observes: Where the parties to an agreement, whatever may be the subject-​matter or the terms, have added a provision for the payment, in case of a breach, of a certain sum which is truly liquidated damages and not a penalty—​in other words, where the contract stipulates for one of two things in the alternative, the performance of certain acts, or the payment of a certain amount of money in lieu thereof—​equity will not interfere to decree a specific performance of the first alternative, but will leave the injured party to his legal remedy of recovering the money specified in the second.20 (emphasis added)

Courts apply this general principle even when they hold that in a particular case a promisee’s right to specific performance of trade survives a liquidated damages clause. For example, a Florida case holding that “[a]‌provision for liquidated damages in a contract does not necessarily bar injunctive relief against its breach” adds, in the next sentence, “If, however, it appears that the liquidated damages clause was intended to furnish a party the alternative of performance or payment or was to be an exclusive remedy, an injunction will not be issued” (Beery v Plastridge Agency, Inc, 142 So 2d 332, 334 [Fla Dist Ct App 1962]).21 The law thus adopts the dual performance hypothesis’s understanding of the expectation remedy as a conceptual matter, even where the law concludes, with respect to a particular contract, that a promisor is not entitled to transfer in lieu of trade. Of course, our earlier economic analysis suggests that sophisticated parties typically do write dual performance contracts. Finally, a case may even be made that the law generally or at least commonly interprets contracts that do not contain liquidated damages clauses as making an appropriate

20 

See also Duckwall, 86 NE2d at 462. The court cites, among other authorities, to Restatement (First) of Contracts § 378, which is the predecessor to Restatement (Second) § 361. Id. 21 

 

34    DANIEL MARKOVITS AND ALAN SCHWARTZ transfer into an alternative performance. Consider, for example, the treatment of cases in which a contract fails explicitly to make a stipulated remedy exclusive, the promisor volunteers transfer under the remedy, and the promisee seeks more. The UCC addresses these cases in two provisions: Section 2-​7 18 directs courts to enforce liquidated damage clauses and Section 2-​7 19 directs courts to enforce clauses that limit remedies, though it adds, in Section 2-​7 19(1)(b), that “resort to a remedy as provided [by the contracting parties] is optional unless the remedy is expressly agreed to be exclusive” (UCC 2004, §2-​7 19(1)(b)). This language raises the question whether Section 2-​7 19(1)(b)’s requirement of an express exclusivity agreement for remedy limitations also applies to the liquidated damage clauses that Section 2-​7 18 regulates. The answer is that it does not: liquidated damages clauses adopted under Section 2-​7 18 are interpreted to exclude other remedies even without an express statement. To see why, begin with the language of the statute, which recites that liquidated damages are not subject to the express exclusivity requirement that governs remedy limitations. Section 2-​7 19(1) makes its exclusivity requirement “subject to … the preceding section on liquidation and limitation of damages” (§ 2-​7 19(1)). Courts have taken this direction seriously; a prominent opinion observes that a liquidated damage clause is “not a limitation on a remedy” (N Ill Gas Co v Energy Coop, Inc, 461 NE2d 1049, 1056 [Ill App Ct 1984]).22 Rather, “the concepts are separate and distinct,” so that liquidated damage clauses are governed not by Section 2-​7 19(1)(b) but rather by Section 2-​7 18, which does not “impose the additional restraints” attached to limitations of remedy (N Ill Gas Co v Energy Coop, Inc, 461 NE2d 1049, 1056 [Ill App Ct 1984]). A liquidated damage clause, the court concluded, is the promisee’s sole remedy against a promisor who rejects trade even when the clause is not made expressly exclusive. Indeed, the court reached this broad conclusion although, in the case at hand, the liquidated damages transfer constituted less than 10 percent of the value the promisee would have realized from trade. Hence, the clause had the same practical effect as a limitation of remedy (N Ill Gas Co v Energy Coop, Inc, 461 NE2d 1049, 1056 [Ill App Ct 1984]). As another court observed, “a liquidated damages clause, without evidence to the contrary, is so inconsistent with any other [d]‌amage remedy as to require a conclusion that it contemplates exclusiveness” (Ray Farmers Union Elevator Co v Weyrauch, 238 NW2d 47, 50 [ND 1975]).23 This approach—​and in particular, its insistence on the formal distinction between remedy limitations and liquidated damages clauses even in the face of the two provisions’ 22 

The court’s view is correct. A remedy limitation attempts to allocate efficiently between sellers and buyers the duty to repair and preserve the goods. The remedy aspect requires the seller to repair or replace when she can do this most efficiently; the limitation aspect puts risks on the buyer that he can best reduce by careful use. A liquidated damages clause has a different function. 23  The inclusion of the phrase “without evidence to the contrary” signals that the parties may, of course, create a contract that identifies a sum of money as merely substitutionary relief if they so choose. And some courts, latching on to the specifics of contractual language in particular cases, have given particular provisions this effect. See, also, Beck v Mason, 580 NE2d 290, 293 (Ind Ct App 1991). This possibility is entirely consistent with the dual performance hypothesis, which does not make the rule that transfer can count as performance mandatory.

 

(In)Efficient Breach of Contract    35 substantially identical practical effect—​would be nonsensical if contract damages provided only substitutionary relief. The comment to UCC Section 2-​719 observes: “Subsection (1) (b) creates a presumption that clauses prescribing remedies are cumulative rather than exclusive” (UCC § 2-​719 cmt 2 [2004]). Accordingly, if a liquidated damages clause were understood merely to identify a substitutionary remedy for the promisor’s refusal to trade, then this remedy would naturally fall under the UCC’s presumption in favor of cumulation and against exclusivity. That the remedy does not fall under this presumption, but instead is held to be exclusive even if the contract does not so state could reflect rational drafting only if the UCC understands liquidated damages clauses to be different things from remedy limitations. In the Code’s view, parties do not write liquidated damage clauses merely to identify substitutes for a promisor’s failure to perform the contract’s trade terms; rather, as the dual-​performance hypothesis proposes, parties intend compliance with these clauses to be an alternative means of performance. Consequently, a court that orders a transfer pursuant to a liquidated damage clause is directing specific relief of an obligation in the alternative. This is the basic insight achieved by courts when they observe that UCC Section 2-​ 718, which governs liquidated damages provisions, takes precedence over Section 2-​7 19’s rules concerning limitations of remedies. As another court explained, it is a “valid argument generally … that if a liquidated damage clause [is] created under Section 2.718, it … logically self operate[s]‌” so that the other remedies generally contemplated by the law are no longer available (McFadden v Fuentes, 790 SW2d 736, 738 ([Tex Ct App 1990]).24 The turn to the idea of “self-​operating” is instructive; it suggests, as under the dual-​ performance hypothesis, that the liquidated damages clause in itself identifies the content of the promisor’s contractual obligation. There is no need to feed the clause through the conventional substitutionary logic of the law of remedies in order to fix its legal effect. Indeed, there are opinions that adopt the language in which the dual performance hypothesis is cast, saying that an appropriate “provision for liquidated damages limits the non-​breaching party to a suit for specific performance of the liquidated-​damages provision” Mkt Place P’ship v Hollywood Hangar, LLC, No CA 06-​749, 2007 WL 1086573 (Ark Ct App Apr 11, 2007) (emphasis added).25 The UCC’s treatment of liquidated damage provisions is neither a narrow technicality nor an outlier (that is, a departure from the common law). Instead, it tracks the interpretive presumptions associated with the expectation remedy quite generally.26 The UCC is striking merely because it recapitulates these presumptions in a somewhat surprising arena—​surprising because of the contrast between the treatment of liquidated damage 24  The edits in the quotation indicate that the court’s statement was counterfactual because the court found that the liquidated damages clause at issue in that case was invalid for independent reasons. 25  It is commonplace for courts to hold that a liquidated damages clause forecloses claims not just for the money value of trade as substitutionary relief but also for specific performance of the promise to trade. See Gilman Yacht Sales, Inc v FMB Invs, Inc, 766 So 2d 294, 296 (Fla Dist Ct App 2000). 26  Other sections of the UCC also support this chapter’s view, at least in some measure. The chapter confines discussion of these sections to the margin because they do not go directly to the dual performance hypothesis, in its core application, so much as reveal that law decides peripheral matters in ways that are consistent with the dual performance approach. Section 2-​508 (which governs cure by

 

36    DANIEL MARKOVITS AND ALAN SCHWARTZ provisions under Section 2-​7 18 and remedy limitations under Section 2-​7 19(1)(b), a contrast that lays bare what would otherwise remain hidden. These observations naturally carry over to contracts without express liquidated damages provisions, supporting the view that the expectation remedy is not a form of substitutionary relief provided by the law but is adopted by the parties as a liquidated damage clause, whose textual expression appears through the price term and that term’s implications for surplus sharing.27 The law’s preference for the expectation remedy over specific performance, conventionally understood, is now revealed to be a direct analog to the UCC’s treatment of more ordinary liquidated damages clauses: just as the UCC treats conventional liquidated damages clauses as presumptively exclusive, so the common law treats the expectation remedy as presumptively exclusive, that is, as precluding specific performance of trade terms. And just as with respect to the UCC’s rules, the common law’s approach would be inexplicable if the expectation remedy merely gave promisees access to a form of substitutionary relief. The same intuition that underlies UCC Section 2-​7 19(2)—​that contract remedies should be cumulative—​would apply to the common law also, to reject the interpretive presumption that the expectation remedy is a promisee’s exclusive recourse when a promisor refuses to transfer. Just as with respect to UCC Section 2-​7 18, the common-​law rule that makes expectation the preferred remedy for sellers whose performance has failed to satisfy the perfect tender requirement of Section 2-​601) allows the parties to “reach an agreement as to the type of cure provided … and … [to] agree that a money allowance against the price is to be given by the seller to compensate for defects in the goods” (Lord 2010). Moreover, some courts have observed that a money allowance may be established not only by express agreement but also by trade usage. See N Am Steel Corp v Siderius, Inc, 254 NW2d 899, 904 (Mich Ct App 1977). These rules adopt a version of the dual performance hypothesis, in effect making transfer of part of the value of trade (coupled with imperfect trade) into an alternative form of performance. Admittedly, no cases were found in which transfer of the full value of the trade was treated as a “cure” for the “imperfect tender” of not tendering trade at all. In addition, the dual performance hypothesis receives support from doctrines that make it easier for sellers to recover the price than for buyers to receive specific performance of trade terms. Compare UCC § 2-​709 (2011), with id. § 2-​7 16. If contracts contained only simple promises to trade, and expectation damages were merely substitutionary, then this difference would find no justification in the basic structure of contract law but would appear, rather, to reflect a special privilege for sellers (justified, perhaps, because it is cheaper to enforce promises to pay money than to do other things). In the context of a dual performance promise, by contrast, the seller’s “action for the price” under § 2-​709 and the buyer’s “right to specific performance” under § 2-​7 16 are not perfect analogs. Compare UCC § 2-​709, with id. § 2-​7 16. Whereas sellers promise to trade or to transfer money equal to the buyer’s value of trade, buyers promise to pay the price or to transfer money equal to the seller’s value of receiving the price in exchange for the goods. The money to be transferred under the second prong of the buyer’s promise will—​for example, where the buyer has accepted the goods—​often be simply the price. Giving sellers the right to receive the price therefore does not reflect any preference for sellers or give sellers greater access than buyers to direct relief. Rather, the difference between these provisions reflects an asymmetry in the content of the parties’ substantive entitlements under their dual performance contracts. 27 

A liquidated damages clause states a number. The expectation-​interest remedy is a formula for creating a number (that is, value less price). Parties have an incentive to use the number when the formula cannot be applied because the buyer’s value is unverifiable. The parties’ goal does not change with the choice between a number and a formula, however. In both cases, the parties usually prefer to permit the promisor to choose between trade and transfer.

 

(In)Efficient Breach of Contract    37 breach of contract thus implies that contracts should be interpreted, pursuing the logic of our model, to make transfer of a sum equal to the promisee’s expectation an alternative form of performance. In taking this approach, the law interprets common agreements as being Contract Bs—​the contracts that reflect the dual performance hypothesis. The general legal treatment of the expectation remedy thus is best understood in terms of an implied-​in-​fact liquidated damages clause (fixed by the price term), along the lines suggested here. To be sure, decision makers and commentators sometimes characterize the expectation remedy as providing substitutionary relief (damages) for breach of a contractual obligation to trade. But both what courts do in administering the expectation remedy and the rules under which they do these things are best explained (indeed, understood at all) only if this remedy is seen to provide direct relief for breach of the transfer prong of a promise in the alternative.28 The law thus adopts the conceptual structure associated with the dual-​performance hypothesis, allowing the parties to treat transfer as an alternative form of performance, as that hypothesis recommends. Moreover, the law commonly adopts the interpretive presumption associated with the dual-​performance hypothesis: the rule that a liquidated damage clause is the promisee’s exclusive remedy (even though not expressly made exclusive) is understandable only if the clause establishes the transfer it specifies as an alternative form of performance; and the law’s underlying preference for the expectation remedy over specific performance makes doctrinal sense only if this remedy is understood through the model of liquidated damages.

2.7. Conclusion The expectation remedy is commonly cast as providing merely substitutionary relief of contractual promises to trade goods or services for a price. The conventional theory of efficient breach implicitly adopts this account and defends the remedy, so understood, by arguing that expectation damages provide efficient incentives for promisors to perform or to breach. Critics of the remedy, and of the theory, insist that breaching is wrong even if it is efficient. The dispute between the supporters and critics of efficient breach theory rests on a false premise, which is that efficient breaches exist. Rather, if contract terms are efficient, then breaches cannot be, because a breach is the failure to comply with a contract term. Courts suppose that sophisticated parties write efficient terms so the relevant question 28 

These are the natural explanada of functionalist and formalist accounts of law, respectively. No prominent approach to understanding law devotes substantial attention to editorial characterizations of the law. Indeed, such editorializing (even coming from courts) does not belong to the primary law at all but rather is itself a secondary effort to explain the law—​an alternative legal theory rather than a new datum for theory to explain.

 

38    DANIEL MARKOVITS AND ALAN SCHWARTZ is interpretive: what contract did the parties write? Thus, if the contract required the promisor to trade a specified item (called Contract A above), then the failure to deliver the item would be a breach; but if the contract required the promisor either to trade the item or to transfer to the promisee his expectation (called Contract B above), then the failure to trade the item would not be a breach. But the failure either to trade or to transfer would be. And neither breach would be efficient. Parties write Contract B rather than Contract A  when they are symmetrically informed and do not use the contract to induce relation-​specific investment.29 Both contracts yield ex post efficiency—​parties trade only when trade is efficient—​but Contract B is less costly to write and to enforce. Contract law effectively enacts Contract B as the default because the law protects only the promisee’s expectation. Hence, the expectation interest is an efficient remedy.30 And when a court confronts a true breach of a dual promise—​Contract B—​and awards expectation damages, the court provides not substitutionary but rather direct relief. The expectation remedy, properly understood, is thus a form of specific performance. Critics of efficient breach theory therefore are right and wrong. They are right that contract breaches violate promisee rights and may be inefficient. But they are wrong because they see breaches where none exist. Supporters of efficient breach theory also should give up. Insofar as contracts are efficient, breaches are not.

Acknowledgments The arguments in this chapter borrow from our prior work, including, Markovits and Schwartz (2011) (from a symposium in honor of the thirtieth anniversary of the publication of Contract as Promise and (2012)) and Markovits (2014).

References Adras Building Material Ltd v Harlow & Jones Gmbh, (1995) 3 Restitution L Rev 235, 240, 242, 246, 249, 261, 268. Ajaxo Inc v E*Trade Grp, Inc, 37 Cal Rptr 3d 221, 248 (Cal Ct App 2005). Anderson, Roy Ryden. 2015. “The Compensatory Disgorgement Alternative to Restatement Third’s New Remedy for Breach of Contract.” Southern Methodist University Law Review 68, n. pag. Beck v Mason, 580 NE2d 290, 293 (Ind Ct App 1991). Beery v Plastridge Agency, Inc, 142 So 2d 332, 334 (Fla Dist Ct App 1962).

29 

When information is asymmetric, parties prefer either liquidated damages or specific performance, which is Contract A. Contracts would sometimes best protect investment with penalties, but penalties are difficult to enforce. See Edlin and Schwartz (2003). 30  That the expectation remedy is efficient is unsurprising. Common-​law contract rules that have survivorship value commonly are efficient. See Schwartz and Scott (2016).

 

(In)Efficient Breach of Contract    39 Birmingham, Robert L. 1970. “Breach of Contract, Damage Measures, and Economic Efficiency.” Articles by Maurer Faculty. Paper 1705. Available at:  [Accessed 18 July 2016]. Botterell, Andrew. 2010. “Contractual Performance, Corrective Justice, and Disgorgement for Breach of Contract.” Legal Theory 16(3), pp. 135–​160. Brooks, Richard R.W. 2006. “The Efficient Performance Hypothesis.” (2006). Faculty Scholarship Series. Paper 1698. Available at:  [Accessed 18 July 2016]. Calabresi, Guido and Melamed, Douglas A. 1972. “Property Rules, Liability Rules, and Inalienability: One View of the Cathedral.” Faculty Scholarship Series. Paper 1983. Available at:  [Accessed 18 July 2016]. Cunnington, Ralph. 2008. “The Assessment of Gain-​Based Damages for Breach of Contract.” Modern Law Review 71(4), pp. 559–​560. Daily v Gusto Records, Inc, No 3:94-​1090, 2000 US Dist LEXIS 22537, at *6 (MD Tenn Mar 31 (2000). Dastgheib v Genentech, Inc, 438 F Supp 2d 546, 552 (ED Pa 2006). Davis v Isenstein, 100 NE 940 (Ill 1913). Duckwall v Rees, 86 NE2d 460, 462 (Ind App 1949) (en banc). EarthInfo, Inc v Hydrosphere Res Consultants, Inc, 900 P2d 113, 119–​20 (Colo 1995). Edlin, Aaron S. and Schwartz, Alan. 2003. “Optimal Penalties in Contracts” 78 Chi.-​Kent Rev. 33. Available at:  [Accessed 18 July 2016]. Ferriell, Jeff. 2009. Understanding Contracts. 2nd ed. LEXISNEXIS. Friedman, Daniel. 1989. “The Efficient Breach Fallacy.” Journal of Legal Studies 18(1), pp. 1–​24. Gassner v Lockett, 101 So 2d 33, 34 (Fla 1958). Gilman Yacht Sales, Inc v FMB Invs, Inc, 766 So 2d 294, 296 (Fla Dist Ct App 2000). Hillman, Robert A. 2009. Principles of Contract Law. 2nd ed. Eagan, MN: West. Kull, Andrew. 2001. “Disgorgement for Breach, the ‘Restitution Interest,’ and the Restatement of Contracts.” Texas Law Review 79, pp. 2021–​2053. Lord, Richard A. 2010. 18 Williston on Contracts § 52.28. 4th ed. (“Nature of Cure”). McFadden v Fuentes, 790 SW2d 736, 738 (Tex Ct App 1990). Markovits, Daniel. 2011. “Promise as an Arm’s Length Relation.” In: Hanoch Sheinman, ed. 2011. Promises and Agreements: Philosophical Essays. New York: Oxford University Press. Markovits, Daniel and Schwartz, Alan. 2011. “The Myth of Efficient Breach: New Defenses of the Expectation Interest.” Virginia Law Review 97, pp. 1939, 1959–​1970. Markovits, Daniel and Schwartz, Alan. 2012. “The Expectation Remedy and the Promissory Basis of Contract.” Suffolk Law Review 45, pp. 799–​825. Mkt Place P’ship v Hollywood Hangar, LLC, No CA 06-​749, 2007 WL 1086573 (Ark Ct App Apr 11, 2007). Moss & Raley v Wren, 120 SW 847 (Tex 1909). N Am Steel Corp v Siderius, Inc, 254 NW2d 899, 904 (Mich Ct App 1977). N Ill Gas Co v Energy Coop, Inc, 461 NE2d 1049, 1056 (Ill App Ct 1984). O’Shield v Lakeside Bank, 781 NE2d 1114 (Ill App Ct 2002). Pomeroy, John Norton. 1879. A Treatise on the Specific Performance of Contracts. New York: Banks and Brothers. Posner, Richard A. 1972. Economic Analysis of Law. New York: Little Brown. Ray Farmers Union Elevator Co v Weyrauch, 238 NW2d 47, 50 (ND 1975). Restatement (Second) of Contracts §344, cmt a (1981) American Law Institute.

 

40    DANIEL MARKOVITS AND ALAN SCHWARTZ Restatement §235(2). Restatement (Third) of Restitution and Unjust Enrichment § 39(1) (2011). Schwartz, Alan. 1990. “The Myth that Parties Prefer Supracompensatory Remedies:  An Analysis of Contracting for Damage Measures.” Yale Law Journal 100, pp. 369. Schwartz, Allan and Scott, Robert E. 2016. “The Common Law of Contract and the Default Rule Project.” Virginia Law Review 102, pp. 1523. Shavell, Steven. 1980. “Damage Measures for Breach of Contract.” Bell Journal of Economics 11, pp. 466–​90. Shiffrin, Seana Valentine. 2007. “The Divergence of Contract and Promise.” Harvard Law Review 120, pp. 708–​753. Shiffrin, Seana Valentine. 2009. “Could Breach of Contract be Immoral?” Michigan Law Review 107, pp. 1551–​1568. Shiffrin, Seana Valentine. 2012. “Must I Mean What You Think I Should Have Said?” Virginia Law Review 98, pp. 159–​176. Snepp v United States, 444 US 507, 515–​516 (1980). Thel, Steve and Seigelman, Peter. 2009. “Willfulness versus Expectation: A Promisor-​Based Defense of Willful Breach Doctrine.” Michigan Law Review 107, pp. 1517, Cumulative Supplement 233–​241 Thel, Steve and Seigelman, Peter. 2011. “You Do Have to Keep Your Promises: A Disgorgement Theory of Contract Remedies.” William & Mary Law Review 52, p. 1181. UCC § 1-​305(a). UCC §2-​7 19. UCC Article 2, in § 2-​7 16(1). UCC (2011, § 1-​201). UCC §2-​7 19(1)(b) (2004). UCC § 2-​7 19 cmt 2 (2004). Univ of Colo Found, Inc v Am Cyanamid Co, 342 F3d 1298, 1311 (Fed Cir 2003). X-​It Prods, LLC v Walter Kidde Portable Equip, Inc, 155 F Supp 2d 577, 658 (ED Va 2001). Yorio, Edward. 1989. Contract Enforcement:  Specific Performance and Injunctions. New York: Little Brown. 439–​448.

 

Chapter 3

EC ONOM ICS OF TORT  L AW Jennifer Arlen

3.1. Introduction Every day, people take actions for their own benefit that impose a risk of harm on others.1 They use the health and safety of others as a means to their own ends. Many risky activities benefit both the risk-​imposer and society; others only benefit the risk-​imposer, and impose a net cost on society as a whole. Thus, most societies seek to regulate, rather than prohibit, activities that create risk. Social welfare is maximized when society deters risk-​producing activities whose expected costs exceed the social benefits and induces risk-imposers to invest optimally in precautions needed to reduce risk (see generally Coase 1960; Calabresi 1970; Shavell 1980). Tort liability is one of the most potentially effective mechanisms for optimally deterring risk. When properly structured, tort liability can use the threat of liability for harm caused to deter socially harmful activities and induce optimal precautions by both injurers and victims (e.g., Shavell 1980; Landes and Posner 1980, 1987). The central aim of the economic analysis of law is to identify the rules governing liability, damages, and procedure that induce optimal investment in risk reduction and optimal activity levels. Yet in order to determine the structure of optimal tort liability, it is important to identify the central challenges that tort liability is designed to address. Tort liability is far from costless. The tort system itself imposes social costs in the form of litigation costs, the fixed costs of a court system, and the costs associated with liability-​induced distortions in incentives (see, generally, Calabresi 1970). It also is not the only mechanism available to deter people from creating excessive risk of harm. Others mechanisms include private ordering, ex ante regulatory duties and monitoring, and ex post regulatory enforcement. 1  Jennifer Arlen is Norma Z. Paige Professor of Law, New York University School of Law. I benefited from the helpful comments of Giuseppe Dari-​Mattiacci, Mark Geistfeld, Jennifer Reinganum, Francesco Parisi, and Abraham Wickelgren, as well as from the financial support of the D’Agostino/​Greenberg Fund of the New York University School of Law.

 

42   JENNIFER ARLEN This suggests that, in order to be optimal, tort liability should be employed to induce optimal precautions only when it is a welfare-​enhancing alternative or supplement to alternative mechanisms, such as private ordering or regulation (see, e.g., Coase 1960; Calabresi and Melamed 1972; Epstein 1976; Spence 1977; Shavell 1980, 1984; Landes and Posner 1987; Polinsky 1980). Thus, economic analysis of torts must address both the optimal domain and structure of tort liability. Indeed, these two inquiries are inextricably linked. Tort liability is needed in certain circumstances and not others, and these circumstances determine the goals that optimal liability rules should be designed to achieve. Tort liability thus is not justified by the presence of risk-​producing activities alone. Instead, tort liability is justified by the combination of risk-​producing activities and substantial information and transactions costs. Tort liability is not needed when information is costless and transactions costs are low because, in this situation, private ordering will induce optimal risk-​taking. When transactions costs are low and parties are perfectly informed, private bargaining or market forces should induce optimal precautions (Coase 1960; Calabresi and Melamed 1972; see, e.g., Spence 1977; Shavell 1980; Polinsky 1980). Private ordering will not suffice when transactions costs are high (Coase 1960). But even here tort liability may not be needed when everyone is perfectly informed. In this situation, the state may be more effectively able to induce the desired precautions through regulation: it could specify the optimal precaution, and use its costless observation of actual conduct to intervene to sanction noncompliance (e.g., Kaplow 1992; Shavell 1984; Shavell 2014; see Epstein 2013). Tort liability is needed, and is potentially superior to regulation, when information is sufficiently costly that regulators cannot optimally determine and specify the optimal precaution for each activity ex ante, adequately monitor conduct to ensure compliance, or detect (and sanction) breach ex post (e.g., Kaplow 1992; Shavell 1984, 2014; see Epstein 2013).2 The conclusion that tort liability is needed to optimally deter risk when information costs are substantial has two important implications for the economic analysis of tort liability. First, it reveals that economic analysis of optimal tort rules generally should 2 

This discussion only touches on the considerations that determine the use of liability versus regulation. Other considerations include potential insolvency, interest group capture, and differences between private and social incentives to sue. Whatever are the considerations affecting the decision to use tort liability, these considerations should be taken into account when determining the optimal structure of tort liability and the features of the models used to analyze it. One potential consideration that is not seriously addressed in this chapter is the fact that tort liability provides compensation to victims (Shavell 1987, 206–​27). There are several reasons not to focus on this distinction. First, it is not an essential difference: regulators, in theory, could (and in some cases do) impose restitutionary sanctions in order to compensate injured victims. Second, when negligence functions optimally, injured victims are not compensated in equilibrium because injurers take due care (Shavell 1980; but see Arlen and MacLeod 2005a). Third, tort liability generally cannot be justified primarily on compensation grounds if lower cost first-​party insurance is readily available, because liability is a very costly and time-​consuming way of getting compensation to victims. What justifies tort liability, instead of insurance or no-​fault, is deterrence. When we look at deterrence-​based arguments for liability, information costs (and related considerations) tend to lie at the foundation of arguments for imposing tort liability in addition to (or instead of) regulation.

 

ECONOMICS OF TORT LAW    43 employ economic models where information is costly. Second, it reveals that the goals of optimal tort liability should extend beyond optimal precautions (and activity levels), as classically understood. In many situations, people undertaking risky decisions are imperfectly informed about the available precautions and their costs and benefits. They can, but may not, invest in obtaining information needed to improve their decisions. In these situations, a central purpose and effect of tort liability should be to induce optimal acquisition of information needed to identify the optimal level of care. In addition, when information is costly, people conducting complex activities that naturally require multiple participants are more likely to conduct these activities through organizations—​generally corporations—​than through contracts (Coase 1937). In this situation, information costs alter the scope of optimal tort liability by introducing an additional player, the organization, whose incentives and capacity to influence care must be considered and guided toward optimal decisions. Tort liability also can enhance deterrence by providing risk-​imposers incentives to make decisions regarding care within and through an organization, when this would reduce total expected accident costs (including the expected cost of information acquisition). This chapter presents economic analysis of optimal tort liability focusing on the use of liability where information is costly, and private parties cannot provide optimal incentives through private ordering. It shows that the central motivations for tort liability—​ imperfect contracting and costly information—​alter its optimal structure and incentive effects, both as applied to individual injurers and risk-​imposers operating within organizations. Section 3.2 examines optimal tort liability in the context where liability is most obviously needed: where injurers and victims are “strangers,” in that they cannot plausibly bargain over optimal risk prevention or responsibility for losses. This section begins with the foundational analysis of accidents between strangers when all parties possess perfect costless information. This analysis shows that many liability rules—​negligence (with and without contributory or comparative negligence) and strict liability with contributory negligence)—​induce optimal behavior by both potential injurers and victims (e.g., Brown 1973; Shavell 1980; Landes and Posner 1987). It then examines optimal liability when information is costly: when injurers or courts must incur costs to determine optimal (or actual) precautions and can do so only imperfectly. This section examines how information costs affect the goals of optimal deterrence, the optimal structure of liability and damages rules, and the effect of liability on injurers’ and victims’ incentives to deter risk optimally. Section 3.3 examines tort liability when injurers and victims are in a market relationship, as is the case with product liability and medical malpractice. This part identifies the factors justifying the liability in market settings. The analysis of strict liability focuses on product liability; the analysis of negligence liability focuses on medical malpractice. Again, information costs are shown to affect the optimal structure and incentive effects of liability and damage rules. Section 3.4 examines the argument that liability in market settings need not be imposed by the state because it will be optimally supplied by contract. It shows that this

 

44   JENNIFER ARLEN argument generally is not correct because information costs and other impediments to optimal contracting will usually render contracting over liability inefficient. Finally, Section 3.5 extends the analysis of optimal tort liability to the situation where risk-​imposers respond to information costs by conducting their activities through organizations, such as corporations. It shows how liability should be structured to induce optimal behavior by organizations and the agents who work for them, and it discusses limitations with existing liability rules on these issues.

3.2.  Accidents between Strangers This section examines the incentive effects and the optimal structure of tort liability when the injurer and victim are “strangers” with no market relationship and no ability to contract or bargain with each other. This section first presents the classic model of liability with perfect information and zero litigation costs, and then it examines tort liability when information about optimal and actual precaution is costly.

3.2.1. Classic Model of Accidents between Strangers: Full Information Many, if not most, accidents involve two parties, each of whom can take precautions that affect the probability that the accident occurs and/​or the magnitude of the harm caused. These accidents fall into one of two categories. The most common are “bilateral-​risk” cases, where two parties each undertake an activity that presents a risk of harm to themselves and the other. Automobile accidents involving either two cars, or a car and a pedestrian, are classic examples of bilateral risk accidents (Diamond 1974; Arlen 1990a, b; 1992). The other standard type of case involves “unilateral-​risk and bilateral-​care” accidents (hereinafter bilateral care): where one person (the injurer) undertakes an activity that imposes a unilateral risk of harm on the other (the victim), but both parties can affect the probability that the accident occurs (Brown 1973; Shavell 1980; Landes and Posner 1987). Product defects that injure nonconsumers and activities that produce environmental risks are examples of potential torts with well-​defined potential injurers and victims where both parties may be able to affect the probability or magnitude of the harm, but only one side imposes a risk of harm on the other (absent liability). In both types of cases, social welfare is maximized when both care and activity levels are optimal. Specifically, every risk-​imposing party should undertake the activity only when, and up to the point that, the social benefit of the activity equals or exceeds the expected social cost. In addition, when they conduct the activity, they should invest optimally in precautions to reduce the risk of harm to others or themselves (or both).

 

ECONOMICS OF TORT LAW    45 In each type of case, the motivation for tort liability is the same: rational, self-​ interested, utility maximizers will not behave optimally absent liability because they set care and activity levels without considering to the risk of harm to others. Tort liability can induce risk-​imposers to take optimal care and activity levels by making them bear the social costs of the accidents they cause. This is easily accomplished by holding injurers strictly liable for all harms caused. Yet in order to induce optimal care, tort liability also must ensure that victims invest in optimal precautions to protect themselves. Victims will not do this if all accidents are paid for by injurers (Brown 1973; Shavell 1980). To induce optimal care by both parties—​whether by two injurers in the bilateral risk case or the injurer and a victim in the bilateral care case—​tort liability must be structured to ensure that each expects to bear expected accident costs if they fail to take optimal care. This will ensure existence of an equilibrium in which each takes optimal care. Optimal tort liability rules that satisfy this requirement include pure negligence, negligence with contributory (or comparative) negligence, and strict liability with contributory negligence (Brown 1973 [bilateral care]; Shavell 1980 [bilateral care]; Arlen 1990a [bilateral risk]; Arlen 1992 [bilateral risk]; Cooter and Ulen, 1986 [comparative negligence]). By contrast, strict liability with full compensation damages will not induce optimal care by both injurers and victims because it insulates victims from expected accident costs, eliminating their incentive to take due care. These conclusions hold whether injurers impose risk unilaterally on victims (Brown 1973; Shavell 1980; Landes and Posner 1987) or both parties to the accident impose risk on each other (Diamond 1974; Arlen 1990, 1992).

3.2.1.1. Formal Analysis: Bilateral Care The classic model assumes that information and litigation is costless; expected accident costs depends on a single input by each party, “care,” given by x for injurers and y for victims. The cost of care is given by C(x) and c(y), respectively, with C′(x), c′(y) >0; and C″(x), c″(y) > 0. Expected accident costs are given by p(x,y)H, where H is the harm to the victim and 1 > p(x,y) > 0 is the probability that the harm occurs, where pi(x,y) < 0, pii(x,y) > 0, i = x, y. All parties and the court know the optimal level of care for each party ex ante; each party’s actual level of care is verifiable ex post. Social welfare is maximized when injurers and victims invest in the level of care (x and y, respectively) that minimize expected accident costs:

C(x ) + c ( y ) + p(x , y )H (1)

This implies that social welfare is maximized when injurers take care x* and victims take care y* as given by:

C ′(x ) = − px (x , y )H (2) c ′( y ) = − p y (x , y )H (3)

 

46   JENNIFER ARLEN Thus, each party should invest in care up to the point where the marginal cost of care equals the social marginal benefit of care, where the latter is given by the reduction in expected accident costs resulting from a marginal increase in care. Absent tort liability, injurers will not take optimal care. Injurers minimize their own expected accident costs, given by C(x), and thus take no care. Victims do take optimal care (given injurers’ care levels) because victims bear their own accident costs and thus select care to minimize c(y) + p(0,y)H.3 As a result, they select care to minimize the total private (and here social) cost of accidents, given the injurer’s suboptimal investment in care. Nevertheless, their care-​taking is not first best. If the marginal reduction in the probability of an accident resulting from victim care-​ taking is lower when injurers take no care than when they take optimal care, then victims will take less care than is first-​best optimal because injurers under invest in care. By contrast, all of the standard liability rules, except pure strict liability, can induce injurers and victims to take due care. Pure strict liability is inefficient because it produces the mirror result of no liability. Under strict liability, each injurer bears all expected accident costs; but each victim does not bear any of his own damages, assuming that damages equal the victim’s harm, H. In this case, each victim minimizes c(y) + p(x,y) (H–​D) =  c(y). Victims take no care because they have no reason to spend money to avoid accidents that injurers inevitably pay for. Each injurer thus selects care to minimize C(x) + p(x,0)D = C(x) + p(x,0)H, and thus selects the level of care at which: C ′(x ) = − px (x , 0)H (4)



The injurer will select the level of care that is optimal given the victim’s suboptimal behavior (i.e., second best optimal care), but will not select first-​best optimal care, x*. Under pure negligence, injurers are liable only if they fail to take “due care.” Thus, an injurer can, by selecting care x* instead of zero care, avoid all liability for the victim’s expected accident costs. We know that an injurer who expects the victim to take due care will do so as well. The definition of optimal care implies that C(x*) + p(x*,y*)H < C(x) + p(x,y*)H which in turn implies that the injurer incurs lower expected costs if he takes optimal care, C(x*), than if he does not and faces C(x) + p(x,y*)H. A victim who expects the injurer to take due care knows he must bear his own accident costs. He thus faces expected cost of c(y) + p(x*,y)H and takes optimal care (Equation (2)). This equilibrium is unique. An equilibrium will not arise in which both parties decide to be negligent. Both parties cannot find it in their best interests to be negligent because we know that C(0)+ c(0) + p(0, 0)H > C(x*) + c(y*)+ p(x*,y*)H, thus it cannot be the case that the injurer and victim would both be better off being negligent. Under negligence with contributory negligence, injurers are liable only if they failed to take due care and the victim took due care. Victims bear losses whenever injurers took due care or the victim did not. This rule also induces optimal care by both parties. 3 

In the bilateral-​risk case, where each party can injure the other and be injured by them, then neither party takes optimal care.

 

ECONOMICS OF TORT LAW    47 Victims will always take due care because they are better off taking due care whether they expect injurers to do so. If they expect injurers to be negligent, then victims will take due care in order to shift their own expected accident costs to injurers. If they expect injurers to take due care, then victims will take due care because they bear the full costs of accidents, and we know that their expected costs c(y) + p(x*,y)H are minimized when y = y*. Injurers in turn will be nonnegligent because they know victims will take due care. In this case, injurers face expected costs of C(x) + p(x,y*)H if they are negligent and expected costs of C(x*) if they take due care. Thus they take due care to minimize their costs. Negligence with comparative negligence also yields an equilibrium where both parties take optimal care (Cooter and Ulen 1986). Strict liability with contributory negligence also can induce optimal care by both parties. In this situation, it is the victim who always has incentives to invest in care (no matter what he expects the injurer to do), because the victim, by taking due care, shifts all accident costs onto the injurer. The injurer in turn will take due care because he expects to bear expected costs of C(x) + p(x,y*)H, which are minimized when he takes optimal care (see Equation 2).4

3.2.1.2. Discussion and Analysis Several features of this model and equilibrium are worth noting. First, under the assumptions of this model, negligence liability (with or without contributory negligence) would be the lowest cost rule were there are litigation costs, because injurers always take due care, and thus no one ever sues anyone. Therefore, negligence accomplishes its task without a single tort action ever being filed (Shavell 1980). Second, and related, in this model, all negligence is deliberate: no one ever fails to take due care accidentally (compare with Arlen and MacLeod 2003, 2005a). Third, strict liability only induces optimal care when damages precisely equal the harm caused because strict liability in effect sets a price on risk-​taking. The rule provides optimal incentives only when the expected price equals the expected social cost of accidents (Cooter 1984). By contrast, negligence can induce optimal care (by both parties) even when damage awards deviate from the social cost of harm, H. Excessive damages do not distort care-​taking when everyone is perfectly informed because excessive damages simply provide injurers with additional motivation to take due care. They do not incentivize excessive care. Injurers take due care leaving victims with expected costs of c(y) + p(x*,y)H, which is minimized at y*. Damages less than H also can induce optimal care as long as damages equal or exceed the level at which C(x*) < C(x) + p(x,y)D for all x 0, q″(e) < 0. Injurers who are not informed select suboptimal precaution. The cost of expertise is given by C(e), where C′(e) > 0, C″(e) > 0. Investment in expertise is unverifiable. We assume that ex post the court can accurately determine both optimal care and the injurer’s actual precaution. Social welfare is given by Equation (5), assuming that uninformed injurers always select the suboptimal precaution x0:

b − q(e) {c(x i ) + p(x i )H } − (1 − q(e)){c(x 0 ) + p(x 0 )H } − C(e ) (5)

Social welfare is maximized when two conditions are met. First, informed injurers (who exist with probability q(e)), should select the precaution that minimizes the total cost of accidents, c(x) – ​p(x)H. Thus, they should select optimal precaution, x*. Second, injurers should invest optimally in expertise. Social optimal expertise is the expertise that maximizes social welfare, assuming that informed injurers select optimal precautions and uninformed ones do not. It is given by the expertise such that:

q ′(e){[ p(x 0 ) − p(x * )]H − [c(x * ) − c(x 0 )]} = C ′ (e ) . (6)

Absent liability, the potential injurer does not bear any accident costs. Accordingly, he takes too little care and under-invests in information. Indeed, given that he would take

 

54   JENNIFER ARLEN no precaution even if informed, the injurer will not invest in information about precautions at all. Consider now the effect of negligence on both the ex ante decision to invest in expertise and the precaution decision. In most circumstances, courts can observe precautions but cannot observe expertise. Thus, one form of precaution is directly governed by negligence liability, but the other (expertise) is not. Nevertheless, negligence liability can induce both optimal precaution and optimal investment in expertise. Consider first the incentives of an informed injurer to select precaution under a negligence regime. The informed injurer will select the precaution that minimizes expected costs:

c(x i ) + p(x i )D i , (7)

where Di is the damage award, with i = *,0; D* = 0 and D0 = H. We know from previous analysis that an informed injurer facing damages of H for losses caused by negligence will minimize expected costs by selecting optimal care, x*, thereby avoiding liability. As for expertise, the injurer invests in the level of expertise that maximizes his expected welfare, assuming that he selects optimal care when informed. Thus, he selects expertise to maximize

b − q(e) {c(x * )} − (1 − q(e)){c(x 0 ) + p(x 0 )D} − C(e). (8)

He thus sets expertise such that the marginal cost of expertise equals the net marginal benefit of expertise, where the latter equals the reduction in liability minus the added cost of selecting optimal care instead of negligent care (accidentally):

q′(e){ p(x 0 )D − (c(x * ) − c(x 0 ))} = C ′(e). (9)

Accordingly, the injurer will invest optimally in information and e​ xpertise so long as the expected damage award for accidental negligence, p(x0)D, precisely equals the benefit to victims of expertise: p(x 0 ) − p(x * )H . Actual optimal damages for accidental harm thus equal:

D =

( p0 − p* )H < H. (10) p0

This implies that the optimal damages for injuries resulting from a knowing decision to select suboptimal care exceed the optimal damages for accidental negligence, even when liability is imposed for all injuries attributable to injurer negligence. By contrast, setting damages equal to H for both types of cases induces excessive investment in expertise (Arlen and MacLeod 2003; 2005).

 

ECONOMICS OF TORT LAW    55

3.2.2.2.3. Formal Analysis: Strict Liability Unlike negligence, strict liability can induce both optimal precaution and optimal investment in information when damages equal the harm caused in all cases. We know that damages equal to H suffice to induce informed injurers to select the optimal precaution. Thus, under strict liability with full compensation damages the injurer faces expected costs of:

b − q(e) {c(x * ) + p(x * )H } − (1 − q(e)){c(x 0 ) + p(x 0 )H } − C(e) (11)

A comparison of Equation (11) and (5) reveals that injurers expected costs of care and expertise equal the social costs; thus they invest optimally in expertise and care.

3.2.2.3. Courts Err When Determining Optimal Care The preceding analysis assumed that courts are perfectly and costlessly informed. But courts also must incur costs to obtain information, and regularly are only imperfectly informed. This affects both the cost and the accuracy of the litigation process.10 The possibility that courts will be imperfectly informed affects both the relative efficacy of strict liability and negligence and the impact of negligence on incentives to invest in precautions. Strict liability can provide optimal incentives, even if courts have no information on optimal care, as long as courts set damages correctly and the parties have (or can optimally obtain) information on optimal care (Cooter 1984). By contrast, negligence is potentially (but not always) vulnerable to court error in determining optimal care (Cooter 1984; Craswell and Calfee 1986) and damages (Arlen and MacLeod 2005a). To assess the impact of error, we must first identify more precisely the type of court error, as well as whether the affected party can predict the court’s decision. Assume first that courts err in determining due care, but injurers accurately predict the error. If courts predictably set due care too low, then injurers also will select suboptimal care, assuming damages are set correctly (Shavell 2007, 161). This under-​investment in care also can affect other precautions. For example, when due care is suboptimal, injurers may under-​invest in expertise—​and obtain it on the “wrong” precautions (from society’s perspective) because injurers gain nothing by determining optimal care. Thus, if damages are set second best optimally, then injurers will select suboptimal precaution when informed and will have an excessive risk of accidental error. If, by contrast, courts set due care too high, court error will not necessarily induce excessive care. Should courts set due care so high that the cost of compliance exceeds the reduction in expected liability, then injurers will not try to comply. In this case, 10  Ex ante information costs do not inevitably translate into costly or even inaccurate adjudication. After all, if the parties invest optimally in information about optimal precautions ex ante, ex post adjudication would not entail additional costs to obtain information if the parties can credibly share their information about optimal care and information on actual conduct is readily available. Nevertheless, often the information available to courts is not only costly but also imperfect.

 

56   JENNIFER ARLEN negligence in effect becomes strict liability: injurers will take optimal care if damages equal the harm caused (Shavell 2007, 161). Injurers also will invest optimally in information and expertise, provided damages equal the harm caused (see Section 3.2.2.2.3). By contrast, if courts set due care too high, but not so high that injurers would prefer to be deliberately negligent, then injurers will take excessive care (Shavell 2007, 161). This excessive care will also distort investment in information, causing injurers to seek information on due care (excessive care), not optimal care. It also will lead to less investment than is optimal because the injurer gains less marginal benefit from taking due care when due care is set too high than does society when care is set optimally. Alternatively, courts may err in setting damages. Strict liability is very vulnerable to error in setting damages because liability in effect imposes a price that the injurer must pay for his activities. Charging a price less than the social cost will induce too little care and excessive activity levels (Cooter 1984). By contrast, the traditional analysis finds that negligence is less vulnerable to errors in setting damages. As long as damages exceed the damages at which the injurer is better off taking optimal care—​which is the D at which c(x*) = c(0)+p(x*)D—​then negligence will induce due care. Damages thus often can be less than H and still induce optimal care. Damages also can substantially exceed H without inducing excessive care-​taking because injurers can avoid all expected liability by taking due care (Cooter 1984). These conclusions do not hold, however, when injurers can be negligent accidentally and can reduce the risk of accidental negligence by investing in expertise. In this situation, all errors in setting damages affect expected accident costs through the impact on expertise. Negligence liability holds injurers liable for accidental negligence. In effect, this operates to “price” the injurer’s decisions to invest in information. As we have seen, this price must be set precisely equal to the social marginal benefit of expertise in order to induce optimal expertise (Arlen and MacLeod 2003, 2005). Finally, courts may err in setting the standard of care in ways that cannot be predicted ex ante. In this case, under negligence liability, court error may induce injurers to take excessive care, even if, on average, courts set due care equal to optimal care (Calfee and Craswell 1986; see Diamond 1974). To see this, assume that injurers expect the due care to be set equal to x * ± ε , where ε is an error term. Assume that half the time ε > 0 and the other half ε < 0. In this situation, negligence liability will induce each injurer to take excessive care. An injurer who takes excessive care x* + ε incurs unnecessary expected care costs since there is a 50% probability the court will set care too low: .5{c(x* + ε )–​ c(x* – ε​ )}. By contrast, when the court sets due care too high, injurers obtain a large benefit from taking excessive care: they can avoid any liability for injuries caused. Whenever the expected liability savings exceeds the marginal increase in care, injurers will over-​invest in care: p(x* –​ ε )D > c(x* + e)-​c(x* – ​e) (Calfee and Craswell 1986). The conclusion that court error induces excessive care-​taking does not hold in all situations, however. Negligence may not induce excessive care—​or the effect will be less pronounced—​in bilateral care cases that include a defense of comparative negligence, provided the uncertainty or risk of error affects both parties (Cooter and Ulen 1986;

 

ECONOMICS OF TORT LAW    57 see Dari-​Mattiacci and Hendriks [2014], finding comparative negligence is welfare-​ enhancing when due care is set above optimal care). In addition, negligence may not induce excessive care if courts accurately apply causation rules (Kahan 1989). The preceding analysis assumes that small deviations between the injurer’s level of care and due care can have large consequences—​causing the injurer to bear liability of H for all harms caused. Under negligence liability, injurers are not liable for harms caused unless it is more likely than not that, had the injurer taken due care, the injury would not have occurred. Accordingly, if the court sets due care at x*+ε , but the defendant only took care, x*, he nevertheless will not be held liable unless the plaintiff can show that it is more likely than not that the injury would not have happened if the injurer took due care (x*+ε ) rather than allegedly negligent care, x*. In other words, if we consider all the ways the harm could have happened given care x*, more than half the risk of harm would need to be removed by an additional marginal investment of ε . Given that x* is optimal and the marginal benefit of care is declining, in most circumstances, failure to take excessive care rather than optimal care will rarely be the legal cause of the harm, unless courts err by a wide margin. To the extent that injurers anticipate this, uncertainty will not induce them to take excessive care (Kahan 1989; see Grady 1983; see, generally, Hylton 2013, 100–​103).

3.2.2.4. Implications for Future Research Comparing Section 3.2.2 and Section 3.2.1 we see that tort liability is more effective at minimizing the expected cost of accidents the lower the cost to injurers, courts, and victims (see infra Section 3.2.4) of determining both optimal and actual care and the greater the marginal benefit of information relative to the marginal cost. This suggests that a productive avenue for scholarship and tort reform includes mechanisms for improving information flows both into the tort system, as well as out of the tort system, to those making decisions about due care and whether to litigate (e.g., Daughety and Reingaman [2005], discussing secrecy and settlement).

3.2.3. Risk-​Averse Victims When victims are risk averse but injurers are not, the social cost of accidents is higher when victims bear their own losses than when injurers do. This can affect optimal liability rules. By definition, a risk-​averse person would prefer to receive $X with certainty than to accept a risky bet with an expected value of $X. This implies that the social cost of accidents is higher when losses fall on a risk-​averse person than when they fall on someone who is risk neutral because an accident introduces variance in expected outcomes. Thus, when injurers are risk neutral (e.g., large corporations) and victims are risk averse, tort liability can reduce the social cost of accidents simply by shifting losses from victims to injurers, all else equal. This risk-​spreading benefit potentially provides an argument for favoring strict liability (with contributory negligence) over any form of negligence

 

58   JENNIFER ARLEN liability, as strict liability provides victims compensation for losses even when injurers took due care (Shavell 1987, Chapter 9). By contrast, when victims and injurers are each risk averse—​as with automobile accidents—​then tort liability cannot increase or decrease expected social welfare by shifting the loss from one party to the other. Nevertheless, even when only victims are risk averse the social benefit of using strict liability to insulate victims from accident costs purely for risk-​spreading reasons may not be as large is it might at first appear. First, tort liability is not the only mechanism for insulating victims from expected accident costs. First-​party insurance, such as health insurance and life insurance, provides coverage against many costs associated with accidents more quickly and with lower administrative costs compared with tort liability (see, e.g., Weiler 1991). Insurance is particularly attractive because even under strict liability, victims generally would have to purchase first-​party insurance. First, victims inevitably face a risk of suffering harms for which they will not receive tort compensation (e.g., because the harm was caused by an act of nature, causation cannot be shown, or the injurer is judgment proof). Second, tort recovery rarely arrives in time to cover the mounting medical bills of a seriously injured person. Thus, even with tort liability, victims need to purchase first-​ party insurance, the cost of which may not be significantly lower under strict liability than under negligence if the risk of non-​tort-​based accidents and the cost to insurers of pursing claims against injurers is high (see Shavell 2004, 268–​269; see also Epstein [1985] for additional discussion of limitations of tort liability as insurance). Thus, while victims can benefit from the risk-​spreading benefits of tort liability, in practice, the risk-​spreading benefits of strict liability versus negligence may not be sufficiently large, on net, to justify favoring the former or the latter independent of the deterrence benefits of liability.

3.2.4. Litigation Costs and Settlement Litigation costs also affect the optimal choice of liability rule. As between several equally effective rules, the optimal liability rule is the one that optimally deters at the lowest cost (in terms of administrative and litigation costs). Strict liability (with or without contributory negligence) would appear to be more costly because it generates more litigation (Posner 2011). After all, in a perfect world, no one sues under negligence because injurers always take due care (Shavell 2007, 155). Nevertheless, once we expand the analysis to include information costs and other imperfections, injurers will fail to take due care even under an optimal negligence rule (see supra Section 3.2.2). In this case, relative administrative costs are less clear. Negligence generates fewer suits than strict liability does. Nevertheless, each negligence action may be substantially more expensive because each party may incur enormous expenditures to establish optimal or actual care.11 Negligence also may reduce 11 

This conclusion may not hold if we compare negligence with strict liability with contributory negligence if courts applying the latter must calculate optimal care by injurers to determine optimal

 

ECONOMICS OF TORT LAW    59 parties’ willingness to settle if parties are more likely to have divergent expectations of outcomes under negligence (Spier 1997; Shavell 2007, 155; Wickelgren 2013).12 Finally, negligence liability may undermine optimal deterrence if victims cannot easily determine ex ante whether injurers took due care. In this case, victims may be less likely to sue under negligence than under strict liability, even when litigation would be publicly and privately optimal under full information, because litigation costs exceed expected recovery when victims are uncertain. In this situation, injurers who fail to take care may face a lower risk of liability under negligence than strict liability, leading them to take too little care.13 This result is particularly likely if victims know they were injured, but cannot identify who injured them without paying for an investigation (as with many environmental wrongs). Accordingly, reforms that increase victims’ upfront litigation costs—​as arbitration appears to do14—​may undermine the deterrent effect of the tort system if it reduces litigation and expected damage awards below the level needed to induce injurers to take optimal care.

3.3.  Products Liability and Medical Malpractice Much of the risk of harm that people face is not imposed by strangers. Instead, people often, in effect, invite risk of harm into their lives through the goods and services (e.g., medical care) that they purchase, seeking to improve their lives. This situation differs from strangers cases in two respects. First, when potential injurers sell risky goods and services to consumers, both producers and consumers are better off ex ante when potential injurers are able to credibly commit that they will invest optimally in care. Optimal care maximizes the value of the product to the consumer and

care by victims, as is the case in the traditional model (Shavell 1987, 16–​17), but this might not be the case when courts can optimally set victim’s due care without calculating the injurer’s optimal care. For example, courts may optimally conclude pedestrians should not jaywalk or rush out into traffic, without determining the optimal care of drivers. 12   Negligence also may increase the risk of underdeterrence if information to determine the injurer’s care is costly and victims rationally fail to incur this cost, even when it would be optimal for them to do so, because the harm is one that could have occurred even absent negligence. 13  Tort liability could induce optimal litigation in this situation through supercompensatory damage awards. Yet actual tort damages rules for accidental injuries are not supercompensatory. Punitive damages tend to be reserved for harms that result from deliberate (or wanton and willful) breaches. 14  In litigation, the victim often can hire a lawyer on a contingency fee basis and does not pay for the judge. By contrast, under arbitration, each party not only must pay his own litigation costs, but also must pay the arbitrator. Thus, even when arbitration reduces each person’s own lawyer’s fees by shortening the process, it may increase the victim’s litigation costs by requiring him to pay for a decision maker who otherwise would be provided by the state. This may reduce incentives to sue, particularly if arbitrators tend to award lower expected damages.

 

60   JENNIFER ARLEN thus the consumer’s willingness to pay. Second, in this context the justification for tort liability does not root in traditional transactions costs: transactions costs generally are low since the producers and consumers are in a market relationship (Spence 1977; Polinsky 1980). Instead tort liability is needed when information costs render markets inefficient (Spence 1977) and impediments to optimal contracting render contracting over liability inefficient (Arlen 2010). This section examines the justifications for and optimal structure of tort liability to govern these market relationships. It highlights the importance of victim information costs in both justifying liability in the first place and victim ​or injurer information costs in justifying the use of mandatory liability instead of contractual liability. Specifically, this section shows that tort liability is preferred to contractual liability when, as is often the case, the parties cannot contract optimally because consumers lack the required information (e.g., Geistfeld 1994) or contracting is plagued by inefficiencies, such as collective goods, adverse selection, or time-​inconsistency problems largely arising from injurers’ imperfect information (Arlen 2010). Tort liability thus emerges as a potentially valuable supplement to contract, enabling the parties to reduce inefficiencies produced by information costs.

3.3.1. All Parties Are Perfectly Informed Informed producers of goods and services (e.g., medical care) will invest optimally in precautions that affect the risk of harm to consumers or patients if purchasers are perfectly informed about either investments in care or the expected accident costs associated with each individual injurer (Spence 1977; Polinsky 1980). Tort liability is not needed. The intuition behind this result is straightforward. Consider producers operating in a competitive market making goods that are identical on all dimensions except expected accident costs. It might appear that producers would seek to minimize their expected costs by not investing in care. But producers know that consumers want to purchase the product with the lowest total expected cost to them, which includes the expected accident costs associated with the product. Accordingly, using the notation from Section 3.2, consumers select the producer of the product with the lowest P + p(x)H = c(x) + p(x)H, where P is the competitive market price (which equals the marginal cost of the product, c(x)). A producer seeking to minimize the total cost of his product thus must invest in care to minimize the consumer’s total expected costs. He thus selects care to minimize c(x) + p(x)H, which is optimal care (see Section 3.2.1) (Spence 1977; Polinsky 1980; see Daughety and Reinganum 2013, 70–​73). Activity levels also are efficient. Activity levels are efficient when producers only produce up to the point where the social marginal benefit of the last unit made (as given by the marginal consumer’s willingness to pay for that unit) equals the marginal cost to society of making the product (c(x) + p(x)H). When consumers are informed, each consumer will only demand the product if his willingness to pay equals or exceeds the

 

ECONOMICS OF TORT LAW    61 cost of the product to him, which equals c(x) + p(x)H. Thus, activity levels are optimal (see Polinsky 1980; Shavell 1980).

3.3.2. Product Liability When Consumers Cannot Observe Quality Consumers of products and purchasers of medical care rarely can accurately determine the expected risk associated with purchasing a good or service from a particular producer. Consumers of products often can get information on the relative reliability (in terms of repair rates) of products made by different producers, but they rarely have good information on either the precise probability that they will be injured by a product or the expected magnitude of the harms caused (e.g., Geistfeld 1994, discussing information problems).15 When consumers cannot directly observe the producer’s choice of care before purchase,16 each producer knows that his investment in care will not help him compete for consumers (but see Section 3.3.4, discussing signaling). Producers in competitive markets thus will not invest in care as low care enables them to compete by lowering prices. Thus, absent liability, producers make suboptimal-​quality products and expected accident costs are too high (Polinsky 1980; Shavell 1980). Activity levels, however, may be second-​best optimal—​optimal given actual risk. Although consumers cannot observe care, they can predict that producers will take zero care. Consumers thus will be able to correctly calculate the total cost to them of the product, including expected accident costs, provided they can estimate p(0) and H (Daughety and Reinganum 2013, 75). By contrast, if consumers underestimate product risk, then they will underestimate the total cost to them of the product, and may purchase the product even when the total expected cost of the product is less than its benefit. This results in excessive activity levels (see Spence 1977; Shavell 1980).

15 

For example, consumers of pharmaceuticals are provided information through warning labels about harms that may occur, but rarely receive good information about the precise probability of each adverse event. They have even less information about the risks they face given their personal health characteristics. Similarly, patients seeking medical care can obtain some information on their care-​ givers. But they cannot obtain accurate information on the probability of medical error associated with receiving treatment from any particular physician or hospital because this information is not publicly disclosed (Glied 2000; Arlen and MacLeod 2003; see, generally, Arrow 1963). In addition, even if it were disclosed, the market is unlikely to function optimally as patients’ choice of provider often is distorted by both health insurers—​which favor some providers over others—​and by geography, as patients often cannot obtain long-​term care too far from home. 16  Specifically, we now consider the situation where information asymmetry produces a moral hazard problem. Information asymmetry also can produce an adverse selection problem when unobservable ex ante investments result in some firms being higher-​quality than others. In this case, strict liability is superior to no liability. For a discussion of how adverse selection affects the optimal liability rule see Daughety and Reinganum (2013, 76–​79).

 

62   JENNIFER ARLEN Strict tort liability for product-​related harms can enhance the ex ante welfare of both producers and consumers by inducing producers to take optimal care. This enables consumers to get the quality of product that they want and are most willing to pay for. It also induces optimal activity levels. The analysis is similar to the analysis in Section 3.2.1. Under strict liability, each producer bears the full social cost of his product—​both production costs and expected accident costs. Accordingly, to minimize total expected costs, they each take optimal care. Each producer then sets his price equal to his marginal cost of making the product, including expected liability: c(x*) + p(x*)H. Consumers thus face a price equal to the full social cost, including their expected accident costs. This leads to optimal activity levels as consumers who bear the full expected social cost of the product will only purchase it if their willingness to pay equals or exceeds the social cost of the product (Polinsky 1980; Shavell 1980). Here, unlike in Section 3.3.1, the price leads to optimal activity levels even if the consumer under-​estimates expected accident costs. Negligence liability also can induce optimal care; whether it induces optimal activity levels depends on the source of the consumers’ imperfect information. Negligence liability will induce optimal care if due care equals optimal care and damages equal the harm caused (or the minimum amount needed to induce due care) (Shavell 1980; Polinsky 1980). Activity levels also are optimal, but only if consumers accurately estimate product risk. Under negligence, all producers take due care and thus do not pay damages. Accordingly, they each charge a price equal to the marginal cost of the product (P = c(x*)). Activity levels nevertheless will be efficient if, but only if, consumers accurately estimate expected accident costs when care is optimal. In this case, they will anticipate expected costs per unit equal to the price plus their expected accident costs, even if consumers cannot observe actual quality. In this case, activity levels will be optimal because consumers purchase the product only if their willingness to pay exceeds the total expected cost to society of making the product, c(x*) + p(x*)H. By contrast, if consumers have no information on product quality, then under negligence consumers will predicate their purchasing decision on the price plus their inaccurate guess of expected risk. As a result, activity levels will be inefficient.

3.3.3. Producers Also Are Imperfectly Informed: Medical Malpractice Information costs can affect both producers and consumers. This is particularly an issue with medical care.17 Evidence shows physicians regularly provide erroneous treatment;18 17  The present analysis focuses on Arlen and MacLeod (2003, 2005a). For an analysis of products liability where producers can invest in research and development related to product safety see Daughety and Reinganum (1995, 2006). 18  See Institute of Medicine (2007). Patients seeking medical treatment face a serious risk that they will be severely injured or be killed by the treatment they receive. Studies suggest that 4%–​18% of patients seeking care in hospitals are the victims of preventable medical error, with many suffering serious injury.

 

ECONOMICS OF TORT LAW    63 moreover, medical error generally is accidental (see Mello and Studdert 2008; see also Studdert et. al 2006). Medical providers often err accidentally because they lacked the information or expertise needed to properly diagnose the patient, identify the correct treatment,​ or provide the treatment correctly (Arlen and MacLeod 2003, 2005a; see Mello and Studdert [2008], identifying inadequate knowledge as an important cause of medical negligence).19 Physicians can reduce the probability of accidental error by investing in expertise and systems that reduce the risk error (such as health care technology). Thus, expertise constitutes a form of precaution that affects patients’ safety (Arlen and MacLeod 2003, 2005). Optimal deterrence thus requires that liability induce optimal investment in expertise by uninformed physicians, as well as optimal care when physicians are informed about how to best care for their patients. In many ways, the analysis of malpractice liability with expertise is similar to Section 3.2.2.2 supra. But there are two differences that warrant giving it separate attention in the formal section. First, in the medical care context, information and expertise are collective goods. Physicians’ investments in the expertise needed to properly diagnose patients and select treatments, and in the systems and health care technology needed to ensure treatment is properly delivered, constitute “collective goods” because they affect the quality of care a physician provides to all of his patients. As a result, liability that enhances expertise also is a collective good, as a physician’s incentive to invest in expertise to protect each patient depends on his expected liability for accidental harm to all of his patients (Arlen and MacLeod 2003, 2005a; Arlen 2010, 2013). We develop the implications of this in Section 3.3.4 infra. Second, medical markets usually involve an additional party—​the health insurer—​ who is in a contractual relationship with both the patient and the medical provider. Insurers alter the analysis because they bear most of the cost of medical services ex post and enter into contracts ex ante with physicians designed to alter treatment choices often to reduce costs relative to the treatment the patient would often prefer ex post.

(Weiler et al. [1993], reviewing written hospital records, found that 3.7% of the patients were victims of an error that caused significant harm; Andrews 2005, finding that 17.7% of patients were the victim of at least one error that extended their hospital stay). About 1% of hospital patients suffer errors that constitute medical negligence (Brennan et al. 1991). Indeed, medical error increases average hospital costs by $1,246 per patient admission, and, increases average costs in the riskiest hospitals by $4,769 per patient admission (Mello et al. 2007, 847). Moreover, medical error reaches beyond hospital walls: physicians routinely provide their patients less than medically recommended care (McGlynn et al. [2003, 2641] finding that patients on average receive only about 55% of recommended care; Schuster et al. [1998, 521] finding that, for chronic conditions, only “60% [of patients] received recommended care and 20% received contraindicated care”). Overall, medical error costs about $17–​29 billion per year (Institute of Medicine 1999). 19  In addition, even when physicians want to provide optimal treatment, their ability to do so depends on whether they and the medical institutions within which they practice invested optimally in the systems and health care technology needed to reduce optimally the risk of medical error (Abraham and Weiler 1994; Mello and Brennan 2002; Arlen and MacLeod 2003).

 

64   JENNIFER ARLEN Section 3.3.3.1. evaluates optimal negligence liability for medical malpractice assuming that patients pay a fixed price for treatment and physicians bear both all subsequent treatment costs, and the cost of obtaining information on optimal treatment for the patient’s condition. Section 3.3.3.2 considers the situation where the health insurer covers some or all of the patient’s treatment costs.

3.3.3.1. Formal Analysis: No Insurance20 Assume that each patient seeks treatment from a physician who he must rely on entirely to select the medically appropriate treatment. For simplicity, we assume that the physician can select one of two treatments: (1) high-​quality and higher cost treatment, t*, and (2) lower cost treatment, t0.21 Lower cost treatment imposes a higher risk of harm on the patient. We assume that the expected benefit to the patient of receiving treatment is given by b minus expected accident costs, which are given by p(ti)H, where i is an index of treatment choice and p(t0) > p(t*). It is assumed that the net social benefit of high cost treatment is higher than the net social benefit of low cost treatment: (p(t0)–​ p(t*))H > c(t*)–​c(t0), where c(t) is the cost of treatment. Thus, treatment t* is both the optimal treatment and the treatment that the patient would prefer, whether or not he bears his own medical costs. We assume that treatment quality is unobservable and noncontractible. Thus, it is assumed that the patient pays a price for treatment that is based on expected quality, but the patient and physician cannot contract in advance to ensure the physician selects t*. Physicians do not automatically know which treatment is optimal. Instead, each physician must invest e in expertise at a cost of C(e).21 This investment determines the probability, given by q(e), that the physician correctly identifies the optimal treatment for each patient’s condition.22 Thus q(e) is the probability that the physician provides “informed” treatment. We assume that the physician invests in patient safety after contracting with the patient. The analysis applies, as well, to unobservable investments made pre-​contract when investment is nonverifiable and the physician bears this cost directly. Physicians who are “informed” select the treatment that maximizes their welfare. When uninformed, physicians are assumed to provide suboptimal treatment.23 Patients cannot observe either the amount the physician invests in patient safety or the probability he selects suboptimal treatment. 20   The following analysis is based on Arlen and MacLeod (2003, 2005a) who provide a model of medical malpractice in which patient welfare depends on both physician’s ex ante investment in expertise and information on the patient’s condition and the physician’s treatment choice when informed. 21 C′(e)>0, C″(e)>0. 22 q′(e)>0, q″(e) 0 (with R″(q) < 0). Assume that each unit imposes a risk of harm on third parties, given by p(x)H, where H is the harm caused, p(x) is the probability of the accident, and x is the employee’s level of care (x is unobservable ex ante). Assume that employees bear the cost of effort, c(x). Social welfare is given by the joint welfare of the employee, firm, victim, and consumer R(q) − (c(x ) + p(x )H )q. (17)



Differentiating with respect to care and activity levels, we see that social welfare is maximized when employees take the level of care at which the marginal cost of care equals the marginal benefit of care: c ′(x ) = − p ′(x )H , (18)

and activity levels are such that

R ′ (q ) = c ( x ) + p ( x ) H . (19)

Assume now that strict liability is imposed solely on individual employees. The principal maximizes profits subject to two constraints. First, it must ensure the employee nets his reservation wage (which we set equal to zero). Second, the firm cannot dictate effort; instead, the agent selects the effort that maximizes his welfare (incentive compatibility constraint). Accordingly, the principal and the agent will solve the following problem (per unit sold) assuming competitive product and labor markets:

P − w (20)

subject to

w = c(E(x )) + p(E(x ))H ; (21)



E(x ) is the x that maximizes w − c(x ) − p(x )H , (22)

where E(x) is the employee’s expected level of care, P is the price per unit (which equals marginal cost), w is wages, and tort damages are given by D=H. Employees will select the level of care that minimizes their expected costs as given by Equation (22). Differentiating by x reveals that they take optimal care. Given this, the individual rationality constraint, Equation (21), implies that the firm must pay wages equal to the c(x*) + p(x*)H. In turn the firm will set the price equal to c(x*) + p(x*)H. This induces optimal activity levels:  consumers purchase up to the point where the marginal benefit of the last unit equals the price, which in turn equals the social cost of

 

ECONOMICS OF TORT LAW    81 the product (Kornhauser 1982; Sykes 1984; Segerson and Tietenberg 1992; Polinsky and Shavell 1993).38 Assume now that only the firm is strictly liable for harms caused by employees. The firm initially bears liability of p(x)H. To minimize its price, which includes the cost of its expected liability, it needs to incentivize its employees to take care. It can do this by imposing a sanction on employees who cause harm. Accordingly, the firm will solve the following maximization problem, where s is the sanction imposed on employees:

P − w − p(x )(H − s) (23)

subject to

w = c(E(x )) + p(E(x ))s; (24)



E(x ) is the x that maximizes w − c(x ) − p(x )s. (25)

Combining Equations (23) and (24), we see that in equilibrium, the firm bears expected cost of c(x) + p(x)H regardless of what sanction it selects. It will incorporate these costs into its price. Firms operating in competitive markets seek to minimize prices and thus expected costs. As a result, the firm will seek to induce its employees to take optimal care. To achieve this goal, it will select the sanction that induces optimal care. Equation (25) implies that the firm will set the sanction equal to H, the harm caused, thereby inducing optimal care. Equation (24) implies that the firm will have to pay wages of c(x*) + p(x*)H. Thus, it sets prices equal to the social cost of the product, inducing optimal activity levels (Kornhauser 1982; Sykes 1984; Segerson and Tietenberg 1992; Polinsky and Shavell 1993). Thus, corporate and individual liability each induce optimal care and activity levels in the simple model.

3.5.2.  Nonneutrality: Economic Justification for Corporate Liability Although individual liability can induce optimal behavior by firms and employees in the simple model, in most real-​world situations individual liability will not produce optimal care and activity levels. Individual liability will not induce optimal activity levels when liability for accidents is governed by negligence and not strict liability, unless consumers are perfectly informed about product quality. In addition, individual liability alone will not induce optimal behavior when optimal deterrence depends on firms taking actions that affect (but are 38  Firms facing wage payments equal to the expected cost of crime have optimal incentives to invest in measures to deter crime. Thus, in this mode, when the state imposes optimal individual liability, firms have optimal incentives to prevent crime. This implies that they will not act because individual liability is sufficient to deter crime optimally, in this model.

 

82   JENNIFER ARLEN independent of) employees’ care-​taking care and are neither observable nor contractible ex ante. These investments include systemic investments that reduce employees’ risk of accidental error, monitoring, and self-​reporting (Arlen 2012; see Shavell 2007, 171–​172). Finally, pure individual liability will not induce optimal behavior by agents or firms if agents cannot pay optimal damages under pure individual liability (Kornhauser 1982; Sykes 1984).

3.5.2.1.  Agents Liability Governed by Negligence Pure individual liability will not induce optimal behavior by firms if agent liability is governed by negligence. Pure individual negligence liability does not induce optimal corporate activity levels because employees take optimal care and thus are not liable. As a result, the firm does not bear expected accident costs and thus does not incorporate them into product prices. This leads to excess activity levels if accidents fall on strangers or consumers who under-​estimate the risk of harm (Polinsky and Shavell 1993). By contrast, firms will have optimal activity levels if individual negligence liability is combined with strict liability for firms (Polinsky and Shavell 1993).

3.5.2.2.  Firms’ Noncontractible Conduct Directly Affects Expected Accident Costs Expected accident costs regularly depend on investments by both the employee and the firm in care. For example, the firm often can reduce expected accident costs by investing in technology, equipment, or systems. We can represent this formally by assuming that expected accident costs are given by p(x,y), where y is the firm’s investment in safety. This investment may affect expected accident costs directly and also may make employees’ care investments more effective, pxy(x,y)>0. Employees often cannot observe or contract over the firm’s investment. When organizations can take actions that directly affect expected accident costs, the organizations (or the individuals making those decisions) must be held liable. Liability can either be imposed for all harms or for harms resulting from the organization’s failure to invest optimally in care. Relying entirely on individual liability targeted at employees who directly determine care, x, will not induce optimal organizational precautions when these precautions are unobservable because under individual liability the firm only bears expected liability through employees’ wages. These wages will be based on employees’ expectations of organizations’ investment in precautions. When firms are not liable and precautions are unobservable, employees will expect firms not to take precaution. They will insist on higher wages no matter what the firm does. Organizational investment also is suboptimal if employees do not understand how organizational precautions affect their expected liability (Shavell 2007, 170–​171). In either case, both firms and employees would be better off if firms also are held liable, as this enables them to credibly commit to optimal precautions, thereby lowering wage payments (see Arlen 2012; Arlen and MacLeod 2005a; see also Shavell 2007, 170–​171).

 

ECONOMICS OF TORT LAW    83

3.5.2.3.  Employee Asset Insufficiency Corporate liability also is an essential prerequisite to achieving optimal deterrence if employees do not have sufficient wealth to pay the optimal damage award. In this situation, employees take too little care under individual liability. As a result, firms’ activity levels are too high. Under individual liability, firms bear employees’ expected care and liability costs through wages. Since asset constrained employees take too little care and bear less than full liability, firms do not internalize the full expected costs associated with their activities (Kornhauser 1982; Sykes 1984). Moreover, under pure individual liability, firms have incentives to create an insolvency issue by strategically selecting asset-​constrained employees in order to lower costs, as when firms hire thinly-​capitalized outside contractors (Arlen and MacLeod 2005b). Corporate liability promotes optimal deterrence by inducing both optimal corporate activity levels (Polinsky and Shavell 1993) and corporate actions that induce optimal (or second-​best optimal) care-​taking by employees (Kornhauser 1982; Sykes 1984; see Arlen 2012). Activity levels are (second-​best) optimal because the firm bears the full cost of accidents and employees’ care costs; thus, prices will result in the full social cost of the product. Corporate liability also can improve employee care-​taking. Under corporate liability, firms bear their employees’ expected accident costs and thus have optimal incentives to select employees who are less likely to be asset constrained (Arlen and MacLeod 2005b). They also may intervene to induce optimal care by using a combination of direct mandates, ex ante monitoring, and non-​harm contingent sanctions imposed on any employee who takes suboptimal care even if no harm occurs. The latter approach increases employees’ care-​taking by increasing employees’ expected sanction for selecting suboptimal care from p(x)W to W (if all negligence is detected) (see Kornhauser 1982; Sykes 1984). Third, if corporate liability is properly structured (see Section 3.4.3), it can be used to induce firms to render individual tort liability more effective by reporting tortious harms and helping victims sanction negligent employees (see Arlen 1994; Chu and Qian 1995).

3.5.3.  Optimal Corporate Liability Respondeat superior holds organizations, and other principals, strictly liable for their employees’ torts committed in the scope of employment. Strict entity-​level liability can be used to induce efficient activity levels, as we have already seen. It also can induce optimal investment in the type of precautions that reduce the probability of an accident without affecting the probability that harm or negligence is detected. These actions include screening employees, super-​compensatory wages, and firm-​level precaution. Strict corporate liability with full compensation damages will not induce firms to undertake optimal precautions that take the form of corporate

 

84   JENNIFER ARLEN “policing”—​precautions that increase the probability that a harm is detected, negligence is proved, or causation is established (see Arlen 1994; Chu and Qian 1995; Arlen and Kraakman 1997; Arlen 2012). This is important because in many situations (e.g., pharmaceuticals), the organization that produced the risk is the least cost provider of information about both the tortious nature of the harm and the identity of the individual(s) responsible. Moreover, in the case of environmental harms, product defects, and other widespread harms, corporate action is needed to induce firms to both detect tortious conduct and report them to authorities so that they can warn potential victims and reduce harm (see Arlen 1994; Arlen and Kraakman 1997). Firms held liable through respondeat superior for all harms will not optimally invest in these “policing” measures because policing enhances the firm’s expected liability for any employee torts that do occur. Thus, when damages equal H, the net benefit to the firm of policing does not equal the social benefit of the harms deterred, as is needed to provide optimal incentives to police. Instead, the firm’s benefit equals its benefit from all harms deterred minus the increase in its expected liability for any harms that do occur resulting from its policing efforts (Arlen 1994; Arlen and Kraakman 1997; see Chu and Qian [1995], discussing negligence liability). Indeed, when liability is high and policing detects many torts that otherwise would remain hidden, respondeat superior may deter policing (see Arlen 1994; see Arlen and Kraakman 1997; cf. Shavell [1994], examining the effect of mandatory disclosure on incentives to acquire information about product risks).39 Entity liability can be structured to induce firms to invest optimally in corporate policing—​e.g., measures to detect tortious conduct and identify responsible individuals. But liability must be structured so that firms that undertake optimal policing bear lower expected liability than those who do not. When optimal deterrence requires optimal investment by the firm in prevention and corporate policing, then the optimal corporate liability regime imposes respondeat superior liability on the firm with expected liability equal to the harm caused, coupled with enhanced regulatory sanctions imposed only on firms that fail to optimally monitor, self-​report, and cooperate by providing evidence. These regulatory duties will induce optimal investment in information and self-​reporting so long as firms that breach these duties are subject to enormous sanctions, whereas firms are not subject to enhanced sanctions if they comply with their duties and harm nevertheless results. In turn, the residual liability for harm caused imposed on all firms ensures that firms will induce optimal care-​taking and that activity levels are optimal (see Arlen and Kraakman 1997; Arlen 2012). 39 

This analysis focuses on strict corporate liability with a fixed sanction equal to H, or, in the case of imperfect detection, H/​P, where P is the expected probability of detection. For a discussion of strict corporate liability when liability equals H/​P(c), with P(c) equaling the actual probability of liability given the firm’s behavior, see Arlen and Kraakman (1997).

 

ECONOMICS OF TORT LAW    85

3.5.4.  Limitations of Existing Corporate Liability In addition to the inefficiencies discussed in the preceding section, corporate liability may fail to induce optimal corporate behavior as a result of legal rules: specifically, limited liability and the independent contractor rule.

3.5.4.1.  Limited Liability Organizational liability induces optimal care-​taking by people who own (or control) firms only if those in control bear the expected costs of their failure to induce optimal investment in care. Even when tort liability rules are optimal, corporate law allows owners to avoid bearing the full expected cost of the risks they create if they conduct their risky activities through corporations and do not personally engage in the risky conduct. Corporations enjoy limited liability: a tort plaintiff can seek recovery from the firm, but cannot go after the personal assets of the owners (as long as the owner follows corporate formalities). Moreover, owners can retain the benefits of limited liability even if they enhance the asset insufficiency problem by removing almost all profits from the firm each year. Limited liability thus will lead smaller, less-well-capitalized firms to under-​ invest in care (see Hansmann and Kraakman 1991).

3.5.4.2.  Independent Contractor Rule Under respondeat superior, firms are liable for harms caused by their agents if the agent and principal had a “master–servant” relationship, giving the principal the right to control the conduct of the agent. By contrast, the principal generally is not liable if the agent is an independent contractor. This rule has been justified on the grounds that there is little reason to hold firms liable for agents whose conduct the firm does not directly control (Sykes 1988; see Epstein and Sykes 2001). Yet a dynamic perspective reveals that corporate liability for independent contractors often is needed to induce firms to take optimal steps to deter risk-​taking by their independent contractors. Firms can affect care-​taking by their independent contractors in a host of ways including (1) their choice of agent, (2) compensation structure, and (3) sanctions for harm caused. The independent contractor rule fails to provide optimal incentives to firms and can actually deter socially valuable corporate actions. To see this, consider a firm that has hired an independent contractor to undertake a risk-​producing activity. Under U.S. law, the independent contractor would be liable for any torts he causes and will charge the firm for his expected liability (and care) costs. Absent corporate liability, the firm can reduce its costs by hiring independent contractors who are asset constrained because they will have lower expected liability costs and thus will charge less (Arlen and MacLeod 2005b). In addition, under the independent contractor rule, a firm that would have optimally hired an agent as an employee in order to exert control and oversight may choose instead to hire the employee as an independent contractor in order to avoid liability. This is a serious issue if the employee is asset constrained. Consider a firm who must

 

86   JENNIFER ARLEN hire an agent to perform an important task. Assume the firm can hire the agent as an employee or an independent contractor. Assume further that all available agents would be judgment proof. In this situation, it often will be socially optimal for the firm to hire the agent as an employee in order to increase care by monitoring. Yet, under the independent contractor rule, firms may rationally eschew control, even when control is optimal, because they can avoid being held liable for all expected accident costs if they hire asset constrained agents as independent contractors instead of as employees (Arlen and MacLeod 2005b; see Sykes [1988], suggesting the independent contractor rule should depend not on the actual relationship but instead on whether the agent would optimally be hired as an independent contractor or an employee).

3.6. Conclusion Tort liability is vital to our society’s ability to prosper because it deters excessive risk-​ taking by those seeking personal gain at the expense of others. Indeed, as our society has become more complex—​with new technologies for risk-creation and risk-​reduction emerging constantly—​tort liability is likely to play an ever more central role. Rapid technological change, and globalization of production, has placed severe strains on efforts to deter risk through regulation. The more rapid the development of new risk-​producing activities, and the farther flung the production locations, the more difficult it is for regulators to develop reasonable safety standards and oversee compliance. Tort liability with actions brought by private plaintiffs is needed to provide adequate deterrence to those who would benefit at a potential cost to others. Tort liability can enhance welfare and protect safety if it is structured to optimally deter. Yet the tort systems must seek optimality in a sea of imperfection arising, in large part, from information costs. Indeed, the same information costs that justify the use of tort liability as a supplement to regulation also affect the operation of the tort system. They affect risk-​imposers, victims, and courts in ways that alter the purposes and effects of tort liability. Each of these parties must invest in information to determine and implement optimal care. Accordingly, a tort system that seeks to optimally deter should treat optimal information acquisition and use by the parties and courts as a core goal of optimal deterrence to be taken into account when structuring liability and damage rules. Information costs also are present in less obvious ways. Information costs produce the litigation costs that drive a wedge between optimal tort liability and our existing system. Contingency fees paid to obtain legal expertise and payments for investigation and experts reflect, in part, litigators’ asymmetric information (including expertise). Information costs help explain the numerous risk-​imposing activities done by corporations through their own employees, instead of by hiring outsiders (Coase 1937). They also help limit the firm’s control over its own activities and introduce an additional role for the tort system.

 

ECONOMICS OF TORT LAW    87 Economic analysis of tort liability has provided considerable insights on how rules governing liability, damages, and procedures should be structured in order to optimally deter in a world of costly information, as this chapter has highlighted. This chapter also provides insights on productive avenues for both future scholarship and optimal tort reform. It suggests that optimal tort reforms may include measures that reduce the distortion of costly information, whether by lowering information costs or by extending liability to those (e.g., organizations) who can better address them. Finally, many fundamental and important questions about liability in a world of costly and dynamic information remain to be addressed by future scholarship.

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Chapter 4

ESTIMATI NG PA I N-​ AND-SU FFERING DA MAG E S Ronen Avraham

4.1. Introduction When a person is injured, tort law recognizes several types of losses: the victims’ economic loss (actual medical costs and diminished earning capacity) and noneconomic loss, which serves as a catchall for many losses, such as pain and suffering, mental anguish, emotional distress, and loss of enjoyment of life. Historically, the common law recognized pain-​and-​suffering losses only in intentional torts. In negligence claims, by contrast, the common law implicitly, and sometimes explicitly, expected the plaintiff to get over it. Over the years as courts have started to award pain-​and-​suffering damages in negligence cases, courts have struggled to clearly define and distinguish different aspects of these damages (Whaley 1992).1 One of the consequences of this struggle is the emergence of a confusing array of terms meant to elucidate the content and scope of pain-​and-​suffering damages. Courts refer, among other terms, to mental anguish, emotional losses, emotional distress, loss 1 

Part of this confusion arises from the distinction between contract cases and tort cases, and part arises from the differences in intentional and negligent torts. The negligent performance of a contractual duty may be both a tort and a breach of contract. Similarly, bad-​faith breach of contract may be deemed a tort, thus opening the door for emotional-​distress damages. Regarding intent, courts often allow actions for emotional distress in intentional torts, but only the minority of courts allows negligent infliction of emotional distress claims. As courts have gradually widened emotional distress claims, the demarcations between precedent related to intentional and negligent infliction have likewise been obfuscated. There is even confusion arising from a distinction between psychological damages and the more physical damages that make up pain and suffering. While pain and suffering actually covers many categories of nonpecuniary loss, including physiological pain, anguish and fear, emotional distress from losing someone you love, and the enduring loss of enjoyment of life, all of these are psychological losses. However, some types of physical loss are also included under pain and suffering. For instance, Chamallas and Wriggins (2010) point to reproductive harm as a physical loss that still represents nonpecuniary loss.

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    97 of consortium, hedonic damages, and psychic damages (Croley and Hanson 1995). With so many different terms, it is no wonder that confusion has been rampant. For example, damages for loss of enjoyment of life, alternatively known as hedonic damages, are intended to compensate for the loss of quality of life (Schwartz 2004). Some courts have had significant difficulties interpreting this term, and have even expressed doubts about “whether loss of enjoyment of life is compensable at all, and if so, whether it is part of pain and suffering, mental anguish, or physical impairment, or is a separate, independent category of damages” (Golden Eagle Archery, Inc. v Jackson, 116 S.W.3d 757, 768 [Tex. 2003]; Schwartz and Silverman 2004). While most jurisdictions treat loss of enjoyment of life, or hedonic loss, as a part of pain and suffering, other jurisdictions allow recovery of hedonic damages as a separate category of damages. In yet other states, either there is no clear ruling or hedonic damages are allowed in some instances and not in others (Schwartz and Silverman 2004).2 With respect to their content, some courts have indicated that these awards compensate for “the inability to perform activities which had given pleasure to this particular plaintiff ” (McGarry v Horlacher, 775 N.E.2d 865, 877-​78 [Ohio Ct. App. 2002]). Other courts have treated hedonic damages not as affirmative distress or suffering, but forgone gains, such as being unable to engage in activities that the victim valued, such as athletics or sex (Day v Ouachita Parish School Bd., 823 So. 2d 1039, 1044 [La ct. App. 2002]; Allen v Wal-​Mart Stores, Inc., 241 F.3d 1293, 1297 [10th Cir. 2001]; Varnell v Louisiana Tech University, 709 So. 2d 890, 896 [La. Ct. App. 1998]). Some courts have anchored them in the loss of something recognizable such as a limb or mental capacity (Pierce v N.Y. Cent.R.R.Co., 409 F.2d 1392 [Mich. 1969]; Matos v Clarendon Nat. Ins. Co., 808 So. 2d 841, 849 [La. Ct. App. 2002]; Kirk v Wash. State Univ., 746 P.2d 285, 292 [Wash. 1987]; Nemmers v United States, 681 F. supp 567 [C.D. Ill. 1988]). With so much inconsistency and indeterminacy, one should not wonder that pain-​ and-​suffering damages are under constant attack and are a major component of every tort reform. Opponents of pain-​and-​suffering damages argue that, unlike pecuniary damages, pain-​and-​suffering damages are hard to quantify accurately (King 2004). They argue that victims exaggerate their losses to receive higher damage awards, so that awarding pain-​and-​suffering damages may frustrate the function of tort law by compensating the victims too highly and arbitrarily. Another argument against pain-​and-​suffering damages is that the difficulty in objective measurement leaves the potential for enormous variance in awards at the discretion of individual judges and juries (Diamond 1998). This individual discretion may create a lack of horizontal equity and thus impede consistency among awards for like victims (Bovbjerg 1989).

2  States that treat hedonic damages as part of pain and suffering include Kansas, Nebraska, New York, Ohio, Pennsylvania, California, Minnesota, and Texas. States allowing hedonic damages in addition to pain and suffering include Maryland, New Mexico, South Carolina, and Wyoming.

 

98   RONEN AVRAHAM Avraham (2015) recently argued that from a law and economics perspective, pain-​ and-​suffering damages should be fully compensated and should receive the same “respect” that economic damages receive. I provided several arguments for that view. First, Avraham (2105) argued that the lack of horizontal equity might not represent a problem with damage calculations. Factfinders may treat like cases differently, but there is another possible explanation for heterogeneity in awards for injuries that, on the surface, appear to be “the same.” Judges and juries may be aware that there is great variation in how individuals subjectively experience pain and suffering (Chamallas and Wriggins 2010). In other words, factfinders in individual cases are aware of facts that are not available to researchers afterward. Moreover, evidence shows that observable seriousness of the physical injury is a reliable predictor of the size of award (Sloan and Hsieh 1990; Vidmar 1999; Vidmar, 1993; Diamond 1998). Another indication that pain-​ and-​suffering awards are not as wildly variant as some critics claim is that even though European countries have implemented rules to minimize horizontal inequity in damage awards, European pain-​and-​suffering awards are similar to those in the United States (Sugarman 2005). Still, even if there is real horizontal inequity in pain-​and-​suffering awards, the conclusion that they should be abolished does not follow. Rather, the inequity merely indicates the need for a more determinate process for factfinders to follow. Just because damage is difficult to quantify does not mean it should be ignored. The difficulty of quantification and the lack of horizontal equity it might cause do not justify setting damages at zero. Second, pain-​and-​suffering damages are not the only kind that prove difficult to quantify. Economic damages are often equally difficult (Rabin 1993). Lost wages and future medical expenses, for instance, have been drastically miscalculated by courts, showing that even these pecuniary losses are difficult to estimate precisely (Seffert v Los Angeles Transit Lines, 364 P.2d 337 [Cal. 1961]). There is no justification to single out for elimination pain-​and-​suffering damages from among all the difficult-​to-​quantify categories of damages. Third, the mere fact that some plaintiffs may exaggerate their symptoms provides no justification to eliminate pain-​and-​suffering damages. Courts have developed methods of correcting for this possibility. They have been estimating pain-​and-​suffering losses in intentional tort cases for centuries. Fourth and perhaps most importantly, scientific developments in the field of neuroimaging are creating the possibility of understanding and even verifying both pain and some emotional conditions (Kolber 2007). One recent study successfully used fMRI processes to identify specific neurologic signatures that identified pain sensation with very high accuracy levels (Wager et al. 2013). It is possible that science will soon be able to verify an accident victim’s subjective level of pain. Exaggeration may soon be impossible because judges and juries may have access to objective, scientific methods of quantifying pain and suffering as accurately as the quantification methods available for physical damages.

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    99 This kind of scientific progress is especially important as a potential response to the problem of malingering, which is when an individual continues to report pain even after it has stopped for the purpose of extending disability benefits or inflating a damage award (Cunnien 1997). It is hard to estimate malingering, but it may be a factor in 34% to 40% of chronic pain cases (Mittenberg 2002; Gervais 2001; Kolber 2007). Further, studies show that treatment outcomes are worse for people involved in personal injury litigation than for those who do not seek compensation (Mendelson 1997). Even if the litigation is a cause of malingering, it could be because the stressors and delays of the tort system retard the healing process. Or, people who are prone to poor treatment may also be more likely to file a lawsuit. Recent scientific advances may obviate the need for this type of speculation by creating objectively verifiable pain metrics. In sum, the best solution for dealing with the high cost of administrating pain-​and-​ suffering damages and the alleged variation in horizontal quality is to reduce the cost of administration and to increasing uniformity, not limit plaintiffs’ recoveries. The best way to accomplish this is via simplifying ways to estimate pain-​and-​suffering losses. In this chapter, I survey a number of solutions discussed in the literature on how to simplify the estimation of pain-​and-​suffering damages to cut administrative costs. My goal is to demonstrate the feasibility of the task of estimating the loss more than to recommend any specific path to it.

4.2.  How To Estimate Pain-​ and-​Suffering Damages As the court in Botta v Brunner said, “For hundreds of years, the measure of damages for pain and suffering following in the wake of a personal injury has been ‘fair and reasonable compensation.’ This general standard was adopted because of universal acknowledgment that a more specific or definitive one is impossible. There is and there can be no fixed basis, table, standard, or mathematical rule that will serve as an accurate index and guide to the establishment of damage awards for personal injuries” (Botta v Brunner, 138 A.2d 713, 718 [N.J. 1958]). Defining and monetizing “fair and reasonable” has been a matter of protracted difficulty. Indeed, the problem of standardizing and achieving horizontal and vertical equity in pain-​and-​suffering damages has been a hot topic for both scholars and courts for decades, but no common understanding has emerged. (Horizontal equity means similar compensation for injuries of similar severity, and vertical equity means more severe injuries receive more compensation than less severe ones do. These principles are not well served by the current tort system.) This chapter will demonstrate that there have been various attempts to provide some structure to the definition of “fair and reasonable compensation,” and it will critically

 

100   RONEN AVRAHAM survey a number of mechanisms used to quantify and monetize damages. Some of these are tailored specifically to pain and suffering, and others are used to determine a total award without distinguishing the amount awarded (if any) for pain and suffering. Some are individualized and some are not. For some of these systems (such as Worker’s Compensation and per diem), calculations have been used by courts, whereas for others (such as Quality-​Adjusted Life Year [QALY]) such methods have been used only by nonjudicial institutions. In short, this chapter details available methods for analyzing pain-​and-​suffering damages. I start by discussing the individualized approaches: the golden rule, per diem, medical costs as a basis for pain and suffering, utilizing a loss of pleasure of life scale, and finally, QALYs. Then, I discuss the non-​individualized (routinized) approaches: fixed amounts of pain-​and-​suffering damages, fixed caps on noneconomic damages, flexible caps on noneconomic damages, fixed amounts for the entire injury, legislated damages schedules, court-​based damages schedules, and commission-​created damages schedules. While I  do not necessarily recommend a specific approach, my main goal is to demonstrate that contemporary complaints about the high costs associated with valuing pain and suffering cannot serve as a sound reason to limit or eliminate pain-​ and-​suffering damages from tort law: there are many cheaper and more feasible alternatives to estimating them.

4.2.1. Individualized Approaches This section looks at individualized approaches to estimating pain-​and-​suffering damages. Most of these approaches have been examined by courts in one form or another.

4.2.1.1. The Golden Rule One way to operationalize the idea of fair compensation is via the “Golden Rule” jury instruction. The Golden Rule approach to valuation asks tort juries to place themselves in the shoes of the plaintiff when determining damages. That is, jury members should estimate the amount of money they would require as (ex post) compensation for having to experience the victims’ pain and suffering (Avraham 2006). The Golden Rule has been widely rejected by courts because, to achieve the goal of compensating for the injuries suffered, courts have observed that we need “fair and impartial jurors who are not governed by sympathy or bias” (American Law Reports 2d, 1964). There are several possible variations of the Golden Rule. The one that has been examined and rejected by courts looks at the plaintiff ’s willingness to accept (WTA) compensation (ex post) for her injury. Other variations exist that potentially have a greater chance of success in courts. One possible variation is to ask the jury to estimate how much the plaintiff would have been willing to accept (ex ante) to bear the

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    101 risk of injury. These two variations of plaintiff ’s WTA can be contrasted with her willingness to pay (WTP) to prevent the harm, or a certain chance of a particular harm. In the debate on how to optimize regulation, these two concepts (WTA versus WTP) have received considerable attention. The debate, however, is thousands of years old.3 Asking people what they would be willing to accept in payment for incurring the loss might be problematic because some evidence suggests people will demand more to give up a good than they would be willing to pay to obtain that good in the first instance. (Thaler 1991; Sunstein 1986). Endowment effect theory has been used to explain why studies have found that WTP (for something you do not have) is routinely lower than WTA (to depart with something you have). Yet, failures in the design of the experiments that found the gap probably provide the best explanation for this phenomenon (Plott and Zeiler 2005). The WTP/​WTA gap often disappears when experimental procedures are altered to eliminate alternative explanations (Klass and Zeiler 2013). In a similar fashion, some suggest that the WTP metrics should be used to measure hedonic loss (Viscusi 1998). Geistfeld (1995) has considered using a similar approach as a method for determining pain-​and-​suffering damages. He asks what price would a consumer pay to avoid a 1/​10,000 chance of injury, rather than asking what they would pay to avoid certain injury. He uses a methodology employed by regulatory agencies, and believes that it can provide an objective basis for determining pain-and-suffering damages. This approach, however, is prohibited in tort cases because the question of damages is not decided by valuing risks, but instead by valuing the damages after they occur (Viscusi 1988; Sunstein 1993). Some argue that the WTP method also inflates the valuation because of the underestimation of hedonic adaptation, which is people’s tendency to adjust to their new disability and restore their level of overall happiness. Hedonic adaptation suggests that the plaintiff ’s WTP has the potential to be substantially higher immediately following the injury than it will be later, at the conclusion of the lawsuit (Bronsteen, Bucafusco, and Masur 2008). In addition, WTP is determined by the use of hypothetical questions about experiences the respondents have never had. Further, WTP varies with income and wealth, which would lead us to conclude wrongly that poor people suffer less pain (Abel 2006).

3  The Mishna (Judaism’s first major book describing Jewish law written around 200 A.D.), has instructions on compensations for pain. It says, “they assess how much a person such as [the injured] would be willing to be paid in order to suffer such pain” (mBK 8.2). This is a WTA approach. The Talmud (Judaism’s second major book completed in the 5th century A.D., which is comprised of commentaries on The Mishna), contemplates a WTP approach. It says that pain-and-suffering damages should be appraised by estimating one’s willingness to pay to have an anesthetic drug for the amputation of his arm, which by the decree of the government must be amputated by a sword (tBK 8).

 

102   RONEN AVRAHAM Even though the Golden Rule is prohibited in the United States, in practice, plaintiffs’ lawyers openly advocate and attempt to find ways around the Golden Rule to encourage the jurors to sympathize with the plaintiff. In a case where a plaintiff lost an arm, some jurisdictions allow counsel to ask the jury how much the plaintiff would have sold the arm for (McElheney 1987). Because the jurors have no way of knowing what the plaintiff would do in this situation, this selling-​price perspective on damages encourages the jurors to consider how much money they personally would accept in return for the injury (McCaffery 1995). This is just one of many techniques used by plaintiff ’s attorneys to encourage the jury to empathize with, or put themselves in the place of, the plaintiff. Yet, plaintiff ’s lawyers making Golden Rule arguments risk a mistrial, as in Velocity Express Mid-​Atl., Inc. v Hugen, 585 S.E.2d 557 (2003).

4.2.1.2. Per Diem Courts have considered the per diem approach for estimating pain and suffering. Per diem arguments are a mechanism allowed by some states (e.g., Arizona) whereby a lawyer argues that the ongoing pain and suffering should be calculated according to a short period, such as a day, an hour, or a minute, and then multiplied by the victim’s remaining life expectancy (Totaro 2006). Most states have deemed the use of a mathematical formula in determining an award for pain and suffering to be a per diem if the amount is derived from a multiplication of a unit of time and a dollar amount (Giant Food Inc. v Satterfield, 603 A.2d 877 [Md. 1992]). Many states have ruled that is improper for counsel to suggest per diem valuations, and that such arguments are prohibited as a matter of law. But some states have decided that the argument is appropriate and can be given at any time. Some states have decided that the use of the per diem argument is within the discretion of the trial court judge (King 2003), while still other states permit per diem arguments only when accompanied by a caution from the judge that the arguments are not “facts” (Debus v Grand Union Stores, 621 A.2d 1288 [Vt. 1993]). Reasons against allowing per diem arguments have been advanced by both scholars and courts alike. Among many others, they include lack of evidentiary basis for the conversion of pain and suffering into monetary damages, misleading the jury into making larger awards, and disadvantaging the defendant because the defendant must rebut an argument with no basis in evidence (Giant Food, 603 A.2d at 879). Scholars have also argued that per diem arguments promote cognitive anchoring (assigning a value according to the only suggested number you have heard and adjusting slightly from that number), in the face of “the impossible task of converting in some rational way pain and suffering into a sum of money” (King 2003). Overall, it seems plausible that a juror would have an easier time estimating the value of a day’s worth of suffering than a lifetime’s worth, and, since so much subjectivity is involved, this seems like an appropriate technique. On the other hand, some argue that damage awards generated by per diem calculations are generally inflated because they are suggested by plaintiff ’s counsel for this purpose and thus do

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    103 not serve the goal of a “fair and reasonable compensation,” as is the goal of tort law. The answer to this claim is that defendant’s lawyers are always free to offer a different number or a different way to get at the number than that proposed by plaintiff ’s lawyers. Indeed a recent study that analyzed real jury deliberations suggests that plaintiff ’s lawyers requests do not serve as an anchor for the jury damages determination (Diamond et al. 2011).

4.2.1.3. Medical Costs as Basis for Pain and Suffering In an effort to streamline and simplify pain-​and-​suffering damage calculations, one suggestion has been to use a victim’s economic loss (also known as special damages) as a starting point. A common approach sometimes used by insurance adjusters treats special damages as a reference point, which is then multiplied by a factor of three or more to arrive at the settlement amount. This approach is known as “three times specials.” However, sometimes “three times specials” means three times the medical bills, exclusive of damages for loss of income. Eliminating loss of income from the calculation is sensible on the ground that the legal system should not recognize differences in pain and suffering based on the victim’s earning capacity. A more sophisticated approach will be to use a multiplier of medical costs that is not fixed but rather increases as medical costs increase (Avraham 2006). The specific multiplier could be determined by precedent or by state or federal law, and could be different for different categories of torts. For example, in a system of Non-​binding Age-​Adjusted Multipliers (NBAAM) multipliers would adjust for the age of the victim, and calculated according to the anticipated remaining years of life. These multipliers will not be binding, leaving discretion in the hands of the jury, while providing non-​binding guidelines that increase both horizontal and vertical equity. Because medical costs can be determined by evidence, this decreases the guesswork for which tort awards of pain-​and-​suffering damages are widely criticized. The main problem in adopting NBAAM is a lack of evidence relating to what the multipliers should be, and what factors should be considered when calculating these multipliers. Despite these difficulties, NBAAM has been used in courts. One court applied a multiplier of 1.5 to medical costs (Rhoades v Walsh, 2009 U.S. Dist. LEXIS 75784, 47). Another court would have used NBAAM if medical cost information had been available (Henderson v Atl. Pelagic Seafood, LLC, 2011 U.S. Dist. LEXIS 33727, 34). Recent empirical work lends some support, as well as suggesting some possible guidelines for NBAAM calculations. A recent study of Taiwanese district court accident cases shows that nonpecuniary damages are strongly correlated with amounts awarded for medical expenses and the level of injury (Chang et al. 2013). The authors of that study also find that the U.S. tort system awards nonpecuniary damages at roughly the same percentage of total damages as Taiwan does, indicating that nonpecuniary damages in the United States may also be influenced by the same factors. These findings not only indicate that judges and juries intuitively anchor their nonpecuniary awards to the

 

104   RONEN AVRAHAM amount of medical expense but also may provide a reasonable mechanism by which to calculate the precise multiplier that should be used as a guideline for triers of fact in the United States. Implementing a formal mechanism for NBAAM could simultaneously help to eliminate the irrational tendency cognitively to anchor nonpecuniary damages to the amount requested by the victim’s lawyer, while preserving the rational tendency of judges and juries cognitively to anchor nonpecuniary damages to the amount of medical damages. It would also allow introducing other relevant factors into the calculation, such as the age of victim. NBAAM can thus serve as both a preservation of and an improvement upon the current system.4

4.2.1.4. Loss of Pleasure of Life Scale Another suggested method for rating hedonic losses is the Lost Pleasure of Life (LPL) Scale, which asks a psychologist to evaluate a person’s postinjury lifestyle in comparison to her preinjury lifestyle (Berlá 1989). The psychologist is asked to gauge the ability of the person to experience pleasure in four areas: practical functioning, emotional functioning, social functioning, and occupational functioning. A zero rating is an individual who has lost no ability to function, whereas a 100 rating means that the individual is unable to function and cannot derive any pleasure from a particular area. Each of these four functionalities is judged upon the percentage loss from the preinjury state. Losses are divided according to those percentages into minimal, mild, moderate, severe, extreme, and catastrophic. This method would also consider age and length of time that a person’s loss of pleasure is likely to persist (Berlá 1989). The goal is to provide an objective, consistent, and expert recommendation about the degree of LPL. One weakness in the LPL measure is that it does not solve the problem of translating these measures into dollars. Indeed, courts’ citations to the LPL are relatively scarce, although courts have used it to estimate damages (Schwatz and Silverman 2004; Brookshire and Smith 1992–​1993; Hunt v K-​Mart Corp. 981 P. 2d 277 [June 1999]).

4.2.1.5. Quality Adjusted Life Years QALY is a concept imported from the field of health economics, and it refers to the value of living a year of life with a certain health impairment. In fact, it is an umbrella term for various different ways of comparing diseases and injuries to one another and to a condition of perfect health. It is a form of cost-​effectiveness analysis where health states that persist for a period of years have been ranked by patients who experienced the states, by physicians who treat the states, or by members of the general population (Adler 2006). The rankings are on 0–​1 scale, where 0 is death and 1 is perfect health. The “life year” concept enables the rankings to address both the severity and the duration of health impairments. 4  One problem with this approach is that it might create incentives to inflate medical costs in order to obtain higher pain and suffering damages and higher contingency fees. For a rejoinder to this concern, see Avraham (2006).

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    105 QALY’s are increasingly used by regulatory agencies as the basis for their rulemaking. Agencies such as the FDA, EPA, OMB, and Public Health Service have all used the QALY cost-effectiveness analysis in varying capacities.5 QALY is preferred by many to a traditional cost–​benefit analysis because cost–benefit analyses require placing dollar valuations on the outcome of any program or intervention, whereas QALY only requires choosing between options based on their relative returns in QALY.6 Using QALY requires controversial decisions, such as determining the appropriate dollar amount of each QALY and the appropriate QALY scale to determine the weight each injury should receive. Still, with more research and analysis, QALY may provide a reliable reference point for calculating pain-​and-​suffering damages in courts (Karapanou and Visscher 2010). Yet, somewhat surprisingly, despite the expansive use of QALY in evaluating health programs and medical treatments, the concept has not penetrated tort law. Only a couple of papers have proposed that QALY research could be converted for use in tort cases by basing pain-​and-​suffering awards on the impact of the health impairment (Miller 2000; Karapanou and Visscher 2010). Whereas Miller (2000) proposed choosing QALY scales on a case-​by-​case basis, Karapanou and Visscher (2010) proposed using general QALY weights as a starting point for a more individualized assessment of the plaintiff ’s injury. Either of these two methods provides some objective measurement in which pain-​and-​suffering damages could be grounded.

4.2.2. Non-​Individualized Approaches: Routinization Routinization is defined as an attempt to establish a form of “orderliness and predictability that is conducive to individuals’ planning their lives” (Goldberg and Zipursky 2010). As third-​party insurance has expanded, so have the numbers of repeat players in the tort system: even small-​time defendants are represented by insurance companies with vast experience in settling tort claims (Robinette 2013). Generically, a routinized system is one that permits a victim to file a claim, dispenses with a prolonged inquiry into fault, and results in a very large percentage of victims receiving compensation without having to deal with the difficult issues of individualized monetizing of pain-​and-​suffering damages. Such systems—​of which Worker’s Compensation is a prime example—​generally erase the distinction between pecuniary and nonpecuniary components of harm (Goldberg and Zipursky 2010).

5  Food and Drug Administration, Environmental Protection Agency, Office of Management and Budget, Public Health Service. 6  “To many in the worlds of medicine and public health, any attempt to place a value on human life is anathema. Thus most ‘economic’ evaluations of health care have applied [cost effectiveness] analysis, which limits the analyst’s responsibility to providing information about the efficiency with which alternative strategies achieved health effects” (Garber 1999).

 

106   RONEN AVRAHAM Routinization can make compensation more predictable, efficient, and administrable: benefiting all of the repeat players in the system. Defendants prefer predictable liability payments because they reduce defendants’ liability premium. Insurers prefer predictable payments because they facilitate premium and profit calculations that are more accurate. Plaintiffs’ lawyers working on a contingent fee prefer a large judgment or settlement in relation to the amount of hours spent on the case. All of these interests favor the prompt resolution of cases. There are, of course, major drawbacks to routinizing pain-​and-​suffering damages. Too much routinization puts people into classes while ignoring relevant individual circumstances. For example, a violinist who loses a finger and a law professor who loses a finger do not experience the same suffering. If their recovery were routinized so that they received the same compensation, the violinist would be undercompensated whereas the law professor would be over compensated. In addition, routinization fixes damages for years without updating them for changes in victim’s experience. Depending on the type of routinization, this problem could possibly be overcome; for example, by regular inquiries into appropriate values. Section 4.2.2.1 will show that if unpredictability is the primary objection to pain-​and-​suffering damages, there are viable possibilities to allay the concern. Section 4.2.2.1 surveys the major forms of routinization.

4.2.2.1. Fixed Amount of Pain-​and-​Suffering Damages When one event has many victims, it sometimes makes sense to award each one the same amount or very close to the same amount. The most famous example is the 9/​11 Victim’s Compensation Fund, which set pain and suffering at $250,000 for most cases, giving little consideration to individual circumstances. While the plan drew heavy criticism from plaintiff ’s lawyers and victims, it was implemented and executed quickly (Glaberson 2001). As with all other routinization mechanisms, nuance and individualization are sacrificed in favor of administrative efficiency. Awarding fixed amounts is an example of the biggest such sacrifice. If the amount is low, everybody might be undercompensated. If the amount is high, everybody might be overcompensated. A medium amount, might cause the severely injured to be undercompensated and the least severely injured to be overcompensated. Even though a predetermined payout system does eliminate the need for litigation, some determinations must still be made. For instance, in the 9/​11 Victim’s Compensation Fund, there were arguments that people who had suffered extraordinary harm should be paid a higher amount for their pain and suffering (Steenson and Saylor 2009). The claimants were entitled to a hearing on request to make a case for higher than average pain-​and-​suffering awards, but in practice, the awards remained uniform. In addition, the administrators of the Fund represented the final word on claims. Once victims chose to make a claim with the Fund, they waived any tort claim against any potential tortfeasor (except the terrorists) so that litigation was no longer a possibility and their only option for compensation was through the Fund administration. There was literally no appeals process, which on the one hand promoted streamlined payouts but on the

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    107 other hand provided no recourse for an undercompensated individual to seek review of his case. The 9/​11 Victim’s Compensation Fund is an example of how routinized payouts setting a fixed amount for pain and suffering might play out. Despite its weaknesses, the legislature succeeded in what it set out to accomplish by establishing the Fund. Litigation against the airlines (and other possible tortfeasors) was minimized, and claimants were paid swiftly and surely. The 9/​11 Fund was created at a time of unprecedented patriotism and cooperation in the United States (Steenson and Saylor 2009). It remains to be seen if a project of similar magnitude under other circumstances could be administered as efficiently. Moreover, it is unlikely that routine claims and payouts from a fund would be useful outside the context of major catastrophes with a large number of victims and one entity (or a very few) potentially liable. However, the 9/​11 Fund might represent a possible solution to avoid the high administrative costs of claim payouts when liability is not a question.

4.2.2.2. Noneconomic Damage Fixed Caps Damage caps represent a hybrid approach between individualized and entirely routinized damages. More than half of the fifty states have passed legislation imposing caps on noneconomic damages (Avraham 2014). State caps have varying degrees of flexibility. Some impose an absolute cap on damages, irrespective of any background circumstances. For example, California capped noneconomic damages for medical malpractice actions at $250,000 in 1975, even though the real value of that amount has declined dramatically over the last 40 years (Cal. Civ. Code §3333.2 [2004]). Other states have caps that are adjusted for inflation each year. For example, Idaho adjusts its noneconomic damages cap annually based on average wage data (Idaho Code §6-​1603 [2004]). There are also states that have attempted to eliminate some of the rigidity in their damage caps, by allowing the judge or jury to waive the damages cap if aggravating circumstances justify a higher award. Caps maintain the traditional duty of the jury to assess pain-​and-​suffering damages (and in that respect provide no help on how to do it), but they limit the discretion so that any harm above the cap is truncated and thus undercompensated. Thus, caps solve the problem of factfinders erroneously overcompensating the least severely injured but leave unresolved the problem of undercompensating the most severely injured. Moreover, caps do not help courts determine damages for injuries below the caps. In sum, caps do not reduce administrative costs, and they do not increase equity by much or at all. And yet, caps are the most common tort reform in the United States.

4.2.2.3. Noneconomic Damage Flexible Caps In Australia, judges take the role occupied by juries in the United States (Masada 2004). Judges are finders of fact and assess damages.7 Perhaps the fact that judges 7 

Australia also requires fees for legal services to be payable on an hourly basis, instead of contingency fees which discourage attorneys from pursuing speculative claims.

 

108   RONEN AVRAHAM are repeat players in assessing damages is why New South Wales, the largest state in Australia, passed a somewhat complicated liability reform for health care providers in 2001. The law imposes a cap of AU$350,000, which is adjusted each year for market conditions, but it is much more nuanced compared with the hard caps used by states in the United States. It delineates a damages estimation scheme and imposes a minimum loss requirement, as well as a loss threshold below which nonpecuniary losses are not awarded. Specifically, the New South Wales law compares all cases to a hypothetical most extreme case. For example, a hand injury would be compared with losing the whole hand. The judge is asked to find a specific percentage of the “most extreme” case for each injury seeking compensation. No noneconomic damages are awarded if the severity of the noneconomic loss is less than 15% of the most extreme case. For injuries where the noneconomic loss is between 15% and 33%, a table provides the maximum recovery as a percentage of the maximum possible recovery. For example, when the severity of the noneconomic loss as a proportion of the most extreme case is 15%, the damages (as a proportion of the maximum amount that may be awarded) is 1% of the AU$350,000 cap. When the severity is 25%, the damages are 6.5% of the cap, etc. For any injury where the injury surpasses 34% of the most extreme case, noneconomic damages will be the same percentage of the maximum amount. That is, an injury that is 50% as severe as when the most extreme case will result in AU$175,000 in damages for nonpecuniary harm (Masada 2004). Australia’s tort reform measures, including the “most extreme case” rule, has been successful in achieving some of its aims. Unlike statutory damages limitations in the United States, in Australia there are no constitutional questions causing insurers to be uncertain about the stability of tort reform (King 2010). And perhaps for that reason, the Australian damages reform has had the unambiguous effects of reducing litigation and of lowering insurance premiums. In his 2010 article, King argues that despite these apparently desirable effects, the tort reform made consumers economically worse off by forcing them to bear the risk of suffering an injury resulting in losses that exceed those limits. However, if reducing litigation and lowering insurance premiums are main policy goals in the United States, the Australian system, which has been in place since 2002, might provide a good model (Sugarman 2005; Sullivan 2005).

4.2.2.4. Fixed Amount for the Entire Injury While the tort system has experienced considerable informal routinization in recent years, trust systems provide a more formal model of routinization. For example, Agent Orange was an herbicide used by the U.S. Army in Vietnam (to kill plants that provided cover to the Vietnamese). It was widely believed to cause a variety of forms of cancer (Weinstein 2006). A class action was filed against the manufacturers of Agent Orange, and Judge Weinstein approved a settlement that set up a trust fund to provide compensation for anybody who could show a minimum possible connection to exposure. There was a list of diseases that were compensated according to matrices based upon age, time

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    109 since exposure, nature of the disability, and similar conditions. No distinction was made between pecuniary and nonpecuniary harm; the compensation was for the entire injury. Judge Weinstein believed that this system provided a mechanism to avoid the costs and delays of litigation for victims, while maximizing the impact of available funds by providing insurance policies instead of direct recovery, which covered a range of diseases for anybody who became ill.8 Another example is the British Petroleum (BP) Deepwater Horizon Oil Spill. The 2010 oil spill was the worst in American history, and it precipitated thousands of lawsuits (Mullenix 2011). Lawyers for BP and the plaintiffs entered into a settlement that relies upon the Specified Medical Conditions Matrix.9 In addition to listed baseline amounts for certain conditions, the variables on the matrix include length of hospital stay, geographic location at the time of exposure, and status of the victim (whether resident or clean-​up worker). The matrix is open to the public, but actual payment amounts are determined by a court-​appointed claims administrator and are subject to challenges. The settlement is open-​ended. Therefore, even though BP put $20 billion in trust, it must still pay out claims according to the matrix after the trust fund runs out. The matrix and the court-​approved settlement are available online (Deepwater Horizon Claims Administrator 2012). A similar solution was used for compensating victims of injuries resulting from the Dalkon Shield birth control device (Vairo 1992). The Dalkon Trust offered three settlement options with differing payouts and standards of proof. Option 1 awarded each claimant $725 (plus $300 for the husband) if the claimant merely stated she had used the device and suffered injury. Option 2 was for claimants with medical proof of use and injuries, but alternative causation complications, and it awarded claimants between $850 and $5500. Option 3 offered settlements based on prepetition claim values (excluding all transaction costs). The Dalkon Trust worked very well by almost all accounts (Vairo 1992; Chamblee 2004). It has even been hailed as a “paradigm of fairness and efficiency” because it “gave individual claimants a voice” (Chamblee 2004). The claims were paid out 9 years ahead of schedule, and the Trust ended up with extra funds. Despite minor criticism, the Trust 8  Asbestos trusts are similar. The ARPC (Analysis Research Planning Corporation) manages an aggregated trust from nearly all the large-​scale asbestos defendants, and uses a web-​based claims-​ processing system, which has processed millions of claims and paid billions of dollars with “cost to benefit ratios that are far lower than comparable settlement approaches” (U.S. Government Accountability Office, 2011). 9  Matrices have been used in other aggregate settlements; notably, the Vioxx litigation settlement included developing a matrix. Vioxx was a painkiller that was associated with increased risk of heart attacks and strokes. Merck, the manufacturer, settled with the plaintiffs for $4.85 billion. A third-​party claims administration used a points system to “score” plaintiffs based upon factors such as severity of the injury, age, and the presence of other risk indicators. The Vioxx settlement, like the Agent Orange settlement, differs from the BP settlement matrix in that it was for a fixed amount of money. Also, the Vioxx plaintiffs had no way of estimating how much their award would be before they had to opt in or out of the settlement, because the dollar value per point was not determined until after all the claims had been made (Erichson and Zipursky 2011).

 

110   RONEN AVRAHAM was considered successful. Keeping in mind its limited application, the Dalkon Shield Trust has the potential to serve as a model for large-​scale distribution of payouts for tort claimants (Vairo 1992). Another example of fixed amounts for the entire injury is the Hokie Spirit Memorial Fund, which was funded by private donations to compensate victims of the 2007 Virginia Tech shooting. The Hokie Spirit Fund paid out fixed amounts for the entire injury, and this was accomplished with minimal administration. Families of victims who died received lump-​sum payments of $180,000. The victims who survived received payments of either $40,000 or $90,000, depending on how long their hospital stay was. There was no discretion to vary this payment schedule at all. The Hokie Spirit Memorial Fund was very different from the 9/​11 Fund because it was created solely by charitable contributions, and the claimants were not required to waive their tort remedies. In fact, the Hokie Spirit Fund was not created or administered with tort liability in mind, and it had no legal effect on subsequent litigation (Feinberg 2007). Still, it demonstrates that pain-​and-​suffering losses can be rolled into a lump-​sum amount compensating victims for their entire injuries.

4.2.2.5. Legislated Damage Schedules Although damage schedules have been widely adopted overseas, they have never been adopted in the United States.10 In the U.S., courts have hinted at scheduling but have no authority to adopt such a mechanism (Sebok 2005; Rabin 2005; Seffert v Los Angeles Transit Lines, 364 P.2d 337 [Cal. 1961]). Indeed, the only damage schedules in the United States were adopted by legislation, such as in the Worker’s Compensation system. The U.S. Worker’s Compensation system offers a trade-​off wherein pain-and-suffering damages are not awarded in any case, and there is no option to sue in the tort system, but in return, there is no question of fault, and damages are awarded to every injured worker. The Worker’s Compensation system schedules damages in a predictable way (Larson and Larson 2008). This is designed to eliminate the transaction costs, delays, and uncertainty inherent in the tort system. The Workers’ Compensation model thus provides a no-​fault alternative that displaces tort law within a major field of accidents (Rahdert 1995). For example, the Longshore and Harbor Worker’s Compensation Act provides for four tiers of damages: Permanent Total Disability, Temporary Total Disability, Permanent Partial Disability, and Temporary Partial Disability (33 U.S.C. §908 [1988]; 5 U.S.C. §8105 [a]‌Total Disability [2011]). Total Disability is defined as loss of any two of hands, arms, feet, legs, or eyes. Total Disability benefits are 66.67% of average weekly wages to be paid during the continuance of the total disability. Partial disability is defined where loss of specific limbs, senses, and digits, and other impairments are scheduled according to severity. To illustrate the high and low end of the schedule, 10  Comparison studies of European and U.S. recovery levels for pain and suffering indicate that the United States provides more damages that are nonpecuniary: at least a 10:1 ratio. Differences in the strength of the social safety net, loser pay rules, and stronger regulatory rules resulting in fewer injuries might explain part of this difference.

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    111 the loss of an arm awards 312 weeks compensation at 66.67% of salary, and loss of a fourth finger provides just 15 weeks compensation. The schedule gives specific compensation periods for loss of phalanges—​a rating scale for where a digit or limb must be amputated—​and a variety of other metrics. All of the damages are awarded according to the schedule and for 2/​3 of wages before the accident. While the Workers’ Compensation scheme eliminates the messiness and expense inherent in the current system of determining and awarding pain-​and-​suffering damages, it does so at the cost of awarding no pain-​and-​suffering damages, even to the most deserving victims. This trade-​off has been seen every time the law has expanded liability itself: in such expansions, general (nonpecuniary) damages are always reduced or eliminated (Diller 2003; Abel 2006). The Worker’s Compensation scheme is relevant to the monetization of pain-​and-​ suffering damages because it demonstrates that various disabilities can be scheduled and quantified. One way to understand the Worker’s Compensation scheme is that the damages allocated include compensation for pain-​and-​suffering losses. Under this understanding, pain-​and-​suffering losses are understood to depend on one’s salary. As mentioned, in the context of NBAAM, it is hard to justify such an approach. Another way to understand the Worker’s Compensation scheme is that it quantifies all pain-​and-​ suffering damages at zero. Even under this understanding, there is nothing that prevents policy makers from treating pain-​and-​suffering losses in the same way, as a fixed amount according to the severity of the injury. Indeed, there has recently been some legislative action moving toward damage schedules. In 2004, the Washington legislature established a task force to promulgate a schedule for noneconomic damages (Washington State Legislature 2004). The purpose of the advisory schedule was to increase “the predictability and proportionality of settlements and awards.” The task force report authors believed that a schedule would promote both horizontal and vertical equity across noneconomic compensation awards (State of Washington Task Force 2005). The task force suggests that creating a schedule will take two steps: delineation of levels of severity and assignment of dollar values to the tiers. They suggest using a severity scale developed by the National Association of Insurance Commissioners, which is the best-​known and most widely used quantitative scale for classifying injury severity (Sowka 1980; Studdert 2011). As for assigning dollar values to the tiers, the task force report indicates that there is a significant lack of data available, but that the best source of data would be precedent. In a 2011 article by the same authors, which was written to supplement and emphasize the feasibility of the task force report recommendations, they referenced a 3-​year study done for the Canadian government called the Ontario Noneconomic Loss Study (ONELS) (Studdert 2011). The ONELS study conducted face-​to-​face interviews, where participants were asked to rate injury severity with thirty-​eight explanatory variables. This produced ratings for loss of quality of life for a variety of benchmark conditions (Sinclair and Burton 1994, 1997; Studdert 2011). The authors then used the weights to each injury derived from the ONELS study to compare with a Harvard Malpractice

 

112   RONEN AVRAHAM Insurers Medical Error Prevention Study (MIMEPS) to assign a monetary value to the categories of injuries (Ghandi 2006; Rogers 2006; Studdert 2006). Trained physician specialists reviewed claim files for malpractice insurance companies and used the payouts in those cases to determine a monetary value. Thus, the National Association of Insurance Commissioners table serves as the severity scale; the ONELS and MIMEPS studies assign a monetary value to the different severities; and together they form a schedule of damages. While scheduling damages has not yet materialized in legislation in the United States, the task force report for the State of Washington and the follow-​up research done to supplement this report indicate that it is conceivable to see some legislated damage schedules in the future.

4.2.2.6. Court-​Based Damage Schedules The previous section discussed legislated damages schedule. In Britain, a Judicial Studies Board publishes guidelines every few years for general damages in personal injury cases (McKay 2010). Designed for British courts when settling personal injury claims, these guidelines are non-​binding, but they are generally adhered to absent extenuating circumstances. The recommendations purport to cover “general damages,” which would include all nonpecuniary damages unrelated to medical costs. The guidelines give a narrow range for awards based on a variety of factors. Age and life expectancy are included in virtually all of the calculations. Other factors include the existence and extent of pain, depression, range of movement, and other physical limitations. The numbers are based on data derived from precedent and are adjusted according to statistical methodologies. The guidelines are increasingly referenced in scholarly works on the issue of pain-​and-​ suffering damages in the United States. They are thorough (with the exception of small claims with slight injury), and increasingly authoritative not just in Britain but in other European jurisdictions.11 The guidelines use the amount of damages awarded in reported cases as indicators in slotting particular injuries into its framework. They are intended to “distil the conventional wisdom contained in the reported cases,” and they provide consistency between awards as required by justice. The categories of damages include Paralysis, Head Injuries, Psychiatric Damage, Sensory Damage, Organ Damage, and many others (McKay 2010). Each is broken down into specific kinds of injuries (e.g., location and type of trauma), and divided into minor, moderate, moderately severe, and very severe on the severity scale. The guidelines are now in their thirteenth edition and are considered a must-​read by all personal injury lawyers in Britain because they serve as a jumping-​off

11  The introduction to the Guidelines describes the voluntary nature of the adoption of these standards by the courts. It further explains that the lack of data is the primary reason that small injury awards are not included. The introduction also explains that contesting the amount of the award has become much less prevalent in Britain because both plaintiff and defendant are very often willing to accept the Guidelines’ suggested award, so that litigation is limited to material disagreement about facts and evidence (McKay 2010).

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    113 point for damage negotiations in most disputes. Similar guidelines exist in other countries such as Ireland.12 Other countries that use a form of non-​binding schedules are Germany and the Netherlands. They utilize past pain-​and-​suffering awards to decide how much to award in a particular case, so that there is more horizontal and vertical equity. In Germany, official tables are used, and in the Netherlands, there is an overview of cases published regularly that serves as a guideline. Like the British system, courts in Germany and the Netherlands still enjoy a certain amount of discretion, but they are expected to consult the compilations of past awards. This process produces modest awards compared with other methods. Italy and Belgium also rely on tables to inform tort damage awards, although the tables were not created by precedent. Italy’s tables consist of awards corresponding to percentage-​based invalidity points. The first nine percentage points have legislatively mandated award amounts, but injuries that are more serious are left to the discretion of the court. Similarly, Belgium has a table specifying amounts to award for personal injuries, basing the percentage of invalidity on a victim’s inability to work following the injury. As in the other systems discussed in the chapter, these tables are advisory to the courts and are not mandated.

4.2.2.7. Damage Schedules Created by a Commission In Sweden, compensation for iatrogenic injury is provided through voluntary, contractual Patient Compensation Insurance that provides compensation without proof of provider fault through an administrative mechanism (Danzon 1994).13 Although patients retain the right to sue in tort, this administrative mechanism has largely displaced tort claims. The system is funded by a tax on medical care, internalizing costs to the medical care system, but without specific deterrence or fault assigned to particular institutions. Pain-​ and-​ suffering damages are determined according to the schedule defined by the Traffic Injuries Board and approved by the courts. The Road Traffic Injuries Commission (Commission) deals with loss of income and noneconomic compensation. Noneconomic compensation is partly composed of pain and suffering during the period of acute sickness, and it is determined according to standardized tables. Two other forms of noneconomic compensation are provided; inconveniences in daily life, and, for those who return to work, inconveniences at work. In an attempt to ensure impartiality, the Commission’s chair is appointed by the government, and the three categories of members are a panel of judges, a panel of insurance representatives, and a panel of laypeople recommended by Labor Organizations. This panel is tasked with creating a schedule of damages, which, like the British system noted in Section 4.2.2.6, 12 See http://​www.jsbni.com/​Publications/​personal-​injury-​guide/​Documents/​Green%20Book.pdf.

13  Danzon’s (1994) article lays out the structure, incentives, and constraints individuals face, along with the success and limitations of the Swedish Tort System. The Danish system is modeled after the Swedish system (Studdert and Mello 2011). Finally, Studdert, et al. (1997), discussing the Swedish model and the similar New Zealand model, concluded through their research that the Swedish model would result in lower costs and a greater number of compensated victims than would the current systems in Utah and Colorado.

 

114   RONEN AVRAHAM is based on past precedent, but also adjusted according to inflation and the opinions of experts. The Commission conducts investigations into each individualized case and gives a recommendation of damages based on the findings of the investigation and the damage schedule. The recommendations are then sent to both the injured individual and the insurance company. The Commission thus serves as a “guiding force regarding the development of the law in the field of personal injury compensation in Sweden” (Sweden Road Traffic Injuries Commission 2008).

4.3. Conclusion Pain-​and-​suffering damages in the United States are an unsettled and volatile area of the law. There is great disparity both in the types of damages allowed and in the judicial theories justifying the award, or denial, of damages. The lack of an objective metric and the resulting inconsistencies are so troubling that they have led some commentators to conclude that pain-​and-​suffering damages should be eliminated from tort law altogether. However, pain-​and-​suffering damages in tort law represent legitimate transfers compensating injured victims for very real losses and deterring potential tortfeasors from taking insufficient care. The mere fact that pain-​and-​suffering damages—​like almost every other form of tort damages—​are difficult to quantify is not a reason to set them at zero. Instead, the inconsistency that opponents of pain-​and-​suffering damages have identified is a reason to address the problem of finding or creating a simplified theoretical framework or structure for awarding pain-​and-​suffering damages. Once the case for simpler pain-​and-​suffering damages is established, it remains to be seen how best to estimate them. There are a number of approaches available. Individualized approaches include the Golden Rule, per diem, and multiplier of medical costs. Although some individualized approaches have generally been rejected by courts, it may behoove the legal system to examine them anew. If the goal of reducing disparity and administrative costs of pain-​and-​suffering damages is recognized, judges may see these approaches as a viable method of increasing equity and predictability while still compensating victims for their individual and unique injury. The non-​individualized approaches, both formal and informal, may be more appealing to the critics who value predictability and simplicity above other considerations. These approaches include fixed amounts of pain-​and-​suffering damages, fixed caps, flexible caps, fixed amounts for the entire injury, legislated damages schedules, court-​ based damage schedules, and damage schedules created by a commission. Both the informal routinization that is currently spreading through the tort system and the more formal mechanisms represented by the trust examples and the 9/​11 Fund can serve as a model for reducing the delays and transaction costs associated with tort claims. While pain-​and-​suffering damages have traditionally represented an expensive and volatile area of the law, they need not continue to do so. Although none of the alternatives explained herein is flawless, the very existence of such a number and variety of

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    115 methods to simplify pain-​and-​suffering denies the contention that it is best to eliminate them altogether. Maybe some of these methods could be used in conjunction with others, or maybe one method is appropriate in certain types of cases, whereas another method is appropriate in others. Either way, future research and judicial consideration of pain-​and-​suffering damages can and should approach the problem from a solution-​ based perspective, taking into account the availability and viability of numerous alternatives. This is especially true now, when objective measures of pain and suffering are becoming more realistic owing to recent scientific breakthroughs in brain science.

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116   RONEN AVRAHAM Chang, Yun-​Chien, Eisenberg, Theodore, Li, Tsung Hsien, and Wells Martin T. 2013. An Empirical Study of Pain and Suffering Damages in Personal Injury Cases. Paper presented at the 2013 Conference on Empirical Legal Studies. Philadelphia: University of Pennsylvania Law School. 15–​36. Clark, Stuart and Harris, Christina. 2005. “Tort Reform in Australia:  Fundamental and Potentially Far-​Reaching Change.” Defense Counsel Journal 72, pp. 16–​23. Croley, Steven P. and Hanson, Jon D. 1995. “The Non-​Pecuniary Costs of Accidents: Pain-​and-​ Suffering Damages in Tort Law,” Harvard Law Review 108, pp. 1785–​1789, fn. 11. Cunnien, Alan J. 1997. “Psychiatric and Medical Syndromes Associated with Deception.” In:  Richard Rogers, ed., Clinical Assessment of Malingering and Deception. 2nd ed. New York: Guilford Press. Chap. 2. Danzon, Patricia. 1994. “The Swedish Patient Compensation System: Lessons for the United States.” Journal of Legal Medicine 15(2), pp. 199–​247. Debus v Grand Union Stores, 621 A.2d 1288 (Vt. 1993). Deepwater Horizon Medical Benefits Claims Administrator. 2012. https://​deepwaterhorizonmedicalsettlement.com/​en-​us/​home. aspx [Accessed 15 August 2016]. Diamond, Shari Seidman, Saks, Michael J., and Landsman, Stephen. 1998. “Juror Judgments about Liability and Damages:  Sources of Variability and Ways to Increase Consistency.” DePaul Law Review 48, pp. 301–​317. Diamond, Shari Seidman, Rose, Mary R., Murphy, Beth, and Meixner, John. 2011. “Damage Anchors on Real Juries.” Journal of Empirical Legal Studies 8(s1), pp. 148–​178. Diller, Matthew. 2003. “Tort and Social Welfare Principles in the Victim Compensation Fund,” DePaul Law Review 53, p. 719. Erichson, Howard M. and Zipursky, Benjamin C. 2011. “Consent versus Closure.” Cornell Law Review 96, pp. 279–​280. Feinberg, Kenneth. 2007. “Compensating the Victims of Catastrophe:  The Virginia Tech Victims’ Assistance Program.” Virginia Law Review in Brief 93, p. 181. Gandhi, Tehal K. et  al. 2006. “Missed and Delayed Diagnoses in the Ambulatory Setting: A Study of Closed Malpractice Claims.” Annals of Internal Medicine 145, p. 488. Garber, Alan M. 1999. “Advances in Cost-​Effectiveness Analysis of Health Interventions.” Working Paper No. 7198, NBER. Geistfeld, Mark. 1995. “Placing a Price on Pain and Suffering: A Method for Helping Juries Determine Tort Damages for Nonmonetary Injuries.” California Law Review 83, 773. Gervais, Roger O. et al. 2001. “Effects of Coaching on Symptom Validity Testing in Chronic Pain Patients Presenting for Disability Assessments.” Journal of Forensic Neuropsychology 2, pp. 13–​14. Giant Food Inc. v Satterfield, 603 A.2d 877 (Md. 1992). Glaberson, William. 2001. “Federal Plan for an Aid Formula is Criticized.” New York Times. Nov 7. B7. Goldberg, John C. P. and Zipursky, Benjamin C. 2010. Oxford Introduction to U.S. Law: Torts. Oxford: Oxford University Press. 394. Golden Eagle Archery, Inc. v Jackson, 116 S.W.3d 757, 768 (Tex. 2003) (compiling cases). Henderson v Atl. Pelagic Seafood, LLC, 2011 U.S. Dist. LEXIS 33727, 34, fn. 9. Hunt v K-​Mart Corp. 981 P. 2d 277 (June 1999). Idaho Code Ann. § 6-​1603 (West 2004). Karapanou, Vaia and Visscher, Louis. 2010. “Towards a Better Assessment of Pain and Suffering Damages.” Journal of European Tort Law 1(1), pp. 48–​74.

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    117 Kelly, Carly N. and Mello, Michelle M. 2005. “Are Medical Malpractice Damages Caps Constitutional? An Overview of State Litigation.” Journal of Law, Medicine & Ethics 33, pp. 515–​517. King, Joseph. 2003. “Counting Angles and Weighing Anchors:  Per Diem Arguments for Noneconomic Damages,” Tennessee Law Review 17(1), pp. 13–​14. King, Joseph H. Jr. 2004. “Pain and Suffering, Noneconomic Damages, and the Goals of Tort Law,” S.M.U. Law Review 57, p. 163. King, Stephen P. 2010. “Does Tort Law Reform Help or Hurt Consumers?” Economic Record 86(275), pp. 563–​577. Kirk v Wash. State Univ., 746 P.2d 285, 292 [Wash. 1987]. Klass, Gregory, and Zeiler, Kathryn. 2013. “Against Endowment Theory:  Experimental Economics and Legal Scholarship.” UCLA Law Review 61, pp. 2–​64. Kolber, Adam J. 2007. “Pain Detection and the Privacy of Subjective Experience.” American Journal of Law & Medicine 33, pp. 433–​435. Larson, Lex K. and Larson, Arthur. 2008. Workers’ Compensation Law: Cases, Materials and Text. Newark: LexisNexis/​Matthew Vender. §5 at 1. Maletic, V., Robinson, M., Oakes, T., Lyengar, S., Ball, S. G., and Russell, J. 2007. “Neurobiology of Depression: an Integrated View of Key Findings.” International Journal of Clinical Practice 61(12), pp. 2030–​2040. Masada, Steven. 2004. “Australia’s ‘Most Extreme Case’: A New Alternative for U.S. Medical Malpractice Liability Reform.” Pacific Rim Law and Policy Journal 13, pp. 181–​184. McCaffery, Edward J., Daniel J. Kahneman, and Matthew L. Spitzer. 1995. “Framing the Jury: Cognitive Perspectives on Pain and Suffering Awards.” Virginia Law Review 81, pp. 1341–​1378. McElheney, James W. 1987. McElheney’s Trial Notebook. 2nd ed. Chicago:  American Bar Association. 515–​516. McGarry v Horlacher, 775 N.E.2d 865, 877–​878 (Ohio Ct. App. 2002). McKay, Colin and Great Britain Judicial Studies Board. 2010. Guidelines for the Assessment of General Damages in Personal Injury Cases. Oxford: Oxford University Press. Mendelson, George. 1997. ‘Outcome-​Related Compensation:  In Search of a New Paradigm’ in Richard Rogers, ed., Clinical Assessment of Malingering and Deception. 2nd ed. New York: Guilford Press. 220, 222. Miller, Ted R. 2000. “Valuing Nonfatal Quality of Life Losses with Quality-​Adjusted Life Years: The Health Economist’s Meow.” Journal of Forensic Economics 13, p. 145. Mittenberg, Wiley et al. 2002. “Base Rates of Malingering and Symptom Exaggeration.” Journal of Clinical and Experimental Neuropsychology 24, pp 1094–​1096. Mullenix, Linda S. 2011. “Prometheus Unbound: The Gulf Coast Claims Facility as a Means for Resolving Mass Tort Claims-​A Fund Too Far.” Louisiana Law Review 71, 819–​912. Pierce v N.Y. Cent.R.R.Co., 409 F.2d 1392 [Mich. 1969]. Plott, Charles R., and Zeiler, Kathryn. 2005. “The Willingness to Pay–​Willingness to Accept Gap.” The American Economic Review 95(3), pp. 530–​545. Rabin, Robert L. 2005. “Pain and Suffering and Beyond:  Some Thoughts on Recovery for Intangible Loss.” DePaul Law Review 55, 359–​376. Rahdert, Mark. 1995. Covering Accident Costs:  Insurance, Liability, and Tort Reform. Philadelphia: Temple University Press. 19. Rhoades v Walsh, 2009 U.S. Dist. LEXIS 75784, 47 fn. 26. Robinette, Christopher J., 2013. “Two Roads Diverge for Civil Recourse Theory.” Indiana Law Journal 88, pp. 543–​550.

 

118   RONEN AVRAHAM Rogers, Selwyn O., et al. 2006. “Analysis of Surgical Errors in Closed Malpractice Claims at 4 Liability Insurers.” Surgery 140, p. 25. Rubin, Paul. 1993. Tort Reform by Contract. Washington, DC: AEI Press. Schwartz, Victor and Silverman, Cary. 2004. “Hedonic Damages:  The Rapidly Bubbling Cauldron.” Brooklyn Law Review 69, pp. 1037–​1043. Sebok, Anthony J. 2005. “Translating the Immeasurable: Thinking about Pain and Suffering Comparatively.” DePaul Law Review 55, pp. 379–​392. Sinclair, Sandra and Burton, John F. 1994. “Measuring Non-​economic Loss: Quality-​of-​Life Values versus Impairment Ratings.” Worker’s Compensation Monitor, July–​Aug. 5. Sinclair, Sandra and Burton, John F. 1997. “A Response to the Comments by Doege and Hixson.” Workers’ Compensation Monitor, July–​Aug. 15. Sloan, Frank and Hsieh, Chee Ruey. 1990. “Variability in Medical Malpractice Payments: Is the Compensation Fair?” Law and Society Review 24, p. 997. Sowka, M. Patricia, ed. 1980. Malpractice Claims: Final Compilation. Brookfield, WI: National Association of Insurance Commissioners. State of Washington Task Force on Noneconomic Damages. 2005. Report to the Legislature. 15–​70. Available at http://​www.ofm.wa.gov/​rmd/​publications/​nedfinalrpt.pdf.29. [Accessed 15 August 2016]. Steenson, Mike and Sayler, Joseph Michael. “The Legacy of the 9/​11 Fund and the Minnesota I-​35w Bridge-​Collapse Fund: Creating A Template for Compensating Victims of Future Mass-​Tort Catastrophes.” William Mitchell Law Review 35, 524–598. Studdert, David M. et  al. 1997. “Can the United States Afford a “No Fault” System of Compensation for Medical Malpractice Injury?” Law and Contemporary Problems 1, pp. 32–​33. Studdert, David, et  al. 2006. “Claims, Errors, and Compensation Payments in Medical Malpractice Litigation.” New England Journal of Medicine 354, p. 2024. Studdert, David et  al. 2011. “Rationalizing Noneconomic Damages:  A  Health-​ Utilities Approach.” Law & Contemporary Problems 74, pp. 57–​70. Sugarman, Stephen D. 2005. “A Comparative Law Look at Pain and Suffering Awards.” DePaul Law Review 55, pp. 399–​413. Sugarman, Stephen D. 2005. “Tort Reform through Damages Law Reform:  An American Perspective.” Sydney Law Review 27, p. 507. Sullivan, Mathew C. 2005. “Mississippi Tort Reforms as Compared to Other Jurisdictions Abroad—A Sensible Treatment Protocol for the US Tort System Ills or Not.” Temple International and Comparative Law Journal 19, pp 507–​519. Sunstein, Cass R. 1986. “Legal Interface with Private Preferences.” University of Chicago Law Review 35, pp. 1129, 1146. Sunstein, Cass R. 1993. After the Rights Revolution:  Reconceiving the Regulatory State. Cambridge, MA: Harvard University Press. 161. Sweden Road Traffic Injuries Commission (Trafikskadenämnden). 2008. “The Activities of the Road Traffic Injuries Commission.” www.trafikskadenamnden.se/​upload/​Om%20TSN/​ Om%20n%C3%A4mnden%20p%C3%A5%20engelska.pdf [Accessed 15 August 2016]. Thaler, Richard. 1991. Quasi Rational Economics. New York: Russel Sage Foundation. Totaro, Martin. 2006. “Modernizing the Critique of Per Diem Pain and Suffering Damages.” Virginia Law Review 92, pp. 289–​290.

 

ESTIMATING PAIN-AND-SUFFERING DAMAGES    119 U.S. Government Accountability Office. 2011. “Asbestos Injury Compensation: The Role and Administration of Asbestos Trusts,” 16 GAO-​11-​819. http://​www.gao.gov/​assets/​590/​585380. pdf. [Accessed 15 August 2016]. Vairo, Georgene, M. 1992. “The Dalkon Shield Claimants Trust: Paradigm Lost (Or Found)?” Fordham Law Review 61, pp. 617–​633. Velocity Express Mid-​Atl., Inc. v Hugen, 585 S.E.2d 557 (2003). Vidmar, Neil and Jeffrey Rice. 1993. “Assessments of Noneconomic Damages Awards in Medical Negligence: A Comparison of Jurors with Legal Professionals.” Iowa Law Review 78, pp. 883–​898. Vidmar, Neil et al. 1999. “Jury Awards for Medical Malpractice and Post-​Verdict Adjustments of Those Awards.” DePaul Law Review 48, pp. 265–​269. Viscusi, W. Kip. 1988. “Pain and Suffering in Product Liability Cases: Systematic Compensation or Capricious Awards?” International Review of Law and Economics 8, p. 203. Viscusi, W. Kip. 1991. Reforming Products Liability. Cambridge, MA: Harvard University Press. 50. fn. 183. Wager, Tor D., Atlas, Lauren Y., Lindquist, Martin A., Roy, Mathieu, Woo, Choong-​Wan, and Kross, Ethan. 2013. “An fMRI-​Based Neurologic Signature of Physical Pain.” New England Journal of Medicine 368(15), pp. 1388–​1397. Washington State Legislature, Chapter 276, Laws of 2004, Section 118, ESHB 2459. Weinstein, Jack B. 2006. “Preliminary Reflections on Administration of Complex Litigations.” Cardozo Law Review 2009(1), pp. 6–​9. Whaley, Douglas J. 1992. “Paying for the Agony: The Recovery of Emotional Distress Damages in Contract Actions.” Suffolk University Law Review 26, p. 935.

 

Chapter 5

MEDICAL MAL PRAC T I C E Ronen Avraham and Max M. Schanzenbach

Medical malpractice reform has been the focus of significant attention from policy makers in the United States for decades. Hundreds of reforms to medical malpractice, including caps on noneconomic and punitive damages, reform of joint and several liability rules, and changes to evidentiary standards, have been enacted, struck down, and reenacted at the state level since the 1970s.1 A national cap on noneconomic damages in medical malpractice cases has been proposed numerous times and very nearly became a part of the Affordable Care Act.2 Physician groups, private health insurers, and both Presidents Bush and Obama have argued that medical malpractice reform will reduce healthcare costs.3 The impulse for limiting medical malpractice liability rests in part on a broader dissatisfaction with the U.S. healthcare system. The U.S. healthcare system is widely criticized, not only because of the costs associated with treatment but also because of the overuse and misuse of medical treatment (Becher and Chassin 2001). In fact, the high cost of healthcare in the United States is often attributed to the “overconsumption” of medical treatment. An Institute of Medicine (IOM) report estimated that unnecessary medical services cost $210 billion dollars a year (Smith et al. 2012). Surprisingly, although Americans are consuming healthcare at high rates, they often receive substandard care and medical errors abound (Andel et al. 2012; Graham et al. 2011; Van Den Bos et al. 2011). 1 

At first, many of these reforms were general reforms to tort law. Since the 1990s, most reforms have been targeted only to medical malpractice. 2  Patient Protection and Affordable Care Act of 2010, Pub. L. No. 111-​148, 124 Stat. 119. 11th Congr. (2010). 3  See the president’s remarks at the 2004 President’s Dinner (Obama 2009). America’s Health Insurance Plans (AHIP) buys advertisements promoting tort reform, arguing that medical malpractice liability has increased the cost of providing health insurance. AHIP asserts that “the current litigation system for compensating patients injured by medical negligence is expensive, slow, and does little to benefit the injured patients.” Available at: http://​www.ahip.org/​content/​default.aspx?bc=39|341|320.

 

MEDICAL MALPRACTICE   121 Proponents of limiting medical malpractice liability argue that the threat of liability is one cause of the systematic overtreatment given to Americans, and reducing liability pressure will help reduce healthcare costs without affecting, and perhaps improving, patient care. This claim rests on several potentially testable assumptions. The first is that medical malpractice liability imposes significant costs on the healthcare system through direct litigation costs and, more importantly, by inducing healthcare providers to treat patients too aggressively (so-​called defensive medicine). The second assumption is that limitations to malpractice will not induce offsetting behavior that also imposes significant medical and social costs. Most obviously, limiting providers’ liability could increase the rate of medical errors, increasing pain and suffering and the costs of remedial care. Some scholars have also recently suggested that medical malpractice limitations may free providers to pursue riskier, but more profitable, procedures. This phenomenon is called induced demand or offensive medicine, and it is of particular concern when providers may choose between alternative procedures and interventions, as in obstetric and cardiac care (Currie and McLeod 2006; Shurtz 2014; Avraham and Schanzenbach 2015). Though the effect of damage limitations has received the most attention in the empirical literature, other reforms to medical malpractice may actually be more relevant to changing provider behavior. Both the adoption of national standards of care (as opposed to local standards) and the increasing importance of Clinical Practice Guidelines in determining standards of care have been largely overlooked until recently. Additionally, communication and disclosure programs, though not directly a creature of legal reform and not yet widely implemented, offer some promise of systemic improvement of the medical system. The purpose of this chapter is to assess the theories and evidence regarding the efficacy of medical malpractice liability and limitations to it in achieving better healthcare outcomes, and to identify the unresolved issues that merit further attention from scholars. First, we will explore the theoretical and legal background on medical malpractice. Our discussion here is just a sketch of the issues, but it lays out the basic framework from which most scholars have worked. We next turn to the available evidence by focusing on three basic areas of study:  (1)  the effect of malpractice limitations on payouts and litigation; (2) the effect of malpractice limitations on overall healthcare costs; and (3) the effect of malpractice on two major cost drivers in the healthcare system: cardiac and obstetrics practice. We conclude that limitations on liability did not (and likely cannot) significantly reduce healthcare costs. Finally, we discuss new and important trends in the literature regarding reforms to standards of care and the role of Clinical Practice Guidelines, as well as communication and disclosure programs. There is some evidence that healthcare providers are very sensitive to the legal standard of care, and correctly setting the standard of care is one of the greatest challenges faced by the healthcare system. Thus, standard setting in conjunction with medical liability has potential to improve medical treatment.

 

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5.1.  Theoretical and Legal Background From an economic perspective, the relationship between patients and providers can be characterized as that of principal and agent. The goal of malpractice liability is, therefore, to align the interests of healthcare providers and patients by making providers internalize the costs of their behavior. Providers externalize costs in three ways. First, there are large information asymmetries between providers and patients regarding treatment options and provider performance. Second, providers are largely reimbursed for their costs by third-​party health insurers, mostly based on fee for services provided. This means that medical problems caused or exacerbated by substandard care do not result in a loss to providers unless they face liability for them. In fact, to the extent victims of substandard care require further medical treatment, the result is a gain to providers who are reimbursed for the subsequent care they provide to their victims. Finally, physicians and some hospitals are in practice fully insured against medical malpractice liability, and for various reasons, insurance companies do not engage in significant experience rating of physicians(Weiler 1993). To align the interests of patients and providers, U.S.  law has developed a highly detailed body of case law (often overlaid by statutes) that imposes malpractice liability.4 This liability is imposed ex post for the harm arising out of violations of a standard of care. Standard of care refers not merely to typical examples of medical malpractice such as negligent misdiagnosis or careless errors during surgery. Standard of care also induces choice of treatment and diagnostic regimes (e.g., when to seek an MRI; whether and what type of surgery to perform). If the standard is set correctly, malpractice liability will produce better patient outcomes. Moreover, private law has advantages over regulatory frameworks by providing flexibility through an organic, bottom-​up approach, accounting for local variance and patient-​specific factors. In order for the medical malpractice system to cost-​effectively reduce harm, it must set the standard of care correctly while detecting negligent acts and sifting out unwarranted litigation. If the tort system is functioning as intended, negligent care should be thwarted and there should be little incentive to undertake defensive medicine. Moreover, if the standard of care is set correctly, offensive medicine should also be deterred because overtreatment is also negligent. But is the medical malpractice system functioning as intended? Advocates of limitations to medical malpractice liability have argued that (1) the tort system, especially the jury system, has difficulty setting the proper standard of care; (2) the tort system is not well tuned to detecting medical errors; and (3) the system is costly to apply because of high administrative costs and because liability induces defensive medicine. In short,

4  Although victim compensation is often a goal of tort law, in the case of medical malpractice, it is a relatively unimportant feature because of rampant underclaiming and the unusually high costs of medical malpractice litigation.

 

MEDICAL MALPRACTICE   123 medical malpractice litigation may be haphazard, costly, ineffective, and overdeterring, meaning that damage limitations could improve social welfare by reducing the litigation rate and increasing certainty in damages. Opponents of limitation, in contrast, argue that the tort system is actually rational and that most malpractice litigation is well founded. On this view, the real failure in the system is that the rate of claiming is too low because malpractice is often undiscovered or too expensive to prosecute. We now discuss these ideas in turn.

5.1.1. The Standard of Care Defining the standard of care required by professionals in the medical context is fraught. Historically, most jurisdictions eschewed a reasonable physician standard set ex-​post by courts. Instead, they have applied a standard of care determined by actual custom. The Second Restatement of Torts states that the physician must “exercise the skill and knowledge normally possessed” by other physicians (§ 299A [1965]). This effectively allows the medical industry to set the standard of care, a privilege unique to the profession. In the rest of tort law’s domain, the standard of behavior is “reasonableness,” a legal fiction that essentially enables courts to set the standard of care. Although custom may be evidence of reasonable behavior, it is not dispositive of the question. Initially, states applied the customary standard by reference to physicians in the state or locality. Over the past few decades, most states have redefined custom by national standards of care reflected in growing numbers of “Clinical Practice Guidelines” or CPGs. The majority of states now follow a national standard of practice.5 Nonetheless, there is ample evidence that physician practices can vary dramatically by location (Chandra et al. 2012; Skinner 2012). The use of the “customary” standard is likely a response to the view that juries and judges will have great difficulty implementing a “reasonableness” standard. However, the customary standard, whether national or local, is criticized on several grounds. First, the customary standard may inhibit innovation in medical practice, including the adoption of promising new procedures, because it encourages doctors to hold to past practice. Second, determining liability by custom effectively narrows the jury’s role to that of a mere factfinder, eliminating its normative function. Finally, under either the custom or reasonable physician standard, the standard of care is often a contested issue of fact. The lack of a uniform standard of negligence that is easily ascertainable prior to trial creates uncertainty that could inhibit the implementation of sound practices. The custom standard has been the majority rule since the late nineteenth century. Indeed, some states have explicitly enacted statutes that establish the standard of the profession as the test for negligence. A small number of states apply the “respectable minority rule,” which exempts physicians from liability when they follow a practice used 5 

Frakes (2013) surveys the law and reports that sixteen states retain some reference to local custom in their medical malpractice standard of care law.

 

124    RONEN AVRAHAM AND MAX M. SCHANZENBACH even if by only a small number of respected practitioners. Similarly, some states use the “error in judgment rule,” which exempts physicians from liability if they committed only an error in judgment in choosing among several therapeutic approaches. A few jurisdictions have moved toward a “reasonable physician” standard of care for at least certain types of medical practice (Peters 2000). The inquiry under the reasonable physician standard is not what other physicians would do, but what a reasonable physician would do.6 The industry custom is relevant to the question of whether the physician acted reasonably, but it is not conclusive. On the one hand, courts can find that a physician acted negligently even if the physician fully complied with customary standards. On the other hand, the reasonable physician standard frees doctors to make decisions based on recent research, even where that decision is not yet in keeping with the industry custom. On their face, the two standards may not seem very different. What a “reasonable” physician would do is likely informed, at least in part, by what other physicians practice. However, the custom standard may be more relevant if a state retains its locality rules. Local custom can deviate from national norms, and national norms informed by expert committees are more likely to be reasonable. Do providers pay attention to standards of practice? There is ample anecdotal evidence that they do, and Frakes (2013) shows systematically that changes in standards can produce large changes in provider behavior. Frakes examined what happens to geographical treatment variation in obstetrics and cardiac care when negligence standards were altered from local standards to national standards. He found that when states move to a national standard, local practices converge to that standard. In states that had intense treatment regimens relative to the national standard, treatment intensity was reduced. By contrast, in states with less intensive treatment, treatment intensity increased following a move to a national standard. A move to national standards reduced the overall gap between state and national treatment rates by 30%–​45%, without any measurable impact on patient outcomes.

5.1.2. Detecting Errors Even assuming that the standard of care is set correctly, a cost-​effective system must still detect enough medical error to create some incentive for caretaking, while not making too many false positives. Medical errors are well known to be expensive and common, possibly affecting 1.5  million persons annually and causing over 100,000 premature deaths (see Andel et al. [2012]; Van Den Bos et al. [2011]; Institute of Medicine [2000]; collecting studies and applying various methodologies). Given the volume of error, imposing significant malpractice liability holds out much promise for reducing overall healthcare costs and other social costs. However, there 6  For example, even if prevailing customs did not provide for a glaucoma screen, it was unreasonable for a doctor to fail to recommend to the patient this safe, cost-​effective test for a condition that, if caught early, is treatable. See Helling v Carey, 519 P.2d 981,981-​82 (Wash. 1974).

 

MEDICAL MALPRACTICE   125 is some reason to doubt malpractice liability’s efficacy. Despite widespread medical error, very few negligent medical injuries result in a paid damage claim. The National Practitioner Data Base reports between 10,000 and 15,000 positive payouts in medical malpractice cases (trials and settlements) per year over the last 20 years, a tiny fraction relative to the universe of possible claims. Studdert et al. (2006) examined two hospitals, audited the medical records of patients, and found that only 2.5% of negligent injuries resulted in malpractice litigation. Contrary to the conventional wisdom in the popular press, most researchers conclude that claims of rampant frivolous litigation are overblown. There is evidence that many weak claims are filed, but these also receive much lower average payouts (see Studdert and Mello [2007] for a review of the evidence). The disparity between injury rates and successful litigation raises grave doubts about the efficacy of medical malpractice liability as a means to reduce errors. However, the system’s weak propensity to detect error is not dispositive of the debate. We do not observe the errors the system avoids and hence must be cautious about inferring a counterfactual from the rate of litigated injuries. Moreover, the perceived liability pressures, even if unfounded in evidence, could still create incentives to standardize and assess practices and create internal risk-​management infrastructures to the benefit of patients. As discussed below, doctor surveys suggest liability may be a salient factor in treatment decisions.

5.1.3. Defensive Medicine, Offensive Medicine, and Administrative Costs The cost of the malpractice system is open to some debate. The direct costs of medical malpractice to the healthcare system, in terms of insurance, payouts, and litigation expenses, have been reckoned to be between 0.4% (Mello et al. 2010) and 1.5% (CBO 2004) of all medical spending.7 Thus, reducing medical malpractice liability, even if it reduced direct liability costs by half, would have little effect on overall health spending. Moreover, such small savings could easily be overwhelmed if reduced liability exposure causes an increase in medical errors. Most advocates of tort reform are therefore left to argue that, although the direct costs of the liability system are not large, the system incentivizes doctors to undertake expensive forms of defensive medicine. Defensive medicine is care that is not medically advisable but prescribed nonetheless in the belief that treatment may prevent liability for malpractice. Most likely, this unneeded care comes in the form of hospital admissions and noninvasive procedures such as medical imaging. The theory of defensive medicine is in some tension with the aforementioned fact that malpractice litigation is not very common, even relative to the universe of 7 

How the Congressional Budget Office estimate was arrived at is not fully explained.

 

126    RONEN AVRAHAM AND MAX M. SCHANZENBACH potentially negligent injury. Moreover, in practice, most physicians are fully insured against malpractice claims. Medical malpractice insurance and the bankruptcy remoteness of many assets (such as homes and retirement savings) generally protect physicians from having to pay large awards. Almost all claims are settled and fully paid out through malpractice insurance.8 Nonetheless, one survey found that 93% of Pennsylvania doctors admitted that they sometimes or often engage in defensive medicine practices (Studdert 2005). Certain professions are particularly susceptible to medical malpractice litigation, in particular obstetrics, neurosurgery, and cardiac care (Jena et al. 2011), and one would consequently expect to see greater response to liability limitations among these practitioners. A recent survey of neurosurgeons found that most admit to practicing defensive medicine and that their propensity to do so is correlated with their perception of legal risk (Smith et al. 2012). More importantly, the survey found that perception of litigation risk correlated with the actual legal environment and likelihood of litigation in the state in which the neurosurgeon practiced (Smith et al. 2012). These survey results, which evidence significant doctor sensitivity to liability pressures, are somewhat puzzling. Why would doctors practice defensive medicine if the probability of facing a suit is low and they are, in practice, fully insured? An easy answer is that doctors both strategically exaggerate their plight and have irrationally high fears of litigation. There are several additional possible answers that do not rely on fear or subterfuge. The first is that patients are poorly informed about healthcare choices and the cost of defensive medicine is largely externalized to third-​party payors, so even the small incentive doctors have to reduce exposure to liability can elicit a large response in increased treatment intensity. Second, the probability of a lawsuit, rather than the magnitude of awards, may be a key motivator. The incentives to avoid litigation include the desire to avoid reputational harm, the stress of litigation and bad publicity, and the lost time associated with defending a claim. Thus, even with a small risk of successful suits and the fact that losses are covered by liability insurance, the threat of malpractice litigation influences doctor behavior. Dranove et al. (2012) provide the clearest evidence of physician harm from litigation, in particular a finding that physicians take less remunerative patients after being sued. Moreover, hospitals, clinics, and practice groups are key players in setting practice standards and monitoring physician behavior and these providers can also reduce their exposure through defensive medicine. These groups may self-​insure to some extent or carry higher deductibles. Thus, defensive medicine may provide significant benefits to healthcare providers by increasing revenue and decreasing their exposure to various costs associated with malpractice liability. Third, it is possible that defensive medicine is actually effective at avoiding litigation, and, consequently, the level of litigation is endogenous to the practice of defensive medicine. The threat of liability induces defensive action by providers, which in turn reduces the probability of litigation. Thus, doctors prescribe aggressive treatments or admit 8 

This is a widely held view. Zeiler et al. (2007) provide evidence of this from the Texas close-​claimed database.

 

MEDICAL MALPRACTICE   127 patients, even if not medically necessary, because it provides evidence that all possible steps were taken to protect the patient. But even if defensive medicine is important, it is not likely to be the whole story regarding overtreatment. A counterpart to defensive medicine is “induced demand,” or “offensive medicine.” Some have posited that medical malpractice may deter offensive medicine-​related overtreatment, particularly in the case of invasive procedures more likely to result in complications (Currie and MacLeod 2008). Excessive care in medical treatment is believed to be a widespread problem in healthcare. Studies on the effect of reimbursement schemes, for example, have found that moves away from fee-​for-​service care can reduce costs without harming patient care. Moreover, when different procedures are available and context permits physician discretion, as in birth delivery method or cardiac care, procedure choice appears sensitive to reimbursement rates (Dranove and Wehner 1994; Gruber and Owings 1996; Gruber et al. 1999; Clemens and Gottlieb 2014; Avraham and Schanzenbach 2015). It may be relatively difficult to win a malpractice claim based on a procedure being inappropriate or unnecessary. Informed consent authorizing the procedure and challenges of proof regarding procedure choice, which is often discretionary, are significant barriers. However, medical malpractice likely provides a deterrent nonetheless because more remunerative procedures are likely to be more invasive (e.g., Cesarean sections and cardiac bypass), and they may be more likely to involve complications leading to claims for breach of the standard of care. Given the degree of overtreatment thought to be present in U.S. healthcare, reducing overtreatment is a significant potential benefit of medical malpractice liability. In sum, there are reasonable arguments that damage limitations could increase, decrease, or have little effect on treatment intensity. The empirical measurement of the overall effects of liability limitations, under a variety of reimbursement schemes and in different medical care contexts, is therefore essential.

5.2.  The Effect of Damage Limitations Creating an effective system of malpractice liability is a daunting task. The system must set standards correctly and detect errors. There are reasons to think it does not do either well. Moreover, policy makers have not been very interested in directly improving standard setting and detection, with the exception of moving toward a national, custom-​ based standard. Instead, most reforms have been aimed at indirectly reducing the incentives provided by medical malpractice liability by capping or otherwise reducing damages. The assumption of reform, then, has been that the perverse incentives of the system to provide defensive medicine should be tackled by limiting liability. Opponents of damage limitations argue that this undermines deterrence. Given this policy background, the empirical study of medical malpractice has been focused on the following questions: Do doctors, in fact, practice defensive or offensive medicine? If they do, is the

 

128    RONEN AVRAHAM AND MAX M. SCHANZENBACH practice sensitive to liability pressures? Can tort reform significantly limit liability pressures? Are there offsetting effects to malpractice limitations, in terms of patient care and medical injuries, observed? To answer these questions, empirical studies have focused primarily on the effect of medical malpractice limitations on (1) damage awards and claiming; (2) general healthcare utilization; and finally, (3) cardiac and obstetric practice in particular.

5.2.1. Are Damage Limitations Effective at Reducing Awards and Claiming? The answer to the question of whether damage limitations affect litigation pressure should be straightforward. In particular, it is reasonable to expect that low caps on noneconomic damages should reduce payouts, because noneconomic damages constitute a large percentage of medical malpractice jury awards (Hyman et al. 2009; Studdert et al. 2004; Pace et al. 2004). Caps on damages and other limitations reduce expected payoffs, which should reduce the probability of litigation and damages paid. It is also possible, however, that caps would have little effect if caps were set too high to be reasonably effective or if lawyers had significant flexibility to shift around damages between types of damages that are statutorily capped and types that are not. To study the effect of tort reform on litigation and awards, scholars have used the National Practitioner Data Base, which purports to report all positive payouts and settlements of medical malpractice claims. Despite a comprehensive national database and clearly defined reforms (usually passed by a state legislature), a number of early studies from the 1980s and 1990s examining claim frequency, payout amounts, and malpractice premiums reached mixed conclusions on the effect of various tort reforms, some finding the expected outcome that limitations reduced payouts and lawsuit probabilities, but others finding little or no effect.9 Nonetheless, two surveys concluded that tort reform—​particularly caps on noneconomic damages—​reduce payouts and claims. Holtz-​Eakin (2004) concluded that caps on damages are consistently found to reduce the number of lawsuits and the size of awards. Mello’s (2006) survey concluded that, in addition to caps on noneconomic damages, collateral source reforms and joint and several liability reforms are also associated with reductions in awards and (more weakly) with physician supply.10 Other surveys of the literature also concluded that there was limited evidence that rates of growth in medical malpractice premiums have been slower on average in states that enacted caps on noneconomic damages than in states with more limited reforms (GAO 2003; Danzon et al. 2004). 9  For a survey, see Sloan and Chepke (2008, 100), collecting studies and detailing their varying findings. 10  Joint and several liability reform generally required some apportionment of liability between the physician and the hospital or practice group, whereas the common law rules generally allowed collection

 

MEDICAL MALPRACTICE   129 It is now clear that several data issues and a misunderstanding of legal institutions interfered with many earlier studies. First, malpractice premiums are particularly influenced by the investment performance of insurance funds (Sloan and Chepke 2008; Baker 2004). As a consequence, premiums are a very noisy measure of malpractice pressure. Born et al. (2009) consider long-​run medical malpractice insurers’ loss ratios (the extent to which payouts are below premiums collected). This measure has the advantage of removing the noise contained in investment returns, and, using it, Born et al. (2009) found that tort reform significantly reduced insurers’ losses. Second, the dataset coding tort reforms employed by most researches was produced by American Tort Reform Association, and this dataset contained significant errors (Avraham 2007; Currie and MacLeod 2008). Avraham (2006) produced and has since maintained a comprehensive tort reform database, which has been subject to improvements and checks from other scholars as well (Currie and MacLeod 2008). Finally, previous research did not take into account that while statutory reforms are prospective, such reforms, especially damage caps, were often struck down by state supreme courts, and such strike downs were retroactive. Thus, the law governing observed settlements and claiming rates was sometimes significantly miscoded. Moreover, many reforms, particularly caps on noneconomic damages, are struck down within the first few years of enactment. The legal uncertainty surrounding reforms that faced credible state constitutional challenges would tend to depress the effect of reform, and some scholars suggested removing reforms that were quickly struck down from the analyses (Frakes 2012; Avraham et al. 2012). Additional work, with a more careful appreciation for timing of reforms and legal frameworks, has confirmed that tort reform is effective in reducing physicians’ liability exposure in both the amount of payouts and the probability of a positive payout. Avraham (2007) examines medical malpractice settlements in the National Practitioner Data Base using his own tort reform coding and accounting for the retroactive application of reforms. He finds that some noneconomic damage caps decrease the number of claims by roughly 5% to 13% and total annual payouts by more than half. Likewise, Paik et al. (2013) allow for the gradual nature of reform phase in owing to prospective enactment and find strong evidence that caps reduce claiming and payouts, in some cases by over half. The effect was particularly pronounced (as would be expected) for large claims. A study of Texas claims, based on that state’s unique closed claim database, similarly showed a dramatic reduction in payouts a result of caps on noneconomic damages (Paik et al. 2012).

from any party found liable. Thus, reform to the joint and several liability rule would tend to reduce recoveries because insurance caps for physicians are reached much sooner, though it may also have some incentive effects. Collateral source reform reduces recoveries for any collateral source that paid out for injuries. The common law rule generally disregards the injured party’s insurance payouts in calculating damages. Thus, collateral source rules tend to reduce recoveries, as well, by preventing a double recovery if disability and medical insurance payments were paid out as a result of the injury.

 

130    RONEN AVRAHAM AND MAX M. SCHANZENBACH

5.2.2. Are Damage Limitations Effective at Reducing Healthcare Utilization? An important line of studies has used broad datasets on costs or procedures to study how medical practice changes after malpractice reform. These studies then make inferences about defensive medicine based on these changes. The challenge inherent in the work is that both the outcome variable (general healthcare utilization) and the independent variable of interest (liability pressure) are difficult to measure. General healthcare utilization studies have relied heavily on data from Medicare expenditures, which is limited to a subset of the population less likely to generate liability pressure. Studies that focus on a very specific procedure may have an excellent measure of that procedure but lose generalizability. Most studies employ a difference-​in-​difference strategy around the adoption of damage caps and other liability limitations to measure the effect of tort reform, but some studies look to other measures of liability pressure such as average or total payouts. Both approaches have drawbacks. Limitations to tort liability, particularly damage caps, are not uniform, but they are often treated as such in the identification. For example, caps on noneconomic damages vary tremendously (from $250,000 to more than a $1 million), and some states have exceptions for serious injuries. Using malpractice payouts as a measure of liability pressure is also problematic. Payouts may be endogenous to the legal environment. For example, a cap on noneconomic damages creates savings that may be partially offset by greater payouts caused by less caretaking. Increasing malpractice liability may lead to provision of more or better treatment, which, if effective, would tend to reduce payouts. It is important to keep these limitations in mind when evaluating the studies.

5.2.2.1. Medicare Studies Several studies use Medicare datasets, likely because Medicare spending is well tracked and the procedures are coded in detail. Baicker et al. (2007) found that a 10% increase in average malpractice liability payments per physician within a state was associated with a 1.0% increase in Medicare payments for total physician services and a 2.2% increase in the imaging component of these services. Baicker et al. did not find that higher malpractice liability costs were associated with reductions in total or disease-​specific mortality, potentially indicating that these increases in payments are the result of defensive medicine. Sloan and Shaddle (2009) look across a variety of ailments and find little evidence that tort reforms reduce Medicare costs, though they have a relatively small sample size.11 Likewise, studying the 2003 Texas noneconomic damage cap, Paik et al. (2013) concluded that Medicare spending did not decline as a result of reform. They employ a quasi-​experimental design in which they consider baseline litigation rates at the county level, reasoning that tort reform should have a larger impact in counties that were more litigious. 11 

For example, they have fewer than 3,000 heart attacks.

 

MEDICAL MALPRACTICE   131 The work on Medicare spending suggests that there are no or very small effects of tort reform on healthcare utilization for a large and important group of healthcare consumers. However, we doubt that the studies of Medicare patients are generalizable to non-​ Medicare patients. Indeed, there is good reason to think that the Medicare population’s treatment should be little affected by tort reform. First, the median age of a Medicare patient in the Sloan and Shaddle study is almost 80 years. Given shorter life expectancies even without medical error, the lack of significant economic damages, and the naturally higher risk of procedures involving elderly patients creating evidentiary problems, it seems unlikely that a great deal of medical malpractice pressure comes from this group. Indeed, studies have found that those aged 65 and older comprise around 10% of all damage payouts for medical malpractice (Paik et al 2012; GAO 1993) and they are far less likely to sue (Studdert 2000) even though per-​capita healthcare spending on those 65 and older is 4.5 times that of those under 65 (Health and Human Services 2005). Second, almost one-​quarter of Medicare spending is done during end-​of-​life care, usually in the course of a terminal illness and repeated hospitalizations (Calfo et al. 2012; Hogan et al. 2001). Such spending seems unlikely to be influenced by the minimal threat of potential liability in such cases.

5.2.2.2. Non-​Medicare Studies Studies outside of the Medicare context have found small but measureable reductions in healthcare expenditures after tort reform. Using a proprietary insurance premium database with highly detailed plan information, Avraham et al. (2012) found that some tort reforms, primarily caps on noneconomic damages, reduce health insurance premiums by up to 2%. Moreover, the reduction appears to come entirely from health insurance plans that are not managed care plans. The authors interpret the price decline as evidence of reduced treatment intensity and that more tightly managed-​care plans reduce defensive medicine even in the absence of tort reform. Avraham and Schanzenbach (2010) using the Current Population Survey, found that caps on noneconomic damages increase health insurance coverage for price-​sensitive groups. The authors interpret their findings as evidence that tort reform reduces healthcare costs, which are ultimately reflected in health insurance prices. Cotet (2012) uses county-​level data on procedures and admissions and finds that caps on noneconomic damages lead to a 3.5% decrease in surgeries, a 2.5% decrease in admissions, and a 4.5% decrease in outpatient visits, but no significant effect on emergency room visits. Cotet suggests that decisions to visit the emergency room are largely made by patients and, consequently, the finding that emergency visits are not responsive to liability pressure makes sense. There are several consistent findings across this work. The first is that the effect of tort reform on healthcare prices or usage is small, approximately a 1% to 2% decrease outside the Medicare context, and an even smaller or no effect within the Medicare context. The second is that there are heterogeneous treatment effects from limitations on damages. For example, elective procedures are more affected than emergency procedures are because there is less discretion in emergency procedures, and the cost savings may depend on whether individuals are covered in managed care–​type plans. Heterogeneous

 

132    RONEN AVRAHAM AND MAX M. SCHANZENBACH effects are also suggested by the lack of findings from the Medicare patients; the effect of tort reform is likely to be smaller among the elderly. But do these limited results finding small to modest reductions in treatment intensity provide evidence of defensive medicine? Answering that question would require knowledge of whether the spending reductions occurred among cost-​justified procedures or non-​cost-​justified procedures. This question could be answered by looking to changes in the quality of care post tort reform. To the extent the studies discussed above measured quality, they did so using crude measures such as hospital mortality, and therefore cannot fully answer the question. However, it is possible to make an informed guess about the likely effect of reduced treatment intensity. For the most part, the reimbursement schemes in the U.S. healthcare system tend to push providers toward more, not less, spending. The marginal procedure is likely unnecessary, and if the marginal procedure is affected by tort reform, then the procedures forgone were not cost-​justified. As a theoretical matter, then, it seems likely that reductions in treatment intensity post reform are coming from unnecessary treatment, but that assertion has not been clearly established empirically. The only incentive for providers to reduce care is for care that is unlikely to be adequately reimbursed. This may occur particularly among the marginally insured or uninsured, or those for whom reimbursement rates are very low, such as Medicaid recipients. Thus, the inadequately insured or uninsured could face reductions in cost-​justified care after liability limitations. But there is an alternate story too. It is possible that medical malpractice liability, as an added cost, leads to avoidance of serving this patient population, and liability reductions might encourage providers to give more, not less, treatment to them. The effect of tort reform on costs is small, but it does not follow that defensive medicine is therefore a small component of health spending. The studies here measure the response of treatment intensity to tort reform on the margin. It could be that defensive medicine is an important component of healthcare costs, but that providers’ behavior is insensitive to the scope of damage limitations measured here. Provider insensitivity to liability levels could be due to a high level of physician risk aversion to litigation combined with third-​party payment systems that provide strong incentives to treat. The conclusion to be drawn from the empirical work on general healthcare utilization is that, on net, tort reform reduces treatment intensity slightly. For very important groups such as the elderly, there is likely no effect on treatment intensity from damage limitations. Given the magnitude of the results, interpreting them in the social welfare context is difficult. The small reductions in measured treatment intensity could easily be outweighed by additional but unmeasured uncompensated pain and suffering caused by medical errors. However, the results at least demonstrate that reductions to treatment intensity are not outweighed by the medical costs of increased medical errors or a greater freedom among providers to induce demand. This finding is consistent with the broader health economics literature that suggests that there are much stronger demandand supply-​side factors than defensive medicine that drive increases in health spending, including new technologies, a system of third-​party payers, tax incentives, and the financial incentives of providers (for a careful survey, see Skinner [2012]). The law is

 

MEDICAL MALPRACTICE   133 not terribly important to the complex story of high U.S. health costs. Indeed, astonishingly large variations in patient expenditures occur between counties within a state, and therefore within a single legal regime (Gawande 2009).

5.2.2.3. Cardiac and Obstetric Care Even if tort reform does not reduce overall healthcare costs much, it can still reduce healthcare costs in some contexts. Certain practice areas face very high liability pressures, and two have been studied extensively in this regard: cardiac and obstetric care.12 In addition to the intensity of liability pressure faced by these specialties, they have been the focus of study for three additional reasons. First, they involve common procedures that consume a significant amount of medical expenditures. Cardiac care has historically accounted for as much as one-​seventh of all healthcare spending (Cutler et  al. 1998). In the United States, births are dramatically more expensive than they are in many other countries, and the United States has a high rate of Cesarean sections (Rosenthal 2013). The second reason that these procedures have been studied is because outcomes can be reliably assessed. Infant and maternal mortality is well recorded and, because of a well-​known infant health scoring system (APGAR), there are validated measures of birth outcomes. Heart treatment success can be measured at least partially by complication and mortality rates. Finally, there is the possibility of substitution between procedures in both cases, a fact that helps researchers identify the motivation behind treatment choices. In the case of cardiac care, medical management, Percutaneous Transluminal Coronary Angioplasty (PTCA), and CABG (Coronary-​Artery Bypass Graft) are available treatment options. In the case of births, the choice between vaginal births and Cesarean section has been the topic of much debate and concern, with evidence of widely varying practices and increasing rates over time (Baicker et al. 2006). In a well-​cited study, Kessler and McClellan (1996) examine Medicare beneficiaries treated for serious heart disease in 1984, 1987, and 1990 and found that malpractice reforms that directly reduce provider liability pressure lead to reductions of 5% to 9% in medical expenditures without substantial effects on mortality or medical complications. Based on these results, Kessler and McClellan concluded that liability reforms reduce defensive medical practices for patients with heart diseases. In a later study, Kessler and McClellan (2002) repeated their 1996 work but controlled for costs containment achieved by managed care. The magnitude of the results of their 1996 study were reduced by half, likely because tort reform was correlated with increases in managed care. This result is consistent with Avraham et al. (2012) who found the effects of tort reform were lower for non-​Medicare managed care plans as well. Clouding the picture further, a 2004 study by the Congressional Budget Office, applying the methods used in the Kessler and McClellan study to a broader set of ailments, as well as heart disease, could not replicate their results (Beider and Hagen 2004). Another 12  Neuro and cardiovascular surgeons face the greatest likelihood of litigation, with a roughly 18% chance of having a claim filed each year. Obstetricians face high pressure as well, though not as high compared with general surgeons (Jena et al. 2011).

 

134    RONEN AVRAHAM AND MAX M. SCHANZENBACH study on Medicare heart patients by Sloan and Shadle (2009) also failed to find significant effects of tort reform on costs or outcomes for cardiac patients. Unfortunately, however, Sloan and Shaddle had significantly smaller sample sizes compared with the Kessler and McClellan sample, sometimes as little as 1% of the Kessler and McClellan sample size, so Sloan and Shaddle’s failure to replicate could be attributed to sample-​size differences. 13 These competing studies suffer from the significant drawbacks, detailed earlier, of using Medicare samples. Avraham and Schanzenbach (2015) used a nationwide inpatient sample of those coded as having had acute myocardial infarctions. The authors exclude those 85 years and older, yielding an average age in their sample of 68 years, which encompasses many non-​Medicare patients in contrast to prior studies. They find that the probability of PTCA interventions decline by as much as 2 percentage points after the enactment of caps on noneconomic damages. However, this decline is partially offset by a slight increase in the rate of CABG of roughly .5 percentage points.14 The CABG rate increases only for those with insurance, which the authors interpret as evidence consistent with tort reform facilitating induced demand (or offensive medicine). A competing explanation, however, is that before tort reform doctors were inefficiently deterred from treating risky patients who needed CABG. As a highly invasive procedure, liability is more likely to follow from CABG, even if CABG in the long-​run yields better outcomes. Even though practice behavior changed, Avraham and Schanzenbach find no evidence of changes in mortality from heart disease; if anything heart disease mortality declined after caps on noneconomic damages. Obstetricians face the highest risk of medical malpractice liability of any medical specialty. A number of studies from the 1990s examined the relationship between malpractice insurance rates and obstetric practice. Localio (1993) found an association between malpractice claims risk and the rate of Cesarean delivery in the state of New York in 1984, and Dubay and Waidmann (1999) found that greater malpractice pressure leads to a higher probability of Cesarean delivery for the period 1990–​1992, without any significant improvement in health outcomes. Sloan et al. (1995) found no systematic improvement in birth outcomes because of medical malpractice pressure, and Baldwin (1995) found no association between the malpractice exposure of individual physicians and an increase in the use of prenatal resources or Cesarean deliveries for the care of low-​risk obstetric patients. The results of these studies are not consistent, which may be a result of 13  Dhankhar, Khan, and Bagga (2007) examined heart conditions with the data employed herein, but only considered 1 year of data; hence, their analysis was cross sectional. They considered the more limited question of the effect of medical malpractice costs on resource use and mortality of heart patients, finding that an increase in medical malpractice risk leads to a reduction in resource use and improvement in health outcome. 14  The authors do not find robust evidence of expenditure declines, but in models with state-​specific trends, they find a roughly 4% price decline, a magnitude similar to that estimated by Kessler and McClellan (2002).

 

MEDICAL MALPRACTICE   135 using medical malpractice insurance or award levels as the source of variation. Awards, payments, and malpractice insurance levels are quite noisy as they depend on many factors apart from actual liability pressure. Moreover, it is possible that award levels are endogenous if higher liability leads to more avoidance of risky patients or other loss-​ avoidance techniques. Currie and MacLeod (2008) revisited Cesarean sections using tort reform as the source of variation. They found that caps on noneconomic damages increased unnecessary Cesarean sections and led to worse outcomes for mothers. They attribute these effects to reduced care taking and more offensive medicine resulting from limitations on liability. Cesarean sections have higher complication rates for mothers relative to vaginal births when not medically indicated, but they are much more remunerative than vaginal births. The authors take this as evidence that caps on noneconomic damages can raise medical costs and damage outcomes not through less care taking but rather through induced demand. Indeed, there is prior evidence of induced demand in the Cesarean context (Gruber et al. 1999; Gruber and Owings 1996). In contrast to their finding regarding caps on noneconomic damages, Currie and MacLeod find that reform of the rule on the legal doctrine of joint-​and-​several liability has reduced Cesarean section rates while improving delivery outcomes. Reform of joint and several liability rules tends to place more liability on the doctor relative to hospitals, and Currie and MacLeod attribute the reduction in Cesarean section rates and improved outcomes to more liability being placed on the obstetrician, the primary decision maker. Frakes (2012) uses the National Hospital Discharge Survey to examine Cesarean section rates over a much broader timeframe (1979–​2005) than that of Currie and MacLeod, encompassing many more reforms. Frakes fails to find any measureable impact of caps on noneconomic damages or joint and several liability reform on Cesarean section rates. He attributes the differing results to the fact that only four caps on noneconomic damages were enacted within the Currie and MacLeod study. However, Frakes does find some evidence of decreased use of other procedures, such as episiotomies, after the enactment of caps on noneconomic damages. Iizuka (2013) used the Nationwide Inpatient Survey and found that reform to the collateral source rule15 worsened birth outcomes, reform to the joint and several liability rule improved birth outcomes, and that noneconomic damage caps had no measureable effect, though the sign of the effect suggested birth outcomes may have improved after non-​economic damage caps were enacted. The collateral source results, however, rely on only one enactment, which makes Iizuka’s results questionable.16 Frakes and Jena (2014)

15  The collateral source rule prevents deductions made from other sources of recovery, such as medical and disability insurance. Reform to the rule creates an offset to recovery from insurance, thereby reducing plaintiff ’s overall recovery. 16  Two other reforms were enacted but were done so simultaneously with Joint and Several Liability reform. See Iizuka (Table 1, p. 169).

 

136    RONEN AVRAHAM AND MAX M. SCHANZENBACH question Iizuka’s results in light of the fact that caps on noneconomic damages usually are found to have the largest impact. Shurtz (2013), using Texas data and examining the 2003 Texas cap on noneconomic damages, provides a possible avenue toward reconciling some of the differing results on tort reform and obstetric practice. Shurtz considered the financial incentives providers faced post reform for privately insured mothers versus mothers insured by Medicaid, which reimbursed at lower rates for Cesarean sections. Cesarean rates increased for those with private insurance but appeared to decrease for those with Medicaid coverage. The net effect of reform on Cesarean sections was quite small, but the net effect masked underlying changes that depended upon doctor’s financial incentives stemming from the patients’ level of insurance. Shurtz’s finding that Cesarean sections increased for those with private insurance post tort reform is consistent with Currie and MacLeod’s theory that caps on noneconomic damages may facilitate induced demand in the obstetric context. The studies of cardiac and obstetric care suggest that tort liability may affect treatment intensity, but in a potentially ambiguous fashion. In particular, Currie and MacLeod (2008); Shurtz (2013); and Avraham and Schanzenbach (2015) have demonstrated the need to investigate tort reform’s interaction with reimbursement schemes and the possibility that increases in offensive medicine may offset decreases in defensive medicine. Nonetheless, the failure to find consistent effects across periods and data sets, particularly in the case of obstetric care, prevents any firm conclusions from being drawn.

5.2.3. Tort Reform and the Quality of Care As discussed previously, studies of specific treatments have narrowly analyzed quality of care after tort reform. There is at present little work on the broader effect of tort reform on quality of care, though this effect is a key part of the assessment of tort reform’s social impact. Using cause of death records, Cotet (2012) finds that mortality from “medical error” increased after tort reform, and infers that treatment quality declined. But this could also be an endogenous coding response, with providers more willing to admit errors in the face of reduced liability. Baicker et al. (2007), finding a small decrease in spending in the Medicare data, also found no effect of liability pressure on mortality. Mortality, in any case, is a fairly blunt measure, and, as discussed, the elderly may not be the population most affected by changes in liability standards. The most comprehensive study of the effect of medical malpractice on patient outcomes is by Frakes and Jena (2014). The authors examine a number of clinically validated measures of healthcare quality, including inpatient mortality rates and avoidable hospitalization rates, and find a precisely estimated null effect of caps on noneconomic damages and most other tort reforms on these quality measures. No published study, to our knowledge, has otherwise explored the impact of tort reform on patient outcomes.

 

MEDICAL MALPRACTICE   137

5.3.  Future of Reform: Medical Malpractice and Clinical Practice Guidelines With insurance coverage expanding in the United States under the Affordable Care Act, cost and quality control have become the primary challenges of the U.S. healthcare system. Most observers agree that provider incentives will be the key factor in improving the system’s performance (Kinney 2011). It is clear that state-​level tort reforms, relying primarily on caps on noneconomic damages, have not brought about economically significant reductions in healthcare cost or utilization. Damage limitations also run the risk of creating offsetting costs and increased utilization in some circumstances. On the other hand, there is little evidence that the current system of medical malpractice, with or without damage caps, is close to optimal. The system is characterized by underclaiming and perverse incentives created by uncertain and potentially incorrect standards of care. Improving the incentives provided by medical malpractice liability could hold some promise for improving care. In particular, two ideas have regained the attention of scholars: (1) the use of Clinical Practice Guidelines (CPGs) to set the standard of care and thus direct medical practice norms ex ante, and (2) Disclosure and Resolution Programs (DRPs), which provide incentives to disclose and address errors and thereby address the underclaiming in the system.

5.3.1. Clinical Practice Guidelines and Medical Malpractice CPGs are statements that detail the optimal clinical practices that physicians should apply in providing care for patients. CPGs are developed by groups of medical professionals who review the scientific evidence and assess the benefits and harms of alternative care options. A number of different organizations have drafted CPGs (such as private organizations and public organizations, including advocacy groups, state agencies, and commercial entities). Currently, more than 350 groups have drafted more than 2,700 CPGs in the National Guidelines Clearinghouse (run by the U.S. government) (Avraham 2014). CPGs, if well drafted, may be combined with the medical malpractice system to change the norms of medical practices. If providers are sensitive to medical malpractice liability standards, then by tying liability standards to validated best practices, CPGs can encourage higher-​quality care. Moreover, to the extent that CPGs become safe harbors from malpractice litigation, they will reduce the incentive to practice defensive medicine. Moreover, CPGs may avoid the potential deadening influence of the reliance on custom to determine liability by instead relying on flexible and evolving standards. A variety of commentators has suggested the CPGs have promise for distilling the

 

138    RONEN AVRAHAM AND MAX M. SCHANZENBACH overwhelming information on optimal care and communicating it effectively to providers (Havighurst 1991; Rosoff 2001; Avraham 2011; Frakes 2014). The uncertainty of the standard of negligence deters hospitals and providers from pursuing the creation of collectively valuable medical practices, adversely affecting patient safety. Further, in cases where the legal system assesses medical negligence based on customary practices, generally accepted defensive medical procedures may lock in suboptimal standards. Healthcare providers already lack sufficient incentive to invest privately in optimizing care because they do not fully capture the benefits of their innovations as other providers learn from technique. There are several other reasons to think courts are not optimally positioned to fix the healthcare system, especially given that their main “tool” is rendering ex post judgments about the provider’s practice. First, as discussed previously, malpractice detection rates are low, and even when malpractice is detected, the high costs of medical malpractice litigation mean that only the high damages cases are brought. Because so few negligence cases are pursued, the legal system’s signal to doctors and hospitals is weak (Hyman and Silver 2006). Second, even among those cases that are litigated, audits indicate that courts render correct judgments on average about three-​ quarters of the time (Studdert et al. 2006). Courts’ errors might be biased (toward or against defendants) because courts are not exposed to all the pertinent facts or because of numerous cognitive biases such as the “hindsight bias,” or because defendants have “deep pockets,” as well as for a host of other reasons. Moreover, the problem of offensive medicine (induced demand) is largely outside of tort law’s radar because in the vast majority of cases in which offensive medicine occurred, there are no direct observable injuries and the costs are externalized to the insurance pool or the government, which bear the costs of excessive care. In sum, the signal provided by court judgments regarding care is infrequent, muddled, and reflects only a subclass of medical errors. The signal is far too weak to inform determinations about patients’ healthcare. When the tort system does not work well, direct regulation of the activity becomes more attractive (Shavell 1984). However, regulatory agencies can face the same information problems faced by the courts, and they are subject to political pressures from which the courts are at least partly insulated. As a way out of all this mess, several scholars have advocated for a more extensive and nuanced use of CPGs to both harness state-​of-​the-​ art research about best practice without directly regulate the standard of practice itself (Havighurst 1991; Rosoff 2001; Avraham 2011; Frakes 2014). From a legal perspective, the promise behind CPGs is to provide physicians with a safe harbor against liability, effectively replacing the custom standard with a published scientific standard that is open to change as science advances. This would move the profession much closer to the ideal of “reasonable” standard of conventional tort law. Implementing CPGs would serve one of the major purposes of medical malpractice liability by providing incentives for physicians to follow guidelines and choose correct treatments, while reducing incentives to overtreat through the practice of defensive medicine.

 

MEDICAL MALPRACTICE   139 CPGs are more likely to reduce the number of unnecessary and incorrect medical procedures because of their direct focus on providing informed guidelines for delivering proper care to patients rather than focusing on providing incentives for the physicians to find the proper care themselves. It is impossible for a physician (especially a solo practitioner) to stay abreast of all of the developments in medical research occurring constantly. For example, a cardiologist would have to read ten articles per day, 365 days a year to stay current (Ayres 2007). With the continuous expansion and development of technological devices such as smart phones, tablets, and laptops, CPGs become even more effective because physicians can pull up up-​to-​date CPGs on their technological devices instantaneously. While there are many benefits associated with CPGs, implementation of them faces several challenges. First, physicians often do not follow even widely accepted guidelines. One example is the guideline promulgated by the U.S. Preventative Services Force for the process of screening for prostate cancer, which recommended against Prostate-​ Specific-​Antigen (PSA) based screening for prostate cancer for a number of evidence-​ based reasons (e.g., false positives and complications arising from follow-​up biopsies) (U.S. Preventative Task Force 2012). After the recommendation against the screening was issued in 2012, a survey found that while 49% of physicians agreed with the recommendation, only 1.8% planned to stop using the test. Among the reasons given for failure to comply with the recommendation were the following: physicians believed their patients expected to receive the screening; physicians thought patients would feel their healthcare was being rationed; and others felt they did not have time to explain such changes to their patients (Kliff 2012). Additionally, there are serious challenges in drafting CPGs. CPGs are currently produced by various entities and organizations, including professional medical organizations, hospitals, healthcare maintenance organizations (HMOs), liability insurers, and government agencies. Until recently, the guideline authors could have conflicts of interest. A publication by the American Medical Association found that conflicts of interest were present for 71% of the chairpersons and 91% of the committee co-​chairpersons of guideline producers (Kung 2012). Sometimes indirect connections with medical device and pharmaceutical companies remain. For example, since 2010, pharmaceutical companies can no longer fund the creation of CPGs, but they can still pay for their distribution and updating, thereby retaining some influence on the process (Avraham 2011b). Consequently, many doctors question the guidelines’ ability to deliver unbiased and evidence-​based advice (Cabana et al. 1999). Even if they avoid conflicts of interest, the organizations that produce CPGs do not face financial liability for their guidelines and therefore may lack sufficient incentives to promulgate optimal CPGs. Even if unbiased, the entities producing guidelines do so with differing goals. CPGs produced by medical associations focus intently on improving patient outcomes; CPGs produced by third-​party payers such as HMOs are focused on cost-​containment; and CPGs produced by malpractice insurers focus on reducing the risk of malpractice. Therefore, “[i]‌f physicians try to follow every CPG, they may find themselves trying to serve potentially conflicting goals:  to provide the best quality of care for their patients, to secure

 

140    RONEN AVRAHAM AND MAX M. SCHANZENBACH reimbursement for their services, and to avoid the risk of malpractice liability” (Recupero 2008). Moreover, there is no method of ensuring that the CPGs are updated and that obsolete recommendations are removed from circulation. Organizations that produce CPGs often struggle to update them because of a lack of resources and financial incentives to invest in incorporating quickly evolving scientific research (Avraham 2011b). The results are guidelines that are lacking in adequate scientific support: at least one study found that only a small percentage of CPGs are based on scientific evidence (Shekelle et al. 2001). To deal with problems in drafting CPGs, at Congress’s direction the Institute of Medicine promulgated eight standards with respect to the optimal development of CPGs (IOM 2011).17 These standards are meant to address problems with transparency, conflicts of interest, external review, and updating the guidelines as needed, which are critical to ensuring the reliability of CPGs. The IOM also proposed that a public–private mechanism examine the procedures used to produce CPGs and certify whether these organizations’ CPG development procedures comply with the standards for trustworthy CPGs (IOM 2011). The IOM’s proposed model requires that a public–​private entity approve the process the existing guideline developers follow so that they meet these standards. This is not the only possible model for promulgation of CPGs. While the IOM’s approach maintains that the CPGs should be produced in an unbiased manner and should be expert and convergent, this is likely not achievable. The IOM itself recognizes the myth of neutrality surrounding current CPGs, and acknowledges that CPG authors inevitably bring their personal and professional biases to the table (Graham et al. 2011). The IOM attempts to resolve these conflicts of interest through regulating procedure—​that is, ensuring that the chairs of guideline development groups will not have conflicts of interest individually, and keeping the other members of the group separate from financial investments. An alternative approach would be to accept the unavoidability of bias and the diversity among CPGs and substitute regulation for a market-​based system: On the one hand, letting CPG developers profit from their product by allowing them to license it, but on the other, holding them liable for the outcomes of the CPGs rather than for the process of producing them. In short, the law could treat CPG developers the same way the law treats manufacturers. CPGs produced under this system could be more scientifically accurate and trustworthy because of transparency combined with legal accountability (Avraham 2014).

5.3.2. Communication and Resolution Programs Communication and Resolution Programs (CRPs) involve voluntary disclosure and resolution of errors by the healthcare provider itself. In essence, these programs hope to 17 

The standards were as follows: (1) transparency; (2) management of conflicts of interest; (3) the composition of guideline development groups; (4) the intersection of CPGs and systematic review of technology; (5) evidence foundations for guidelines and rating the strength of recommendations; (6) articulation of recommendations; (7) external review of developed guidelines; and (8) updating the guidelines.

 

MEDICAL MALPRACTICE   141 increase the abysmal error-​detection rate evident in conventional medical malpractice, while reducing hospital costs by addressing problems early on and preserving the relationship with the patient. The current malpractice system fails to produce adequate information about errors for two reasons. First, there is rampant underclaiming, likely exacerbated by enactments of damages caps. Second, the threat of liability leads providers to adopt a deny-​and-​ defend approach, such that errors are not subject to the internal review that one would hope. Communication and Resolution programs attempt, among other things, to increase the flow of information to healthcare providers by encouraging open communication and compensation where it is appropriate. The basic design of a CRP is as follows: After an adverse event, the care facility initiates an investigation to determine whether the harm was caused by substandard care. The conclusion of this investigation is then disclosed to the patient. If the facility determines that care was not substandard, the facility will defend the physician in any lawsuit. On the other hand, if the investigation determines that the care was substandard, the facility communicates with the patient about her needs and voluntarily offers appropriate compensation and remedial measures if needed. Some argue that the amount of compensation under a CRP should be based upon the patient’s needs rather that upon an approximation of a possible jury verdict (Sage et al 2014). Perhpas most importantly, CRPs could facilitate the implementation of higher standards of care. Changing standards of care during the course of litigation could be evidence of substandard care. If a CRP succeeds in quickly procuring a resolution after an adverse event, the facility is free to immediately set and instill better standards of care and avoid a recurrence of the harm. To be effective, CRPs must do three things: (1) actually communicate information and not engage in cover-​ups; (2) save money for providers, which is possible through reduced liability; and (3) instill better standards of care which will reduce future rate of errors. The effect of these programs has not been conclusively assessed. In 2009, the federal government authorized $25 million to planning and demonstration grants to develop CRPs (Sage et al. 2014). Early results from these projects are promising, but longer studies would be necessary to produce truly reliable data (Mello 2014). Early information from the grant projects suggests that CRPs have the potential to reduce costs and medical mistakes. Like CPGs, they will require more study but offer some promise of an improvement over the traditional system of medical malpractice liability.

5.4. Conclusion Medical malpractice reform has become a persistent political issue, and it will remain on the political agenda. Damage limitations are popular with healthcare providers, particularly physicians in high-​risk specialties. Yet, evaluations of the impact of damage limitations, particularly caps on noneconomic damages, suggest that policy makers should be

 

142    RONEN AVRAHAM AND MAX M. SCHANZENBACH cautious about such reforms. Damage limitations are highly unlikely to affect healthcare costs significantly, and they have potential offsetting effects that may outweigh any savings. Our conclusion from various studies using different approaches is that there is no clear answer to whether caps and other damage limitations are detrimental or improving to social welfare. What clearly emerges from the studies, however, is the conclusion that damage limitations will have small effects on outcomes such as provider behavior, costs, and patient welfare, even if the direction of these effects are uncertain or vary by practice area. Despite the relatively low impact of damage limitations on the healthcare system, medical malpractice is still highly relevant. Providers pay close attention to standards of care and change practices accordingly. Future reforms should focus not on limitations to damages, but rather on direct ways to help the system function more effectively. Clinical practice guidelines and conflict resolution programs offer some promise of reducing costs and improving care, and future research should tend toward evaluating these more relevant avenues of reform.

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Chapter 6

EC ONOMI C S OF PROPERT Y L AW Henry E. Smith

6.1. Introduction The economic analysis of property has rarely been applied to the first question of property theory: what is property?1 Law and economics has made impressive strides in the area of property, but further progress will come only when we apply economic tools to analyzing the institution of property as a system. An economic analysis of property law as a system reveals it to be the law of “near separation” of clusters of activities of private actors into interacting components, or modules. Among the most important of these modules are the legal things that mediate many of the relations between actors. Like its sister areas in private law—​torts and contracts—​property law is a partial solution to the problem of the horizontal interactions of actors. From an economic point of view, moving away from total chaos, much less achieving efficiency, in such a complex system can be a tall order. Consider the set of all actors and every action each could take with respect to each other. A system of detailed rules that would directly ensure optimal sets of actions would be intractable—​at least for interesting and useful definitions of “optimal.” Such top-​down solutions are not the only possible ones. From the ground level, it is not hard to see how given some starting point, actors might want to make mutually beneficial deals (contracts) and forbear from injuring each other (torts). Where does this leave property? It is mostly left to the philosophical literature to speculate about the origins of property in the service of justifying it as an institution. One modest theory along these lines is that of David Hume (1739–​1740). On Hume’s theory, property emerges in conventions of possession that people recognized as mutually 1  Henry Smith is Fessenden Professor of Law, Harvard Law School, and Director of the Project on the Foundations of Private Law. Email: [email protected]. I would like to thank participants at a Workshop on Private Law at the William & Mary Law School for helpful comments. All errors are mine.

 

ECONOMICS OF PROPERTY LAW    149 beneficial and to which they converged based on what we would now call salience. Robert Sugden (2004 [1986]) has extended this theory using the tools of modern game theory. Building on Hume and Sugden, I will argue that basic possession and many of the more refined features of property law approach the private law problem—​reconciling potentially conflicting complex horizontal interactions among actors—​using a strategy of incomplete separation. “Separation” here refers to taking chunks of this world of free interaction and treating them as semifreestanding groups that can be managed in partial isolation from other groups of interactions. This separation is an example of modularity, a well-​known way of managing complexity (Simon 1981; Baldwin and Clark 2000, 58–​59, 236–​37, 257). Decomposing a network into (possibly overlapping) components in which interactions are dense inside the components but relatively sparse between the components allows complexity to be tamed and evolution to occur without major shocks to the system. This separation or modularization happens on many levels in property. First, by defining things that can be possessed, complementary attributes are grouped together under the control of the possessor, obviating the need for rules dealing with the interactions of the complementary attributes. When soil nutrients and moisture are part of the same “thing,” property law need not deal directly with their complementarity. Second, possession in larger social settings becomes more in rem: the rights and duties between the possessor and others are mediated through the modular thing. The duty (to keep off) need not make direct reference to the possessor and her uses, or the details of the internal attributes of the resource. Third, along the spectrum from possession to ownership, exclusion strategies, supplemented by governance norms and rules of proper use, allow information to be managed at lower cost than in a less modular system. Legal thinghood also allows for easier alienability. Fourth, the law of remedies often suppresses information about uses and attributes of owners, thereby enhancing the protective function of property. Fifth, devices for managing the system keep property more formal and more compartmentalized, again using the notion of a thing as a springboard. Sixth, other forms of separation include complex divisions of property like trusts and corporations—​forms of entity property—​and divisions between property regimes, like common and private property intertwined in a semicommons. What all these forms of separation have in common—​thinghood, in rem status, formalization and standardization, and divided rights and regimes—​is that they permit specialization at the cost of strategic behavior. By focusing decision makers on some information to the exclusion of other information, actors can specialize in maximizing the value of given assets or subsets of attributes. The stability afforded by property to the expectations of owners allows them to plan, invest, and develop information about their assets. Closely related to these benefits of property is the problem of strategic behavior: overly narrow-​minded decision-​making by owners (and other interest holders) will sometimes fail to maximize value for others, and overall. Classes of such situations involving exploitation often travel under familiar labels. Thus, “externalities” involve spillovers of uses that affect someone beyond the scope of one’s property

 

150   HENRY E. SMITH rights. The tragedy of the commons involves arbitrage between two systems: the fish in the pond is common (including its ability to help regenerate the resource) but the fish taken from the pond is private. Worse still, highly informed actors will engage in strategic behavior: they may take deliberate advantage of the modular system in order to arbitrage off its structure for wealth-​destroying private gain. When regimes of common and private property come together, people will act as commoners with too much regard for their interests in the private property system: this is true from medieval open fields (common grazing and private grain growing) to joint ventures and standard setting organizations (common project and private intellectual property) (Smith 2000a). Property faces a trade-​off: property law characteristically tackles the private law problem of complex horizontal interactions through the device of separation, but this separation makes possible a range of strategic behavior. To deal with this potential strategic behavior, property law employs more targeted rules and standards—​governance structures like nuisance, the interface of property with contract law in covenants, the interventions of equity, and organizational law.

6.2.  Property as a Collection or as a System It is easier to see how economic tools can be used to analyze property as a system if we have a benchmark for the analysis. The “private law problem” of generalized horizontal interactions among actors in society (or the state of nature) is one such reference point. Closely related are benchmarks from economics, including the zero transaction cost world of the Coase Theorem and the “full” property system that would be possible in such a world (Coase 1960). As we will see, disaggregated views of property—​the so-​called “bundle of rights” or “bundle of sticks” —​take these benchmarks as more realistic than they actually are. But this has things backward. Positive transaction costs point to why some bundles (and rather lumpy ones that) characterize our world and to why property law is a system rather than (as the bundle view tends to see it) a collection of detachable rules.

6.2.1. The Full Property Benchmark Property law, along with contracts, torts, and restitution, forms the traditional bedrock of private law. In the United States and the Commonwealth, these subjects sport a large common law component, although legislation has played an important role, especially in property. In civil law systems, these areas, and property in particular, constitute the core of the civil code. When we turn to economics, its practitioners appear to focus intensely on “property rights,” and economists do engage in a lot of talk about property.

 

ECONOMICS OF PROPERTY LAW    151 But economic analysis in general and law and economics in particular employ very different notions of property from legal ones. Starting with Coase, law and economics has adopted an extreme version of the bundle of rights picture of property (Merrill and Smith 2001b, 2011). The idea of property as no more than an aggregate of rights, duties, privileges, and so on, availing between the owner and others, especially if defined in terms of a list of uses, has been familiar since the Realists adapted Hohfeld’s scheme of jural relations to their ends (Hohfeld 1913, 1917). The bundle of rights picture is both an analytical device and, for many, a substantive claim about property: property is not more than a bundle of sticks, with no unifying theme. As such, there are few presumptions about how sticks are collected or structured, and the bundle picture typically contains no glue holding the notion of property together. In particular, property is not about things at all, and serious social scientists and policy makers have supposedly got beyond the myth that it is (Grey 1980; see also Symposium 2011). The bundle of rights got a big boost from Ronald Coase, and later from law and economics. This choice was an understandable one for Coase, whose main goal was to show the impact of the law on the economy. For this purpose, the bundle of rights picture is made to order. Coase’s purpose was not to explain the law of property—​or the law at all. His target was neoclassical economics, with its unrealistic approach of assuming away the institutional framework governing the interactions of economic actors (Coase 1988, 174). To make his point he shows (in what has come to be known as the Coase Theorem) that if transaction costs were zero, the same pattern of resource use would occur regardless of the set of initial entitlements (or in a weaker version maximum efficiency given a set of initial entitlements) (Coase 1960). In our positive transaction cost world, this guarantee disappears, and the lesson is that we must do comparative institutional analysis to figure out which is the least bad arrangement from an economic point of view (Allen 1991; Eggertsson 1990, 101–​116; McCloskey 1998; see, generally, Posner and Parisi 2013). The analytical convenience of the bundle of rights picture can be carried too far. If property is a collection of rights, duties, privileges, immunities, and so on, with no inherent content, no interaction between them, and no glue holding them together, then one can vary a stick—​Who has the right to create vibrations or prevent them? Who has the right to let cattle graze or to prevent them from doing so?—​and the effect of this variation can be traced out on economic behavior, hypothetically under zero transaction costs and more realistically under various institutional arrangements. The usefulness of the bundle picture for analytical convenience accounts for some of its popularity. “All else equal” is easier to achieve (or to assume) when the various legal relations and legal rules are detachable from their context. One can ask, as law and economics, especially in its early phase, was inclined to do, whether a given “legal rule” was efficient. This procedure is familiar from contracts and torts, where studies of damages rules in contracts and negligence versus strict liability in torts became central topics. For the most part, legal economists treated property in a similar fashion, even though property is—​as I will argue—​less well captured by a rule-​by-​rule analysis than are contracts and torts. It is precisely the system aspects of property that are left out in this approach.

 

152   HENRY E. SMITH Once positive transaction costs come into the picture, the bundle of rights picture shows weaknesses, as well as strengths. For example, one could ask whether various good faith purchaser rules and exceptions for trespass (like necessity) increase efficiency. Notably, these applications of economics to property law occurred especially where property overlaps with torts and contracts. More systemic aspects of property such as land surveying and recording systems received less attention in the formative period of law and economics. I will argue that these other aspects of property are less amenable to the rule-​by-​rule style of analysis popular in first generation law and economics.

6.2.2. Property as a Modular System Economic analysis of property law as a system does not come naturally. System effects and emergent properties are more difficult to measure than rules in isolation. Perhaps because the isolation of legal rules was easier in areas of property that overlapped with torts and contracts, much of the first wave of law and economics focused on parts of property law that are the most contractual or tort-​like, rather than property itself. Indeed, property was treated as the working out of contract and tort principles (Merrill and Smith 2001b). To borrow a civilian term, the view of property implicit in law and economics was an “obligational” one.2 Damages rules in contracts or negligence-versusstrict liability, it seemed, could be treated in isolation for modeling purposes. When it came to property, the analysis tended to be an extension of these strands of analysis, with the law of nuisance taking center stage. To get at what is unique about property law, we can return to the theoretical benchmark of the world of zero transaction costs. We can derive a Coase Corollary from the Coase Theorem:  in a zero transaction cost world, the form of property entitlements would not matter to resource allocation (Merrill and Smith 2011). Or to put it more concretely, in the absence of transaction costs, much of what is done by the law of property could indeed be accomplished using only tort and contract. Taking the true lesson of the Coase Theorem (and the Coase Corollary) seriously, we can ask what is the “essential role” of property in a positive transaction cost world?: what does property law make possible that could not be accomplished by contract?3 Property law owes its actual contours to positive transaction costs. Return to the basic problem in private law—​the problem of potentially conflicting activities by members of society. Think of all the actors and all the resource attributes,

2  The law of obligations embraces contracts, torts, and restitution, and in civil law, an “obligation” is “a two-​ended relationship which appears from the one end as a personal right to claim and from the other as a duty to render performance.” (Zimmermann 1996, 1). 3  I borrow the “essential role” terminology from Hansmann and Kraakman (2000), who use it to analyze what contribution organization law makes that cannot be replicated by contract. They conclude that organizational law is property law.

 

ECONOMICS OF PROPERTY LAW    153 and all the actions each might take that could possibly impact the others. We could theo­ retically define legal relations for each pair of actors, each resource attribute, and each action. If we stopped there, we would be assuming very strict separation between activities and attributes, but this is not realistic. Certain collections of attributes go together (in a compositional dimension of property) (Barzel 1997; Smith 2001). For example, someone with the right to determine how soil nutrients are used might need control over the moisture level, etc. To handle these interdependencies, the rules governing the super thin slices of the world of our thought experiment would themselves have to be very complex and interdependent, or we would need rules of priority among the rules. In a zero transaction cost world, this would all be costless, but in our world, it would be prohibitively costly. Property law economizes on transaction costs by providing massive shortcuts over this fully articulated or “complete” property system. In our world, property law provides a first cut at this problem that aggregates some of these slices, along various dimensions (Lee and Smith 2012; Smith 2012). Complementary resource attributes are collected into things or assets. Rights are defined over many uses by using exclusion strategies over these collections, supplemented as needed by governance strategies referring to particular uses (Smith 2002; see also Field 1989; Rose 1991). The more specific governance rules and standards partially override the background exclusion regime (which applies to the more heterogeneous “otherwise” or “elsewhere” pattern of situation). Thus, licenses or (more robustly) easements displace the exclusion rule (trespass) because they refer more specifically to uses and users. (When two devices or rules apply, the more specific applies over the more general. Very general rules that have many disparate exceptions (because they are displaced by many specific devices) apply “otherwise” or “elsewhere” (Smith 2014a)). In an external shortcut, owners of these collections of attributes have rights defined against other generally—​in rem rights—​that deal with duty bearers in a wholesale fashion. Property is a shortcut over the “full property” that could be achieved in the zero transaction cost world. In an analogy to the incomplete contracts literature, we can call property inherently “incomplete” in our world.4 The degree of this shortcut can be captured using algorithms for finding community structure in a network. There is a large body of literature on finding optimal structures of modules in a network (Newman and Girvan 2004; Newman 2006). We can model emergent legal relations by considering actors as the nodes and their activities as the edges (possibly of varying strengths) (Sichelman and Smith ms.). Then a family of algorithms instructs one on how to remove the edges of most “betweenness”—​the ones that are on the most paths between nodes (based, for example, on shortest walk or random walk), leaving the semi-​isolated modules. The virtue of these models is that they do not prejudge the structure of the system: we can model the emergence of clustering of interactions around legal things if they really do tend to lend the system a modular structure, 4  In the incomplete contracts literature, contracts are incomplete because of positive transaction costs. Property’s incompleteness likewise stems from the costs of more complete property. Note too that it is recognized that in a world of complete contracts, there would be no role for ownership (Maskin and Tirole 1999).

 

154   HENRY E. SMITH i.e., with more interactions internal to them and relatively sparse (but important) interactions in between. For example, the law of trespass tracks modular parcels, whereas nuisance focuses to a greater extent on a few important relations between the users of adjacent parcels. Second, algorithms for finding community structure do not prejudge the level of grain that the law should implement. The structure-​finding algorithm can tell one where modularity is maximized, and it can be combined with the costs and benefits of delineation effort to predict how fine-​grained legal relations should be if they respond to efficiency concerns, either through evolutionary pressures or by design. The use of network theory and measurable modularity carry the potential to open up avenues of empirical work on property as a system.

6.3.  An Ontology for Property Unlike much of the rest of property, economics has offered a bottom-​up theory of possession. The word possession covers many different phenomena, ranging from prelegal notions of control to rights of possession protected by trespass and adverse possession.

6.3.1. Salience and Convention Robert Sugden (2004 [1986]) has reinterpreted Hume’s theory of property using salience and focal points. Thus, when two actors might want to use a resource, a convention may emerge based on who is nearer to the resource or has control over it. According to Sugden, the relevant game is Hawk-​Dove,5 but what level of cooperation of conflict can be left open, as long as it makes sense for people to pick an equilibrium based on salience. Hume and (to some extent) Sugden see the salience that breaks the symmetry between actors approaching a resource as a matter of psychology and inductive reasoning. As David Friedman (1994) points out, the norms of property that emerge from such a bottom-​up process based on salience will reflect a very local version of morality and efficiency, because it must work in pairwise encounters of actors. The question remains open how much this ground-​level morality and efficiency scale up to society. Nonetheless, conventions characterized by this local morality and efficiency place relatively modest informational demands on actors, compared to norms that reflect bigger-​ picture notions of moral desert, distribution, or efficiency (Gold and Smith 2016; Merrill and Smith 2007). A rule of property that required actors to optimize the overall use of resources would not be useful to guide behavior (or litigation). Yet, salience may relate to economic usefulness, in the sense of the benefits of one actor’s use or his or her control over the resource. In Yoram Barzel’s theory of property 5 

In the Hawk-​Dove game, each player’s best outcome would be to play hawk (assert oneself) if the other plays dove (yields), but the worst outcome results for each when each plays hawk.

 

ECONOMICS OF PROPERTY LAW    155 (Barzel 1997), resources are analyzed into their constituent attributes and changes in property rights tend toward efficiency if those with a greater ability to affect the mean return of a collection of attributes get the residual claim over them.6 Contracting parties can be expected to move toward this result (transaction costs permitting), and even nonconsensual activities will have this tendency under some conditions. Barzel disclaims an explanation of how property got started (likening it to a Big Bang), but his approach is a useful supplement to the theory of Hume and Sugden. In a world of actors encountering undifferentiated resources, it often makes sense for those who have the ability to affect the mean return of collections of resources to have de facto possession over them, which includes a legitimate claim that persists beyond the moment. Breaking resources into attributes highlights two points about a bottom-​up theory of property (Smith 2014a). First, notions of possession and thing definition go hand in hand. The law of accession most directly reflects the process of thing definition. “Accession” can refer to a principle of lesser assets (or attributes) going to the owner of related greater assets (or attributes). This principle is reflected in a wide variety of doctrines, including the law of increase (the calf goes to the owner of the mother cow) and fixtures (chattels go with the land they are attached to). In common law, “accession” also refers to what was called “specificatio” in Roman law: someone who innocently mixes labor with material and either transforms it or adds most of the value can keep the new object and pay damages for the things worked upon (or replace it with an equivalent). This branch of accession deals with the persistence of things over time (Newman 2009; Smith 2007). Accession overall can be interpreted as the law of thing definition and claim scope or as an acquisition principle (compare Newman [2009] and Smith [2007], with Merrill [2009]). As we have seen, both Hume and Sugden explain accession on the basis of salience. At any rate, in a possessory claim we need to know the scope of the claim. Accession can be thought of as basic thing definition and maintenance, which feeds into possession. Accession has been analyzed from an economic point of view, mainly as an acquisition principle, as has possession (Merrill 2009). When it comes to first possession, rules that designate a clear winner early in the process tend to be efficient (Lueck 1995; see, also, Posner 2000), and we can note the role of salience and control in establishing a good candidate for someone uniquely well positioned to compete (and use) the resource. Likewise, accession can head off costly competition for unclaimed resources by designating a clear (salient) winner—​the owner of salient resource X gets lesser resource Y. By contrast, where potential appropriators are equally well positioned to access the resource, a rule of first possession can easily lead to the tragedy of the commons. Here homogeneity of appropriators can help maintain rules of property use, in a governance regime (Lueck 1995; Libecap 1989). What we need for the rest of property law is a basic ontology for purposes of social and legal norms. An ontology separates out the basic elements and their relations, including who counts as an actor, what a thing is, and how actors may act with respect to one 6 

Barzel’s theory has some parallels in the theory of asset ownership (Grossman and Hart 1986; Hart and Moore 1990), but Barzel explicitly endogenizes the assets.

 

156   HENRY E. SMITH another.7 Some of these relations are mediated by the things of the ontology: if A possesses resource R, then others have a duty to forbear from entering it, touching it, and so on, depending on the nature of the resource. What attributes are grouped—separated— into things and who has possession of them both respond to considerations of salience and utility.

6.3.2. Possessory Things and Ownership For property law, a key shortcut over “complete” property constructed from contracts is the legal thing. The relation of those with possessory rights and those with corresponding duties is mediated through the thing. When one walks through a parking lot, one need only avoid taking or damaging the cars if one does not own them: the duty bearer need not know anything about the owner’s characteristics or planned uses (Penner 1997, 75–​76). Particularly as possession becomes more formalized into law, there is less need to assess the qualities of the possessor or the potential challenger in order to follow the Humean custom of mutual forbearance. Parcel definition greatly simplifies the law of trespass, particularly when the law develops persistent rights to possess such that the owner need not be actually present in order to be in possession and therefore have the right to possess protected by trespass. Customs of possession are formalized in the process of being adapted into the law. Thus, in the mining camps, miners had a right to work a spot without interference, in a custom called pedis possessio. When the custom was adopted by courts and in legislation, the boundaries of the spot were identified with the formal boundaries of the claim, even when this meant expansion (Smith 2009, 2014a). (More recently, courts have resisted extending it beyond the boundaries of a single claim, as the uranium industry has long wished.) That is, possession itself separates the possessory norm from a great deal of personal information of the actors. As possession becomes “more legal” and more widely applicable, the thing plays a greater role, such that even details of the thing itself do not matter to the duty. As mentioned earlier, when custom and law afford rights to possess to those not actually physically controlling (or even present), the “possessory” right must rely on formal thing definition because the possessor may or may not be around to voice objections. Well-​demarcated boundaries in the case of land serve this function. Extending possession in this way makes sense: property becomes much more useful in terms of investment, specialization, and autonomy by persisting even when actual control or proximity is attenuated, at the relatively low cost of being clear about demarcating the connection of (extended) “possessors” and their “things.” Within possessory norms, we can see nested defaults at work. For example, as we saw, norms of possession arise in particular groups, like whalers on the open seas (Ellickson 7  I am using ontology here as computer scientists do, to refer to the basic set-​up, without making deep metaphysical claims. Here we at least need legal persons, activities, things, and relations between persons with respect to things and activities.

 

ECONOMICS OF PROPERTY LAW    157 1989, 1991). The famous “fast fish loose fish” rule provided that a whale belonged to the first one to harpoon it as long as the harpoon was attached to the whaler’s boat. The physical connection is salient and close to de facto possession. For particularly valuable and dangerous sperm whales, the rule was that of the “first iron,” which gave the first harpooner exclusive rights as long as fresh pursuit continued. The “first iron” rule is less salient, more costly to promulgate, and more specific. It partially displaces “fast fish loose fish,” which was the general rule. One would expect a new species of whale with no special dangerousness to fall under the general rule. Likewise, Ellickson’s findings in Shasta County are consistent with a theory of nested defaults (Ellickson 1991). He found that regardless of whether the formal law is fencing in (ranchers have responsibility for damage caused by their animals on land belonging to others) or fencing out (no such responsibility), the informal norm was for animal owners to take responsibility. In the area of informal norms, the basic possessory norm has a lot of pull. We might further hypothesize that this basic exclusionary regime would be more widespread than expected based on which activity was more valuable in a given small area (Merrill and Smith 2001b). It is the more general default. Layered on top of basic possession and rights to possess are further rules culminating in ownership. At first blush it seems puzzling to have two notions of property-like “control” and to sometimes protect one without the other—​vindicating the rights of nonowner possessors some of the time and nonpossessing owners at others. By layering ownership and title rules on top of possession, property law is able to effect further types of separation, at some cost. The thing in ownership is even more formal than in possession. Indeed possession is often used for low-​stakes everyday interactions: one does not do title searches on the pen one buys from a store. With the layering of ownership and title rules on possession, we see a further example of nested defaults, or the specific over general principle. Rules of title and ownership are more specific (and used for higher stakes) and displace possessory rules that would “otherwise” apply. This means that possession applies whenever it is not displaced, in a very heterogeneous pattern (called “elsewhere”) (Smith, 2014a). This means that finding a unifying theme of possession, other than being a more general partially displaced stratum of law is unlikely to succeed. Indeed, ownership is so formal that some property theorists outside of economics have proposed that property is an office (Essert 2013; Hart 1982: 208; Katz 2012). The idea is that duties avail to the owner qua owner without the need for personal information. Further, when the owner’s property right is transferred to another, the right need not change in content: the new owner just steps into the old owner’s shoes. There is no need to say that the right is different even though an old duty bearer is now a right holder and the old right holder is now a duty bearer. Ownership as an office captures the impersonality of the right but may be overkill. In keeping with the bottom-​up theory, the “legal thing” itself is impersonal, and ownership need not rise to the level of a full-​blown office for separability and alienability of the right to be possible. The key to alienability is depersonalization of the right, which happens through the definition of the thing.

 

158   HENRY E. SMITH What the impersonality of duties and the ease of alienability require is not that ownership be an office but that legal things be depersonalized (Smith 2012). Again, think of the parked cars in the parking lot. The duty bearer need not know whether the car is on loan to the owner’s sister, or whether the owner is a non-​natural person like a corporation. (These divisions of rights stem from further forms of separation that will be taken up in Section 6.6.) The separation of the legal thing from its context allows for this degree of in rem simplicity (Smith 2012). It also allows transfers to take place more smoothly: potential purchasers have less to inquire into, and the transfer happens automatically in many respects. The more formal ownership and title rules allow for more elaborate forms of separation than does simple possession. Divided rights are not really possible when all we have is a notion of possession. Either one is in possession or not. For divided rights, something more is needed including a method of keeping track of more connections between persons and things in order to divide rights. At the very least, we need rights to possess that persist despite their holder not being in possession. Title is one method of keeping track of these connections. Furthermore, ownership allows for divisions over time and by use, such as easements.

6.4.  Delineating Property Rights In moving from possession to ownership and the division of rights, we are in the realm of delineating property rights. Economists going back to Demsetz (1967) and carried through in the New Institutional Economics (e.g., Barzel 1997) have focused a great deal of attention on the delineation of property rights, including the descriptive question of how they evolve in response to background conditions and what efficiency properties we should expect (or not) from systems of property rights. Demsetz’s theory was a demand side theory: the Demsetz Thesis holds that property rights will evolve in order to deal with externalities as they arise (Symposium 2002). Other branches of the literature ask how property rights are supplied, often very imperfectly relatively to an ideal baseline (Alston, Harris, and Mueller 2012; Libecap 1989; Ostrom 1990; Wyman 2005).

6.4.1. Exclusion Versus Governance One aspect of property rights definition is the problem of separating out clusters of activities and attributes and then dealing with the problems of strategic interaction that such separation gives rise to. Property rights are typically delineated with some combination of exclusion and governance (Smith 2001, 2004a). An exclusion strategy is low cost and low precision: it defines basic modules and takes care of problems wholesale. The law of trespass reflects an exclusion strategy, and the message is a simple one: keep off unless you have permission. This leaves important spillovers unaddressed, and

 

ECONOMICS OF PROPERTY LAW    159 where the stakes are high enough, they are sometimes worth dealing with through a governance strategy. A governance strategy focuses in on a narrower class of uses, as in covenants, easements, and nuisance law. This part of property law enriches the interface between parcels in real property law. Because most personal property has no fixed location, restrictions on use generally are achieved exclusively through in personam contract, tort law, product standards, and safety regulations, rather than through the law of servitudes. Separation of attributes and their associated activities into clusters gives rise to problems of strategic behavior. The separation into modules is not complete. Modularization allows for specialization—​each owner can become more informed and skilled than others at using his or her asset—​but property rights also lead to myopia (or worse). Some of this goes under the heading of “spillover” or “externality.” Some of these spillovers can even be created to extort others, as, for example, opening a horse stable in order to be paid by neighbors to shut it down, or emitting pollutants to receive subsidies for stopping (Kelly 2011). Further, what counts as a thing for property has to be stable in the face of strategic behavior. Gathering attributes together into “units” needs to be done in order to reduce measurement costs (Barzel 1982), and what counts as a unit may change depending on the legal treatment: taxes and legal rules that burden or benefit units or things can call forth effort at changing the underlying unit or thing (Barzel 1976; Smith 2000b). Thus, taxes on cigarettes have resulted in longer cigarettes, and access to riparian rights has resulted in “bowling alley” parcels. Property law needs doctrines to prevent strategic reconfiguring of things. Various combinations of exclusion and governance may be better at containing strategic behavior. Putting the effects of an entire interaction within the scope of a parcel would be one method—​by removing the module boundary that causes the externality (see Ellickson 1993, 1322–​1335). This comes at the cost of any specialization that would be facilitated by a more fine-​grained parcel definition with a boundary through the activity. Another method to contain strategic behavior is to supplement the partial exclusion with a governance regime that addresses the potential opportunism. Thus could be by easement, contract, nuisance, or regulation. Or various forms of entity property could be used to govern the wider interaction—​as, for example, in a common interest community.

6.4.2. Law Versus Equity One pervasive governance-​like device aimed at containing opportunism is equitable decision making by courts (or arbitrators or administrators). Separate courts of law and equity are mostly a thing of the past, but law and equity persist as partially separate when it comes to substantive law and remedies. Economic analysis mostly treats the law versus equity divide as irrelevant, and treats the distinction as faintly reflected in the choice between rules and standards (Kaplow 1992), and property rules versus liability rules (Calabresi and Melamed 1972; Ayres 2005). I argue that equity is a functionally distinct

 

160   HENRY E. SMITH decision-​making mode that is particularly necessary when it comes to cleaning up the strategic behavior made possible by incomplete separation. One problem with formal law, including the part of property law that defines property rights, is that some actors with a lot of information will take unforeseen advantage of these systems. This is a problem very familiar from tax law (Weisbach 1999; Lawsky 2009). Economists have not been of one mind about the usefulness of opportunism as a category for analysis. Oliver Williamson relies heavily on opportunism in his version of New Institutional Economics, in which he shows how a variety of contractual and organizational devices can be used to prevent opportunism that would otherwise prevent cooperation. Williamson adopts a very broad definition of opportunism as “self-​interest seeking with guile” (1985, 47). This is broad in the sense that Williamson includes all manner of rule violations and promise breaking as opportunism. It is narrow in the sense that it is not clear that full-​blown deception should be required for opportunism. Others have argued that opportunism is simply self-​interest, and all a system should do is its best to provide an environment where self-​interest is consistent with efficiency (compare Barzel [1985, 10–​11] with Williamson [1993]). On this skeptical view, failure to do so does not call for hand wringing about the immorality of the actors within the system. Elsewhere I have defined opportunism as: […] behavior that is undesirable but that cannot be cost-​effectively captured—​ defined, detected, and deterred—​by explicit ex ante rulemaking…. It often consists of behavior that is technically legal but is done with a view to securing unintended benefits from the system, and these benefits are usually smaller than the costs they impose on others. (Smith 2010, 10–​11)

The key from the point of view of legal design is to come up with proxies that can trigger presumptions against the potential opportunists, along with further rules of thumb for evaluating behavior once the equitable safety valve is triggered. Here too, it is not surprising that the law tracks widely accepted morality. Taking unforeseen advantage of a situation in order to appropriate more of a smaller pie does meet with disapproval. More importantly, an institutional analysis will keep on the table the full range of responses to such opportunism. These include better ex ante rules, ex post equitable standards, and tolerating some residual opportunism. It should also be noted that social norms do much of the work in getting people not to act opportunistically (a point to which I return below). Much of what goes under the heading of equity (and used to fall under equity jurisdiction) and which further drew on an Aristotelian strand of thinking about equity, sees a need for an ex post, morally infused discretionary standard that would be targeted in personam) to people engaged in opportunism (Ayotte, Friedman, and Smith 2013; Feldman and Smith 2014; Smith 2010, 2014b). Crucially from an institutional design perspective, this decision-​making mode is implemented in a system of proxies and presumptions that constrain the operation of equity in order to prevent it from chilling legitimate behavior. Consider as a prototypical example a building encroachment. It is

 

ECONOMICS OF PROPERTY LAW    161 sometimes said that building encroachments (at least in the old days) would automatically call forth a harsh remedy of injunctions but that modern courts worried about hold-outs will now usually give damages. This is not totally wrong, but it gives an incomplete picture. Continuing trespass (of which a building encroachment is an example) gives rise to a rebuttable presumption for an injunction. However, we are worried about overcompliance (Craswell and Calfee 1986; Sterk 2008), and, from a “less economic” point of view, ex post unfairness. So the law allows a shift to damages where the encroacher has made a good faith mistake and the encroachee would face disproportionate hardship. This meant that the injunction would harm the enjoined party far more than it would benefit the moving party—​a torn down building would be a classic example. It did not mean equipoise or some other kind of cost–benefit test that would ask whether the particular proposed injunction’s benefits would exceed its costs. Nevertheless, if the encroacher is in bad faith, an injunction should issue. The scheme of proxies and presumptions, keyed to good versus bad faith and to disproportionate (or “undue”) hardship, is designed to solve a two-​sided opportunism problem that is set up by the system of boundaries between parcels and the ad coelum rule.8 We have to worry about the hold-out on one side and the land-​thief on the other. Here equity works though the different remedies on offer in the various situations that carry more or less dangers of opportunism. I return to remedies in the next subsection. Equity is thus a safety valve largely defined by the proxies and presumptions that trigger this kind of inquiry. Like governance (versus exclusion) and ownership (versus possession), equity is a more specific regime that overrides the law in particular circumstances (it is second-​order “law about law”). The proxies that trigger the presumption against the possible opportunist are more specific than the general rules. Where does this happen? The idea that some situations are so pregnant with the danger of opportunism that a class of transactions will not be enforced or will be subjected to searching scrutiny is familiar across private law. Unconscionability in contract law, another outgrowth of equity, was traditionally keyed to “constructive” or “near” fraud. The dangers of opportunism and error can be given an economic interpretation as in Epstein’s (1975) theory of unconscionability: some transactions have indicia of fraud that cannot be directly proven and, given the possibilities of type 1 and type 2 errors, it sometimes makes sense to refuse enforcement of transactions (even if this will prevent a few positive deals) (see, also, Leff 1967). He draws an analogy to the statute of frauds: withholding enforcement of certain kinds of contracts not in writing could be better than enforcing them all or picking and choosing (this is an empirical question).9

8  Under the ad coelum rule (short for the maxim “cujus est solum, ejus est usque ad coelum et ad inferos,” which translates as “one who owns the soil owns also to the sky and to the depths”), the boundaries of a parcel extend upward and downward (presumptively, with adjustments, for example, for overflights). 9  Interestingly, the statute of frauds was an early alternative to the system of land records, another device to prevent shady dealings in property—​a topic to which I return in Section 6.5.

 

162   HENRY E. SMITH Equity relies on a type of local morality, in a fashion similar to the one we saw in connection with possession. Equity historically had a role in enforcing custom, and was the vehicle by which some customs could be adapted into the law. The theory of social norms suggests that close-​knit groups will come up with wealth-​maximizing norms (Ellickson 1989, 1991). There may be outgroup externalities, as there were with whaling norms, which were good at dealing with (pairwise) conflicts between whaling ship crews but led to the overhunting of whales (Ellickson 1989; Friedman 1994). Further, some customs will scale up better than others will. There is the danger of enforcing in an end game situation customs that presuppose an ongoing interaction and of thereby distorting the process of norm formation (Bernstein 1996). Nevertheless, custom has been and can be a source of new legal norms under the right conditions (Parisi 2000). As we saw, part of the process of making a custom more widely applicable is to formalize it (Smith 2009). Despite its reputation as discretionary and detailed, equity probably had a role in simplifying custom for use by the law. In particular, rough judgments about whether one is violating a custom could inform determinations of good faith. There is as always a danger here too of distorting the norm or the law in the process of “enforcing” it. Equity acts in personam in the remedies it offers, and normally it intervenes in a targeted fashion. It acts as a (higher-​order) safety valve, in which a court can intervene—​ based on the proxies and presumptions—​against a specific instance of opportunism. On the theory offered here, equity’s contours reflect the strategic interaction of parties with each other and with courts. But the existence of the system is announced to the world. Indeed, the possibility of equitable intervention leads to the possible chilling effect, much emphasized by the opponents of equity throughout its history. Whether the net effect is chilling, or reassurance on the part of ordinary non-​opportunistic actors is an empirical question. Legal designers also face the question of how the possibility of equitable intervention, especially when it is couched in sometimes-​ambiguous moral-​sounding terms (such as good faith), will reach its target audience, or audiences. When the law sends a different message to different audiences, legal theorists call this “acoustic separation” (Dan-​ Cohen 1984). The term was introduced by Meir Dan-​Cohen to describe the possibility that conduct rules directed at primary actors might differ from decision rules used by judges or other officials. For example, the criminal law might tell people not to steal, but give judges or prosecutors discretion not to enforce, or to show leniency, in certain situations. Equitable intervention may work similarly. The same moral-​sounding directives that tell highly informed opportunists that courts will come down on their misdoing, may sound like everyday morality and provide reassurance to those with no nefarious intent. In “behavioral equity,” the equitable message may promote compliance and prevent evasion by the opportunists, while not interfering with the intrinsic moral motivation of ordinary people (Feldman and Smith 2014). Insights from behavioral decision theory can be integrated into the familiar rules versus standards paradigm, in this as in other areas of property law.

 

ECONOMICS OF PROPERTY LAW    163

6.4.3. Damages Versus Injunctions We have already seen in building encroachments that conventional law and economics uses the lens of property rules versus liability rules to analyze questions of remedies in property and other areas. Calabresi and Melamed (1972) defined a property rule as protection for an entitlement that aims at forcing a would-​be taker to obtain the holder’s consent. If an entitlement is protected by a liability rule, it can be taken, with the only consequence being the payment of officially determined damages. (Calabresi and Melamed also introduced inalienability rules, which forbid the transfer of the entitlement.) The primary example for Calabresi and Melamed, as for Coase, was the law of nuisance. Calabresi and Melamed applied their criteria of efficiency and fairness (and, in principle, “other justice considerations”) to this question and argued that where transaction costs are low property rules should be used, in order to ensure that takings of entitlements are welfare increasing. Where transaction costs are high, because of potential holdouts among those affected by the nuisance—​think of a factory and residents—​or because of free riders among those who might pay to shut down the nuisance, liability rules could improve matters over the corresponding property rule. The polluter would take external harm into account because of the damages, and those affected by the pollution would be compensated. Of course, the determination may be incorrect, and subjective values are left out of the picture. Calabresi and Melamed (1972) derived four rules from a two-​ by-​ two choice. Following Coase’s (1960) notion of reciprocal causation,10 they posited that the “entitlement”—​for example, to emit smoke or to enjoy clean air—​could be “given” to either party, for example a factory owner and a resident (or residents). The entitlement (in either party) could be protected by a property rule or a liability rule. This yields four possibilities. Under Rule 1, the resident has the entitlement to clean air protected by a property rule, and so can get an injunction to shut down a polluting factory. Rule 2 affords the resident the entitlement but only protected by a liability rule, namely damages. Flipping things around so that the factory owner has the “entitlement,” they say that the entitlement (to pollute) can be protected by a property rule or a liability rule. They identify the property rule in the polluter, Rule 3, as the resident’s inability to get an injunction and the factory’s ability to continue to pollute. In the most innovative move, they pointed out that the polluter could be protected by a liability rule, in Rule 4, where the resident would have the right to take the entitlement to pollute from the factory owner but the resident would have to pay damages (the factory owner’s shut down costs). Others have pointed out that Rules 2 and 4 are like call options and have explored put options (forced 10 

Coase argued that causation was reciprocal in the sense that in any resource conflict, the conflict would not arise but for the presence of each of the parties. Thus, the crops contribute to the trampled crops as do the cattle, and in the example under consideration, the resident causes the conflict, as well as the factory.

 

164   HENRY E. SMITH sales) (Morris 1993; Ayres 2005). Additional rules are possible (e.g., higher-​order rules) (Ayres 2005). It is the entitlement structure itself that typically receives too little attention in the economic analysis of property law. One symptom of the problem is that the law against theft, hardly controversial in general, has been considered difficult to capture in law and economics. What if thieves value entitlement more than “victims” do? Part of the explanation is that the law of theft obviates elaborate precautions by owners, which would otherwise be wasteful (Hasen and McAdams 1997). The same can be said for broad use of undercompensatory liability rules: holders will use self-​help to avoid the taking, and property rules can save on some of the costs of self-​help (Hylton 2011; Smith 2004b). More generally, entitlements are not as thin and malleable as this literature assumes (Rose 1997, 2178–​2179; Merrill and Smith 2001b). Again, for Coasean transaction cost reasons, the entitlement structure is lumpy and asymmetric (Lee and Smith 2012; Merrill and Smith 2001, 2011; Rose 1997; Smith 2004a, 2012; see, also, Fennell 2012). We do not ask against a blank slate whether pollution should or should not occur. The background set of entitlement includes a right to be free from more than de minimis pollution, depending on the nature of locality, and, subject to safety valve exceptions, this entitlement is protected by a property rule. Crucially, the general right to exclude sweeps in this type of right without it needing to be separately delineated. As noted earlier, property solves these types of problems wholesale, subject to retail-​level adjustments for situations of bad faith, extreme holdouts, and the like. And because entitlements are lumpy, they are far from being symmetric. Consider again the factory-​resident example. If an entitlement in the resident protected by a property rule is Rule 1, and an entitlement in the resident protected by a liability rule is Rule 2, it is problematic to switch things around and expect symmetry as Calabresi and Melamed do. Thus, “Rule 3” is not the mirror image of Rule 1: there is in the default package of entitlements no right to pollute, in the sense of being able to sue the resident for not accepting the pollution (for example, if the resident blows it back). At most, Rule 3 means the denial of an injunction such that the polluter can exercise a liberty to pollute. A polluter may have a right to pollute if it has an easement to pollute (or some non-​property tradable permit relating to pollution), by either grant or prescription, but these are adjustments to the interface between the modules, the legal things corresponding to the adjacent parcels. They are a step on the road to governance and modify basic exclusion. Thus, if we move from Rule 1 (injunction for the resident) to Rule 2 (damages for the resident) in certain situations of extreme holdout behavior (roughly), there is no corresponding need to go from Rule 3 to Rule 4, because the nature of the “entitlements” is very different. Because the default package of rights does not include a right to pollute, there is no corresponding need to “soften” it with a Rule 4. The famous coming-​to-​the-​nuisance case of Spur Industries, Inc. v. Del E. Webb Development Co.,11 in which the court required the victim side to pay the costs of shutting down the feedlot,

11 

494 P.2d 700, 708 (Ariz. 1972) (en banc).

 

ECONOMICS OF PROPERTY LAW    165 is anomalous—​and indeed such a result has not occurred again (Epstein 1997; Smith 2004a). A subsequent (vast) literature further developed the framework of property and liability rules, and much of the tenor of this work is pro-​liability rule. Ever more elaborate schemes of liability rules can do better than a simple estimate of market value of the entitlement taken (Ayres 2005). One interesting result in the liability rule literature is that in contexts like nuisance, an average harm rule can be better than a property rule (Kaplow and Shavell 1996). If the liability rule is based on average harm and the courts’ estimate of liability is unbiased, then ex ante the polluter and the victim will be presented with a correct expected value, and their incentives will also be correct. The same cannot be said for a property rule, which will deter some takings where the potential taker values the entitlement more than does the holder (potential takee). There is, however, a problem of separation involved in this strand of liability rule literature. The assumption that liability rules can be based on an unbiased estimate of value (or harm) is stronger than it appears, because the actuarial classes involved may not be stable (Ortiz 1994: 403–​06; Smith 2004b). The problem is the familiar one of partial separation and consequent strategic behavior. Once a liability rule is in place, knowledgeable takers may be able to cherry pick assets that are more valuable than the court is likely to find them to be, based on its imperfect proxies. This is a form of arbitrage, and it fits under the heading of opportunism discussed earlier. And not surprisingly, the injunction is used here, especially in situations of subjective value and putative game playing. Indeed, as discussed in the building encroachment situation, sometimes the problem in remedies is potential strategic behavior on both sides, which is accounted for on the traditional test for injunctions (Gergen, Golden, and Smith 2012). For example, traditional injunction jurisprudence was keyed to good faith. It also was based not on a cost–benefit test but on disproportionate or undue hardship, not equipoise. Thus, in the central examples to the liability rule literature like Boomer v. Atlantic Cement Co.,12 the law of injunctions is flattened out in both the more recent law and in the conventional economic literature (Gergen, Golden, and Smith 2012; Laycock 2011). Older law, far from giving automatic injunctions, was attuned to the two-​sided opportunism problem, and it provided a safety valve for holdouts while doing less damage to the entitlement to be free from nuisance. Generally, we may say that the term property rule was chosen advisedly after all, and there is an information–​cost rationale for the prevalence—​surprising on the conventional approach—​of property rules. In addition to the abatement of self-​help, more generally, broad entitlements protected by property rules solve some problems of strategic behavior, while causing others. Property rules and liability rules correspond to sanctions and prices, respectively, in the terms of Cooter (1984), and we can see why. Protection of a set of entitlements through a property rule is a sanction in the sense that expected liability takes a jump at a certain signal (e.g., crossing the boundary of a parcel

12 

257 N.E.2d 870 (N.Y. 1970).

 

166   HENRY E. SMITH or taking away a chattel), which corresponds to the notion of doing something wrong. It is not a price, which is a charge for doing something permitted, and which varies continuously with harm (assuming harm is continuous). As Cooter points out, sanctions are more appropriate where we know the correct standard of behavior and know less about the extent of harm in a given case, whereas prices are more appropriate where we know more about marginal harm than about the optimal level of an activity. The sanction does not vary with variance in behavior, making them less subject to those forms of strategic behavior like the cherry-​picking problem. Correspondingly, owners can develop information about their assets without having to worry whether they can prove harm to a court. When holdout behavior becomes too strong, the rationale for the sanction is diminished. The cost of a property rule is the strategic behavior of holdouts and the problem of externalities that span the boundary of the legal thing and the rest of the system. It is for this reason that we do not have only the law of trespass or a rule of automatic injunctions. Governance strategies and more tailored remedies—​conditions on and exceptions to injunctions—​are designed to deal with remaining strategic behavior at some cost. Again, the question is how the system overall deals with horizontal interactions, including the strategic behavior presented by various forms of partial separation into modules.

6.5.  Managing the System Property features many principles, doctrines, and institutions that aim to manage the problem of separation and strategic behavior. Property law is known (and often criticized) for its formalism, but it is not completely formal or equally formal across the board. Formalism is a type of separation—​the relative invariance of a rule, statement, or system—​to its context (Heylighen 1999). Thus, the language of first-​order logic is more formal than natural language, and written language tends to be more formal than spoken language. Likewise, everyday mathematical notation is less formal than the language used in proofs, because it is a sort of shorthand for those who are in the know (including the writer). The separation involved in the formalism of property involves making property more (but partially) invariant to contextual information. This is helpful where in rem duty bearers are involved (Smith 2003). All legal systems, and property law in particular, face a basic communication trade-​off: at the same cost, one can communicate in an informationally intense way (much information per unit of effort) to a socially closer audience or in a more stripped down formal way to a more impersonal and extended audience (Smith, 2003). Elliptical communication, as when someone asks that a window be closed by mentioning it is cold, is more possible in contexts that are more personal. Correspondingly, rights can presuppose background information in contract law (in personam) more than in property (in rem). More can be expected by neighbors as duty bearers (nuisance) than by the world at large

 

ECONOMICS OF PROPERTY LAW    167 (trespass). Even more can be expected in a scheme of covenants, although familiarity will decrease over time (changed conditions). Property law is more formal in some contexts than in others. More in rem aspects have to reach an audience of large and less informed parties. Making them responsible for idiosyncratic information would make for high processing costs on their part. This is a rationale for the numerus clausus, or the closed list of basic property forms (Merrill and Smith 2000, 2001b). Those creating idiosyncratic property rights will tend not take into account informational externalities. It might be thought that property records remove the need for standardizing property (Epstein 1982; Hansmann and Kraakman 2002). This does not follow. What the impact of property records is on standardization is an empirical question. For one thing, registration systems appear to require a stricter numerus clausus because the registrar, who pronounces valid title, cannot be expected to process a great deal of idiosyncrasy (Arruñada 2003, 2012; Smith 2010). (The registrar does a mini quiet title action and stands in for the set of in rem duty bearers.) In other areas, having a standardized format for information is beneficial even if the information is readily available (e.g., court documents). Standardization happens sometimes spontaneously, sometimes through private actors with a stake (trade associations), and sometimes by the state. There is reason to think that where the state is already enforcing property rights there are economies of scale and scope in the state taking on the standardization function as well (Barzel 2002). Interestingly, the standardization function can be separated from property and placed with special private actors, in standard setting organizations, and we worry there about strategic behavior. Equitable intervention is used to prevent misuse of patents in standard setting organizations and could be used even more systematically (Smith 2013). For areas that fall in between property and contract, we need to find intermediate levels of standardization (Merrill and Smith 2001a). Thus, in bailments, landlord-​tenant, security interests, and trusts, major aspects of the law are not fully in rem or fully in personam, and those aspects that are more toward the in rem side of the spectrum tend to be more formal and standardized: reaching a more indefinite and/​or more impersonal audience requires more formalization and standardization. Also, in general, where contracts are treated as property and made alienable, they are treated more like things. Traditionally, it was equity that lent personal rights a property character and the prerequisite for propertarian treatment was that the contract be unconditional, specifically enforceable, and tied to identifiable property (Worthington 1996; Penner 1997). In other words, property treatment required separation from context. Negotiability is the most extreme form of separation, with cash being the strongest example. One can get good title to cash even with a thief in the chain of title. As elsewhere, separation promotes alienability, but at the cost of potential strategic behavior. Sometimes this behavior is handled by the criminal law, and sometimes (as with a cashier’s check), the drawer chooses to take the risk in the interest of minimizing the need for inquiry by the payee. The costs and benefits of separation and prevention of opportunism all vary by the type of resource and the situations parties are likely to find themselves in.

 

168   HENRY E. SMITH If strategic behavior is enough of a problem, rules can become mandatory. The mandatory rule can provide for notice or protection. Where the externalities from alienation are too great, we sometimes find inalienability rules, such as for human organs, votes, and the like. If there is a mandatory core in fiduciary law, it is justified by very hard to anticipate strategic behavior. And the enforceability of equitable interests against third parties requires notice, and this not surprisingly cannot be contracted around. One benefit of standardization that receives little attention is the interconnection problem. If we had many idiosyncratic property rights, the question would be how they combine. As it is, when two parcels are unified, their basic feature—​the nature of the boundary, the rules of co-​ownership and the like—​automatically do not clash. This is by no means guaranteed to occur without any effort. An indication of the dangers averted by standardization can be found in the area of intellectual property licensing (Van Houweling 2008, 938–​939). If someone is trying to make a work that involves more than one piece of copyrighted material, it is important that the licenses not clash. This problem surfaced in open-​access licenses, which went through several generations. The important aspect of such licenses is that the obligations travel to remote users. Different generations of open-​access licenses specified inconstant duties. This is the type of problem that, on a much larger scale, the numerus clausus and other standardizing aspects of property law are aimed at preventing. Standardization benefits can also be seen in the realm of land surveying and parcel definition. In a series of articles Libecap and Lueck (2011) have shown that the rectangular survey system leads to higher land values and less conflict than the metes and bounds system (Libecap, Lueck, and O’Grady 2011).13 In Libecap and Lueck (2011), they present the results of a natural experiment based on two regions of Ohio, which for exogenous reasons received rectangular survey versus metes and bounds treatment, and found better alignment of parcels, 18 times fewer land disputes in the nineteenth century, 20%–​30% higher per acre value in flat terrain through at least the middle of the twentieth century, and higher population densities, urbanization, and investment in industry in the areas on the rectangular survey side of the boundary. The rectangular system achieves a greater separation of parcel definition from local context, which is more stable over time and allows for better modularization of parcels.

6.6.  Extended Property Rights Property comes in more complicated and flexible forms than the basic set (“estates and future interests”), even supplemented by forms of co-​ownership. Separation can be pursued further to create entity property, the foundation of many organizational forms 13  Under the metes and bounds system, descriptions of parcel boundaries are based on angles and measurements, often using markers like rocks and trees as fixed points. The rectangular survey prescribes a grid within which rectangular parcels can be defined.

 

ECONOMICS OF PROPERTY LAW    169 (Merrill and Smith 2010, 123–​158; 2012, 646–​806). These include the trust, but also the corporation, common interest communities, and the like. The familiar types of property regimes themselves—​private, common, and public—​can also be mixed together in a variety of ways. Both the extension of property into forms of organization and the mix of property regimes raise issues of separation and strategic behavior.

6.6.1. Entity Property As discussed earlier, personal obligations can be treated as property, and equity courts played a large role in this process. The trust is a systematic treatment of personal obligations as property. In a trust, a settlor transfers legal title of the property (the corpus of the trust) to a trustee, who is obligated to manage it for one or more beneficiaries. The beneficiary has equitable title, which means that the beneficiary has rights protected against the trustee, most notably through the fiduciary duties of loyalty and care. The beneficial interest (equitable property) receives some, but limited protection against third parties. If the trustee transfers the property to a third party wrongfully, the beneficiary can claim the property back from the transferee unless the transferee is a good faith purchaser for value. No one with notice can be in good faith, but the law does not impose much of a duty of inquiry on potential transferees. There is another kind of separation involved, which Hansmann and Kraakman (2000) call “asset partitioning.” In affirmative asset partitioning, a pool of assets is designated that is free from the personal creditors of the holders of the asset. In a trust, the corpus is not subject to the personal creditors of the trustee (and through the concept of a fund, the claims of personal creditors of the beneficiary are subordinate to those of the creditors dealing with the trustee qua trustee). The trust involves separation and requires special devices to contain consequent strategic behavior. Conventionally, it is said that a trust involves the separation of legal and equitable title and the fiduciary duties are designed to contain the extreme danger of trustee misbehavior. Beneficiaries are often vulnerable and have difficulty monitoring trustees. The duty of loyalty prohibits self-​dealing and conflicts of interest with a flat ban; good faith and substantive fairness are no defense. The trust is a complex mixture of contract and property, with a different emphasis in different jurisdictions (Lau 2011; Sitkoff 2011). It needs to be in order to respond to this special kind of separation. This is a lot like the equitable safety valve aimed at countering opportunism, except that in response to defined highly dangerous situations, fiduciary law also uses broad ex ante rules as well as targeted ex post intervention (Smith 2013). (Broad ex post intervention would be the most destabilizing of private arrangements.) Organizations like corporations and partnerships also involve affirmative asset partitioning (Hansmann and Kraakman 2000). Some organizations also feature defensive asset partitioning—​known as limited liability in organizational law. Under defensive asset partitioning, the holders of the designated asset pool (the corpus, the firm’s assets) are protected in their personal assets from claims of creditors of the entity. Entity assets

 

170   HENRY E. SMITH can be treated as semiautomatous, which allocates information costs among the various actors and can allow certain actors, e.g., creditors of a firm, to specialize in monitoring a given pool of assets. Unlike defensive asset partitioning, affirmative asset partitioning cannot be replicated by contract (Hansmann and Kraakman 2000). To designate a pool of assets and shield them from the personal creditors of the owners would require a complex set of covenants that would have to be updated, and which would be hard to enforce. The transaction costs would be prohibitive, in a fashion reminiscent of the transaction costs that property law obviates by taking the shortcuts involved in delineating rights by way of legal things. Hansmann and Kraakman identify asset partitioning as a contribution of property to organizational law. Indeed, we can go further: the conventional view of corporations as a nexus of contracts is limited in just the way that the bundle of rights picture of property misses the contribution made by thing definition and related devices in the law of property. Like property law generally, asset partitioning involves separation, here of the asset pool from certain classes of claims. In a way, this is module or thing definition, but of a more entity-​oriented sort. Like other forms of separation, asset partitioning gives rise to potential strategic behavior. In trusts and in organizational law, albeit to different extents, one major method of constraining opportunism is through fiduciary duties. Monitoring and competition may also serve this function, and the greater possibilities of the latter probably explain why fiduciary duties are weaker and more subject to variation by contract in organizational law than in trust law. Separation and encapsulation of information in organizations, with consequent specialization, are a fundamental property-​like contribution to firms in general. Daniel Spulber (2009a, 2009b) applies the Fisher Separation Theorem to define a firm as an organization in which the decision making about the firm’s objectives can be separated from the personal preferences of its residual owners. If possible, such separation facilitates the famous “separation of ownership and control” in corporations, which can be seen as a prominent version of entity property. When Berle and Means (1932) introduced the separation of ownership and control, they regarded it as a challenge to the validity of private property. They emphasized what we would now call agency cost problems. Problems like these are, however, the flip side of the separation that allows for specialization (e.g., management and capital provision). The real question is whether such strategic behavior can be cost-​effectively contained, through fiduciary duties, market competition, and other devices (see, e.g., Jensen and Meckling 1976; Easterbrook and Fischel 1991). Far from undermining the notion of property, the separation of ownership and control in corporations is a paradigm case of separation, specialization, and strategic behavior that is a leitmotif through all of property law. Entity property allows for more complex mixes of exclusion and governance than do the basic property forms. What role asset definition plays in the theory of the firm is still an open question. Problems of measurement and strategic behavior can be dealt with by exclusion strategies in moving firm boundaries (e.g., making instead of buying, vertical

 

ECONOMICS OF PROPERTY LAW    171 integration) or with more elaborate governance rules, both off-​the-​rack and contractual, for specific types of opportunism.

6.6.2. Mixed Regimes Similar complex mixtures of types of rights can also be achieved by mixing different property regimes—​public, common, and private. Private, common, and public property can be mixed together. One system may abut another, in the sense that a thing will be treated differently as it moves from one regime to the other. The tragedy of the commons occurs because the stock is common but units of flow (e.g., fish from a pond) are private if taken by first possession (Cheung 1970; Gordon 1954; Warming 1911). If the fish and pond were common, there would be no tragedy but perhaps there would be insufficient incentive to fish. If both fish and pond were private, there would likewise be no overfishing, but the risk spreading and cheap definition of common property in the pool would be forgone. Which combination is most efficient is an empirical question. Theoretically a property regime, by creating separation, can give rise to strategic behavior and externalities. Thus, if in a private property regime, too many actors have exclusion rights or overfragmented rights given likely use, the multiple-​veto can lead to underuse, in an anticommons (Buchanan and Yoon 2000; Heller 1998; Parisi, Schulz, and Depoorter 2005). There is a higher-​order question of how to motivate actors to create or modify a property system in the first place (Krier 1992; Fennell 2004). In some situations, disparate stakes can make some actors find it worthwhile to create such a system with a combination of positive and negative externalities for others (Levmore 2002; Wyman 2005). Private, common, and public property can be combined in the micro level. In a semicommons, common and private property cover the same things and interact (Bertacchini, de Mot, and Depoorter 2009; Fennell 2011; Smith 2000a). The problem with this type of separation is again strategic behavior. An example is the open fields of medieval and early modern England. Peasants owned long strips that were cultivated as private property for grain growing but would be thrown open for common grazing after harvest and in fallow periods. This allowed for specialization and internalization in grain growing and operation on a larger scale for grazing, which seems to have involved greater scale economies. The problem with this temporal interleaving of private and common property was the potential for strategic behavior: actors could appropriate goods (manure) and fend off bads (excessive trampling) in the common use with regard to how it impacted their private parcels. These scattered strips can be seen as a method of containing the strategic behavior: at some cost of inconvenience and externalities in the grain growing, the strategic picking and choosing, with steering of cattle for trampling and manure, would be too difficult. Similar problems, requiring special solutions, can be seen in a wide variety of areas, especially where the things of property are hard to define, as in water, the Internet, and intellectual property (Grimmelmann 2010; Heverly 2003; Smith 2007, 2009).

 

172   HENRY E. SMITH The public and private property regimes also interact. In addition to the externalities from one set of users to the other, we must also worry about rent seeking resulting in problematic transfers. The takings doctrine polices private to public transfers, and the public trust reins in some public to private transfers (Epstein 2003; Merrill 2011). The partial separation of the two regimes gives rise to strategic behavior that requires policing.

6.7. Conclusion The increasing complexity of property in response to new economic activity is not a reason to jettison formalism outright. In this, the Realists went overboard. Economic analysis, in adopting the bundle of rights and in treating problems in a detached fashion, runs the risk of entrenching this non sequitur. Instead, new developments in the world and in property law call now more than ever for an analysis of property as a system. Part of that project will involve exploring how property separates—​and how and whether it should separate—​chunks of the world of private interactions and how and whether it should deal with the resulting patterns of potential strategic behavior.

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ECONOMICS OF PROPERTY LAW    175 Katz, L. 2012. “Governing Through Owners: How and Why Formal Private Property Rights Enhance State Power.” University of Pennsylvania Law Review 160, pp. 2029–​2059. Kelly, D. B. 2011. “Strategic Spillovers.” Columbia Law Review 111, pp. 1641–​1721. Krier, J. E. 1992. “The Tragedy of the Commons, Part Two.” Harvard Journal of Law and Public Policy 15, pp. 325–​347. Lau, M. W. 2011. The Economic Structure of Trusts. Oxford: Oxford University Press. Lawsky, S. B. 2009. “Probably? Understanding Tax Law’s Uncertainty.” University of Pennsylvania Law Review 157, pp. 1017–​1074. Laycock, D. 2011. “The Neglected Defense of Undue Hardship (and the Doctrinal Train Wreck in Boomer v. Atlantic Cement).” Journal of Tort Law 4(3) art. 2. Lee, B. A. and Smith, H. E. 2012. “The Nature of Coasean Property.” International Review of Economics 59, pp. 145–​155. Leff, A. A. 1996. “Unconscionability and the Code—​The Emperor’s New Clause.” University of Pennsylvania Law Review 115, pp. 485–​559. Levmore, S. 2002. “Two Stories about the Evolution of Property Rights.” Journal of Legal Studies 31, pp. S421–​S451. Libecap, G. D. (1989). Contracting for Property Rights. Cambridge: Cambridge University Press. Libecap. G. D, and Lueck, D. 2011. “The Demarcation of Land and the Role of Coordinating Property Institutions.” Journal of Political Economy 119, pp. 426–​467. Libecap. G. D., Lueck, D., and O’Grady, T. 2011. “Large-​Scale Institutional Changes: Land Demarcation in the British Empire.” Journal of Law and Economics 54, pp. S295–​S327. Lueck, D. 1995. “The Rule of First Possession and the Design of the Law.” Journal of Law and Economics 38, pp. 393–​436. McCloskey, D. 1998. “The So-​ Called Coase Theorem.” Eastern Economic Journal 24, pp. 367–​371. Maskin, E. and Tirole, J. 1999. “Unforeseen Contingencies and Incomplete Contracts.” Review of Economic Studies 66, pp. 83–​114. Merrill, T. W. 2009. “Accession and Original Ownership.” Journal of Legal Analysis 1, pp. 459–​510. Merrill, T. W. 2011. “Private Property and Public Rights.” In: K. Ayotte and H. E. Smith, eds., Research Handbook on the Economics of Property Law. Cheltenham: Edward Elgar. 75–​103. Merrill, T. W., and Smith, H. E. 2000. “Optimal Standardization in the Law of Property: The Numerus Clausus Principle.” Yale Law Journal 110, pp. 1–​70. Merrill, T. W., and Smith, H. E. 2001a. “The Property/​Contract Interface.” Columbia Law Review 101, pp. 773–​852. Merrill, T. W., and Smith, H. E. 2001b. “What Happened to Property in Law and Economics?” Yale Law Journal 111, pp. 357–​398. Merrill, T. W., and Smith, H. E. 2007. “The Morality of Property.” William and Mary Law Review 48, pp. 1849–​1895. Merrill, T. W., and Smith, H. E. 2010. The Oxford Introductions to U.S. Law:  Property New York: Oxford University Press. Merrill, T. W., and Smith, H. E. 2011. “Making Coasean Property More Coasean.” Journal of Law and Economics 54, pp. S77–​S104. Merrill, T. W., and Smith, H. E. 2012. Property: Principles and Policies. 2nd ed. New York: Foundation Press. Morris, M. 1993. “The Structure of Entitlements.” Cornell Law Review 78, pp. 822–​898.

 

176   HENRY E. SMITH Newman, C. M. 2009. “Patent Infringement as Nuisance.” Catholic University Law Review 59, pp. 61–​123. Newman, M. E. J. 2006. “Modularity and Community Structure in Networks.” Proceedings of the National Academy of Sciences 103(23), pp. 8577–​8582. Newman, M. E. J. and Girvan, M. 2004. “Finding and Evaluating Community Structure in Networks.” Physical Review E 69, 026113 pp. 1–​15. Ortiz, D. R. 1994. “Neoactuarialism:  Comment on Kaplow (1).” Journal of Legal Studies 23, pp. 403–​409. Ostrom E. 1990. Governing the Commons: The Evolution of Institutions for Collective Action. Cambridge: Cambridge University Press. Parisi, F. 2000. “Spontaneous Emergence of Law: Customary Law.” In: Boudewijn Bouckaert and Gerrit de Geest eds., Encyclopedia of Law & Economics. Vol. 5. Cheltenham: Edward Elgar. 603–​630. Parisi, F., Schulz, N., and Depoorter, B. 2005. “Duality in Property:  Commons and Anticommons.” International Review of Law and Economics 25, pp. 578–​591. Penner, J. E. 1997. The Idea of Property in Law. Oxford: Clarendon Press. Posner, R. A. 2000. “Holmes, Savigny, and the Law and Economics of Possession.” Virginia Law Review 86, pp. 535–​567. Posner, R. A. and Parisi, F., eds. 2013. The Coase Theorem. Cheltenham: Edward Elgar. Rose, C. M. 1991. “Rethinking Environmental Controls: Management Strategies for Common Resources.” Duke Law Journal 1991, pp. 1–​38. Rose, C. M. 1997. “The Shadow of The Cathedral.” Yale Law Journal 106, pp. 2175–​2200. Sichelman, T. and Smith, H. E. (ms.). “Modeling Legal Modularity.” Simon, H. A. 1981. The Sciences of the Artificial. 2nd ed. Cambridge, MA: MIT Press. Sitkoff, R. H. 2011. “The Economic Structure of Fiduciary Law.” Boston University Law Review 91, pp. 1039–​1049. Smith, H. E. 2000a. “Semicommon Property Rights and Scattering in the Open Fields.” Journal of Legal Studies 29, pp. 131–​169. Smith, H. E. 2000b. “Ambiguous Quality Changes from Taxes and Legal Rules.” University of Chicago Law Review 67, pp. 647–​723. Smith, H. E. 2002. “Exclusion versus Governance:  Two Strategies for Delineating Property Rights.” Journal of Legal Studies 31, pp. S453–​S487. Smith, H. E. 2003. “The Language of Property: Form, Context, and Audience.” Stanford Law Review 55, pp. 1105–​1191. Smith, H. E. 2004a. “Exclusion and Property Rules in the Law of Nuisance.” Virginia Law Review 90, pp. 965–​1049. Smith, H. E. 2004b. “Property and Property Rules.” New  York University Law Review 79, pp. 1719–​1798. Smith, H. E. 2007. “Intellectual Property as Property: Delineating Entitlements in Information.” Yale Law Journal 116, pp. 1742–​1822. Smith, H. E. 2009. “Community and Custom in Property.” Theoretical Inquiries in Law 10, pp. 5–​41. Smith, H. E. 2010. “An Economic Analysis of Law versus Equity.” (Oct. 22) (unpublished manuscript). http://​www.law.yale.edu/​documents/​pdf/​LEO/​Hsmith_​LawVersusEquity7.pdf [Accessed 17 August 2016]. Smith, H. E. 2011. “Standardization in Property Law.” In:  K. Ayotte and H. E. Smith, eds., Research Handbook on the Economics of Property Law. Cheltenham: Edward Elgar. 148–​173.

 

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Chapter 7

C OM MONS AND ANTIC OMMONS Michael Heller

This chapter offers a concise overview of anticommons theory. The anticommons thesis states that when too many people own pieces of one thing, nobody can use it. Usually private ownership creates wealth. But too much ownership can have the opposite effect—​it leads to wasteful underuse. This is a free-​market paradox that shows up all across the global economy. If too many owners control a single resource, cooperation breaks down, wealth disappears, and everybody loses. Conceptually, underuse in an anticommons mirrors the familiar problem of overuse in a “tragedy of the commons.” The field of anticommons studies is now well established, with thousands of scholars detailing examples across the innovation frontier, including drug patenting, telecom licensing, climate change, eminent domain, oil field unitization, music and art copyright, and postsocialist transition. Addressing anticommons tragedy is a key challenge for any legal system committed to innovation and economic growth.

7.1.  Three Motivating Examples Some years ago, a drug company executive presented me with an unsettling puzzle. His scientists had found a potential treatment for Alzheimer’s disease, but they couldn’t develop it for the market unless the company bought access to dozens of patents. Any single patent owner could demand a huge payoff; some blocked the whole deal. This story does not have a happy ending. The drug sits on the shelf though it might have saved millions of lives and earned billions of dollars.1

1 

The fullest account of anticommons theory and solutions appears in Heller (2008). On the anticommons in drug patents, see (49–​78); in telecom, see (79–​106); in land, see (107–​142). See also

 

COMMONS AND ANTICOMMONS    179 Here’s a second high-​stakes puzzle: what’s the most underused natural resource in America? The answer may be a surprise. It’s the airwaves. Over 90% is dead air because ownership of the broadcast spectrum is so fragmented. As a result, America’s information economy is relatively hobbled; wireless broadband capacity lags far behind that in Japan and Korea. The cost of spectrum underuse may be in the trillions. And another puzzle: why do we waste weeks of our lives stuck in airports? Bad law for real estate assembly. In America, air travel was deregulated 35 years ago. The number of fliers has tripled. So how many new airports have been built since 1975? One. Denver. You can’t build new airports, not anywhere, because multiple landowners can block every project. Twenty-​ five new runways at America’s busiest airports would end most routine air travel delays in the country. Imagine that. All these puzzles share a common cause: when too many people own pieces of one thing, nobody can use it. The anticommons thesis is that simple: when too many people own pieces of one thing, nobody can use it. There has been an unnoticed revolution in how we create wealth. In the old economy, twenty or thirty years ago, you invented a product and got a patent; you wrote a song and got a copyright; you subdivided land and built houses. Today, the leading edge of wealth creation requires assembly. From drugs to telecom, software to semiconductors, anything high-​tech demands the assembly of innumerable patents. And it’s not just high tech that’s changed—​today, cutting-​edge art and music are about mashing up and remixing many separately owned bits of culture. Even with land, the most socially important projects, like new runways, require assembling multiple parcels. Innovation has moved on, but we are stuck with old-​style ownership that’s easy to fragment and hard to put together. Fixing anticommons tragedy is a difficult puzzle. Some solutions are entrepreneurial; for example, people can profit from finding creative ways to bundle ownership. Philanthropists can assemble patents for disease cures. Political advocacy and legal reform will be needed to secure solutions. But the first and most important step in solving anticommons tragedy is to name it and make it visible. This chapter takes that step by briefly introducing the anticommons lexicon. With the right language, anyone can spot links among anticommons puzzles, and all can come together to fix them.

7.2.  Commons and Anticommons To understand the dilemma of resource underuse in an anticommons, it is helpful to start with overuse in a commons. Aristotle was among the first to note how shared ownership can lead to overuse: “That which is common to the greatest number has the least

Heller (2011) (collecting and reprinting, in two volumes, the key scholarly articles on the theory and economics of commons and anticommons property).

 

180   MICHAEL HELLER care bestowed upon it … each thinks chiefly of his own, hardly at all of the common interest; and only when he is himself concerned as an individual” (1996, 33).2 Why do people overuse and destroy things that they value? Perhaps they are shortsighted or dim-​witted, in which case reasoned discussion or gentle persuasion may help. But even the clear-​headed can overuse a commons, for good reasons. The most intractable overuse tragedy arises when individuals choose rationally to consume a common pool of scarce resources even though each knows that the sum of these decisions destroys the resource for all. In such settings, reason cuts the wrong way, and gentle persuasion is ineffective. In other words, I do what’s best for me, you do what’s best for you, and no one pays heed to the sustainability of the shared resource. Ecologist Garrett Hardin captured this dynamic well when he coined the phrase tragedy of the commons (1968, 1243–​1244).3 In 1968 he wrote, “Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all” (1244). Since Hardin wrote these lines, thousands have identified additional areas susceptible to overuse and commons tragedy.4 In addition, Hardin’s metaphor inspired a search for solutions. Most solutions revolve around two main approaches: regulation or privatization. Suppose a common lake is being overfished. Regulators can step in and decide who can fish, when, how much, and with what methods. Such direct “command-​and-​control” regulation has dropped from favor, however, partly because it fails so often and partly because of disenchantment with socialist-​type regulatory control. These days, regulators are more likely to look for some way to privatize access to the lake. They know that divvying up ownership can create powerful personal incentives to conserve. Harvest too many fish in your own lake today, starve tomorrow; invest wisely in the lake, profit forever. Extrapolating from such experience, legislators and voters reason—​wrongly—​that if some private property is a good thing, more must be better. In this view, privatization can never go too far. Until now, ownership, competition, and markets—​the guts of modern capitalism—​ have been understood through the opposition suggested by Figure 7.1. Private property solves the tragedy of the commons. Privatization beats regulation. Market competition outperforms state control. Capitalism trounces socialism. But these simple oppositions mistake the visible forms of ownership for the whole spectrum. The assumption is fatally incomplete. 2  Before Aristotle, Thucydides noted that people “devote a very small fraction of time to the consideration of any public object, most of it to the prosecution of their own objects. Meanwhile each fancies that no harm will come to his neglect, that it is the business of somebody else to look after this or that for him; and so, by the same notion being entertained by all separately, the common cause imperceptibly decays” (1910, bk. 1, sec. 141). 3  The power of Hardin’s rhetoric sometimes exceeded the reach of his data. For example, Hardin’s work overlooks the important distinction between “open access” and “limited access commons.” On the implications of this distinction for common pool resource dilemmas, see note 10 and accompanying text. 4  See, e.g., The Digital Library of the Commons (2012).

 

COMMONS AND ANTICOMMONS    181

Commons Property

Private Property

Figure 7.1  The standard solution to commons tragedy.

Commons Property

Private Property

Anticommons Property

Figure 7.2  Revealing the hidden half of the ownership spectrum.

Privatizing a commons may cure the tragedy of wasteful overuse, but it may inadvertently spark the opposite. English lacks a term to denote wasteful underuse. To describe this type of fragmentation, I coined the phrase tragedy of the anticommons.5 The term covers any setting in which too many people can block each other from creating or using a scarce resource. Rightly understood, the opposite of overuse in a commons is underuse in an anticommons. This concept makes visible the hidden half of our ownership spectrum, a world of social relations as complex and extensive as any we have previously known (see Figure 7.2). Beyond normal private property lies anticommons ownership. As one commentator notes, “To simplify a little, the tragedy of the commons tells us why things are likely to fall apart, and the tragedy of the anticommons helps explain why it is often so hard to get them back together” (Fennell 2004). Making anticommons ownership visible is not easy. Let me give you an image that I have found helpful in crystallizing the abstract idea. One thousand years ago, the Rhine was one of the world’s great trade routes. Boatmen traded under the protection of the Holy Roman Emperor. When the Emperor weakened in the thirteenth century, freelance German barons built castles and began collecting their own illegal tolls. The growing gauntlet of “robber baron” castles, over 200 at one point, make for a wonderful bicycling holiday today, but made shipping impracticable back then. The river continued to flow, but for 500 years, boatmen would not bother making the journey. As one boatman’s plaintive song went: The Rhine can count more tolls than miles And knight and priestling grind us down The tollman’s heavy hand falls first, Behind him stands the greedy line Master of tolls, assayer, scribe Four man deep they tap the wine. (Chamberlain 1929) 5  Heller (1998). In turn, my term builds on earlier conceptual work by Frank Michelman. See ibid 667–​669, discussing evolution of the concept; see also Michelman (1982), discussing what he calls the “regulatory regime.”

 

182   MICHAEL HELLER Everyone suffered—​even the robber barons. The European economic pie shrank. Wealth disappeared. Too many tolls meant too little trade. To understand anticommons tragedy, just update this image. Phantom tollbooths today emerge whenever ownership first arises and property is being created all the time in ways many of us do not realize. Today’s robber barons are often private owners and public regulators, all the people holding vetoes on the path to innovation. Today’s missing river trade takes the form of crushed entrepreneurial energy and forgone investment. When too many public decision makers or private owners can block access to a resource, they harm us all. Often, we think that governments need only to create clear property rights and then get out of the way. So long as rights are clear, owners can trade in markets, move resources to higher valued uses, and generate wealth. But clear rights and ordinary markets are not enough. The anticommons perspective shows that the content of property rights matters as much as the clarity. Wasteful underuse can arise when ownership rights and regulatory controls are too fragmented. Making the tragedy of the anticommons visible upends our intuitions about private property. Private property no longer can be seen as the end point of ownership. Privatization can go too far, to the point where it destroys rather than creates wealth. Too many owners paralyze markets because everyone blocks everyone else. Well-​ functioning private property is a fragile balance poised between the extremes of overuse and underuse.

7.3.  The Magical Parking Lot So far, I’ve introduced the nutshell version of the commons and anticommons. To understand the concepts more fully, imagine you’ve discovered an empty paved lot near Leicester Square in London. At first, the parking paradise is free and open to all. No one tickets or tows. You park and go to the theater. No problem. Later, you tell friends, who park there too. No problem. But then others notice, and soon the lot is jammed. Cars are blocked in. Doors are dinged. Fights break out. The lot becomes a scary place. You pay to park elsewhere. This overused lot is an example of a tragedy of the commons. It’s a tragedy because every parker is acting reasonably, but their individual actions quickly sum to collective disaster. Similarly, if a single shepherd has access to a field, the result is well-​trimmed grass and fat sheep. But open the field to all shepherds, each of whom may add sheep without regard to the others, and soon there may be nothing left but bare dirt and hungry animals. Overuse tragedies are everywhere: species extinction, ozone depletion, and highway congestion. After Garrett Hardin popularized the “tragedy of the commons” metaphor in 1968, people gained a new language for a phenomenon that was widely experienced,

 

COMMONS AND ANTICOMMONS    183 but had been difficult to name. The concept helped people give voice to then-​emerging concerns about environmental degradation. Metaphors can be powerful. The tragedy of the commons concept revealed hidden links among innumerable resource dilemmas, large and small. Spotting this shared structure helped people identify shared solutions. For example, the International Association for the Study of the Commons brings together a global network of scholars, policymakers, and practitioners, while the Digital Library of the Commons hosts an online database that cites about fifty thousand articles related to the commons.6 How do we solve such tragedies? There are three distinct approaches: privatization and markets, cooperative engagement, and political advocacy and regulation. Bear in mind that each solution has an analogue on the anticommons side of the property spectrum. Private property and market transactions can solve overuse tragedy. Recall that in the parking example, you were the first to discover the empty lot. You might claim ownership for yourself based on your original discovery and first possession. Being first is a standard (but not necessarily fair or efficient) way to hand out rights in resources. Another path to private ownership passes through state control. The state might reject your claim of original discovery and instead appropriate the lot and auction it to the highest bidder or transfer it quietly to a crony. However the lot arrives in private hands, it will likely be managed better than if it had remained open to all. Owners can profit if they spruce up the lot, repave it perhaps, paint lines, and keep it clean, safe, and well used. As a parker in a private property regime, you lose the freedom of the commons but gain order and access. The moral justifications for private ownership are controversial for philosophers, but as a practical matter, moving to private property often does prevent overuse in a commons. Harold Demsetz, author of the leading economic theory of ownership, argues that this “conservation effect” is the main reason private property emerges in, and provides a benefit to, society (1967, 354–​359). Because of our private-​property focus, we tend to overlook cooperative solutions to overuse dilemmas. Cooperative solutions are often small-​scale, context specific, local, and not reliant on legal structures—​thus invisible. In the case of our magical parking lot, notes under windshields, gossip on the street, and other neighborly devices can coordinate the parkers. Parkers may figure out how to keep the parking lot running smoothly without state coercion or private ownership. In Governing the Commons, Ostrom demonstrated that close-​knit communities around the world have succeeded in managing group property without tragic outcomes.7 There are thousands of stories of successful cooperation that preserve contested resources and promote overall social welfare. 6 

On the IASC, see http://​www.iascp.org (visited 2 October 2012). On the Digital Library of the Commons, see note 5. 7  See generally E. Ostrom (1990, 1–​28), setting out the theoretical framework, and (1999) discussing solutions.

 

184   MICHAEL HELLER Finally, state coercion can solve overuse. Cooperative mechanisms may break down if there are too many newcomers coming and going, if people don’t really know each other, or if it is otherwise hard to discipline deviants. Then, parkers may move from polite notes under windshields to breaking antennae, purposely scratching cars, slashing tires, and fistfights. The state might assert ownership over the lot, put up a gate, and hand out or sell parking permits. But bureaucracy is costly and often capricious. Political pressure may lead to bizarre uses of the lot. States are rarely nimble or efficient parking lot operators. Public ownership and management can eliminate the tragedy of the parking lot commons, but they may create new costs and inconveniences for the parkers. Privatizing a commons may cure the tragedy of wasteful overuse and lead to orderly parking; but it also may inadvertently spark the opposite, a lot that no one can use. The tragedy of the anticommons describes this problem of wasteful underuse. Though the anticommons concept refers at its core to fragmented ownership, the idea extends to fragmented decision-​making more generally. Resource use often depends on the outcome of some regulatory process. If the regulatory drama involves too many uncoordinated actors—​neighbors and advocacy groups; local, state, and federal legislators; agencies and courts—​the sheer multiplicity of players may block use of the underlying resource. How could the parking lot become an anticommons? Recall that underuse in an anticommons is the mirror image of overuse in a commons. Much can go wrong when politicians privatize state-​owned resources, when resources are owned for the first time, or when owners divvy up property later on. For example, in privatizing the lot, politicians might not want to annoy parkers who are also voters. So they might give free parking spots based on every parker’s previous use of the lot. (This is approximately how US regulators have allocated ocean fishing quotas and tradable pollution permits.) If there were thousands of parkers, but say one hundred spots, dozens might have to share each spot. Assembling the fractional shares back into a usable parking lot would require too many deals. Even if each parker behaved reasonably, bargaining is costly. And many of us are not reasonable, especially at seven o’clock in Leicester Square when shows are about to start. So the “privatized” lot may sit empty and unused—​an anticommons. Now substitute sheep in a meadow for the parkers in the lot. If a common field were privatized down to the square inch, no shepherd would be able to graze a single sheep. The same might happen if innumerable heirs separately owned scattered strips of an ancestor’s farm. In an anticommons, the grass may be lush and tall and unused; in a commons, it may be picked bare. In both cases, the pasturage can be wasted and the sheep starve. The parking lot and shepherd’s field show that creating private property can solve the problem of overuse in a commons. But privatization can go too far. When it does, we can tip into an anticommons, and again everyone loses. Adding the concepts of underuse and anticommons makes visible a new frontier for private bargaining, political debate, and wealth creation. Our goal should be to find the sweet spot for property rights, between commons and anticommons.

 

COMMONS AND ANTICOMMONS    185

7.4.  The New World of Use My tales of the magical parking lot are a bit of a sleight of hand. They give a succinct overview of overuse and underuse, commons and anticommons. But underuse and anticommons are still squiggly—​until recently, my Word spellchecker rejected them by underlining each with red squiggles, and instead suggested undersea and anticommunist as replacements. These squiggles are a signal: the nonexistence of a word can be as telling as its presence. When we lack a term to describe some social condition, it is because the condition does not exist in most people’s minds. So, it should be no surprise that we have overlooked the hidden costs of anticommons ownership. We cannot easily fix the problem until we have created a shared lexicon to spot tragedies of the anticommons. Besides highlighting the language problem, the squiggles prompted me to look around the Internet at overuse and underuse. Googling overuse yielded about ten million hits in late 2012, while underuse generated under one million. (Commons had 800 million hits and anticommons had 25,000.) To me, the data immediately suggest two possibilities: either overuse is about ten times more important a social problem than underuse is, or we are only about 10% as aware of underuse as we should be. You will not be surprised that I believe the latter to be correct. To understand the Google results, start with overuse. According to the Oxford English Dictionary, overuse entered the language as a verb in the early 1600s. One of the earliest usages is as apt today as it was centuries ago: “When ever we overuse any lower good we abuse it.” By 1862, the noun form was well recognized: “The oyster beds are becoming impoverished, partly by over-​use.”8 Overuse continues to mean “to use too much” and “to injure by excessive force,” definitions that have been stable for hundreds of years. Many of Google’s top links for overuse come from medicine. Doctors diagnose “overuse syndrome” and dozens of “overuse injuries”—​injuries from too much tennis, running, violin playing, book reading, whatever. So what is the opposite of overuse? Ordinary use. The opposite of injuring yourself through too much use and excessive force is staying injury free by using an ordinary amount of force. Instead of abandoning an activity, do it in a reasonable, sustainable way. In medicine as in everyday language, the opposite of overuse is ordinary use (Figure 7.3). Since the 1600s, overuse and ordinary use have been an either–or proposition. Either you will feel pain in your elbow or you will be able to play happily, if not well. When you overuse a resource, bad things happen. It is much better to engage in ordinary use. How do we achieve ordinary use? Recall the problem of the magical parking lot. The usual solutions to tragedies of the commons are, as I’ve mentioned, privatization, cooperation, and regulation. These three solutions map onto the traditional view that 8 

OED, “overuse,” v., http://​www.oed.com/​view/​Entry/​135291 (visited 2 October 2012).

 

186   MICHAEL HELLER Overuse

Ordinary Use

Figure 7.3  Ordinary use as the end point.

State

Commons

Private

Figure 7.4  The trilogy of ownership.

ownership can be organized into three basic types of property: private, commons, and state (Figure 7.4).9 We all have strong intuitions about private property, but the term is surprisingly hard to pin down. A good starting point is William Blackstone, the foundational eighteenth-​ century British legal theorist. His oft-​quoted definition of private property is “that sole and despotic dominion which one man claims and exercises over the external things of the world, in total exclusion of the right of any other individual in the universe” (Blackstone 1765–​1769). In this view, private property is about an individual decision maker who directs resource use. Commons property refers to shared resources, resources for which there is no single decision maker. In turn, the commons can be divided into two distinct categories. The first is open access, a regime in which no one at all can be excluded, like anarchy in the parking lot or on the high seas. Mistakenly, the legal and the economics literature have long conflated the commons with open access, hence reinforcing the link between commons and tragedy. The second type of commons has many names, but for now let’s call it group access, a regime in which a limited number of commoners can exclude outsiders but not each other. If the ocean is open access, then a small pond surrounded by a handful of landowners may be group access (or consider the shared mews behind houses in Notting Hill, London’s keyholder-​only squares, and New York City’s Gramercy Park). Group access is often overlooked even though it is the predominant form of commons ownership and often not tragic at all.10 State property resembles private property in that there is a single decision maker, but it differs in that resource use is directed through some process that is, in principle, responsive to the needs of the public as a whole. In recent years, state property has 9 

On the property trilogy, see Heller (2001, 82–​92). On open access versus group access property, see Eggertsson (2003, 74–​85). I advocate that we use the term liberal commons to describe many forms of legally sanctioned group ownership. See generally Dagan and Heller (2001). 10 

 

COMMONS AND ANTICOMMONS    187 Commons

Private

Figure 7.5  The familiar split in ownership.

become less central as a theoretical category: the Cold War is over; most socialist states have disappeared; intense state regulation of resources has dropped from favor; and privatization has accelerated. Today, for many observers, the property trilogy can be reduced to an opposition of private and commons property, what one scholar calls simply “all and none” (Figure 7.5) (Barzel 1989, 71). I believe a substantial cause of our cultural blindness to the costs of fragmented ownership arises from the dominance of this too simple image of property. Note how the commons–​private opposition tracks the overuse–​ordinary use opposition. The former implies that there is nothing beyond private property; the latter suggests that we cannot overshoot ordinary use. Together, these oppositions reinforce the political and economic logic of the global push toward privatization. We assume, without reflection, that the solution to overuse in a commons is ordinary use in private ownership. This logic makes it difficult to imagine underuse dilemmas and impossible to see the uncharted world beyond private property. According to the Oxford English Dictionary (OED), underuse is a recent coinage. In its first recorded appearance, in 1960, the word was hedged about with an anxious hyphen and scare quotes: “There might, in some places, be a considerable ‘under-​use’ of [parking] meters.” By 1970, copy editors felt sufficiently comfortable to cast aside the quotes: “A country can never recover by persistently under-​using its resources, as Britain has done for too long.” The hyphen began to disappear around 1975.11 In the OED, this new word means “to use something below the optimum” and “insufficient use.” The reference to an “optimum” suggests to me how underuse entered English. It was, I think, an unintended consequence of the increasing role of cost–​benefit analysis in public policy debates. What happens when we slot underuse into the opposition in Figure 3? Although the result seems simple, it leads to conceptual turmoil (Figure 7.6). In the old world of overuse versus ordinary use, our choices were binary and clear-​ cut: injury or health, waste or efficiency, bad or good. In the new world, we are looking for something subtler—​an “optimum” along a continuum. Looking for an optimum level of use has a surprising twist: it requires a concept of underuse and surreptitiously changes the long-​standing meaning of overuse. Like Goldilocks, we are looking for something not too hot, not too cold, not too much or too little—​just right. Figure 7.7 suggests how underuse changes our quest. How can we know whether we are underusing, overusing, or optimally using resources? It’s not easy, and not just a matter for economic analysis. Searching for an optimum between overuse and underuse sets us on the contested path of modern regulation of risk, an inquiry that starts with economic analysis but quickly implicates our 11 

OED, “under-​use, n.,” http://​www.oed.com/​view/​Entry/​212195 (visited 2 October 2012).

 

188   MICHAEL HELLER Overuse

Underuse

Figure 7.6  The new spectrum of use.

Overuse

Optimal Use

Underuse

Figure 7.7  Goldilocks’ quest for the optimum.

core beliefs. We have to put dollar values on human lives and on the costs of overuse and underuse behaviors—​a process filled with moral and political dilemmas. I note this difficult topic to show that finding the optimum requires the idea of underuse and that this new word in turn transforms the meaning of overuse. Overuse no longer just means using a resource more than an ordinary amount. The possibility of underuse reorients policy making from relatively simple either–​or choices to the more contentious trade-​ offs that make up modern regulation of risk.

7.5.  The Tragedy of the Anticommons Adding the idea of “underuse” sets the stage for the anticommons. Looking back at Figures 7.3–​7.7, there is a gap in our labeling scheme. We have seen the complete spectrum of use, but not the analogous spectrum of ownership. What form of ownership typically coincides with squiggly underuse? The force of symmetry helped reveal a hidden property form. Figure 7.8 shows my path to the anticommons. I coined the term tragedy of the anticommons to help make visible the dilemma of too fragmented ownership beyond private property. Just as the idea of “underuse” transforms the continuum of resource use, “anticommons” transforms the continuum of ownership. It shows that the move from commons to private can overshoot the mark (Figure 7.9). When privatization goes too far, resources can end up wasted in an unfamiliar way. Seeing the full spectrum of ownership has another benefit. Our understanding of commons ownership may help inform solutions to anticommons tragedy. To start, consider the distinction between open access (anarchy open to all) and group access (property that is commons to insiders and private to outsiders). This distinction can do some work on the anticommons side of the spectrum as well. The conventional wisdom has often overlooked group access, but we don’t have to. Under the right conditions, groups of people succeed at conserving a commons resource without regulation or privatization (Ellickson 1991, 167–​183). Cooperation can get us to optimal use. Under what conditions does cooperation work, and what does that teach us about fixing underuse dilemmas?

 

COMMONS AND ANTICOMMONS    189 Overuse Commons

Optimal Use Private

Underuse ???

Private

Anticommons

Figure 7.8  An ownership puzzle.

Commons

Figure 7.9  The full spectrum of ownership.

At the extreme of open access, group norms don’t stick. For example, anyone can fish for tuna on the high seas. Tuna fleets work in relative isolation, and their catches can be sold anonymously to diverse buyers. Conservation norms, such as voluntary limits on fishing seasons, may gain little traction. Gossip and other low-​cost forms of policing don’t work for wide-​ranging international fleets. Unless states intervene, overuse is hard to avoid. Whales were saved from extinction more through naval powers enforcing international treaties than through gossip at the harbor bar. The state can sponsor hybrid solutions. What if the state asserted ownership over lobsters and fish, and then created private rights (such as licenses and tradable quotas) that complement cooperative solutions? Often, such hybrid regimes lead to fairer and higher-​yielding results than informal group access can achieve. For example, in Australia, the government issues licenses for a sustainable number of lobster traps and enforces strict harvesting limits. Lobstermen can wait to harvest until the lobsters mature, or they can sell their government-​created rights, secure in their markets and property. With far less fishing effort, this system yields more and bigger lobsters than US lobstermen catch either in coastal harbor gangs or on the open ocean (see, generally, Tierney 2000; Acheson 1988). Hybrid systems are the cutting edge of natural resource management:  examples include not only tradable fishing quotas but also carbon-​emission markets and transferable air-​pollution permits (Rose 1999). These solutions can work far beyond lobsters and tuna, even beyond natural resources generally. They may reach the edge of high-​ tech innovation. Solutions to commons property dilemmas give clues to solving anticommons tragedy. For open access, like the high seas, states must command resource use directly or create hybrid rights, such as fishing quotas. The anticommons parallel to open access is full exclusion in which an unlimited number of people may block each other. With full exclusion, states must expropriate fragmented rights or create hybrid property regimes so people can bundle their ownership. Otherwise, the resource will be wasted through underuse. There is, however, one important respect in which full exclusion differs from open access: an anticommons is often invisible. You have to spot the underused resource before you can respond to the dilemma. Group access in a commons also has an anticommons parallel: group exclusion in which a limited number of owners can block each other. Recall the multiple owners

 

190   MICHAEL HELLER Zone of Cooperative and Market-Based Solutions

Open Access

Group Access

Private Property

Group Exclusion

Full Exclusion

Figure 7.10  The full spectrum of property, revealed. I develop an early version of this spectrum in Heller (1999, 1194–​1198).

of our magical parking lot. For both group access and group exclusion, the full array of market-​ based, cooperative, and regulatory solutions is available. Although self-​ regulation may be more complex for anticommons resources (Depoorter and Vanneste 2007), close-​knit fragment owners can sometimes organize to overcome anticommons tragedy. For group exclusion resources, the regulatory focus should be support for markets to assemble ownership and removal of roadblocks to cooperation. Group property on the commons or anticommons side of private ownership is exponentially more important than the rare extremes of open access or full exclusion. Much of the modern economy—​corporations, partnerships, trusts, condominiums, and even marriages—​can be understood as legally structured group property forms for resolving access and exclusion dilemmas (see Dagan and Heller 552–​554; Dagan and Frantz 2004). We live or die depending on how we manage group ownership. Now, we can see the full spectrum of property, as shown in Figure 7.10.

7.6.  The Economics of the Anticommons After I proposed the possibility of anticommons tragedy, economist and Nobel laureate James Buchanan and his colleague Yong Yoon undertook to create a formal economic model. They wrote that the anticommons concept helps explain “how and why potential economic value may disappear into the ‘black hole’ of resource underutilization” (2000, 2). According to their model, society gets the highest total value from a resource—​say, the magical parking lot—​when a single decision maker controls its use. As more people can use the lot independently, the value goes down—​a tragedy of the commons. And as more people can block each other from the lot, the value also goes down symmetrically—​a tragedy of the anticommons. Figure 7.11 shows their graphic summarizing this finding. After developing their proof and showing how the anticommons construct may apply to a wide range of problems, Buchanan and Yoon concluded, “the anticommons construction offers an analytical means of isolating a central feature of sometimes disparate institutional structures…. [People] have perhaps concentrated too much attention

 

COMMONS AND ANTICOMMONS    191 Total Value

1

# of Excluders

# of Users

Figure 7.11  Value symmetry in an anticommons and a commons. See Heller (1999, 8). A HERE

B C

THERE

D HERE

E

F THERE

Figure 7.12  Substitutes versus complements.

on the commons side of the ledger to the relative neglect of the anticommons side” (2000, 12). In recent years, economic modeling of the anticommons, including game theory approaches has become quite sophisticated. See Parisi (2002); Parisi, Schulz, and Depoorter (2003); see, also, Fennell (2004), arguing that tragedies of the commons are best modeled as prisoner’s dilemma games and anticommons as chicken games. At the simplest level, anticommons theory can be understood as a legal twist on the economics of “complements” first described by Antoine-​Augustin Cournot in his 1838 Researches into the Mathematical Principles of the Theory of Wealth (and discovered independently by Charles Ellet in 1839 in his work on railway tariffs). Anticommons theory is a partial corrective for modern economic models that focus on “substitutes” and often neglect the role of “complements.”12 What’s the difference? In Figure 7.12, Railways A, B, and C are substitute ways to get from here to there. Say the fare is 9. If railway A finds a way to provide service for 8, it will win riders. B and C must become more efficient to keep up. In markets with robust substitutes, competitors have incentives to innovate, lower prices, and thereby indirectly benefit society as a whole. By contrast, Railways D, E, and F are complements. When inputs are complementary, generally you want all or none of them. Again, assume the fare from here to there is 9. D, E, and F each charge 3. Railway D knows that if you want to ride, you must buy its ticket. So why innovate? Instead, D may raise its 12  On the problem of complements in an information economy, see Varian, Farrell, and Shapiro (2005, 43–​45). On the interaction of substitutes and complements in the anticommons context, see Dari-​ Mattiacci and Parisi (2006).

 

192   MICHAEL HELLER fare to 5, hoping that E and F lower theirs to 2 each. But why would E and F go along? More likely, they too would raise fares, so the total exceeds 9, and ridership falls below the optimal level. With complementary competition, incentives to innovate are blunted: if D did lower fares, then E and F just might raise theirs. It’s the same problem if D, E, and F are complementary patents instead of railways. Then innovators face what economist Carl Shapiro calls a “patent thicket,” many phantom tollbooths on the route to commercializing new technology.13 Cournot proved that in markets dominated by complements—​whether railways or patents—​we can get higher overall social welfare if D, E, and F merge. Here, monopoly trumps competition. Anticommons theory, in turn, moves from railways and patents to ownership and regulation generally. All these concepts describe facets of the same dilemma: too many uncoordinated owners or regulators blocking optimal use of a single resource.

7.7.  Anticommons Puzzles Our Rhine boaters from a little earlier may seem an esoteric example, but there are a near-​infinity of everyday puzzles that share this common structure—​one whose solution could jump-​start innovation, release trillions in productivity, and help revive the global economy. Let me return to the drug patent example that opens this article. The Alzheimer’s drug that never came to market is not alone. Numerous potential drugs may be lost to anticommons ownership. In the past 30 years, drug R&D has been going steadily up, but discoveries of major new classes of drugs have been declining. Instead, drug companies focus on minor spinoffs of existing drugs for which they have already assembled the necessary property rights. How did this new drug discovery gap happen? Patent anticommons. Paradoxically, more biotech patent owners can mean fewer life-​saving innovations. Drugs that should exist, could exist, are not being created. To date, the most debated application of anticommons theory has built on the drug patent example. The field was sparked in part by my article with Rebecca Eisenberg (1998) on the anticommons in biomedical research, an article that has since been cited several thousand times.14 There has been a flurry of follow-​on papers, studies, and reports, many of which conclude that patents should be harder to obtain, in part to avoid potential anticommons tragedy effects.15 The 2011 reforms to the Patent Act, a string of

13  See Shapiro (2001, 119); cf. Burk and Lemley (2009, 75–​78, 86–​92), distinguishing anticommons and patent thickets in the patent context. 14  See, generally, Heller (2008, 49–​78), reviewing 10 years of scholarship and debate on anticommons effects in drug development. 15  ibid 65, discussing three influential policy-​oriented reports that argue for patent reform based on anticommons concerns.

 

COMMONS AND ANTICOMMONS    193 Supreme Court patent decisions, and a number of pending bills before Congress all aim to ameliorate potential anticommons tragedies.16 In their 2009 book, The Patent Crisis, Dan Burk and Mark Lemley review recent literature on patents and biotech innovation and conclude that, “the structure of the biotechnology industry seems likely to run high anticommons risks,” particularly when companies are attempting to bring products to market (see Burk and Lemley 2009, 89). However, the empirical basis for finding that anticommons effects are stifling innovation remains inconclusive. Scholars such as Jonathan Barnett are skeptical.17 This remains an important area for empirical work.18 In addition, the anticommons framework has been used to analyze ownership across the high-​tech frontier, ranging from Thomas Hazlett’s work on broadcast spectrum ownership, what he calls the “tragedy of the telecommons,” to Rosemarie Ham Ziedonis’s study of anticommons effects in technology patenting.19 In my Gridlock Economy book, I show that it is not just biotech that is susceptible to anticommons tragedy. Cutting-​ edge art and music are about mashing up and remixing many separately owned bits of culture.20 And as I earlier said, even with land the most socially important projects often require assembling multiple parcels.21 Anticommons theory is now well established, but empirical studies have yet to catch up. How hard is it to negotiate around ownership fragmentation? How much does ownership fragmentation slow down technological innovation? Does the effect vary by industry?22 It is difficult to measure discoveries that should have been made but weren’t, industries that could exist but don’t. We are just starting to examine these conundrums. In 2006, a team of law, economics, and psychology researchers reported experimental findings that rejected the presumed symmetry of commons and anticommons. They found that anticommons dilemmas “seem to elicit more individualistic behavior than commons dilemmas” and are “more prone to underuse than commons dilemmas are to overuse.” The researchers conclude that “if commons leads to ‘tragedy,’ anticommons may well lead to ‘disaster’ ” (Vanneste et al. 2006).23 16 

See Barnett (2015, 3), collecting sources. ibid. See also Burk and Lemley (“there is little concrete evidence that intensive levels of IP acquisition and enforcement restrain innovation or output”) (2009, 5). 18  Several survey-​based studies have questioned whether anticommons tragedy is blocking academic biomedical research (see, e.g., Walsh, Arora, and Cohen 2004, 285–​340, 324). 19   On the anticommons in the telecom context, see Heller (2008, 79–​106). See also Hazlett (2005); Ziedonis (2004). 20  On the anticommons in the copyright context, see Heller, (2008, 9–​16), discussing tragedy in filmmaking, art, history, and music; 27–​30, discussing the anticommons in online search, such as Google Books. See also Parisi and Depoorter (2003). 21  On the anticommons in land, see Heller (2008, 107–​142), detailing anticommons tragedies and solutions in land resources. 22  The best recent collection of empirical sources addressing these issues is Barnett (2015, 16–​57) detailing numerous mechanisms, such as standard setting organizations, patent pooling, and market-​ making intermediaries, that overcome potential anticommons tragedies in various industries. 23  Follow-​up studies looked at why negotiations fail when presented in anticommons form. They found more failure as the number and complementarity of fragment owners increases. Also, as 17 

 

194   MICHAEL HELLER These preliminary findings of bargaining failure around anticommons ownership may help provide some insight into otherwise puzzling economic phenomena. For example, some of the world’s biggest energy companies have for years failed to agree on joint management of oil and gas fields they own together. If one company pumps the oil too fast, it can wreck the pressure in the gas field; if the other extracts gas too fast, it traps the oil. American law has offered them an effective legal tool, called “unitization,” to overcome anticommons tragedy and smooth joint management of divided oil and gas interests. Yet firms block each other year after year.24 How can this be? Oil units are not a case of two spiteful neighbors arguing over a broken backyard fence. They involve arm’s-​length business negotiations between savvy corporations. Everyone has good information about the underlying geologic and technical issues. The gains from cooperation are in the billions of dollars. Why doesn’t one firm sell its interest to the other? Why don’t the firms merge? What’s going on? The experimental studies are beginning to give us explanations rooted in the psychology of the anticommons. Even the most sophisticated businesspeople can fail to reach agreement when a negotiation is framed in anticommons terms.

7.8.  Rounding out the Lexicon—​ Caveats and Cautions In rounding out the anticommons lexicon, there are some caveats:  first, my term focuses on one form of underuse, the tragedy that arises when ownership is too fragmented. Here, multiple owners block each other from using a scarce resource. Underuse can also arise in the monopoly context, when a single owner blocks access to a resource. This situation may be tragic, but it is not an anticommons tragedy in my sense of the term. In the old economy, many companies held monopolies: Ma Bell (the American telephone monopoly), railways, local water utilities, and others. Society gained the economic benefits of scale and scope from allowing these sectors to be monopolized. The state policed against abuse of monopoly power through complex rate regulation and oversight. Phone lines were cheaper and more available than in many other countries. The costs of these monopolies were often invisible, costs such as deferred and dampened innovation. In an information economy, any piece of intangible property, such as a patent, is also a monopoly. We award patents because monopoly profits create incentives to invent and uncertainty increases, losses become even more pronounced. See also Depoorter and Vanneste (2007, 21–​23). 24 

On the costs of “excessive anarchy” in the oil industry, see Libecap and Smith, (2002). The same tragedy affects excessive pumping of groundwater. See Thompson (2000, 241–​250).

 

COMMONS AND ANTICOMMONS    195 because patents give inventors incentives to disclose their discoveries (without patents people might prefer to invent things they could keep secret). On the other hand, drugs would be cheaper and lives could be saved if competitors could make generic copies at will. To balance the values of innovation, disclosure, and competition, the US Congress keeps shifting the bundle of rights that a patent confers. The dilemmas of any individual monopoly in the old or new economy are a great topic, but are not relevant here. For better or worse, these quandaries are familiar. However, we do not have much experience dealing with the interaction of ownership fragments or an array of blocking patents. The anticommons lexicon addresses not monopoly per se, but ownership multiplicity. Next, here’s a caution: when talking about an anticommons, stay away from absolutes. First, you shouldn’t assume that anticommons ownership is inevitably tragic.25 If we lived in a world where people had perfect information and could bargain with each other at no cost, they could avoid anticommons tragedy every time (just as, in a perfect world, there would be no commons tragedy, or for that matter, tragedy of any sort) (Coase 1960). In practice, however, bargaining is never free: people shirk duties and hold out for payoffs, and there are cognitive limits that shape owners’ decisions. In the real world, anticommons ownership is not necessarily tragic, but it does tend that way. Second, it’s theoretically possible that an anticommons may face overuse instead of underuse.26 For example, consider real estate development along the California coast. It’s a mess. Multiple community groups, environmentalists, neighbors, and government agencies may each prefer different versions of a project. Even in that regulatory morass, though, overbuilding may occur if it is sufficiently costly to exercise each right to veto development. Every opponent of development may prefer to go surfing and hope the others sit through the boring public hearings. If enough people opt for a free ride, a project might face too little opposition, not too much. It’s an empirical question whether the California coast tips toward over-​or underbuilding. That said, in most cases I’ve seen, anticommons regulation tends to be associated with too little economic development, not too much.27 Finally, there is a caveat that comes from the legal theorist Carol Rose. Certain resources, such as roads and waterways, are sometimes owned most efficiently in common. As Rose points out, creating and enforcing private-​property rights is itself costly; sometimes these costs exceed the gains, not just economically but also socially. Village greens and town halls may strengthen communities in ways that are socially valuable but hard to quantify in monetary terms. Rose (1986) coined the phrase “the comedy of the commons” to describe such social and economic benefits that can flow from group access (see also Ellickson 1993, 1336–​1338). 25 

These points are developed in Heller (1998, 676). Fennell develops this insight in her theory of common interest tragedies (see 2004, 934–​937). 27  Just as an anticommons theoretically may lead to overuse, it is possible for a commons to be associated with underuse (ibid). For a real-​world example, see Buzbee (2005). 26 

 

196   MICHAEL HELLER Rose’s insight is equally true on the anticommons side: there are both economic and social reasons that we may prefer group exclusion to sole ownership. For example, it’s possible that creating multiple vetoes may help preserve a treasured resource against transient political pressures for development: for instance, Central Park in New York City or Indian burial grounds in Arizona.28 Similarly, “conservation easements” intentionally use anticommons ownership to foster environmental goals Mahoney (2002, 739–​785). (With a conservation easement, the owner sells or gives away the right to develop land, gets a tax break, and retains the right to continue a current use such as farming.) The underuse created by split ownership may be justifiable if the environmental gains exceed fragmentation costs. On balance, though, I’m skeptical. What happens a generation from now when communities want to reduce sprawl but face a patchwork of easements that make “in-​fill” development prohibitively difficult? Many conservation easements look to me like potential anticommons tragedies.29 The “comedy of the anticommons” insight suggests that sometimes, for some resources, we should promote little or no use. Most of the time, for most resources, however, some positive level of use will be socially most valuable. Underuse is rarely the optimum.

7.9.  Toward a Nonsquiggly Language We have millennia of practice in spotting tragedies of the commons. When too many people fish, fisheries are depleted. When too many people pollute, we choke on dirty air. Then, we spring into action with market-​based, cooperative, and legislative solutions. Similarly, we have a lot of experience spotting underuse caused by a particular monopoly owner. We have created regulatory bodies that know (more or less) what to do with such dilemmas. But underuse caused by multiple owners is unfamiliar. The affected resource is hard to spot. Our language is new. A tragedy of the anticommons may be as costly to society as the more familiar forms of resource misuse, but we have never noticed, named, debated, or learned how to fix underuse. How do we stumble into the problem of too many owners? How do we get out? As a first step, underuse in a tragedy of the anticommons should be squiggly no more. Fixing anticommons tragedies is a key challenge for our time. Individual entrepreneurship and legal reform will be important. But, I want to stress that the first and most 28  On the potential use of an anticommons to preserve Central Park, see Bell and Parchomovsky (2003, 3–​4, 31–​36, 60–​61). 29  See Bell and Parchomovsky (2003, 785–​86) noting potential anticommons tragedy in conservation easements.

 

COMMONS AND ANTICOMMONS    197 important step to solving an anticommons is to name it and make it visible. With the right language, we can all spot links among ownership puzzles, and we can all come together to fix them. Nothing is inevitable about an anticommons. Every ownership puzzle results from choices we make (and thus can change) about how to control the resources we value most.

References Acheson, James. 1988. Lobster Gangs of Maine. Lebanon, NH: University Press New England. Aristotle. 1996. The Politics and the Constitution of Athens. Ed. S. Everson. Trans. B. Jowett. Cambridge: Cambridge University Press. Barnett, J. 2015. “The Anti-​Commons Revisited.” Harvard Journal of Law & Technology 1, 3, pp. 16–​57. Bell, A. and Parchomovsky, G. 2003. “Of Property and Antiproperty.” Michigan Law Review 102, pp. 1–​61. Blackstone, W. 1765–​1769. Commentaries on the Laws of England:  In Four Books. Bk. 2. Oxford: Clarendon Press. Buchanan, S. and Yoon, Y. J. 2000. “Symmetric Tragedies:  Commons and Anticommons.” Journal of Law and Economics 43, pp. 1–​12. Burk, D. L. and Lemley, M. A. 2009. The Patent Crisis and How the Courts Can Solve It Chicago: University of Chicago Press. Buzbee, W. W. 2005. “The Regulatory Fragmentation Continuum, Westway, and the Challenges of Regional Growth.” ’ Journal of Law and Politics 21, pp. 323–​364. Chamberlain, J. P. 1923. The Regime of the International Rivers:  Danube and Rhine. New York: Columbia UP. Coase, R. H. 1960. “The Problem of Social Cost.” Journal of Law and Economics 1, pp. 1–​44. Cournot, A. 1838 [1897]. Researches into the Mathematical Principles of the Theory of Wealth. Trans. N. T. Bacon. London: Macmillan. Dagan, H. and C. J. Frantz. 2004. “Properties of Marriage.” Columbia Law Review 104, pp. 75–​133. Dagan, H. and Heller, M. A. 2001. “The Liberal Commons.” Yale Law Journal 110, p. 549. Dari-​Mattiacci, G. and Parisi, F. 2006. “Substituting Complements.” Journal of Comparative Law and Economics 2, pp. 333–​347. Demsetz, H. 1967. “Toward a Theory of Property Rights.” American Economic Review, Papers and Proceedings 57, pp. 347–​359. Depoorter, B. and Vanneste, S. 2007. “Putting Humpty Dumpty Back Together:  Pricing in Anticommons Property Arrangements.” Journal of Law, Economics, and Policy 3, pp. 1–​28. The Digital Library of the Commons. http://​dlc.dlib.indiana.edu [Accessed 2 October 2012]. Eggertsson, Thráinn. 2003. “Open Access versus Common Property.” In:  T. Anderson and F. McChesney, eds., Property Rights: Cooperation, Conflict, and Law. New York: Princeton UP, 2003. pp. 74–​75. Ellet, C. Jr. 1839. An Essay on the Laws of Trade in Reference to the Works of Internal Improvement in the United States. Richmond: P.D. Bernard. Ellickson, R. C. 1993. “Property in Land.” Yale Law Journal 102, pp. 1315–​1338.

 

198   MICHAEL HELLER Ellickson, R. C. 1994. Order without Law: How Neighbors Settle Disputes. Cambridge: Harvard UP, 1991. Fennell, L. A. 2004. “Common Interest Tragedies.” Northwestern University Law Review 98, pp. 907–​937. Hardin, G. 1968. “The Tragedy of the Commons.” Science 162, pp. 1243–​1244. Hazlett, T. W. 2005. “Spectrum Tragedies.” Yale Journal of Regulation 22, p. 242. Heller, M. A. 1998. “The Tragedy of the Anticommons: Property in the Transition from Marx to Markets.” Harvard Law Review 111, pp. 621–​688. Heller, M. A. 1999. “The Boundaries of Private Property.” Yale Law Journal 108, pp. 1163–​1223. Heller, M. A. 2001. “The Dynamic Analytics of Property Law.” Theoretical Inquiries in Law 2, pp. 79–​92. Heller, M. A. 2008. The Gridlock Economy: How Too Much Ownership Wrecks Markets, Stops Innovation, and Costs Lives. New York: Basic Books. Heller, M. A., ed. 2011. Commons and Anticommons. Cheltenham: Elgar Publishing. Heller, M. A. and Eisenberg, R. S. 1998. “Can Patents Deter Innovation? The Anticommons in Biomedical Research.” Science 280, pp. 698–​701. IASC. On the Digital Library of the Commons. http://​www.iascp.org [Accessed 2 October 2012]. Libecap, G. D. and Smith, J. L. 2002. “The Economic Evolution of Petroleum Property Rights in the United States.” Journal of Legal Studies 31, p. S589. Mahoney, J. D. 2002. “Perpetual Restrictions on Land and the Problem of the Future.” Virginia Law Review 88, pp. 739–​786. Michelman, F. J. 1982. “Ethics, Economics and the Law of Property.” Nomos 24(3), pp. 667–​669. OED, “overuse,” v., http://​www.oed.com/​view/​Entry/​135291 [Accessed 2 October 2012]. OED, “under-​use, n.,” http://​www.oed.com/​view/​Entry/​212195 [Accessed 2 October 2012]. Ostrom, E. 1990. Governing the Commons: The Evolution of Institutions for Collective Action. Cambridge: Cambridge University Press. Ostrom, E. 1999. “Coping with Tragedies of the Commons.” Annual Review of Political Science 2, p. 493. Parisi, F. 2002. “Entropy in Property.” American Journal of Comparative Law 50, p. 595. Parisi, F., Schulz N., and Depoorter, B. 2003. “Fragmentation in Property: Towards a General Model.” Journal of Institutional and Theoretical Economics 159, p. 594. Parisi, F. and Depoorter, B. 2003. ‘Fair Use and Copyright Protection:  A  Price Theory Explanation.’ International Review of Law and Economics 21, p. 453. Rose, C. M. 1986. “The Comedy of the Commons: Custom, Commerce, and Inherently Public Property.” University of Chicago Law Review 53, p. 711. Rose, C. M. 1999. Expanding the Choices for the Global Commons: Comparing Newfangled Tradable Allowance Schemes to Old-​ Fashioned Common Property Regimes.” Duke Environmental Law and Policy Forum 10, p. 45. Shapiro, C. 2001. “Navigating the Patent Thicket: Cross Licenses, Patent Pools, and Standard Setting.” In: A. B. Jaffe. et al., eds, Innovation Policy and the Economy. Vol 1. Cambridge: MIT Press, 2001. 119–​150. Thompson, Barton H.  Jr. 2000. “Tragically Difficult:  The Obstacles to Governing the Commons.” Environmental Lawyer 30, pp. 241–​250. Thucydides. 1910. History of the Peloponnesian War. Bk. 1, sec. 141. Trans. R. Crawley. New York: E.P. Dutton. Tierney, J. 2000. “A Tale of Two Fisheries.” New York Times Magazine 27 August 2000.

 

COMMONS AND ANTICOMMONS    199 Vanneste, S. et  al. 2006. “From ‘Tragedy’ to ‘Disaster’:  Welfare Effects of Commons and Anticommons Dilemmas.” International Review of Law and Economics 26, p. 104. Varian, H. R., Farrell, J. V., and Shapiro, C. 2005. The Economics of Information Technology: An Introduction. Cambridge: Cambridge UP. Walsh, J. P., Arora, A., and Cohen, W. M. 2004. “Effects of Research Tool Patents and Licensing on Biomedical Innovation.” In: W. M. Cohen and S. A. Merrill, eds., Patents in the Knowledge-​ Based Economy. Washington, DC: National Academies Press. 285–​340. Yoram Barzel. 1989. Economic Analysis of Property Rights. Cambridge: Cambridge UP. Ziedonis, R. H. 2004. “Don’t Fence Me In: Fragmented Markets for Technology and the Patent Acquisition Strategies of Firms.” Management Science 50, p. 804.

 

Chapter 8

EC ONOMI C S OF INTELL E C T UA L PROPERT Y L AW Robert P. Merges

The economic study of intellectual property law is now well into its second wave.1 It first emerged in a series of ad hoc writings by pure economists stretching from the nineteenth century to the early 1960s. The first wave culminated in a series of classic articles done in the emerging methodology of Chicago school law and economics. But beginning in the 1980s, there began a new and muscular wave of research. This second wave is characterized by two primary features: (1) increasing methodological diversity and sophistication; and (2)  an emphasis on contextualization—​understanding how intellectual property (IP) law is embedded in larger social and economic systems, and how IP interacts with other aspects of those systems to foster innovative ideas and economic growth. This chapter assesses the state of this second wave. It outlines some chief points of contention in the literature, and points to some frontier issues just now appearing on the horizon. It also strives, in the conclusion, to push scholars to spend less time trying to answer the Big Question in the field—​whether IP law can be justified on economic grounds—​and more time understanding specific features and individual rules in the IP system. The Big Question has proven to be an elusive quarry. Much of the payoff in the field has come from asking a series of discrete Little Questions, so this enterprise should naturally attract most of the effort in the field.

8.1. Introduction It is useful, once in a while, to look at a complex thing in whole cloth, instead of thread by slender thread. When I do that with IP, here is what I see. I see that IP is beginning 1 

Robert P. Merges, is Wilson Sonsini Goodrich & Rosati Professor of Law and Technology, UC Berkeley Law School.

 

ECONOMICS OF INTELLECTUAL PROPERTY LAW    201 to live up to the aspirations of an earlier generation, which yearned to make law a much more expansive field of study, one that integrated the insights of sociology, history, psychology, and economics. All these threads are in place in the IP field now. Gone are the days when virtually every article on the subject began and ended with a discussion of case law and statutes. Now, though straight doctrinal work is far from dead, the pages of academic journals are alive with studies of all facets of IP law, informed and influenced by a wide range of academic disciplines. These disciplines supply a cornucopia of tools, which scholars put to work on all sorts of issues and problems. Scholars no longer stick to the close knitting of IP statutes and cases. What we have now is a very lively tapestry. Take for instance the outlines of a typical article from IP’s “classical” period. Starting from well-​accepted background assumptions—​that IP law is about incentives, for example; or that education is an important value and ought to be fostered by IP law—​a scholar would approach a recent line of cases, or an important decision by the Supreme Court.2 Such facts as entered into the discussion would be drawn from the legal record in the case. The influence of older cases would be plumbed and dissected. Implications of a legal holding would be fleshed out—​incentives are reduced, for example, by tightening patent standards; or educational values will be undermined, by constricting fair use. Based on these observations, the author would advise doctrinal course corrections to set things right. Contemporary work is very different. A book or article might be addressed to foundational assumptions. How does IP work in the overall context of creativity in an industry? What kind of growth has the industry undergone, and what if any role has IP been shown to play in that?3 Do firms and people in the industry rely on informal norms or other techniques—​apart from formal IP rights—​to protect investments in creative works?4 And, within the province of IP doctrine, how do courts actually apply the doctrines found in IP law?5 From a completely different perspective, a scholar might address the cost side of IP protection: what happens in the market when IP rights expire—​for a patented pharmaceutical, for instance, or a copyrighted book?6 To be sure, the literature continues to address topics of interest to first-​wave scholars. Does IP really operate as a viable incentive? In a particular industry or field of creativity? How does IP compare with other motivations and incentives that drive creativity, generally and in specific industries? Did a change in the law actually lead to greater or lesser investment or activity?7

2 

See, e.g., Kitch (1966); see, also, Adelman (1977). See, e.g., Allison, Dunn, and Mann (2007) (patents and the software industry); Mann and Sager (2007) (patents and startup firms in the software industry). 4  See, e.g., Raustiala and Sprigman (2012). 5  See, e.g., Beebe (2008) (empirical study of copyright’s fair use factors); Sag (2012) (analyzing copyright cases so as to predict the outcome of fair use disputes). 6  See Buccafusco and Heald (2013). See also Bechtold and Tucker (2013) (court ruling relaxing trademark enforcement against Google “keyword” ad sales in Europe had little effect on user visits to trademark owners’ websites). 7  Another type of study tests assumptions behind doctrine or doctrinal change. See, e.g., McKenna (2009) (testing trademark law’s assumption that consumers may be confused when a trademark owner’s mark is used in markets unrelated or ancillary to the owner’s primary markets). 3 

 

202   ROBERT P. MERGES These examples highlight two major differences between early or “first-​wave” scholarship and the work of more contemporary “second-​wave” researchers: (1) increased attention to IP rights in a broader economic context (contextualization); and (2) greater methodological diversity. This chapter is organized around these two themes. I first discuss the many ways that second-​wave scholarship seeks to show how IP rights are embedded in broader economic contexts, and thus diverges from first-​wave research, which tended to focus exclusively on IP rights as the central determinants of economic activity. Next, I consider the many different methodologies now being deployed to study issues in the economics of IP rights—​from large-​scale empirical work to surveys to interviews to experimental research.

8.2. Contextualization As a fine poet once wrote, “I have had to learn the simplest things last.”8 This seems true of IP economics. While the earliest forays into the field tended to see the legal rules concerning IP protection as part of a broader set of issues relating to investment in creative works (e.g., Levin et al. 1987), much of first-​wave scholarship conceived of formal IP rights as the sole determinant of various types of economic activity.9 (This is of course a feature of comparative statics, with its famous—​in some quarters, infamous—​ assumption of ceteris paribus.) As applied to IP in its early days, law and economics were concerned with the net welfare effects of tweaking specific rules and doctrines. A  crucial contribution of the second wave of IP economics has been to widen the field of view within which economic activity is studied.10 In this new approach, legal rules are but one determinant of activity in the creative sectors of the economy. Other aspects are just as important:  industry norms; technological protections; structural factors such as lead time (i.e., degree of difficulty to copy new products), the effectiveness of trade secrecy, and the ability to bundle innovative products with other products 8 

Charles Olson. Maximus, to Himself (1983). The full lines are “I have had to learn the simplest things/​last. Which made for difficulties.” 9  See, e.g., Pigou (1924); Clark (1927); and Plant (1934). For an excellent overview of this and other early work, see Menell and Scotchmer (2007) in A. Mitchell Polinsky and Steven Shavell (2007). 10  A body of work by the noted economist of technological change, Richard Nelson, stands either as a glaring exception to the standing assumptions of the first and second wave, or as the vanguard of the third wave; and perhaps both. See, e.g., Nelson and Rosenberg (1993, 3–​5) (“[T]‌he concept [of a system] is that of a set of institutional actors that, together, plays the major role in influencing innovative performance.”). Indeed, the highly influential original “Yale survey” on innovation embodied in 1987 the assumption that formal IP rights were but one among a series of “appropriability mechanisms” through which private firms sought to recoup the costs of their R&D investments. See Levin et al. (1987). Nelson deserves far more credit than he usually gets for thoroughly understanding and forcefully arguing for the “contextual” view of IP at what now seems a very early date. He is truly “Il miglior fabbro,” as T. S. Eliot said of Ezra Pound. For an appreciation, see Dosi (2006). Other early work by Edwin Mansfield also deserves to be mentioned here. See Mansfield (1985, 1986, 1986); Mansfield et al. (1977).

 

ECONOMICS OF INTELLECTUAL PROPERTY LAW    203 or services over which a firm has pricing power so as to recoup investments in innovation.11 Even alternative policy mechanisms such as R&D tax credits or firm relocation credits come into play. In second-​wave thinking, IP is just one of many ways firms make money by creating new things. Formal IP rules are seen as embedded in a larger economic context. This scholarship argues that only by understanding this larger context can we understand the true impact of formal legal rules on “the rate and direction of technological growth.” As mentioned, second-​wave thinking is in one sense simply a return to the roots of the field. One of the earliest survey-​based studies of IP rights asked R&D managers to compare patents with other, non-​legal “appropriability mechanisms”—​techniques for recouping investments in creative works. Perhaps not surprisingly, many respondents listed lead-​time advantage and trade secrecy as more important than formal IP rights such as patents and copyrights.12 Second-​wave research has now returned to this basic theme. In this new line of scholarship, contextualization is explored along a number of dimensions. In this chapter, I want to emphasize just three examples.13 Taken together, these give some idea of the richness that follows from understanding IP as but one aspect of a much broader innovative ecosystem in which creative firms and people operate. First, I will discuss what are known as IP’s “negative spaces”: trades and pursuits in which participants rely on informal norms instead of formal legal protection. These illustrate how IP rights are embedded in a larger system of social norms, which some scholars say render formal IP redundant. Second, I will turn to the function of IP rights in “platform technologies,” for example, cell phone standards and computer operating systems. Firms that own or dominate platforms often use IP selectively to control access to their platforms. For these firms, IP is embedded in a complex strategic game in which they seek profits through some combination of technology platform and complementary products. IP can be used in a number of ways in this game: to erect a toll for access to the platform; to selectively exclude competitors from the platform while sharing access with allies; or to enforce an open or nonproprietary platform model with other industry participants. Third, I will discuss the growing literature that links IP rights to economic organization. Scholars have come to see that IP plays an important role in the setting of firm boundaries, subtly affecting issues such as whether small, R&D-​intensive

11  This particular topic is very well presented in Teece (1986). Other survey-​based studies back this theory with empirical findings. See Cohen, Nelson, and Walsh (2000); Graham et al. (2010). 12  Levin et al. (1987, 794). 13  Three of what could have been main examples, I should add. So for instance, I could have added an entire section on contemporary trademark scholarship, which has shown that simplistic models of trademarks as a way to reduce consumer search costs are incomplete because they ignore the sophisticated techniques of branding experts and marketers. Thus, Jeremy Sheff shows that investments in branding can actually bias consumer’s perceptions about what they need or about the characteristics of a relevant product. See Sheff (2011); Lemley and McKenna (2012) (deploying marketing literature to explore the complexities of brand loyalty, and its impact on the actual economic effects of trademark law); and Lee, DeRosia, and Christensen (2009).

 

204   ROBERT P. MERGES firms can survive independently or instead are fated to be absorbed into large, vertically integrated companies. IP policy, from this perspective, helps determine not only aggregate investments in creativity, but also the locus of innovative activity: individuals, small firms, or large firms. It is a new and exciting aspect of the overall trend toward greater contextualization in the economic study of IP rights.

8.2.1. Case Study in Contextualization: Fields where IP Is “Unnecessary,” or “IP’s Negative Spaces” In recent years, IP scholars have described a number of fascinating trades and pursuits where people get along quite well without the protection of formal, enforceable IP rights. From French chefs (Fauchert and von Hippel 2008) to stand-​up comics (Sprigman and Oliar 2008), and from fashion designers (Sprigman and Raustiala 2006) to tattoo artists (Perzanowski 2013) and magicians (Loshin 2010), creative people working in various industries develop norms and practices that provide an adequate, and perhaps often superior, alternative to formal IP protection. Some have taken to calling these areas, collectively, IP’s “negative spaces” (Rosenblatt 2011). From these studies, a consensus theory has begun to emerge, which holds that IP law is far less necessary than many have traditionally supposed. From a descriptive or positive beginning, in other words, negative space theory often moves to a more normative point: the essential wrongheadedness of the traditional story that IP rights are always and everywhere necessary to call forth creative works. In terms of contextualization, then, negative space theory says at times that IP policy needs to be sensitive to one important aspect of context: the presence of norms that can act as “IP substitutes.”

8.2.1.1. How Big Is the Negative Space? One important point about negative space studies is that they tend to concentrate on “niche” fields, industries, and pursuits that are, in the aggregate, relatively small when compared with the “IP economy” as a whole, Merges (2013). So, for example, French restaurants, stand-​up comedy, and tattoo parlors are relatively modest economic enterprises.14 Compared with the estimated size of the overall IP-​based economy, they represent only a small percentage of activity. The International Intellectual Property Protection Alliance (IIPPA), for example, estimates that the “copyright industries” alone add $1 trillion to the US economy each year.15 It is very difficult to arrive at similar estimates for the “patent industries” because companies in so many industries obtain large numbers of patents every year. But we can say that the pharmaceutical industry is 14 

An exception might be Schultz (2006), who studies norms surrounding the copying of recorded music concerts by fans of “jam bands” such as the Grateful Dead. It is not clear how large this genre is as a percentage of all popular music, but it is clearly substantial. 15  Figures such as these should always be taken with a grain of salt because they are based on large aggregate data sources and prepared by interest groups with a string agenda. See L.A. Times (2013).

 

ECONOMICS OF INTELLECTUAL PROPERTY LAW    205 worth $ 340 billion per year alone,16 and that the chemical industry totals roughly $450 billion.17 Most of the fields that negative space theorists explore are, in reality, fairly small scale. They fit the description of property theorist Robert Ellickson (1993), who some time ago noted that in “close-​knit” groups, formal property rules were often less efficient than an effective set of social norms.18 But, as Ellickson also noted, once groups grow beyond a certain size, and the economic value of their activities passes some threshold, informal norms cease to work. I believe this is as true for IP as for conventional tangible property. So, while we may have some interesting things to learn about context from IP’s negative spaces, the most important lesson in the end may be that most industries, as they grow, end up recapitulating the history of IP protection generally. As the larger context changes, the negative spaces are filled in.

8.2.1.2. Changing Fashions? But there is one industry studied by negative space theorists that is not small scale: fashion. A conservative estimate is that this is a $200 billion per year field (Hemphill and Suk 2009).19 Clearly, the magnitude of this industry is much closer to the “copyright industries” plus pharma/​chemicals. So where does fashion fit into discussions of the “negative space”? Perhaps the most important point to note in this respect is that the fashion industry itself seems quite motivated to escape the negative space. According to Scott Hemphill and Jeanie Suk (2009): The adverse effects of copying explain why many [fashion] designers oppose copying, just as they oppose counterfeiting of handbags. ([The negative space] argument, if correct, ought to apply to fashion trade-​marks and copyrights as well.) [Raustiala and Sprigman] pitch their paradox as an explanation for the otherwise puzzling equanimity with which designers greet copyists. But that premise is faulty. In fact, many designers are vocal advocates against copying, and … make use of the currently limited legal tools available to curb copyists.20

In addition to enforcement using the established (though flawed) legal tools available, fashion designers have been active in lobbying for various new forms of design protection.21 This lobbying effort is perhaps the best indicator that innovative firms are indeed not satisfied with the current copying-​centric equilibrium in the fashion industry. As a number of scholars have noted, in fact, the speed and ease of copying have created a 16 

Wikipedia, Pharmaceutical Industry. www.Chemistryviews.org. 18  See Ellickson (1993, 1520). 19  See Hemphill and Suk (2009, 1148). US apparel sales reached $196 billion in 2007 (NPD Group 2008). Among fashion accessories, considering just one category, handbags, adds another $5 billion in sales. Krim (2007) reports US sales exceeding $5 billion in 2005. 20  See Hemphill and Suk (2009, 1183). 21  See, e.g., Eguchi (2011, 145): “A design protection bill [from 2010] garnered support from several well-​known designers and the Council of Fashion Designers of America (CFDA)—​the creative core of the fashion industry….” 17 

 

206   ROBERT P. MERGES significant threat to the livelihoods of creative fashion designers, making future lobbying more likely.22 Viewed from the perspective of the evolution of IP protection, the fashion industry begins to look less like an instructive outlier and more like a very conventional industry.23 As with many other industries, as the value of the creative products increases, the calls for strengthened IP protection increase as well. It may not be long until fashion crosses the great divide from negative to positive IP space.

8.2.1.3. Learning about Context from Negative Spaces From all this, I think there are two things we can learn. First, there is indeed room for IP-​ free zones—​negative spaces in the fabric of IP protection. IP need not permeate every crease and corner of the economy. Negative space theorists have shown real creativity and resourcefulness in searching out and documenting examples of fields that survive and even thrive outside the shadow of IP protection. As with all empirical research, each case study adds to our understanding of how our economy and society actually function, and the role of IP rights in different economic contexts. Yet, the other lesson from exploring negative spaces has to do with their limits. Careful attention to context reveals that, in most cases, norms are effective substitutes for IP rights primarily in niche industries where participants are relatively close-​knit socially. Out in the larger, more anonymous economy, it remains to be seen whether norms can effectively replace the formal protection provided by IP rights.

8.2.2. IP and Platform Technologies When scholars study IP in context, IP becomes not the sole fulcrum determining economic outcomes but instead one of many interconnected facets of economic activity. On one hand, this diminishes the significance of IP rights in the analysis; they are not the exclusive determinant of investment, innovation, or whatever dependent variable is affected by the existence or strength of IP protection. On the other hand, this more contextualized understanding helps to isolate the unique role that IP rights can play in a large, complex economic system. An example from the world of platform technologies will show what I mean. Platform technologies are technical systems such as computer hardware (e.g., the Apple iPhone or Samsung Android cell phone handsets) or software (the Microsoft Windows or LINUX operating systems). They provide a common starting point for further technological development: the creation of special chipsets for the iPhone: for instance, or a cell phone application designed for use with the Google Android operating system software. For some time, scholars have understood the economic/​technological forces 22  23 

See, e.g., Scafidi (2008). See Merges (2001).

 

ECONOMICS OF INTELLECTUAL PROPERTY LAW    207 at work in these “platform markets” (e.g., Shapiro and Varian 1998). What is of interest to IP scholars is how firms in platform markets use IP rights as strategic instruments. Some firms profit from proprietary platforms, which are covered by various IP rights. For them, exclusive IP rights exclude direct competitors, obviously. But in the case of “allies,” companies that develop complementary technologies or content that increase the overall value of the platform “ecosystem,” IP rights are often purposely waived (see Simcoe 2008; Merges 2008, 2011; Barnett 2011b). So IP law permits a pattern of selective enforcement and selective waiver that is used by sophisticated platform players to advance their interests in this complex area. Some platforms are “open,” rather than proprietary. IP plays a role in this context too. Access to an open platform can be made conditional on agreement to perpetuate the open access policy. This is achieved through licensing contracts granting open-​source participants access to a platform. Licensees agree that in exchange for obtaining access to an open-​source platform, their contributions will in turn be subject to an open licensing policy. Thus—​somewhat paradoxically—​IP rights are the foundation upon which open access is built. The IP rights that cover an open platform are the basis for the legal threat that maintains open access. The literature on IP and platforms treats platform access as a strategic variable that can be manipulated by for-​profit firms, those usually associated with the strong IP rights/​ proprietary innovation model side of the IP debate. So open innovation and profit maximization are no longer opposite ends of an ideological spectrum; the former becomes a strategy pursued by private firms when conditions warrant. This is true of for-​profit companies permitting access to their platforms, but in the case of private investment in open-​source projects. In each case, firms decide strategically to waive their property rights in the service of firm advantage. We see here an illustration of the growing contextualization of IP rights in the economic literature. Scholars have shown that they understand why the ability to waive IP rights selectively is an essential dimension of their usefulness in the context of platform competition. This is a far cry from a simple, unidimensional “incentive” story where an increase in IP protection is tested for its effect on total R&D investment. The effectiveness of IP rights in the platform environment depends not only on the attributes of the IP rights when granted but also on the various licensing and enforcement strategies employed by the holders of IP rights. By studying this very special setting, economists have learned some new important lessons about the effects of IP rights on firm strategy and overall welfare.

8.2.3. IP Rights, Firm Boundaries, and Economic Organization Traditional first-​wave scholarship followed the conventions of classical microeconomics in paying little attention to the organization of economic production. IP rights

 

208   ROBERT P. MERGES influenced the overall production level in society, but it was never mentioned which types of organizations did the producing (e.g., Nordhaus 1969). In these early models, IP rights stimulate creative output (while raising consumer prices), but the precise locus of that output is never mentioned: individuals, small firms, large firms, etc.—​this body of theory abstracts away from these issues. But as with economics generally, IP economics has in later years discovered the fascinating set of issues surrounding firm boundaries.24 This is one of the clearest and most rewarding aspects of the general trend toward the contextualization of IP rights. The basic insight from this literature is that IP rights can actually affect the location of firm boundaries (Teece 1986b). The key to this new understanding of IP is to see it not primarily as something that affects overall incentive levels, but instead as an instrument that affects transactions—​and hence the organization of production (Merges 2005; Arora and Merges 2004; Burk and McDonnell 2007; Barnett 2011a). Advocates of this view see IP as a way for small, specialized firms to protect against opportunism when contracting with larger firms. IP makes it easier for specialized firms to sell technology and know-​how via arm’s-​length contracts, which permits specialized producers to exist as independent firms. IP rights can then be said to affect industry structure; without these rights, specialized knowledge subject to opportunistic copying would have to be produced within large, vertically integrated firms. This in turn would mean a loss of the “high powered incentives” (to use Williamson’s term) available to independent firms who sell their output via contracts (Merges 2005). The upshot is that IP at the margin may enable more small and independent firms to remain viable even in industries where multicomponent products are assembled and sold by large, vertically integrated firms. This literature on IP and the boundaries of the firm thus shows in very clear relief the importance of studying IP rights in context. Context here is everything: IP rights and the nature of the firms that use them are inextricably interlinked. Another insight is that, by affecting the location of firm boundaries, IP may exert an indirect incentive effect that has not been appreciated in the past. As Barnett (2011a, 787) puts it, in the case of patents: “Organizational effects proxy for innovation effects:  where patents alter organizational behavior, they alter innovation behavior.” This is because the smaller firms enabled by stronger IP rights may be more innovative, as compared to their large, vertically integrated counterparts. Barnett (2004) and others make an additional point, which in some sense brings this literature back around to one of the pioneer studies in the contextualization of IP rights (Levin et al. 1987): because large firms have at their disposal numerous ways to recoup expensive R&D investments (e.g., by bundling technology-​intensive products with other products over which the firm has pricing power), while small companies do not (owing to the 24 

Good syntheses of the literature include Burk and McDonnell (2007); Barnett (2011b). See also Heald (2005); Bar-​Gill and Parchomovsky (2009). Perhaps the earliest reference to this theme in the legal literature is Merges (1996), arguing that weak formal IP rights forced the Japanese software industry into a vertically integrated production model that disfavored small, independent firms; however, see Mashima (1996), offering corrections to this thesis.

 

ECONOMICS OF INTELLECTUAL PROPERTY LAW    209 absence of complementary assets), IP rights are particularly important for small firms. The strength of IP rights, as a policy variable, affects small firms disproportionately.25

8.3.  Methodological Diversity The basic methodology of the first wave was comparative statics of one variety or another. The classic version was a formal comparative model, showing overall welfare with and without whichever feature of the IP system was being modeled (see, e.g., Nordhaus 1969). Even the early contributions, from what might be called the primordial era of the first wave, employed this approach. (They used analytic descriptions, or “word models,” instead of “formal” or mathematical models; see, e.g., Plant [1934].)

8.3.1.  The Growth of Empirical Studies The second wave is far more diverse. IP scholars now use all sorts of methods. Chief among them in recent years has been the use of empirical data. Beginning with some path-​breaking work in the late 1980s (e.g., Levin et al. 1987) and 1990s (e.g., Allison and Lemley 1998), and accelerating especially in recent years, empirical research has burgeoned so much that it now has its own specialty abstracting service.26 Rarely does a week go by without some new and interesting contribution looking at music sales, patent prosecution, or trademark searches. Scholars are beginning to specialize; familiarity with large datasets is now almost required in certain subfields of IP economics, especially patent law.27 Some studies rely on traditional data sources, such as patent citation studies. Others are based on novel, labor-​intensive datasets the researchers put together themselves. And more sophisticated statistical methods are brought to bear, compared with the relatively simple early work (see, e.g., Ziedonis 2004; Hall, Jaffe, and Trajtenberg 2005; Galasso and Schankerman 2010). Each study adds to the growing integration of IP empirics into the main body of contemporary social science. A heightened sense of context is evident in the newer generation of empirical work, following the general theme of recent IP scholarship. Early empirical studies were highly aggregated, comparing for example GDP growth with patent grant rates. Recent studies pursue a number of more sophisticated strategies, including a comparison of 25 

While in general a society interested in maximizing social welfare would be indifferent to whether large or small firms did most of the innovating, it has been suggested that the enhanced autonomy which accompanies smaller firms provides an independent social good (Merges, 2011a). Hence, in some cases at least slightly higher transaction costs ought to be tolerated for the sake of this independent social good. 26  See SSRN.com. 27  See, e.g., Alcacer and Gittelman (2006) on the use of patent-​examiner data to study patent examination patterns; Abrams, Akcigit, and Popadak (2013), on sophisticated study of patents through citation data.

 

210   ROBERT P. MERGES how related patents for a single invention fare at three of the major international patent offices, in Japan, Europe, and the US (see Webster, Palangkaraya, and Jensen 2007). Another set of studies identifies variation in patent-​examiner behavior, and the impact this has on patent outcomes such as validity determinations in litigation. See, e.g., Cockburn, Kortum, and Stern (2003). But empirical studies are just one of the methods second-​wave scholars put to use. Structured interviews, experimental methods, and comparative institutional approaches have also become popular in the past ten years or so (see Merges 2000; Vertinsky 2012). These, together with the continued deployment of economic modeling and analysis, represent important elements of the diversity of methods that now characterize the field. And beyond economics, all manner of alternative methodologies are in play as well (see, e.g., Merges 2011; Dinwoodie 2013). In the sections that follow, I describe what I see as the main thrust of several of the most important methodologies being used in the IP field today. As with everything in this chapter, though I try to be comprehensive, the result is no doubt a personal and idiosyncratic survey of the literature.

8.3.2. Models and Analytics Even while a host of newer methods has been brought to bear on IP-​related issues, scholars continue to use traditional approaches as well. For example, economic modeling still plays an important part in the discussion of IP-​related issues. One rich source of modeling-​based studies is the classic article, which a contemporary scholar will explore anew with updated insights. In this genre, consider for example Duffy (2004)—​a thorough reexamination of Edmund Kitch’s classic “prospect theory” of patents (1977). Other recent work considers different types of models, such as Yoo (2004), which describes a product differentiation view of copyright law. Still other work pushes classic insights a step further: for example, Lunney (1996), who argues that allocative efficiency, and not the classic “incentive-​access tradeoff,” ought to drive copyright policy. And an excellent unified synthesis of the economics of IP and innovation is Scotchmer (2006). At the same time, IP has caught the attention of scholars whose interests lie with theorizing about property rights generally. So, for example, several important articles by Henry Smith have pushed his highly analytic synthesis of property theory into the domain of IP law. See Smith (2007, 2009). So too with work by scholars like Fennell (2004, 2009), and Merrill (2009). In each case, IP provides examples for an analytic approach to important issues in property law. The authors integrate IP into the general fabric of property, using it for examples of a new way to conceive or categorize some longstanding bodies of property theory. Merrill, for example, argues that certain patent doctrines embody the property principle of “accession,” or extension of ownership to natural outgrowths of previously owned works. And Fennell (2009) points to interesting twists in IP inalienability rules in support of her argument for a more flexible conception of alienability generally. Still another area where general property theory

 

ECONOMICS OF INTELLECTUAL PROPERTY LAW    211 overlaps with treatment of IP issues is in the study of IP access regimes as a case study in governance of a common resource. See Samuelson (2003).

8.3.3. Experimental Studies A series of articles by Sprigman and Buccafusco describe experimental work on IP rights. One demonstrates that a special version of the well-​known endowment effect28 exists with respect to works covered by IP rights. The article reports that cognitive biases cause creators and owners of IP to set the price for IP considerably higher than what buyers, on average, are willing to pay (Sprigman and Buccafusco 2010). The research therefore suggests that IP transactions may occur at suboptimal levels. They report that cognitive and affective biases are likely to be more serious for transactions in works of relatively low commercial value, or for which no well-​established custom or pattern helps to inform valuation. The article explores the implications their findings have for the structuring of IP rights, IP formalities, IP licensing, and fair use. In a related article, Sprigman and Buccafusco (2011) try to move beyond the simple endowment effect story, to explore valuation issues when the seller of a work covered by IP rights is also the original creator of that work. Not surprisingly perhaps, they find an even stronger version of the endowment effect. They dub this “the creativity effect.” In a cleverly structured series of experiments, they not only confirm the existence of the endowment effect, they also show that when someone creates a work he or she sets an even higher valuation on it than when an owner/​possessor considers selling it. That is, they separate creators from mere owners. This is important in the IP field because IP rights are often justified by the fact that they permit original creators to market their works, which supports creative autonomy and can enhance creators’ incomes. Their conclusion is that markets for IP are systematically distorted by subjective bias. The authors make some interesting points regarding policy implications. An oft-​discussed feature of IP law centers on the fact that large companies own the rights to the creative works of their employees. In the usual discussion, this is seen as a problem, in that incentives to create are diluted by corporate ownership. Sprigman’s results suggest that corporate ownership in fact may not be such a bad thing. By removing the rights over IP-​protected works from the hands of individual creators, aggregating ownership in the hands of large companies may in fact facilitate more efficiency in IP markets. The final paper tests the value of attribution (having one’s name attached to one’s creative works) and publication (reaching an actual audience) in IP markets. The findings here are based again on experiments involving subjects and carefully constructed scenarios. The authors show that artists (in this case, photographers, and painters) place a very high value on having their names attached to their works. This is established by a series of experimental trials in which some artists are given the option of retaining

28 

See “Endowment Effect,” Wikipedia, http://​en.wikipedia.org/​wiki/​Endowment_​effect.

 

212   ROBERT P. MERGES attribution; the value of this right is determined by looking at the price demanded by artists when they retain attribution and the price when they do not. In other words, the authors of the study have a methodology that allows them to infer the value artists attach to attribution. The same is true of the value they place on publication, which again is determined by looking at the price differential under two conditions. Despite its sophistication, this body of work remains somewhat ambiguous as regards its policy implications. The most important issue here is implicit baselines concerning the optimal rate of transactions. On the “creativity effect,” Sprigman and Buccafusco (2011) argue that the valuations placed on creative works by potential buyers and by noncreator “owners” (those who were simply given a work created by someone else) are more reliable guides to the actual market value of those creative works. This sets up the policy conclusion that markets for IP-​protected works are often inefficient because creators themselves overvalue their works. But if intrinsic value is treated neutrally, then a different conclusion might follow: many artists choose to retain sole ownership of their works because, having created them, they are the highest-​value owners on the scene. From this perspective the issue is not “failed transactions” but instead the importance of intrinsic valuation when it comes to creative works. In a related vein, it might be that the studies here show aggregate tendencies. But this does not drive a strong policy conclusion, because all it takes is for some outliers—​some “creative professionals” whose subjective valuation is closer to that of buyers—​to make a market. Under this interpretation, high-​valuation creators will remain outside the market, but low-​valuing creators will enter it. This could in turn drive a sort of “reverse market for lemons” dynamic. “High valuers” will be driven out of the market, because they can’t sell their works at market-​ clearing prices. And “low valuers” will come to predominate. If this became a trend, it would undermine the notion that disparate valuation makes IP markets too “thin.” Another line of research, conducted primarily by experimental psychologists, eschews large-​bore policy prescriptions while testing what might be called the development of intuitions regarding IP rights. The chief characteristic of these studies is that they take insights from cognitive psychology and test their relevance to IP-​specific scenarios. Some study the development of children’s intuitions about ownership (Fasig 2000; Friedman and Neary 2008; Neary and Friedman 2013). Others show that children have an intuitive appreciation for the value of labor in justifying ownership (Kangiesser and Hood 2013). A fascinating branch of this field with special relevance to IP studies developmental cognition, testing whether children have any sense of idea ownership, and if so, at what age. So, for example, cognitive scientists have shown that children as young as 6 years old “apply simple rules of ownership to ideas as well physical objects (Shaw, Li, and Olson 2012, 1389). Further, they also note that young children sense that some ideas are inherently common property, and they will not apply ownership concepts and rules to a common word, for example: “[C]‌hildren and adults used first possession for determining ownership of ideas, but not words” (2012, 1398). It is also worth noting that, according to another set of studies, children begin to recognize and censure plagiarism between the ages of 4 and 6. See Olson and Shaw (2011).

 

ECONOMICS OF INTELLECTUAL PROPERTY LAW    213 There is room here for much more nuance. A critical issue, for example, is whether children’s intuitions about idea ownership are, as some researchers suggest, culture-​ specific. If so, the studies are noteworthy in showing cultural influences over moral intuitions at a very early age. If not, they support a more universalistic claim: that IP rights are rooted in moral intuitions that develop early in the human mind. In any event, it is safe to say that there are a good number of fascinating questions left to explore in this area, and experimental studies of IP law may continue to enlighten the field for some time to come.

8.4. Conclusion I have emphasized two major trends in the economics of IP rights: An increased sense of IP in context, and the growth of methodological diversity. Taken together, they have the field poised for deeper insights and greater policy relevance than ever before. By studying how IP works in various contexts, scholars have progressed significantly from the stylized, simplistic models of the past. Each study is distinct, taking as its starting point a specific economic setting. But taken together, they reveal the many diverse ways IP rights exert an influence on economic behavior. The contrast with older scholarship is striking: contextual studies begin not with simple models but with real-​world industries and practices, and ask how IP rights play into various features of the setting under study. The payoff is a much better understanding of the distinct contribution IP rights make to economic life. Though a unified view of these rights (e.g., as simple incentives or as economic monopolies) is of course sacrificed, a multifaceted reality is revealed that is infinitely more varied and interesting than the simple worldview of the old models. In one sense, the benefits of methodological diversity are even more self-​evident. Each approach, indeed each individual study, has something to teach us about IP rights. An empirical study of variability among patent examiners, for example, might lead to a call for better Patent Office quality control or it might simply push private actors to diversify their patent filings among different examining groups. Better ways of grouping and organizing doctrines might stimulate new thoughts on core features of IP systems. The advantages are as diverse as the methods and studies themselves. But a more significant payoff comes when multiple methodologies reach the same conclusion. Convergence of this sort sends a powerful message. We can more confidently argue for policy prescriptions when multiple scholars, using different tools, arrive at the same conclusion. So, for example, when economic modeling, ethnographic interviews, and large-​scale event studies all indicate that extending the term of copyright protection adds nothing to creators’ incentives, we can be confident in advocating against further increases in the length of copyright. At the very least, consensus on this scale can help reveal the naked power of lobbying groups; a policy proposal that is

 

214   ROBERT P. MERGES opposed by all serious scholars, but which gains political traction nonetheless, teaches just how completely legislative muscle can trump objective policy analysis. Methodological diversity is actually essential if we are to have real confidence in our policy positions. As with the natural sciences, a successful strategy for understanding complex issues such as the place of IP rights requires two distinct phases. The first is highly reductionist: a small feature of the complex system is isolated and studied in great depth. Then, when many such reductionist studies are available, the disparate results are sifted and collected into a new synthesis. In this second phase, the disparate pieces are reassembled into a comprehensive new understanding. This new synthesis can be robust precisely because it is built on many solid, discrete studies. Real confidence comes when we can see the overall pattern that emerges from this diversity of building block studies. To reach this point in the study of IP rights, we will need many more diversified studies of discrete phenomena. But as these pile up, we will arrive at new syntheses that provide a firmer foundation for policy than the field has ever known.

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216   ROBERT P. MERGES Hemphill, C. Scott and Suk, Jeannie. 2009. “The Law, Culture, and Economics of Fashion.” Stanford Law Review 61, pp. 1147–​1155. Kanngiesser, Patricia and Hood, Bruce. 2013. “Not by Labor Alone: Considerations for Value Influence Use of the Labor Rule in Ownership Transfers.” Cognitive Science 37, p. 8. Kitch, Edmund. 1966. “Graham v. John Deere Co.: New Standards for Patents.” Supreme Court Review 1966, pp. 293–​346. Kitch, Edmund. 1977. “The Nature and Function of the Patent System.” Journal of Law and Economics 20, pp. 265–​291. Krim, Tanya. 2007. “There’s nothing ‘Trivial’ About the Pursuit of the Perfect Bag.” Brandweek March 29. Lee, Thomas R., DeRosia, Eric D., and Christensen, Glenn L. 2009. “An Empirical and Consumer Psychology Analysis of Trademark Distinctiveness.” Arizona State Law Journal 41, pp. 1033–​1109. Lemley, Mark A. and McKenna, Mark P. 2012. “Is Pepsi Really a Substitute for Coke?” Georgetown Law Review 100, pp. 2055–​2117. Levin, Richard C., Klevorick, Alvin, Nelson, Richard R., and Winter, Sidney. 1987. “Appropriating the Returns from Industrial Research and Development.” Brookings Papers on Economic Activity 3, pp. 783–​831. Los Angeles Times. 2013. “U.S. Copyright Industries Add $1 Trillion to GDP.” Nov. 19, 2013. http://​articles.latimes.com/​2013/​nov/​19/​business/​la-​fi-​ct-​intellectual-​property-​20131119 [Accessed 20 August 2016]. Loshin, Jacob. 2010. “Secrets Revealed: Protecting Magicians’ Intellectual Property Without Law.” In:  Christine A. Coros, ed., Law and Magic:  A  Collection of Essays. Durham, NC: Carolina Academic Press. 123–​148. Lunney, Glynn S., Jr. 1996. “Reexamining Copyright’s Incentive-​Access Paradigm.” Vanderbilt Law Review 49, pp. 483–​655. Mann, Ronald J. and Sager, Thomas. 2007. “Patents, Venture Capital and Software Startups.” Research Policy 36, pp. 193–​208. Mansfield, Edwin. 1985. “How Rapidly Does New Industrial Technology Leak Out?” Journal of Industrial Economics 34, pp. 217–​223. Mansfield, Edwin. 1986a. “Patents and Innovation: An Empirical Study.” Management Science 32, pp. 173–​181. Mansfield, Edwin. 1986b. “The R&D; Tax Credit and Other Technology Policy Issues.” American Economic Review, Papers and Proceedings 76, pp. 191–​197. Mansfield, Edwin, Rapoport, John, Romeo, Anthony, Wagner, Samuel, and Beardsley, George. 1977. “Social and Private Rates of Return from Industrial Innovations.” Quarterly Journal of Economics 71, pp. 221–​240. Mashima, Rieko. 1996. “The Turning Point for Japanese Software Companies:  Can They Compete in the Prepackaged Software Market?” Berkeley Technology Law Journal 11, pp. 429–​459. McKenna, Mark P. 2009. “Testing Modern Trademark Law’s Theory of Harm.” Iowa Law Review 95, pp. 63–​116. Merges, Robert P. 1996. “A Comparative Look at Property Rights and the Software Industry.” In: David Mowery, ed., The International Computer Software Industry: A Comparative Study of Industry Evolution and Structure. Oxford: Oxford University Press. 272–​303. Merges, Robert P. 2000. “Intellectual Property Rights and the New Institutional Economics.” Vanderbilt Law Review 53, pp. 1857–​1876.

 

ECONOMICS OF INTELLECTUAL PROPERTY LAW    217 Merges, Robert P. 2001. “One Hundred Years of Solicitude: Intellectual Property Law 1900-​ 2000.” California Law Review 88, pp. 2187–​2233. Merges, Robert P. 2005. “A Transactional View of Property Rights.” Berkeley Technology Law Journal 20, pp. 1477–​1520. Merges, Robert P. 2008. Intellectual Property Rights and Technological Platforms. Working Paper, University of Berkeley School of Law. http://​papers.ssrn.com/​sol3/​papers. cfm?abstract_​id=1315522 [Accessed 20 August 2016]. Merges, Robert P. 2011. Justifying Intellectual Property. Cambridge: Harvard University Press. Merges, Robert P. 2011a. “Autonomy and Independence: The Normative Face of Transaction Costs.” Arizona Law Review 53, pp. 145–​163. Merges, Robert P. 2013. “What Can We Learn from IP’s Negative Spaces?” Media Institute—​ Intellectual Property Issues. http://​www.mediainstitute.org/​IPI/​2013/​120913.php [Accessed 20 August 2016]. Menell, Peter S. 1987. “Tailoring Legal Protection for Computer Software.” Stanford Law Review 39, pp. 1329–​1372. Menell, Peter S. 1989. “An Analysis of the Scope of Copyright Protection for Application Programs.” Stanford Law Review 41, pp. 1045–​1104. Menell, Peter and Scotchmer, Suzanne. 2007. “Intellectual Property.” In: A. Mitchell Polinsky and Steven Shavell, eds., Handbook of Law and Economics. Elsevier. Merrill, Thomas W. 2009. “Accession and Original Ownership.” Journal of Legal Analysis 1, pp. 459–​510. Neary, Karen R. and Friedman, Ori. 2013. “Young Children Give Priority to Ownership When Judging Who Should Use an Object.” Child Development 84, p. 6 Nelson, Richard R., ed. 1962. The Rate and Direction of Inventive Activity. Princeton: Princeton University Press. Nelson, Richard R. and Rosenberg, Nathan. 1993. National Innovation Systems: A Comparative Analysis. New York: Oxford University Press. Nordhaus, William D. 1969. Invention, Growth and Welfare:  A  Theoretical Treatment of Technological Change. Cambridge, MA: MIT Press. North, Douglass. 1990. Institutions, Institutional Change and Economic Performance. Cambridge: Cambridge University Press. NPD Group. 2008. “The U.S. Apparel Market 2007 Dresses Up … Way Up.” Business Wire. Mar. 18. http://​www.businesswire.com/​news/​home/​20080318005099/​en/​U.S.-​Apparel-​Market-​ 2007-​Dresses-​Up...Way [Accessed 21 August 2016.] Olson, Kristina R., and Shaw, Alex, 2011. “‘No Fair, Copycat!’:  What Children’s Response to Plagiarism Tells Us About Their Understanding of Ideas,” Developmental Science 14 , pp. 431–​439. Perzanowski, Aaron. 2013. “Tattoos and IP Norms.” Minnesota Law Review 98, pp. 511–​567. Pigou, A.C. 1924. The Economics of Welfare. 2nd ed. London: Macmillan. Plant, Arnold. 1974 [1934]. “The Economic Theory Concerning Patents for Inventions.” In: A. Plant, Selected Economic Essays and Addresses of Arnold Plant. London:  Routledge & Kegan Paul. 35–​56. Priest, George L. 1986. “What Economists Can Tell Lawyers about Intellectual Property: Comment on Cheung.” Research in Law and Economics 8, pp. 19–​24. Radin, Margaret J. 1982. “Property and Personhood.” Stanford Law Review 34, pp. 957–​1015. Radin, Margaret J. 1987. “Market Inalienability.” Harvard Law Review 100, pp. 1849–​1937. Raustiala, Kal and Sprigman, Christopher. 2012. The Knockoff Economy. New York: Oxford University Press.

 

218   ROBERT P. MERGES Rawls, John. 1971. A Theory of Justice. Cambridge, MA: Harvard University Press. Rawls, John. 1993. Political Liberalism. Cambridge, MA: Harvard University Press. Rosenblatt, Elizabeth L. 2011. “A Theory of IP’s Negative Space.” Columbia Journal of Law and the Arts 34, pp. 317–​341. Sag, Matthew. 2012. “Predicting Fair Use.” Ohio State Law Journal 73, pp. 47–​114. Samuelson, Pamela. 2003. “Mapping the Digital Public Domain.” Law and Contemporary Problems 66, pp. 147–​171. Scafidi, Susan. 2008. “F.I.T.:  Fashion as Information Technology.” Syracuse Law Review 59, pp. 69–​81. Schultz, Mark F. 2006. “Fear and Norms and Rock & Roll: What Jambands Can Teach Us About Persuading People to Obey Copyright Law.” Berkeley Technology Law Journal 21, pp. 651–​681. Scotchmer, Suzanne. 2006. Innovation and Incentives. Cambridge, MA: MIT Press. Shaw, Alex, Li, Vivian, and Olson, Kristina R. 2012. “Children Apply Principles of Physical Ownership to Ideas,” Cognitive Science, 36, pp. 1383–​1403. Sheff, Jeremy. 2011. “Biasing Brands.” Cardozo Law Review 32, pp. 1245–​1314. Simcoe, Timothy S. 2008. “Open Standards and Intellectual Property Rights.” In:  Henry Chesbrough, Wim Vanhaverbeke, and Joel West, eds., Open Innovation: Researching a New Paradigm. New York: Oxford University Press. 161–​183. Smith, Henry. 2007. “Intellectual Property as Property:  Delineating Entitlements in Information.” Yale Law Journal 116, pp. 1742–​1827. Smith, Henry. 2009. “Institutions and Indirectness in Intellectual Property.” University of Pennsylvania Law Review 157, pp. 2083–​2133. Social Science Research Network. N.d. Intellectual Property: Empirical Studies eJournal. Ed. Christopher Buccafusco and David Schwartz. http://​papers.ssrn.com/​sol3/​Jeljour_​results. cfm?nxtres=121&form_​name=journalbrowse&journal_​id=1649836&Network=no&SortOr der=ab_​approval_​date&stype=desc&lim=false [Accessed 22 August 2016]. Sprigman, Christopher, and Buccafusco, Christopher J. 2010. “Valuing Intellectual Property: An Experiment.” Cornell Law Review 96, pp. 1–​45. Sprigman, Christopher, and Buccafusco, Christopher J. 2011. “The Creativity Effect.” University of Chicago Law Review 78, pp. 31–​52. Sprigman, Christopher and Oliar, Dotan. 2008. “There’s No Free Laugh (Anymore):  The Emergence of Intellectual Property Norms and the Transformation of Stand-​Up Comedy.” Virginia Law Review 94, pp. 1787–​1856. Sprigman, Christopher and Raustiala, Cal. 2006. “The Piracy Paradox:  Innovation and Intellectual Property in Fashion Design.” Virginia Law Review 92, pp. 1687–​1746. Sprigman, Christopher J., Buccafusco, Christopher J., and Burns, Zachary C. 2013. “Valuing Attribution and Publication in Intellectual Property.” Boston University Law Review 93, pp. 1389–​1435. Teece, David. 1986a. “Profiting from Technological Innovation: Implications for Integration, Collaboration, Licensing and Public Policy.” Research Policy 15, pp. 285–​305. Teece, David. 1986b. “Firm Organization, Industrial Structure and Technological Innovation.” Journal of Economic Behavior and Organization 31, pp. 193–​211. Varian, Hal, and Shapiro, Carl. 1998. Information Rules. Boston: Harvard Business School Press. Vertinsky, Liza. 2010. “Comparing Alternative Institutional Paths to Patent Reform.” Alabama Law Review 61, pp. 501–​550. Vertinsky, Liza. 2012. “An Organizational Approach to the Design of Patent Law.” Minnesota Journal of Law, Science and Technology 13, pp. 211–​262.

 

ECONOMICS OF INTELLECTUAL PROPERTY LAW    219 Webster, Elizabeth, Palangkaraya, Afons, and Jensen, Paul H. 2007. “Characteristics of International Patent Application Outcomes.” Economics Letters 95, pp. 362–​368. Yoo, Christopher. 2004. “Copyright and Product Differentiation.” New York University Law Review 79, pp. 212–​280. Ziedonis, Rosemarie. 2004. “Don’t Fence Me In: Fragmented Markets for Technology and the Patent Acquisition Strategies of Firms.” Management Science 50(6), pp. 804–​820.

 

Chapter 9

T R ADEM ARKS A ND U NFA I R C OM PETI T I ON Clarisa Long

9.1.  Introduction The patent and copyright forms of intellectual property protection both turn on the same underlying dilemma: how to solve the public goods problem. Inventions and artistic creations, if unprotected, become public goods once revealed. Legal rules allow individuals to maintain some elements of control over information that would otherwise be lost to the public domain. By granting exclusive rights to the creative work, legal rules make it possible for creators to be compensated for that revelation.1 Without protection, not enough information will be produced, but with protection, information will be suboptimally distributed. This is an old and familiar story. But that motif does not squarely fit with the traditional justification of trademark law, which has long been classified as a subpart of the law of unfair competition.2 While the stated purpose of the patent and copyright regimes has long been to encourage the creation of inventions and expressive goods—​to “promote the progress of science and the useful arts”3—​trademark law’s historic goal was not to encourage the creation of branded goods per se. As a part of unfair competition law, trademark protection, and its

1  See, e.g., Graham v John Deere Co., 383 U.S. 1, 9(1965) (describing the patent system as “a reward, an inducement, to bring forth new knowledge”); Easterbrook (1984, 21–​22) (observing that inventors would not make information public without the promise of compensation); Machlup (1958) (discussing the “exchange for secrets” theory of the patent system). 2  Two of the classic papers establishing the law and economics approach to trademark law are Landes and Posner (1987, 265) and Economides (1988, 523). 3  See US Const. Art. I, § 8, cl. 8 (“[Congress shall have the power] [t]‌o promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries”).

 

TRADEMARKS AND UNFAIR COMPETITION    221 cousin, false advertising law, was a strand of the common law’s general attempt to implement standards of commercial morality and fair dealing in economic markets. The forerunner to unfair competition law was concerned with protecting established merchants’ entitlement to custom.4 The common law tort of passing off, in which merchant A would represent its own (usually inferior) goods as those of merchant B, was originally made actionable in order to prevent competitors from improperly diverting business from producers in the marketplace. (The common law tort of reverse passing off, in which merchant A buys merchant B’s goods and then falsely represents those goods as being merchant A’s own goods, is relatively rare for obvious reasons. In cases of reverse passing off, merchant A is most likely taking an economic loss and selling merchant B’s goods at or below their purchase price in order to attract customers.) As markets expanded in their geographical scope and market structure became more complex, the relationships between producers and consumers became more attenuated. Consumers no longer necessarily knew the producer of a set of goods personally or as a member of a local community. Trademarks thus began to be important in advertising and product recognition. One commentator has argued that ownership of a trademark was “assigned to the person who adopted the mark for her trade, not because she had created it or its favourable associations, but because such person was conveniently placed and strongly motivated to vindicate the broader public interest in a mark’s ability to identify accurately the source of the goods to which it was attached.”5 By being able to differentiate the products of competing sellers, trademarks allowed consumers to associate a product’s qualities with a single source. One goal of trademark law became, therefore, to police the marketplace to protect consumers from confusion as to the source of a good arising from confusingly similar trademarks being applied to competing goods. On this theory, trademark law served as one way of policing competitive markets and thereby as providing an indirect form of consumer protection. Over the past century, however, the rise of the regulatory state means that trademark law in particular, and unfair competition law more generally, are no longer the dominant modes of regulating competitive behavior in the market. As trademark law in the United States has evolved, one strand of trademark theory—​dilution law—​has gained traction. Trademark dilution law treats trademarks as being valuable for the goodwill they embody. Producers who build up positive associations in the consumers’ minds with the mark or who otherwise amass goodwill from their marked products can reap the benefit, so long as the producer can continue to control the way in which the mark is used. Conferring on trademark holders the power to exclude third parties from nonconfusing uses of the marks allows mark owners to reap the benefits of their investment in product quality. Under dilution theory, the emphasis is not on protecting consumers, but in incentivizing producers to create goodwill.

4  Restatement (3d) of Unfair Competition § 9, cmt. c (1995) (discussing concerns with “the unfairness inherent in a diversion of trade from the owner of the mark through a fraudulent use of the trademark.”). 5  Lunney (1999, 367, 417).

 

222   CLARISA LONG Across the various fields and subfields of modern law, the law and economics mode of analysis, with its emphasis on economic efficiency, has been a more powerful explanatory tool in some fields than it is in others. Trademark law has been one of the fields for which law and economics theories have had explanatory traction. (Unfair competition law generally, with its emphasis on equity, has been more resistant to traditional law and economics analysis.) Commentators have recognized that the law and economics model of trademark law has been well accepted and indeed is the dominant model in theoretical explanations for trademark law today.6 I posit that there are two main reasons for this. The first is to trademark law’s common law foundation. Although Congress comprehensively codified US trademark law in 1946 in the Lanham Act, the statute made few changes to the common law. As a result, the field’s underlying strata of judge-​made rules, many of which can be justified in efficiency terms, remained largely unchanged. The second is the relative balance of power between the courts and Congress. Unlike copyright law, in which Congress has been the dominant evolutionary force in recent decades, Congress delegated interpretive authority over the Lanham Act to the courts.7 Over the past few decades, courts have increasingly used the federal Lanhan Act as a remedy for matters that had long been considered subsumed under state unfair competition law, such as false advertising and copying of trade dress. Courts have maintained an active presence even after trademark law’s codification, which has provided a counterbalancing force to the pressures of interest groups on the legislative process.8 This chapter will summarize the dominant law and economic approach to some of the doctrines comprising the two major strands of modern trademark law: what I call classic trademark law, in which trademark protection is justified as reducing consumer search costs and preventing consumer confusion, and dilution law, which is explained by the more traditional intellectual property justifications of encouraging investment in creating valuable marks and protecting producer goodwill. It does not purport to be a comprehensive description of the field, but rather provides a light overview.

9.2.  The Law and Economics of Classic Trademark Law Trademark law, at least in its classical form, is directed at preventing harm to consumers through the misleading or confusing use of trademarks. Trademarks indicate the source or origin of goods.9 Because many things can serve as source identifiers, trademarks are not confined to words, phrases, pictures, logos, symbols, and other merely literary 6 

See Barton (2004, 621). See Leval (2004, 187, 198). 8  For a discussion of this, see Long (2006, 1029). 9  See 15 U.S.C. § 1127 (2012) (defining trademark as “any word, name, symbol, or device, or any combination thereof [used] to identify and distinguish [a person’s] goods”). 7 

 

TRADEMARKS AND UNFAIR COMPETITION    223 elements. The look and feel of a product, a product configuration, a color, sound, or scent may serve as a source identifier.10 Thus, in this chapter, I refer to all product identifiers protected under the Lanham Act as “marks” and “trademarks,” even though some of these may actually be trade dress or service marks. I shall also follow the convention of indicating a word or logo used as a trademark by displaying it in all capital letters.

9.2.1. Some Benefits of Trademarks Law and economics has posited two economizing functions of modern day trademarks. The first of these is to create symbols that are shorthand for a product’s source. The second is that trademarks communicate something about the trademark holder itself as opposed to a particular product. Balanced against the economizing functions of trademarks, however, must be considered the social costs of trademark protection. The traditional justification for trademarks is that they reduce consumer search costs. On this view, trademarks are a compact and efficient means to communicate information to consumers. Consumers use the mark as source identifier, expecting that goods branded with the mark will be of the quality they have come to associate with past purchases bearing the mark. Use of confusingly similar marks on competing goods may cause consumers mistakenly to purchase goods from another source whose quality may differ from the goods the consumer intended to purchase. In the absence of trademark law, unscrupulous competitors could take advantage of the association between mark and quality in order to “pass off ” their own goods as those of another goods producer. Trademark law thus benefits consumers by allowing them to engage in heuristics that, on balance, save them time and mental processing, as well as protecting consumers from some kinds of deception and unfair competition in the marketplace. Classical trademark theory is directed at protecting this source of trademark value as a reducer of consumer search costs. Producers of competing goods differentiate their goods in various ways, often by varying the attributes of the good. For example, Coke has orange-​flavored undertones, whereas Pepsi tends toward lemon-​based notes. Coke has a higher degree of carbonation, whereas Pepsi is sweeter.11 Some of the attributes of goods are readily observable; others cannot be assessed simply by inspection of the good. On this view, the less readily observable the product attributes, the greater the social value of trademarks. Search costs will vary depending upon the nature of the good. Because consumers can use a trademark as a proxy for a set of hard-​to-​measure product attributes, the 10 

See, e.g., Qualitex Co. v Jacobson Prods. Co., 514 U.S. 159, 162 (1995) (including “color within the universe of things that can qualify as a trademark”); Two Pesos, Inc. v Taco Cabana, Inc., 505 U.S. 763, 767 (1992) (finding restaurant decor to be protected trade dress); In re Clarke, 17 U.S.P.Q.2d (BNA) 1238, 1238 (T.T.A.B. 1990) (scent); In re Gen. Elec. Broad. Co., 199 U.S.P.Q. (BNA) 560, 563 (T.T.A.B. 1978) (sound). 11  For a discussion of the differences between Coke and Pepsi drinks and an example of how a consumer taste test is performed, see Thumin (1962, 358, 358–​59).

 

224   CLARISA LONG identification function of trademarks is especially important for experience goods, or goods that yield information about their qualities over time.12 For example, a particular model of car is an experience good because latent defects or performance advantages generally become apparent only after purchasers have used the car for some time. Reliance goods are particularly hard for consumers to judge on their own. Consumers either lack access to information about the good or lack the expertise to evaluate the available information. Instead, consumers must rely on the assessment of some trusted third party, usually an expert, whose expertise allows the expert to assess the good on the consumers’ behalf. Examples of this include electrical equipment, medical advice, or cryptographic software. Underwriters’ Laboratories can probably find a defect in a lamp faster than the average consumer can. (Most consumers would probably prefer that Underwriter’s Laboratories identify a problem in an electrical device, rather than consumers stumbling on it themselves.) Similarly, consumers often don’t know if medical advice is any good without using some proxy for quality such as asking for a second opinion. Sometimes a consumer can make an assessment on her own, but most of the time she can’t. Trademarks and certification marks are helpful for consumers to assess reliance goods, because the reputation of the producer or the certifier stands as a proxy for the quality of the good. In essence, for both experience goods and reliance goods, the mark encapsulates the experience of the consumer or other consumers, becoming a sort of “expert” signal on which the consumer relies. By contrast, inspection goods such as produce readily yield information about their attributes, often by casual observation.13 Trademarks are less valuable in reducing search costs for inspection goods. Consumer benefit, and by extension social benefit, is enhanced by making sure that when consumers rely on source identifiers, such marks are not used in a confusing manner. The social cost is that competitors of a trademark holder incur avoidance costs; they must create their own nonconfusing trademark. Trademarks and advertising send another kind of signal as well, and that is a self-​ referential message. A consumer can learn something about the company, even if they don’t learn much about a product, from the advertising surrounding the product. One message might be “we advertise, and therefore we must sell a good of sufficiently high quality that we can afford this high-​cost expenditure.” Another message might be “through our advertising you can detect a certain kind of corporate culture or vision which will appeal to you and therefore you should buy our products.” Marks thus are a shorthand way for consumers to associate a lot of information with a single product.

9.2.2. The Boundaries of Trademark Protection As with any form of intellectual property protection, the boundaries of trademark law are important. Trademark’s boundaries tend to be more context-​dependent than other 12 

For a discussion of experience goods and inspection goods, see Landes and Posner (2003, 117, n. 51).

13 See ibid.

 

TRADEMARKS AND UNFAIR COMPETITION    225 forms of intellectual property protection such as patent law. Some of the ways in which the boundaries of trademark law are circumscribed include the strength of the mark, functionality, and allowing recovery for infringement only if the defendant’s use of the same or similar mark results in a likelihood of consumers being confused. Not all source identifiers are created equally, however. Some present higher avoidance costs than others; some are more euphonious or aesthetically appealing than others; some are more memorable.

9.2.2.1. The Continuum of Protection for Word Marks Word marks are arrayed along a continuum of strength. The strongest marks are fanciful marks, which are made up words. Suppose, for example, that a manufacturer was producing a brand new version of a portable device for carrying hot liquids—​otherwise known as a coffee mug—​and wanted to create a mark under which to sell it. The producer could mark it GRODROK, which would be fanciful although not terribly euphonious.14 Slightly less strong but still protected are arbitrary marks, which are pre-​existing words applied in a new concept. If the producer decided to use the mark PIANO to sell the mug, that would be an example of an arbitrary mark. Suggestive marks are weaker on the continuum, and convey to the user some features of the product. In this case, using the mark OASIS would be suggestive of the qualities the producer wants the user to associate with the mug. Marks that are fanciful, arbitrary, or suggestive receive protection from their first use on goods in commerce, and it is easy to see why: they allow consumers to identify the source of the good without removing from the public domain words that other producers need to describe their own products. Words that are deemed descriptive—​those that convey the product’s qualities directly to the consumer—​are unprotected, at least ab initio. For example, attempting to use the mark COFFEE-​PORTER for the mug would likely fail for being descriptive. (Although, to be sure, the line between suggestive marks, which are protected, and merely descriptive words, which are not, is highly context-​dependent and variable.) This makes sense because a descriptive word, without more, does not distinguish the manufacturer’s product from those of other manufacturers. Giving protection to a merely descriptive word ab initio would impose avoidance costs on competitors and consumers alike that would be particularly high because the descriptive word would require competitors to use alternative, non-​protected, words to describe their own products. That could in turn inhibit the communication of useful information to consumers by other producers. Trademark protection is dependent on thick context, however, so over time a mark can move across the line of protection as consumers come to associate it in a particular context with a particular producer. If consumers came to associate a descriptive word such as “coffee porter” with a single source of a product, the descriptive word could receive protection. It would be declared to have “secondary meaning,” which means that 14  Professor Carter cited the fictional trademark GRODROK in his article (1990, 759, 770) as an example of an unlyrical mark. Be that as it may, I find it quite charming, myself. But de gustibus non est disputandum.

 

226   CLARISA LONG in addition to its descriptive qualities, it was recognized by consumers as a source identifier when applied to that product. Generic words do not receive protection because they are the name of the genus of goods for which the would-​be-​marked product is the species. For example, our producer of a portable device for carrying hot liquids could not use the words coffee mug as a source identifier for its product because that would be generic. Once again, the same reasoning applies to the non-​protection of generic words as is applied to descriptive words: allowing a producer to use a generic word to mark its product would require all other sellers of the same product in the marketplace to create a new word to refer to the general class of goods, and would necessitate consumers learning the new word for the genus of goods. If arbitrary and fanciful marks are stronger and provide protection ab initio, why don’t producers always seek to use arbitrary or fanciful marks? Why would they use suggestive marks? Why come up with a mark that is close to the line and therefore risks being deemed descriptive? Imagine the following scenario. You have just moved to a new town in a region of the country unfamiliar to you and are looking for a grocery store. As you drive down the street, you encounter the GRODROK grocery store. That doesn’t sound too appetizing, so you drive on. You next encounter a grocery store with the arbitrary mark ALPHA BETA. (This was the real trademark of a now-​defunct chain of grocery stores in the United States.) At least it’s not stomach churning, but the name doesn’t tell you much about the qualities of the store. As you drive on, you come across the LUCKY grocery store (also the name of a real chain of supermarkets in the United States). This name sounds more promising, but it still doesn’t tell the users much about the qualities of the store. How are consumers going to get lucky? Will they meet the partner of their dreams in the produce aisle? Will they win an in-​store lottery? A few things are left to the imagination. Finally, you encounter the SUPERFRESH grocery store. This name, which most likely comes awfully close to the distinctive/​descriptive line, directly conveys the qualities that the producer would like consumers to associate with the good. The closer a mark comes to the distinctiveness line, the less mental processing consumers need to do. If producers want to communicate information to consumers with the least amount of effort, marks that come close to being purely descriptive accomplish that objective.

9.2.2.2. Trade Dress and Functionality It doesn’t make much sense to try to fit trade dress—​which comprises all non-​word forms of source identifiers, such as product shape—​into the categories of fanciful, arbitrary, etc., that are used for word marks. Nevertheless, trade dress, like word marks, has rules about the boundaries of protection. If denying protection for generic words sets a limitation on the boundaries of protection for word marks, the doctrine of functionality serves as one boundary for trade dress. The doctrine of functionality should be thought primarily as a policy tool intended to exclude trade dress from protection in circumstances where granting protection could have anticompetitive effects. As the US Supreme Court has stated, “The functionality

 

TRADEMARKS AND UNFAIR COMPETITION    227 doctrine prevents trademark law, which seeks to promote competition by protecting a firm’s reputation, from instead inhibiting legitimate competition by allowing a producer to control a useful product feature…. If a product’s functional features could be used as trademarks … a monopoly over such features could be obtained without regard to whether they qualify as patents and could be extended forever (because trademarks may be renewed in perpetuity).”15 There are several formulations for determining if a feature of a product should be denied trade dress protection on the grounds that it is legally functional. One touchstone for determining that an element is functional is if it is “essential to the use or purpose of the article or if it affects the cost or quality of the article.”16 The first of these two types of functionality, which can be thought of as the core of the doctrine of functionality, excludes from protection physical features that have a primarily utilitarian function or that could potentially be eligible for patent protection. For this reason it is often referred to as “mechanical functionality.” For example, the dumbbell shape of a baby bottle could serve as the trade dress for the producer of the baby bottle. But the shape also has a utilitarian function in that it allows the baby to grip the bottle more easily. As a result, the shape of the baby bottle would be denied trade dress protection.17 Usually excluded from the legal definition of functionality, it should be noted, is product packaging. Of course the packaging of a product (think, e.g., of a glass Coke bottle) serves a functional purpose—​to hold the product and keep it from being damaged or dirtied before the consumer can consume it. But although product packaging has a utilitarian purpose, it can also serve as a powerful source identifier. In most such cases, if a court deems that consumers use the product packaging as a source identifier—​and again, the Coke bottle is a good example of strong trade dress—​then its functional characteristics as product packaging do not serve to eliminate trade dress protection. A slightly different set of circumstances under which an aspect of a product will be deemed functional and therefore beyond the realm of trademark protection is where granting protection to the trade dress would have an anticompetitive effect. Under these circumstances, a product’s feature need not be eligible for patent protection or mechanically useful. But if granting protection for that feature could raise manufacturing costs for competitors because competitors would be required to design around it and there are a limited number of alternative designs possible, then the feature will be deemed de jure functional. Such a doctrine, however, appears to be more theoretical than actual. In most cases, courts hesitate to deny trade dress protection on the grounds that competitors will have a hard time designing around it.18

15 

Qualitex Co. v Jacobson Products Co., 514 U.S. 159, 164–​65 (1995). Inwood Lab. v Ives Lab., 456 U.S. 844, 850 n.10 (1982). 17  See, e.g., In re Babies Beat, Inc., 13 U.S.P.Q.2d (BNA) 1729 (T.T.A.B. 1990). 18  For a case denying trade dress protection as on competitiveness grounds, see Valu Engineering, Inc. v Rexnord Corp., 278 F.3d 1268 (Fed. Cir. 2002) (upholding the Board’s determination that the designs were functional as used in the context at issue and thus had a “competitively-​significant application”). 16 

 

228   CLARISA LONG A subspecies of the doctrine of functionality, aesthetic functionality, fits this latter justification. The notion of aesthetic functionality may sound like a contradiction in terms but it is actually consistent with the policy goals of unfair competition law. It attempts to make sure that a popular design is not removed from the public domain, even if that design has no mechanical function.19 A design is considered aesthetically functional if its “aesthetic value lies in its ability to confer a significant benefit that cannot practically be duplicated by the use of alternative designs.”20 For example, a manufacturer selling individual china plates that could be purchased to replace damaged pieces in china patterns already owned by consumers was deemed not to be liable for trademark infringement because the ability to purchase individual plates was beneficial to consumers. Consumers found the design on the replacement pieces of china valuable, not as a source identifier, but because it allowed them to complete sets of china that had had individual pieces broken, rather than having to buy a full set of plates in a new pattern.21

9.2.2.3. Likelihood of Confusion as the Touchstone for Protection under Classic Trademark Law The boundaries of trademark protection, as mentioned previously, are highly contextual. One very important limitation on the boundaries of protection for trademarks under classic trademark law is that use of the mark by other producers in the marketplace by a defendant without the trademark holder’s permission gives rise to liability only to the extent that consumers are confused by the defendant’s use as to the source of the goods.22 This is why, for example, use of the identical word mark DELTA by Delta Airlines for airline services, Delta Dental for dental insurance, Delta Power Equipment Corporation for power tools, Delta Moving and Storage for moving services, and Delta Faucet for bathroom fixtures does not give rise to liability by any of these users against any of the others: in each context, consumers are not confused as to the source of the particular good at issue. Such a doctrine raises both producers’ and consumers’ costs along some margins and lowers them along others. It makes classic trademark protection much more nuanced than it otherwise would be if the rule were to assign strong exclusionary rights on a non-​ contextual basis. As a result, producers who want to use a mark similar or identical to

19   See, e.g., Publ’ns Int’l, Ltd. v Landoll, Inc., 164 F.3d 337, 342 (7th Cir. 1998) (“Gold is a natural color to use on a fancy cookbook.”); Pagliero v Wallace China Co., 198 F.2d 339, 343–​44 (9th Cir. 1952) (stripping away trademark protection when the aesthetically pleasing nature of a trademark conferred market power over the good itself). For a slightly unusual take on aesthetic functionality, see Plasticolor Molded Prods. v Ford Motor Co., 713 F. Supp. 1329, 1335 (C.D. Cal. 1989) (stating in dictum that use of FORD on automobile floor mats by a maker of replacement floor mats is “functional” because it is “designed to help the mats contribute to a harmonious ensemble of accessories and decorate the interior of a car”), vacated after settlement and consent decree, 767 F. Supp. 1036 (C.D. Cal. 1991). 20  Qualitex Co. v Jacobson Products Co., 514 U.S. 159, 170 (1995). 21  Pagliero v Wallace China Co., 198 F.2d 339 (9th Cir. 1952). 22  See Lanham Act §§ 32(1), 43(a), 15 U.S.C. §§ 1114(1), 1125(a) (establishing liability for infringement of registered and unregistered marks, respectively).

 

TRADEMARKS AND UNFAIR COMPETITION    229 one already being used must assess whether consumers would be likely to be confused. This increases producers’ avoidance costs in that they have to make a determination about the consumer perception of various marks. If a new entrant into the market for making residential water pipes wanted to use the mark DELTA, would consumers be likely to confuse it with Delta Faucet? After all, both companies are offering a product through which water is conveyed in a residence. One product is placed inside the walls of the house, whereas the other is external to the walls. The new entrant must identify the appropriate consumer market—​would it be homeowners? contractors? plumbers? all of the above?—​and anticipate whether its use of the mark would be likely to cause confusion as to the source of its product in the relevant market, whatever that might be. On the other hand, a focus on consumer confusion lowers the costs to producers of creating trademarks since they do not need to create marks that are absolutely novel. Using potential consumer confusion as the touchstone for liability preserves classic trademark law’s focus on consumers. If consumers are not harmed, then producers cannot exclude other sellers in the marketplace from using the same mark, much as they may desire exclusive rights. As I will demonstrate, in recent years, trademark law has added a new cause of action—​dilution law—​that allows trademark holders to recover for infringement of their marks under certain circumstances even when consumers are not confused. This represents a fundamental shift away from focusing on consumers as boundary for trademark protection.

9.2.3. Some Costs of Trademarks Commentators have not left unchallenged the economic justifications that have been posited to support a robust system of trademark protection. Some commentators have argued that strong trademark protection can act as a barrier to entry for potential competitors while giving existent market entrants an advantage by virtue of being first.23 Strong trademark protection can raise the costs to sellers of communicating useful information to consumers. As the Restatement (Third) of Unfair Competition notes, “The extension of trademark protection to packaging and product features can undermine the freedom to copy successful products unprotected by patent or copyright. Such encroachments on the public domain can result in higher prices and decreased access to goods and services. Although these criticisms have not undermined the basic commitment to the protection of trademarks, their influence is evident in the continuing effort to delineate the appropriate scope of protection.”24 Trademark protection, whether of word marks or trade dress, imposes avoidance costs on other producers in the marketplace, who must design their own trademarks and trade dress to avoid infringement. Third parties trying to fulfill their duties of avoidance must not just figure out the contexts in which they cannot use a protected mark; 23 

24 

See, e.g., Carter (1990). Restatement (3d) of Unfair Competition § 9, cmt. c (1995).

 

230   CLARISA LONG they must also figure out the contours of what they must avoid. Put another way, other sellers in the marketplace need to define protected marks in order to avoid infringement. The higher the definition costs of the mark, the more costly it becomes to avoid the mark. Concerns about the costs of trademarks can help explain why marks are not allowed to be “warehoused,” and instead must be used on goods in commerce in order to be valid.25 If trademark holders were allowed to stockpile trademarks they were not using in commerce and claim exclusionary rights to them, the avoidance costs to competitors would be positive but the benefits to consumers would be zero. Unlike a patent, a trademark does not have to be registered with the Patent and Trademark Office in order to receive protection. But registration confers several advantages on a trademark registrant, such as putting third parties nationwide on constructive notice of ownership of the mark.26 Registration has the advantage to other sellers of lowering their avoidance costs, since they can search a single source to determine which trademarks not to use for their own products. Trade dress generally presents higher definition costs to trademark holders and third parties alike than do word marks. In recent years, the types of product features that can qualify as protectable trade dress has expanded to include source identifiers, such as product configuration, product design, and product ambience, that often have higher definition costs than traditional pictorial or literary marks. Trademarks composed of words, logos, and pictures can be defined fairly readily by a simple representation on paper. Product design, configuration, and ambience, by contrast, often require descriptions that are more detailed to convey the concept of the trademark. Trade dress is also more likely to remain unregistered than word marks. Why is this? Consider the following example. Pepperidge Farm uses the word GOLDFISH as a trademark for its fish-​shaped cracker.27 It also uses the appearance of the cracker as trade dress. The word GOLDFISH is registered as a trademark with the US Trademark Office, whereas the appearance of the fish-​shaped cracker is not. Registration is one reason that makes the existence and boundaries of the trademark easier for third parties to define than the trade dress of the cracker. Even if the word GOLDFISH were not registered, however, the boundaries of the trademark GOLDFISH would be easy to figure out just by looking at the mark: they are the letters G-​O-​L-​D-​F-​I-​S-​H. Depending on the circumstances, consumers might be confused by misspellings like “Goldfisch,” but even so, there is not much room to expand or contract the zone of protection surrounding the mark. There are several reasons that the boundaries of trademark protection for the cracker’s appearance are more malleable and harder for third parties to define than the contours

25 

Lanham Act § 45, 15 U.S.C. § 1127 (2012). See 15 U.S.C. § 1072 (2012) (stating that federal registration of mark provides constructive notice of ownership). 27  See Reg. No. 0739118 (1962) (GOLDFISH). 26 

 

TRADEMARKS AND UNFAIR COMPETITION    231 of protection for the mark itself. It’s not clear which features of the cracker consumers are using as a source identifier, or whether consumers are using the appearance of the cracker as a source identifier at all. The source-​identifying features could be shape, size, texture, color, smell, flavor, or some combination of these, but competitors in the marketplace cannot be sure, at least not before litigation. Pepperidge Farm’s refusal to register the elements of the cracker that it considers its trade dress means that it has chosen not to commit itself to a definition in advance of a lawsuit. Pepperidge Farm itself may not know what elements of the appearance of the cracker it considers the protected trade dress until a competitor comes along with a similar product. At that point Pepperidge Farm has the incentive to claim that the definition of its protected trade dress maps onto whatever the competitor is doing.28 This helps explain why the owners of trade dress have incentives not to register the trade dress for which they seek protection. The disadvantages of failing to register are often outweighed by the benefits of non-​registration. By refraining from registering trade dress such as product appearance, trademark owners retain the ability to expand and contract the definition of their mark.

9.3.  The Rise and Rise of Trademark Dilution Law If one long-​standing justification for the legal protection of trademarks is that they serve as a source identifier that benefits consumers, another justification for trademark law has arisen more recently. This justification states that producers invest time, energy, and effort into creating positive associations in consumers’ minds about their products. Providing legal protection for trademarks allows producers to reap the benefits of creating goodwill among consumers.29 Over time, consumers can be expected to form opinions about the products they consume or encounter and by extension about the trademarks associated with these products. Such opinions can influence their future purchasing decisions about products associated with the trademark. If consumers’ opinions are positive, trademark holders stand to reap the benefit, but this requires trademark holders being able to control the way in which the mark is used. Conferring on trademark holders the power to exclude third parties from nonconfusing uses of the marks allows mark owners to reap the benefits of their investment in the attributes of the product. 28 

See, e.g., Nabisco, Inc. v PF Brands, Inc., 191 F.3d 208, 218 (2d Cir. 1999), in which Pepperidge Farm argued successfully that the similarities of color, shape, size, and taste between the appearance of its cracker and the appearance of its competitor’s product (a fish-​shaped cracker that appeared as part of a mix of crackers labeled CATDOG) constituted the elements of its protected trade dress whereas the differences (the baker’s markings on each cracker and mix of crackers in the package) did not. 29  The existence of dilution law, in both the United States and the European Union, can be traced back to an article written by Professor Frank I. Schechter (1927, 813).

 

232   CLARISA LONG Before the inclusion of dilution in the trademark statute, the owner of a mark could recover for trademark infringement under the Lanham Act only if the commercial use of its mark by another seller in the marketplace caused consumer confusion. Under its dilution provisions, the Lanham Act protects “[t]‌he owner of a famous mark … against another person who, at any time after the owner’s mark has become famous, commences use of a mark or trade name in commerce that is likely to cause dilution by blurring or tarnishment of the famous mark.”30 Dilution law is a departure from the traditional justification of trademark law, and one that has sparked no small amount of commentary. Commentators have described dilution law as “a fundamental shift in the nature of trademark protection.”31 Judge Richard Posner has worried about dilution’s “seductive appeal.”32

9.3.1. Trademarks and Good Will Dilution law is producer-​focused rather than consumer-​focused, even though some commentators have argued that dilution law is geared toward protecting consumers because the use of a mark by more than one producer increases consumers’ search costs.33 Dilution law seeks to prevent diminution in the value of a famous mark if that mark is used by someone other than the trademark holder.34 The underlying assumption of a dilution theory of trademark law is that even when consumers are not confused by the use of the mark, the unauthorized use of a famous mark by other producers in the marketplace can diminish the mark’s value because it is no longer associated with a single source. Dilution is a more exclusionary variant of the trademark entitlement than the classic likelihood-​of-​confusion form. Because classic trademark law requires consumers to be confused about the source of goods before a defendant could be held liable, it is more nuanced and contextual than dilution law is, which does not ask about consumer confusion. But that does not mean that dilution law is easier to define. There are two variants of trademark dilution, which is an indication that the existence of trademark dilution can be hard to identify. These two variants are dilution by blurring and dilution by tarnishment.35

9.3.1.1. The Definitions of Dilution: Blurring and Tarnishment Blurring is the use of a famous mark by another producer in the marketplace to identify a different product in a way that weakens the connection in consumers’ minds between 30 

15 U.S.C. § 1125(c)(1) (2012). Lemley (1999, 1687, 1698). 32  Posner (2003, 621, 623). 33  See, e.g., Dogan and Lemley (2005, 461, 493) (“[P]‌roperly understood, dilution is targeted at reducing consumer search costs, just as traditional trademark law is.”). 34  What the literature customarily refers to as “dilution law” is technically antidilution law. 35  See 15 U.S.C. § 1125(c)(1) (2012) (setting forth the two forms of dilution). 31 

 

TRADEMARKS AND UNFAIR COMPETITION    233 the mark and the original product, even when the defendant’s use does not create confusion among consumers as to source.36 Dilution by blurring is statutorily defined as “association arising from the similarity between a mark or trade name and a famous mark that impairs the distinctiveness of the famous mark.”37 Blurring can occur when a third party uses a famous mark to identify its own product in a nonderogatory way. One example is the use of the mark TIFFANY as the name of a restaurant.38 Let us assume that the restaurant is upscale, so that tarnishment by association with low-​quality goods is not a problem. Consumers are not likely to confuse the restaurant with the jewelry store, but nonetheless the same mark is now being used on two very different consumption items: restaurant services and jewelry. This arguably increases the cognitive costs to consumers of keeping the products separate. Tarnishment, by contrast, is defined as “association arising from the similarity between a mark or trade name and a famous mark that harms the reputation of the famous mark.”39 Tarnishment can “occur where the effect of the defendant’s unauthorized use is to dilute by tarnishing or degrading positive associations of the mark and thus, to harm the reputation of the mark,” and often involves using the mark to cast aspersions on the mark holder.40 A tarnishment theory of dilution law is used to justify protection of goodwill against association with an unwholesome product, such as pornography or illegal drugs.41 Among trademark plaintiffs, tarnishment as a theory of dilution has tended to be less popular than blurring has.42 Similarly, when courts have granted recovery on dilution claims, they usually have done so on grounds of blurring rather than tarnishment, although it is not always easy to distinguish between the two definitions of dilution.43 Because the actions that give rise to tarnishment claims, such as critical or derogatory uses of a trademark, often have free speech implications, it is important for courts to take this into consideration when adjudicating a dilution claim.

9.3.1.2. Some Boundaries on Dilution Law Dilution law represents a fundamentally different approach to trademark law than the more traditional likelihood of confusion variant. Like other theories of trademark protection, however, dilution law has various boundaries that limit its scope.

36 

See McCarthy (2005), (defining blurring). 15 U.S.C. § 1125(c)(2)(B) (2012). 38  See, e.g., Ty Inc. v Perryman, 306 F.3d 509, 511 (7th Cir. 2002). 39  15 U.S.C. § 1125(c)(2)(C) (2012). 40  See McCarthy (2005) (defining tarnishment). 41  See, e.g., Anheuser-​Busch Inc. v Andy’s Sportswear Inc., 40 U.S.P.Q.2d 1542, 1543 (N.D. Cal. 1996) (holding that “Buttwiser” T-​shirts tarnished BUDWEISER mark); Coca-​Cola Co. v Gemini Rising, Inc., 346 F. Supp. 1183, 1188 (E.D.N.Y. 1972) (finding that “Enjoy Cocaine” posters tarnished ENJOY COCA-​COLA mark). 42  See Long (2006, 1029). 43 See Ty Inc., 306 F.3d at 511 (“Analytically [tarnishment] is a subset of blurring.”). 37 

 

234   CLARISA LONG One boundary placed on dilution law is that the mark must be famous.44 This fits with the justification of dilution law being a means of protecting the goodwill with which a trademark holder has attempted to imbue its mark. Although the definition of “fame” is itself someone malleable, fame can serve as proxy for goodwill. Moreover, the remedy is limited only to injunctive relief unless the defendant has behaved willfully, in which case it can include damages.45 Another limitation exempts several types of uses by defendants from liability. Generally, these uses have speech implications. If trademark holders were allowed to enjoin truthful criticism or discussion of their trademarks by others, this could create social costs by allowing famous mark holders to control truthful speech. Thus federal dilution law creates exceptions from liability for comparative advertising by competitors using the trademark, for descriptive use of the mark that does not constitute a source identifier, for media use of the trademark, and for noncommercial use of the mark.46 Like a likelihood-​of-​confusion theory of trademark infringement, dilution law only requires that plaintiffs prove a likelihood of dilution.47 Since dilution of a mark can take more than one form, asking plaintiffs to prove a mere likelihood of dilution reduces the burden of proof on plaintiffs, but it is not clear that having such a loose proof requirement makes the entitlement more clear. Even with these boundaries, dilution law has expanded beyond its original narrow origins.48 The loosening and expansion of dilution law by, for example, shifting from a standard that required proof of actual dilution to one that required plaintiffs to prove a mere likelihood of dilution has caused one commentator to describe the dilution form of protection as ‘bloated.’49

9.3.2. The Costs and Benefits of Trademark Dilution Law Justification of dilution law on the ground that it allows holders of famous marks to recover for their investment in the good will surrounding the mark is consistent with traditional explanations for intellectual property protection in other areas, such as patent and copyright law. Viewed this way, famous marks with positive consumer associations are a classic public good. The cost of creating a public good is high, but once the 44 

See 15 U.S.C. § 1125(c)(2)(A) (2012) (listing some considerations for determining the fame of a mark for dilution purposes). 45  See 15 U.S.C. § 1125(c)(5) (2012). 46  See 15 U.S.C. § 1125(c)(3) (2012). 47  See 15 U.S.C. §1125 (c)(1) (2012). 48  See Schechter (1927, 813, 828–​31), (proposing a form of dilution law limited to conflicts between identical marks, where the plaintiff ’s mark was not only famous but also arbitrary and where the defendant’s use of the mark was on noncompeting and nonsimilar goods). 49  McCarthy (2005) (stating, “It is my belief that the present state of antidilution law has been bloated far out of proportion to its original purpose and intent.”).

 

TRADEMARKS AND UNFAIR COMPETITION    235 public good is created, the cost to third parties of using it is low.50 Without some form of protection, the reasoning goes, creators of famous marks will not be able adequately to internalize the benefits of the goodwill they have created and will therefore underproduce such marks. Legal protection allows creators of famous marks a greater opportunity to police the use of the mark, prevent third parties from free riding, and thereby enjoy the profits associated with their marks.51 In order for this type of protection to be efficient, however, sellers would need to be incentivized to produce marks with positive goodwill and would not invest sufficiently in creating famous trademarks without protection. Dilution law, if improperly applied, presents the possibility of social cost, so the net benefits of allowing trademark holders the kind of control over their marks that dilution law does must be weighed against the net social costs. Dilution law may create a net social cost, for example, if the net avoidance costs incurred by third parties attempting to avoid the mark exceed the value of the goodwill reaped by the mark holder. Let us consider the costs and benefits to trademark holders when third parties use a mark on their own goods without authorization. The costs to the trademark holder could be positive, zero, or even negative if the trademark holder is benefited by the third-​party use, such as if the third-​party use made the legitimate trademark holder’s goods more desirable. An example of a positive cost to a trademark holder occurs when unauthorized third-​party use of a trademark diverts sales away from the trademark holder toward a cheaper product bearing a counterfeit mark. If the counterfeit product is of lower quality than the authorized product, the mark holder may suffer a cost because consumer perceptions of the trademark are diminished. By contrast, a famous trademark holder may be benefited by another producer’s unauthorized use of the mark if the use gives the mark more airtime in front of consumers.52 Although statistically unlikely, it is possible if the factor driving a mark’s value is the quantity rather than the quality of publicity the mark receives. Producer goodwill is most likely to be damaged in the case of tarnishment of the mark, but this is not always the case. The social welfare calculus surrounding allegedly tarnishing uses is nuanced. Third-​party uses of a mark that trademark holders believe are tarnishing to the mark may in fact have positive social value. Nonconfusing use of a mark by unauthorized third parties for purposes of criticism, social commentary, parody, or other speech-​related purposes can have net positive social benefits that outweigh the harm to the trademark holder. As a result, dilution law explicitly excludes comparative commercial advertising, news reporting, and news commentary from liability of actionable 50 

See Arrow (1962, 609, 614–​16), (describing the public goods phenomenon as related to patented goods) and Lemley (1997, 989, 995–​96), (describing the intellectual property and public goods problem). 51  See Franklyn (2004, 117), (arguing that US dilution law “really is about preventing free-​riding on famous marks.”). 52  See, e.g., Dreamwerks Prod. Group, Inc. v SKG Studio, 142 F.3d 1127, 1129 (9th Cir. 1998) (discussing possibility, in likelihood of confusion context, that harm to a plaintiff trademark holder might be “somehow offset by any extra goodwill plaintiff may inadvertently reap as a result of the confusion between its mark and that of the defendant”).

 

236   CLARISA LONG harm.53 Nonetheless, it is important for courts to police the boundary carefully to assure that claims of harm by tarnishment do not shut down free speech. If trademark holders were allowed to silence parodic or critical speech involving their mark under the guise of tarnishment, the result could be a net social loss. The case for producer goodwill being diminished when blurring occurs is harder to make. What is not clear is whether the benefits to consumers of dilution law translate into benefits for trademark holders. Under a likelihood-​of-​confusion standard, for instance, trademark holders and consumers alike benefit from consumers not being confused by the source of a good. But dilution can occur in the absence of consumer confusion. How is a trademark holder benefited by limitations on the use of the mark by third parties when consumers are not confused? Or put another way, if there is no consumer confusion or tarnishment of the mark, has a trademark holder been harmed when consumers associate its mark with more than one source or product? One could say that when consumers must share their attention between two sources or products associated with the same mark, such as a restaurant named TIFFANY and a famous jewelry store of the same name, they will thus devote less attention to the jewelry store. But should producers have an entitlement to consumers’ attention span? And if so, are producers injured when consumers don’t pay them the attention the producer feels they deserve? As a result, some scholars have argued that the only appropriate justification for dilution law is preventing harm to consumers.54 On this view, dilution by blurring should be enjoined only if the blurring imposes higher search costs on consumers.55 Blurring may harm consumers, so protecting them from blurring may be beneficial. Commentators have argued that blurring can harm consumers by increasing search costs because it requires consumers to devote more mental energy to evaluating the context in which the mark is being used.56 Indeed, there is empirical evidence that blurring of a famous mark can increase consumer search costs.57 One example of harm to consumers from blurring occurs when the use of TIFFANY for a restaurant increases consumers’ cognitive costs in distinguishing the use of TIFFANY for the jewelry store. If it really is the case that the use of the same mark by two different parties on unrelated goods in the marketplace increases consumers’ search costs, then dilution law can be justified on consumer protection grounds. Otherwise, the case for protection against blurring is ambiguous from an efficiency perspective.

53

  See 15 U.S.C. § 1125(c)(3)(A)–​(C) (2012). See Dogan and Lemley (2004, 777, 790–​91) (“[D]‌ilution—​at least as properly understood—​turns on injury to the informative value of a mark.” [footnote omitted]). 55  See, e.g., Klerman (2006, 1759, 1766–​67), (arguing that if the use of the same trademark on two different products does not increase search costs, there is no harm). 56  See O’Rourke (1998, 277, 306–​07, and n.114) (“Dilution by blurring is concerned with preventing the erosion of the distinctiveness of the mark because of its use on non-​related products. The ‘noise’ that this creates around the mark may increase consumer search costs.”). 57  See, e.g., Morrin and Jacoby (2000, 265, 274), (showing that even when consumers correctly matched trademarks with products, they took longer to do so if a mark was associated with more than one product). 54 

 

TRADEMARKS AND UNFAIR COMPETITION    237

9.4. Conclusion The culmination of trademark law in the form of protection again dilution represents completion of a full circle of development of unfair competition law. From its start as a means of protecting merchants’ entitlement to custom, unfair competition law and its subsidiary, trademark law, have evolved in several stages: first as a primitive common law means of regulating markets in the absence of antitrust law, then as a means of protecting consumers in an era when consumer protection law was not as robust as it later became, and finally to encompass a cause of action that allows protection for reasons similar to those contained in the original justification.

References 15 U.S.C. § 1072 (2012). 15 U.S.C. § 1125(c)(1) (2012). 15 U.S.C. § 1125(c)(2)(A) (2012). 15 U.S.C. § 1125(c)(5) (2012). 15 U.S.C. § 1125(c)(2)(B) (2012). 15 U.S.C. § 1125(c)(2)(C) (2012). 15 U.S.C. § 1125(c)(3) (2012). 15 U.S.C. § 1125(c)(3)(A)–​(C) (2012). Anheuser-​Busch Inc. v Andy’s Sportswear Inc., 40 U.S.P.Q.2d 1542, 1543 (N.D. Cal. 1996). Arrow, Kenneth J. 1962. “Economic Welfare and the Allocation of Resources for Invention.” In: Richard Nelson, ed., Nat’l Bureau of Econ. Research, The Rate and Direction of Inventive Activity: Economic and Social Factors. pp. 609, 614–​16. Beebe, Barton. 2004. “The Semiotic Analysis of Trademark Law.” UCLA Law Review 51, p. 621. Carter, Stephen L. 1990. The Trouble with Trademark.” Yale Law Review 99, pp. 759, 770. Clarke, 17 U.S.P.Q.2d (BNA) 1238, 1238 (T.T.A.B. 1990). Coca-​Cola Co. v Gemini Rising, Inc., 346 F. Supp. 1183, 1188 (E.D.N.Y. 1972). Dogan, Stacey L. and Lemley, Mark A. 2004. Trademarks and Consumer Search Costs on the Internet. Houston Law Review 41, pp. 777, 790–​791. Dogan, Stacey L. and Lemley, Mark A. 2005. “The Merchandising Right: Fragile Theory or Fait Accompli?” Emory Law Journal 54, pp. 461, 493. Dreamwerks Prod. Group, Inc. v SKG Studio, 142 F.3d 1127, 1129 (9th Cir. 1998). Easterbrook, Frank H. “Foreword: The Court and the Economic System.” Harvard Law Review 98(4), pp. 21–​22. Economides, Nicholas S. 1988. “The Economics of Trademarks.” Trademark Rep 78, p. 523. Franklyn, David J. 2004. “Debunking Dilution Doctrine: Toward A Coherent Theory of the Anti-​Free-​Rider Principle in American Trademark Law.” Hastings Law Journal 56, p. 117. Gen. Elec. Broad. Co., 199 U.S.P.Q. (BNA) 560, 563 (T.T.A.B. 1978). Graham v John Deere Co., 383 U.S. 1, 9 (1965). In re Babies Beat, Inc., 13 U.S.P.Q.2d (BNA) 1729 (T.T.A.B. 1990). In re Clarke, 17 U.S.P.Q. (BNA) 1238 (T.T.A.B. 1990).

 

238   CLARISA LONG In re General Electric Broadcasting Co., 199 U.S.P.Q. (BNA) 560, 563 (T.T.A.B. 1978). Inwood Lab. v Ives Lab., 456 U.S. 844, 850 n.10 (1982). Klerman, Daniel. 2006. “Trademark Dilution, Search Costs, and Naked Licensing.” Fordham Law Review 74, 1759, 1766–​1767. Landes, William M. and Posner, Richard A. 1987. “Trademark Law: An Economic Perspective.” JL & Econ 30, p. 265. Landes, William M. and Posner, Richard A. 2003. The Economic Structure of Intellectual Property Law. New York: Nicholas Thompson. 117, n. 51. Lemley, Mark A. 1997. “The Economics of Improvement in Intellectual Property Law.” Texas Law Review 75, pp. 989, 995–​996. Lemley, Mark A. 1999. “The Modern Lanham Act and the Death of Common Sense.” Yale Law Journal 108, pp. 1687, 1698. Leval, Pierre N. 2004. “Trademark: Champion of Free Speech.” Columbia Journal of Law & Arts 27, pp. 187, 198. Long, Clarisa. 2006. “Dilution.” Columbia Law Review 106, p. 1029 15. Lunney, Glynn S. Jr., 1999. “Trademark Monopolies.” Emory Law Journal 48, pp. 367, 417. Machlup, Fritz. 1958. An Economic Review of the Patent System, Study No 15, Subcommittee on Patents, Trademarks, and Copyrights of the Senate Committee on the Judiciary, 85th Cong., 2d Sess. 1, 21. McCarthy, J. Thomas. 2005. McCarthy on Trademarks and Unfair Competition § 24:115. 4th ed. Thomas Reuters Westlaw. Morrin, Maureen and Jacoby, Jacob. 2000. “Trademark Dilution: Empirical Measures for a Concept.” J Pub Pol’y & Marketing 19, pp. 265, 274. Nabisco, Inc. v PF Brands, Inc., 191 F.3d 208, 218 (2d Cir. 1999). O’Rourke, Maureen A. 1998. “Defining the Limits of Free-​Riding in Cyberspace: Trademark Liability for Metatagging.” Gonzaga Law Review 33, 277, 306–​307, n.114. Pagliero v Wallace China Co., 198 F.2d 339, 343–​44 (9th Cir. 1952). Plasticolor Molded Prods. v Ford Motor Co., 713 F. Supp. 1329, 1335 (C.D. Cal. 1989). Posner, Richard A. 2003. “Misappropriation: A Dirge.” Houston Law Review 40, pp. 621, 623. Publ’ns Int’l, Ltd. v Landoll, Inc., 164 F.3d 337, 342 (7th Cir. 1998). Qualitex Co. v Jacobson Prods. Co., 514 U.S. 159, 162, 164–​65 (1995). Reg. No. 0739118 (1962). Restatement (3d) of Unfair Competition § 9, cmt. c (1995). Schechter, Frank I. 1927. “The Rational Basis of Trademark Protection.” Harvard Law Review 40, p. 813. Thumin, Frederick J. 1962. “Identification of Cola Beverages.” Journal of Applied Psychology 46, pp. 358, 358–​359. Two Pesos, Inc. v Taco Cabana, Inc., 505 U.S. 763, 767 (1992). Ty Inc. v Perryman, 306 F.3d 509, 511 (7th Cir. 2002). U.S. Const. Art. I, § 8, cl. 8. Valu Engineering, Inc. v Rexnord Corp., 278 F.3d 1268 (Fed. Cir. 2002).

 

Chapter 10

L AW AND EC ONOMI C S OF INFORM AT I ON Tim Wu

Information is an extremely complex phenomenon not fully understood by any branch of learning, yet one of enormous importance to contemporary economics, science, and technology (Gleick 2011; Pierce 1980). Beginning in the 1970s, economists and legal scholars, relying on a simplified “public good” model of information, have constructed an impressively extensive body of scholarship devoted to the relationship between law and information. The public good model tends to justify law, such as the intellectual property laws or various forms of securities regulation that seek to incentivize the production of information or its broader dissemination. A review of the last several decades of scholarship based on the public good model suggests the following two trends. First, scholars have extended the public good model of information to an ever-​increasing number of fields where law and information intersect. An incomplete list of fields covered includes intellectual property, securities regulation, financial regulation, contract theory, financial regulation, consumer protection, communications, and the study of free speech. While scholars in all of these fields are interested in information, they tend to focus on different market failures and different properties of information. Generally, scholars of intellectual property have focused on problems of underproduction—​the concern that, absent government intervention, less than optimal amounts of information will be produced. In contrast, scholars in other fields, like securities regulation or consumer protection, analyze the dissemination of information, or “information asymmetries”—​failures to distribute information in an optimal fashion. Second, over the last decade, scholars have sharply questioned the simplified model, and asked whether, in practice, information actually has the characteristics of a public good. The public good model of information relies on two purported qualities: (1) that information tends to be difficult or impossible to exclude others from, and (2) that its consumption does not eliminate its value for others. The first assumption, in particular, has undergone considerable attack; a closer look suggests that context, subject matter,

 

240   TIM WU and industry structure tend to yield great variation in how much intervention really is required to ensure adequate production or dissemination. This tends to support the existence of dynamic legal regimes attuned to differences in subject matter or perhaps industry structure. The review closes by asking if the public good model, while well established and relatively easy to understand, ought really be the exclusive focus of the economic and legal understanding of information. The article closes by considering other, less investigated, but potentially important, properties of information that have not received as much scholarly attention.

10.1.  Information’s Peculiar Characteristics Information is a complex abstraction that has been the subject of intense study by scientists and philosophers for more than a century. It remains incompletely understood: some physicists, for example, believe that every particle and force in the universe might actually be best understood as a form of information (Wheeler 1990). In the sciences, a minimal, though not-​uncontested definition of information defines it “as one or more statements or facts that are received by a human and that have some form of worth to the recipient” (Losee 1998). What are the economic properties of this abstraction? Economists and legal scholars have generally been uninterested in the scientist’s concept of information and instead more captivated by the premise that information is a “public good.” Stated otherwise, the economic and legal scholarship has sought to analyze information as a member of a category of goods first described in modern times by Mill (1848) as those that require public intervention to ensure an adequate supply. If Mill (1848) did not invent the model, he certainly popularized it. His most famous example of a public good was the lighthouse: something from which all benefited, but might be unwilling to pay for privately. Other classic examples of public goods include a strong national defense, clean air, and so on, and Mill may have seeded the current treatment of information by describing knowledge as follows. “The cultivation of speculative knowledge” wrote Mill, “though one of the most useful of all employments, is a service rendered to a community collectively, not individually, and one consequently for which it is, primâ facie, reasonable that the community collectively should pay.” In the 20th century, Paul Samuelson (1954) stated Mill’s idea more precisely by describing a public good as what he called a “collective consumption good.” According to Samuelson, the category included those goods which” … all enjoy in common in the sense that each individual’s consumption of such a good leads to no subtractions from any other individual’s consumption of that good …” (Samuelson 1954, 1955). Kenneth Arrow (1962) provided one of the first linkages between Samuelson’s concept and

 

LAW AND ECONOMICS OF INFORMATION    241 intellectual property regimes, like patents, by which government intervenes in the market for information.1 By the 1980s, it had become commonplace to link the public good model to government regimes that concerned themselves with information. Meanwhile, from the 1970s onward, the study of “information asymmetries” popularized by George Akerlof and others (notably A. Michael Spence and Joseph E. Stiglitz) has influenced and served as an important complement to the study of information production (Akerlof 1970). The study of asymmetries is essentially concerned with the distribution, as opposed to the creation of information. The basic observation that a suboptimal distribution of information may yield a variety of problems (such as adverse selection, moral hazard, or worse) has influenced most of the writing described here.

10.2.  The Spread of the Public Good Model Today, some version of the public good model of information now dominates analysis of the economics of information production. Among other fields, scholars have applied information-​as-​public-​good arguments to fields as diverse as the regulation of securities, contract, consumer protection laws, communication laws, and constitutional law, among others. However, as we shall see, there are important variations in how the arguments appear in different fields. The use of public good arguments to justify grants of intellectual property has perhaps the longest lineage—​one probably older than the public good model itself. Consider Lord Macaulay’s (1841) famous argument that copyright is a “tax on readers for the purpose of giving a bounty to writers,” justified because it is “desirable that we should have a supply of good books: we cannot have such a supply unless men of letters are liberally remunerated.” But the theory has spread far from its origins in intellectual property. Since the 1980s, a public good theory of information has been used to justify mandating the disclosure of information for consumer or investor protection. “[B]‌ecause information has many characteristics of a public good,” wrote Coffee (1984), “securities research tends to be underprovided.” The related concept of “informational” or “transparency” regulation such as hazard warnings, medical disclosure, and certain forms of campaign finance regulation has been justified using similar concepts.2 Farber (1991) has relied on public good arguments to explain or justify the American First Amendment’s protection of speech. “[I]nformation is likely not only to be underproduced in the private market,” he writes, “but also to be insufficiently protected by the political system.” 1 

“In the absence of special legal protection, the owner cannot … simply sell information on the open market. Any one purchaser can destroy the monopoly, since he can reproduce the information at little or no cost” (Arrow 1962, 609). 2  See, e.g., Fung et al. (2007); Hasen (1996) (media loopholes in campaign finance regulations); Lyndon (1989) (chemical toxicity disclosure); Magat and Viscusi (1992).

 

242   TIM WU In each area, the key theory is that there is a market failure: without state action, important information will either be underproduced or too much will be kept secret from the public. On closer examination, there are actually two different concerns here: underproduction and suboptimal distribution. These, as we shall see, can be more generally tied to two properties of information: nonexclusion and nonrivalry, respectively.

10.3. Underproduction Mill’s (1848) original theory focused on nonexclusion. As he wrote, “it is impossible that the ships at sea which are benefited by a lighthouse, should be made to pay a toll on the occasion of its use.”3 The idea is that if it is difficult or impossible to exclude nonpayers from consuming the good in question, no one will have an incentive to provide the good, justifying public provisioning of the good. Jefferson (1813), writing before Mill, opined similarly that an idea, once divulged, “forces itself into the possession of everyone, and the receiver cannot dispossess himself of it.” In contemporary times, it is commonplace to describe information as “impossible” or “very difficult” from which to exclude anyone.4 It makes sense that a concern about the underproduction of information ought to depend on a concern about nonexcludability. The idea is that if the producer of information cannot exclude nonpayers, he will lack the means to recoup his initial investment, hence eliminating any desire to create information in the first place. If an author invests heavily in writing a book, and then lacks any mechanism to exclude nonpayers, he will be unable to reap the proceeds of his investment later and, therefore, will have no direct financial incentive to write books in the first place (though he might have indirect or personal incentives). More realistically, we might say that if there were no mechanism for excluding nonpayers, then publishers would be unlikely to invest in an author’s work, therefore, making a career as an author difficult to support. The key question then is whether there is something about information that makes it impossible to exclude nonpayers from consuming. A moment’s reflection makes it obvious that in most contexts this premise is cannot be right, at least in its strong form. 3   See also Samuelson (1954). This point was famously challenged by Coase (1974), who established that private lighthouses were funded by port fees. “We may conclude that economists should not use the lighthouse as an example of a service which could only be provided by the government.” 4  See, e.g., Boyle (2003) explaining that “[ideas] are also assumed to be non-​excludable (it is impossible, or at least hard, to stop one unit of the good from satisfying an infinite number of users at zero marginal cost).”; Krawiec (2001) stating that “by labeling informat ion a collective good in this Article, I do not mean to imply that it is literally impossible to exclude nonpurchasers, but rather the slightly weaker condition that such exclusion is extremely difficult.”; Menell (1988) arguing that “as [the National Commission on New Technological Uses of Copyrighted Works] well recognized, the information comprising innovation in application programs is a prime example of a public good. Given the ease and low cost of copying application programs, it is often impossible to exclude nonpurchasers from an application program’s benefits once it is commercially available.”

 

LAW AND ECONOMICS OF INFORMATION    243 Consider the text of a book locked in a vault for which the key is lost: we are all excluded from it. If you don’t have a ticket, you won’t see that movie. The information contained in an engraving written in a lost language, like hieroglyphs before the discovery of the Rosetta stone, is inaccessible to everyone. Two basic ideas from the basic science of information make it clear why the nonexcludability assumption is hard to support. First, information consists of patterns, which must subsist in some physical or electronic form: ink on paper, stored magnetic charges, or whatever else. Second, for a human to process information, that information must reach the brain (unlike, say, national defense, which can be consumed unknowingly), and be in a form that the brain can process. These necessities combine to suggest one can exclude others from information. Why, then, have so many thinkers insisted that information has the “property” of nonexcludability? What writers like Jefferson (1813) or Mill (1848) seem to have meant by nonexcludability seems to be something meant at a high level of abstraction, really a property of knowledge or wisdom more than information. For example, one might be the beneficiary of the Christian injunction to “love thy neighbor as thyself ” without ever hearing the phrase. Similarly, you might enjoy the comforts of air-​conditioning without having read any of the original patents. But this is different from being a property of information. Alternatively, sometimes what is meant by the “nonexcludability” of information is really the idea that it is cheap to copy information. Since the invention of the printing press, and especially since digitalization, copying information is usually far cheaper than creating valuable information. This point can also be expressed by saying that information goods have a high initial and low marginal cost of production. The fact that nonexcludability is not some intrinsic quality of information, but a technological contingency, is a challenge for the intellectual property laws. Breyer (1970) noticed as much when he argued that copyright is hard to justify given the existence of alternative means of exclusion, such as the “lead time” enjoyed by the first publisher of a book.5 Breyer’s argument has been criticized for its technological naiveté (the piece presumed, for example, that software would be hard to copy), but the central insight seems correct; namely, when copying is expensive, the case for government intervention weakens. That’s why, for example, the later Picasso never suffered from a lack of financial incentives to paint, because only he could create a Picasso. The prospect of non-​legal mechanisms of exclusion is what Sprigman and Rastiala (2012) rely on in their study of creative industries, such as fashion, cooking, and stand-​up comedy, which seem to prosper without intellectual property. In each, the industry devises its own means of exclusion, which seem good enough to incentivize production. Moglen (2003) argues that since non-​market mechanisms yield sufficient information production, the actual effect 5  “A copying publisher, faced with the problems of ‘lead time’ and ‘retaliation’ is unlikely to see much profit in copying low-​volume titles. It seems unlikely, for example, that a publisher thinking of copying the type of tradebook that now sells about 4000 copies, would count on selling the 2000 or more copies needed to earn a profit” (Breyer 1970, 301).

 

244   TIM WU of the creation of exclusionary rights in information is merely a giant wealth transfer from the proletariat to the bourgeoisie.6 Nowadays most scholars hedge their bets by describing exclusion as partially nonexcludable, “hard” to exclude people from, or by drawing a line between private and public information.7 Some scholars, such as Christopher Yoo, Amy Kapczynski, and Talha Syed argue that nonexcludability shouldn’t be considered a defining feature of information at all. Yoo (2007) suggested that the costs of exclusion depend on the technological context of consumption, rather than any inherent characteristic of information.8 Hence, it may be very expensive to exclude the ships that benefit from a lighthouse, but that is irrelevant to whether people without tickets may be kept out of a movie theater on opening night. Consequently, Yoo argues that information should be understood an “impure” public good, yielding policy outcomes different from the pure public goods assumption.9 Kapczynski and Syed (2013) argue that excludability is: highly variable across information goods, and is affected not only by formal legal entitlements, but also by existing technologies for detecting or tracing such uses (and their costs); existing social norms regarding ‘acceptable’ or ‘reasonable’ enforcement efforts (in light of concerns about privacy, freedom of thought and speech, and so forth); and the existing institutions—​or social roles, relations, and organizational forms—​within which the predominant uses of the good will be made.

The weakness of the nonexcludability assumption cannot be said to have destroyed the case for intellectual property or other forms of government action. Defenders of the intellectual property regimes have attempted to justify intellectual property by relying on several alternative theories. First, one might rely not on the assumption of nonexcludability, but, as stated previously, the empirical observation that it is, in today’s technological context, usually 6  “Creators of knowledge, technology, and culture discover that they no longer require the structure of production based on ownership and the structure of distribution based on coercion of payment. Association, and its anarchist model of propertyless production, makes possible the creation of free software, through which creators gain control of the technology of further production” (34). See also Breyer (1970, 289), explaining, “we do not ordinarily create or modify property rights, nor even award compensation, solely on the basis of labor expended.” 7  Benkler (2000), in a typical example, writes, “Information is generally understood to be perfectly nonrival and partially nonexcludable.” 8  “Indeed, it has long been recognized that exclusion is typically possible, with the costs of exclusion depending on the state of technology” (Yoo 2007, 659). Yoo attributes this point to Bator (1958) (describing how nonappropriability can cause market failure). 9  Yoo’s (2007) argument is more complex than captured by this sentence. More specifically, he believes that Samuelson’s theory of public goods does not depend on nonrivalry and nonexcludability, but rather, a condition whereby consumers consume the same quantity of the good and signal their preferences by prices, the inverse of the situation with private goods. Yoo believes that this incentivizes users of a public good to understate their true willingness to pay, in the hopes that others will bear the costs of creating that good (670).

 

LAW AND ECONOMICS OF INFORMATION    245 cheaper to copy information than create it in the first place. Whether low marginal costs of production are intrinsic to information or simply a matter of technological context is an interesting one and not subject to easy answer. In the days when monks copied bibles by hand, copying costs were perhaps comparable to the costs of creating the work in the first place. However, ever since the invention of the printing press, copying information has tended to be cheaper than producing it, which is an explanation for the appearance of the earliest copyright laws in that era. In any event, the low marginal cost of production for informational goods creates a free-​riding argument. Represented in accounts by Palmer (1989), among others,10 the argument asserted that the production of information would naturally create, within groups, either problems of collective action or a “tragedy of the commons.” Given an incentive to copy information and thereby free ride on the production efforts of others, none will be incentivized to produce information, therefore yielding less production than might be ideal. This argument depends not on the impossibility of excluding consumers but rather the low costs of copying in certain contexts, as just discussed (Palmer 1989). Second, some scholars justify the existence of government enforcement of intellectual property rights by stressing the costs of the alternatives. The creators of information tend to regard it as theirs, and want to protect it. When private parties rely on private remedies, those remedies may themselves be quite socially expensive. Consider that real property can be defended by its owners using fences and armed guards, yet government grants exclusion rights in land, whether to encourage investment or to facilitate the development of markets. In the Hobbesian sense, the legal system may be a less wasteful alternative to private exclusion schemes: for example, if it displaces expensive warfare between information producers and their copiers (Kovarsky 2006). This scholarship tends to allude to the costs of “races” of various kinds, including “arms races” between copiers and creators. “The existence of a cost-​effective self-​help remedy,” argues Lichtman (2004), should not always preclude “government regulation as a means to accomplish similar ends.” In another example in the scholarship, Hemphill and Suk (2009) argue that in the fashion industry an inability to exclude copiers creates a reliance on “logoification.” That, they argue, “pull[s]‌fashion toward a status-​conferring function and away from the communication of diverse messages.” Third, intellectual property has sometimes been separately justified by what might be described as a Demsetzian theory. The idea is that group use of a given resource, like information, will create externalities of various sorts that should be internalized by property rights. For example, Kitch (1977), in a famous paper, argued that patent ought to give out broad “prospects”—​that is, a patent covering the initial invention and subsequent inventions as well. Otherwise, Kitch argued the owner might lack incentives to make further investments in research beyond the initial invention in research for fear that the benefits will be appropriated by others.

10 

See also Kitch (1977); Dam (1999); Kieff (2001).

 

246   TIM WU Kitch’s idea has faced criticism too voluminous to summarize. Lemley’s (2004) criticism is typical, and it echoes earlier papers by Rose (2003), Gordon (1992), and others.11 Lemley (2004), as in his other work, relies on the nature of information; it “cannot be depleted,” he wrote, and therefore is not subject to a tragedy of the commons or the negative externalities that justify real property rights. Rather, by its very nature, the tendency was for the creation of information to throw off positive externalities, such as the example of the multiple beneficiaries of the invention of the steam engine. Compensation for positive externalities, or spillovers, Lemley argued in this and other works,12 should almost never be the subject of government intervention (Frischmann and Lemley 2007). “If ‘free riding’ means merely obtaining a benefit from another’s investment, the law does not, cannot, and should not prohibit it” (Lemley 2005, 1049).13 Fourth and finally, where the public good model doesn’t strongly justify intervention, it is certainly possible government may have entirely different goals in mind unrelated to the economics of information. For example, a strong copyright or patent regime may be understood as a subsidy for the entertainment or pharmaceutical industries. As such, the law might really draw little justification from the economics of information, but rather be better described as such by a form of industrial policy, or perhaps a component of a “strategic trade policy.” Such laws might also be understood as a form of political patronage. If nothing more, a generation of scholarship on the existence of private exclusion mechanisms should force any contemporary policy maker to consider the comparative efficiency of private and public reward schemes for the production of information products, along with due consideration of the choice among public alternatives. That point is central to Raustiala and Sprigman’s (2012) work on alternatives, and Benkler’s description of alternative means of information production. It has also lead to a flourishing body of literature, including contributions by Steven Shavell and Tangay van Ypersele (2001) among others, examining the potential of reward systems as an alternative to patent for incentivizing product research.14

10.4.  Information Distribution Problems Problems of information distribution, or “underdissemination,” form a problem distinct from underproduction. Here, the problem can be phrased as follows. Markets and 11  Rose (2003, 90) wrote that the case for property rights is inherently weaker in what she labeled “intellectual space” because “there is no physical resource to be ruined by overuse. Books, tapes, and words may be copied, inventions may be imitated, pictures may be reproduced all without the slightest damage to the original.” 12  “Such intervention may be unnecessary and in fact may lead to welfare-​reducing distortions.” Frischmann and Lemley (2007, 299–​300). 13  See also Gordon (1992, 167), noting, “a culture could not exist if all free riding were prohibited within it.” 14  See also Abramowicz (2003). Benkler (2006), similarly, suggests that there may be alternative private models of producing valuable information that depend on what he terms “peer production” models.

 

LAW AND ECONOMICS OF INFORMATION    247 other systems involving human decisions, such as elections, require a certain amount of information to function well and may require that the information be distributed symmetrically among buyers and sellers (or their equivalents). Where information is scarce, or if distributed asymmetrically, systemic failure can be expected. By metaphor, information may act like oil in an engine, and if insufficient, or poorly distributed, the engine may seize. While some quantity of information is disseminated naturally, so to speak, the idea that natural sources will be inadequate tends to support some forms of public or private intervention to ensure enough information is disseminated to keep things running smoothly. As described previously, the problem of information distribution was a focus of the information asymmetry literature that originated in the 1970s. Among that literature’s first prominent area of legal relevance was the analysis of capital markets. In 1984, law professors Gilson and Kraakman (1984) theorized that the distribution of information was a key determinant of capital market efficiency. Hence, institutions (like investment banks) capable of reducing the costs of obtaining information, and thereby making information more widespread, increased the efficiency of the capital markets. Writing in the same year, Coffee (1984) argued that the need for investors to have adequate information to make investment decisions justified the existence of regulations requiring disclosure of financial information. The argument that a market needs information in order to function efficiently has subsequently been used to justify the existence of quasi-​ private institutions like credit rating organizations.15 But capital markets are not the only systems that require adequate and well-​distributed information to function well. Markets for consumer goods and services do as well, yielding theoretical support for interventions like consumer warnings, the publication of nutritional information,16 or the consumer protection requirement that information on labels be generally accurate (Fung et al. 2007; Magat and Viscusi 1992; Sage 1999; Sunstein 1999). Meanwhile, in the regulation of banks, the markets for money claims has been said to depend on the maintenance of symmetric ignorance (Judge 2016). Non-​market systems, like the political system or elections, also require information to function well, which may justify various measures, such as the prohibition of political censorship in the First Amendment (Farber 1991). The extent to which the need for better distribution of information justifies government intervention depends, of course, on whether the private mechanisms of distribution are adequate. This question is very hard to answer in the abstract. Gilson and Kraakman (1984) theorized that the “distribution of a particular piece of information is a function of its cost,” by which they meant the cost of acquiring it or perhaps of producing it. They suggested that private mechanisms, such as investment banks, might aid the distribution of information but they did not make clear when such mechanisms might 15  See, e.g., White (2002, 43–​44), but see Fitzpatrick, IV and Sagers (2009), who question whether CROs can be justified by information-​production or disseminating role. 16  See, e.g., Valuck (2004), discussing the need for government intervention in the provision of information about dietary supplements. More broadly, see Magat and Viscusi (1992)

 

248   TIM WU be adequate. It is also true that markets themselves are, as Fitzpatrick and Sagers (2009) put it, “machines for generating information,” and many financial economists have long supposed that markets generate enough information to generate accurate prices without much intervention. On the other hand, it is obvious that there is much important information that one cannot expect to be widely distributed without any public intervention. Some might be simply too expensive to be worth producing (such as census information), creating the underproduction problem described herein. Alternatively, there are forms of information where the parties who hold it have good reason to hide it. Companies might want to hide their true revenues and profits, or the fact that a product is defective or causes disease. In these sorts of situations, scholars and government have suggested public action is necessary. While the literatures centered on information asymmetries and the previous discussion of underproduction are authored by different groups of scholars, a moment’s analysis reveals that they rely on the same conceptual framework, and ultimately the same observations about information itself. Asymmetries are typically assumed to result from some initial allocation of information that is expensive to overcome. Another way to express the same point is to suggest that high information prices cause problems (Frischmann 2009). But what might make problems of distribution of information different than any other good or commodity? The differences lie in the key concept of “nonrivalry,” which is the link between the information asymmetry literature and the public good scholarship. The concept is simply that consumption of information does not reduce its utility for others. Your reading of my book doesn’t “use it up” the same way that eating my sandwich does. This concept is expressed by economists in various ways, including the idea that information is “infinite in supply,” or experiences “jointness of consumption.” In mathematic models, nonrivalry is captured by the assumption of zero marginal cost of production. Perhaps reflecting its slightly mysterious quality, legal writers have often employed parables or analogies to capture the concept of nonrivalry. Lemley (1997) writes, “if I give you a fish, I no longer have it, but if I teach you to fish, you or I can teach a hundred others the same skill without appreciably reducing its value.”17 Perhaps the most famous parable in the intellectual property tradition is Jefferson’s (1813) analogy to fire and air. “He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me.” Therefore, ideas are “like fire, expansible over all space, without lessening their density in any point, and like the air in which we breathe, move, and have our physical being, incapable of confinement or exclusive appropriation.” Jefferson took this to mean that private rights in

17  See also Goldstein (1994, 12) “A loaf of bread, once eaten, is gone. But ‘Oh, Pretty Woman,’ once sung and heard, is still available for someone else to sing and to hear. Countless fans can listen to the song, indeed copy it, without diminishing its availability to anyone else who wants to sing or listen to or copy it.”

 

LAW AND ECONOMICS OF INFORMATION    249 ideas cannot be justified “[i]‌f nature has made any one thing less susceptible than all others of exclusive property, it is the action of the thinking power called an idea.” Copyright’s fair use doctrine, while sometimes said to overcome failures of bargaining, has sometimes been justified by what is, on closer inspection, the solution to a distributional problem. Provided the producer is unaffected, or not unduly affected, the nonrivalrous nature of information suggests the public should want others to use the information at a price approaching zero. The famous Sony Corp. of America v. Universal City Studio, Inc. (1984) decision, which held legal the home taping of TV shows for later viewing, is easily viewed as the solution to an underuse problem. If the home taping did not actually deplete or affect the value of the television shows, there was no good reason not to allow it. In that case, might say the court set the price at zero. The analogies to fish and fire notwithstanding, it is worth asking, as we did with nonexcludability, does information actually have the characteristics of nonrivalry? In its purest form, this concept would presume that one’s usage of information would have no effect on another’s, that “a unit of the good can be consumed by one individual without detracting, in the slightest, from the consumption opportunities still available to others from that same unit” (Cornes and Sandler 1996). To use a common example, it seems implausible that one person’s use of a stop sign would change that experience for someone else. Some scholars believe that information’s nonrivalry is incontestable, as a matter of physics rather than law or economics. “The degree to which a good is or is not rivalrous is a fact of nature,” writes Benkler (2000), “a thing either does, or does not have this unusual attribute that, once produced, many can enjoy it without added cost.” But others argue that information, like private goods, might in fact sometimes be “overgrazed” or suffer from congestion, like a parcel of land or a highway (Magliocca 2001). The trademark laws, which employ concepts like blurring, tarnishing, and dilution, seems to contemplate this possibility, and Posner and Landes (2003) so asserted explicitly. They argued that excessive use of an image of Humphrey Bogart, for example, over time might cause “confusion, the tarnishing of the image, or sheer boredom … [e]‌ventually the image might become worthless.” Turning to the well-​known character of Mickey Mouse, Posner and Landes argued that the character might similarly become overgrazed without proper management: “not only would the public rapidly tire of Mickey Mouse, but his image would be blurred, as some authors portrayed him as a Casanova, others as catmeat, others as an animal-​rights advocate, still others as the henpecked husband of Minnie.” Posner and Landes’s (2003) assertion has gained a few adherents,18 but it has also been subject to sharp criticism (Yoo 2007; Lemley 2004). Such congestion arguments, argued Mark Lemley (2004), “misunderstand[] the nature of information,” which “cannot be depleted.” Christopher Yoo (2007) argues that the Posner and Landes argument is hard to sustain beyond the particular examples of celebrity images or characters, which have an unusual economics all of their own. Yoo accepts the possibility of congestion, but 18  Barnes (2011, 553) seeks to extend the concept as follows: “analytically, it is useful to distinguish between the simple ‘over-​reproduction’ type of overuse that causes the public to tire of the image and ‘transformative’ overuse that blurs the image.”

 

250   TIM WU notes that usage of information will not predictably decrease its value; moreover, if there are congestion externalities, says Yoo, they might be either technological or pecuniary; and if the latter, the policy implications become highly ambiguous. Examples make clear that congestion problems or overgrazing concerns are certainly not present for all forms of information. (This is a point Landes and Posner (2003) concede by alluding to Shakespeare’s works, which “seem undiminished by the proliferation of performances and derivative works, some of them kitsch[.]‌”) Strictly speaking, Landes and Posner were writing about copyrighted works, which are a subset of information; but consider a useful piece of information such as the circumference of the earth. While clearly a form of valuable information, how it might be used up or tarnished is unclear. Even if made to serve as a central plot element in a bad romantic comedy, the number (40,075 km) would retain its value and remain useful to others. What does seem to be potentially subject to dilution or tarnishing is not the information itself, but something like the reputation attached to the information, which seems an analytically distinct category. The idea that underusage is a problem also depends on information actually being nonrivalrous, or infinite in supply, not just as an ideal object, but as a market reality—​ how often is the information itself actually the relevant good? Nachbar (2007) argues that for many purposes, it is other economic factors with which policy should concern itself. “Intellectual works” he states, “do not exist except as the product of human labor, which is itself the subject of considerable rivalry.” For example, in the case International New Service v. Associated Press (1918), as Nachbar (2007) explains, it may have been true that the information taken from one news service by another was a public good. However, the court, according to Nachbar, was not concerned with the unusual properties of information, but with competition for profit as between the two news services. His point is that esoteric questions about the nature of information, such as those just considered at length here, can often be irrelevant for many markets. * * * We can here summarize the current state of understanding. Information is widely agreed to have unusual properties as compared with physical resources, chief among which are some measure of nonrivalry, nonexclusivity, and a low marginal cost of production. These properties have been used both to justify specialized legal regimes designed either to overcome underproduction and asymmetry problems. The extent of all of these properties is contested, both as a matter of theory and of market reality, or is said to be context dependent. This tends to suggest that the case for laws governing information is difficult to state generally, and may vary widely by industry, context, or the means of production involved. While describing information as a public good provides a simple justification for government intervention, as Coase (1974) famously pointed out with respect to lighthouses, the reality is often far more complex (there were, in fact, private lighthouses). This might lend support to the idea, for example, that the subject matter of copyright and patent might be better served by rules that are adjusted by an ongoing judicial process, rather than being subject to blanket rules. In areas outside of intellectual property,

 

LAW AND ECONOMICS OF INFORMATION    251 it similarly suggests that regulators ought to pay careful attention to determine whether, in fact, the information they wish to see disclosed requires intervention, and how effectively consumers will really make use of the information. Meanwhile, a continuing problem for regulators lies in dealing with informational asymmetries as a class. For while most government interventions seek to get more information “out there,” an asymmetry is not necessarily cured by interventions designed to increase the production of information, for unless the information gets into the right hands, it may in fact worsen the problem. It is also curious that, given the myriad properties of information, nonexcludability and nonrivalry have received so much attention. One may be suspicious that the attention is prompted by how neatly this model fits into the pre-​existing concept of a public good more than the underlying realities of what properties information holds. In any event, it is worth suggesting that lawyers’ or economists’ understanding of information’s properties might be broader and might begin to draw less on just anecdotal examples but more on the study of the science of information. It may turn out that information’s other less-​studied properties will be equally important for public policy. Consider, for example, the question of what effect usage has on the market value of information. While the question has not been well studied, two views are implied by the literature: namely the “overgrazing” view that information necessarily degrades or is tarnished by usage, and its rejoinder that usage cannot have any effect on the value of information. Neither seems to be correct, and the relationship between usage and value may in fact be more complicated than first appears. It is interesting to notice that many suppliers in the information economy devote themselves to trying to convince the public to consume information, and will even sometimes pay them to do so. The idea of the “attention economy” refers to concentrated efforts by suppliers not to avoid the usage of their information but to encourage it to the broadest extent possible—​captured by the desire to see information “go viral” and reach millions of users. This is not a new phenomenon: record labels have long wanted their music to play on the radio, and have long been willing to pay radio stations to, in effect, give away their product for free. If information were predictably subject to overgrazing, this would be a terrible idea; similarly, if information’s value could not possibly be affected by usage, why try so hard to get people to consume it? Something is missing. There exist several potential explanations for the phenomenon. Some theorists describe a certain class of informational goods that gets more valuable with usage. They are what Sunstein and Ullmann-​Margalit (2001) call “solidarity goods”:  goods that increase in value with joint consumption. As the authors write, “Solidarity goods have more value to the extent that other people are enjoying them.” While solidarity goods are not exclusively informational, many of Sunstein and Ullmann-​Margalit’s examples are forms of information. “The value of a magazine or television program focusing on a current topic (genetic engineering of food, e.g.) may increase significantly if many other people watch or read them.” This suggests that, rather than trying to discourage usage of some information, the owner of the information has some incentive to increase consumption of the information in question and to maximize the value of the good.

 

252   TIM WU The theory of solidarity goods also seems an incomplete explanation. It does not explain, for example, the intuition that a song may become more valuable by repeated play to even a single consumer, regardless of any group effects. Another and perhaps more obvious explanation is that one seeks to push information out for free as a form of advertising. Advertising, at least in Galbraith’s (1958) account, is a tool for creating demand, and, by this theory, the song is played to create demand for itself. But that doesn’t tell us enough: the usual definition of the word advertising is something that “calls attention to goods for sale.” It seems a different matter when information generates demand for itself and, therefore, by usage, increases its own value. Watching the exploits of a copyrighted character like Iron Man on the screen or page may generate an insatiable appetite for more Iron Man. By establishing itself in the minds of consumers in this way, information can become incredibly valuable, in part, because it can then be used to draw consumers to still other objects by an attention merchant.19 A different theory suggests that we are approaching the problem incorrectly, for someone listening to a “free” song or watching a “free” video is actually paying for it, not in units of money, but in human attention, a different scarce resource. By this measure, deciding to spend time with any information should be seen as an expenditure, dissolving the apparent paradox. In the law, trademark is best acquainted with this dynamic. With its doctrines of blurring, tarnishment, and dilution, trademark seems to recognize that certain uses of information might reduce the value of information, or its reputation. On the other hand, firms pay millions to have their brands announced during sporting events, or placed in Times Square to be consumed by millions without payment, or even to have the brand mocked or portrayed in strange circumstances, so long as there is exposure (consider the prominent role played by FedEx in the film Cast Away). The result of such mass exposure is rarely degradation, but rather, the creation of brands, which are easily the most valuable form of intellectual property. In any event, understanding these mechanisms is one of many ways we might better understand the information economy and its regulation. It might entail trying to understand better the competition for cognitive space and attention that is so central to the information economy.

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LAW AND ECONOMICS OF INFORMATION    253 Arrow, Kenneth J. 1962. “Economic Welfare and the Allocation of Resources for Invention.” In:  National Bureau of Economic Research, The Rate and Direction of Inventive Activity: Economic and Social Factors. Princeton NJ: Princeton University Press. 609–​626. Barnes, W. David. 2011. “Congestible Intellectual Property and Impure Public Goods.” Northwestern Journal of Technology and Intellectual Property 9, pp. 533–​563. Bator, Francis M. 1958. “The Anatomy of Market Failure.” Quarterly Journal of Economics 72, pp. 351–​379. Benkler, Yochai. 2000. “An Unhurried View of Private Ordering in Informational Transactions.” Vanderbilt Law Review 53, pp. 2063–​2080. Benkler, Yochai. 2006. The Wealth of Networks. New Haven, CT: Yale University Press. Boyle, James. 2003. “The Second Enclosure Movement and the Construction of the Public Domain.” Law and Contemporary Problems 66, pp. 33–​74. Breyer, Stephen. 1970. “The Uneasy Case for Copyright:  A  Study of Copyright in Books, Photocopies, and Computer Programs.” Harvard Law Review 84, pp. 281–​351. Coase, Ronald. 1974. “The Lighthouse in Economics.” Journal of Law and Economics 17, pp. 357–​376. Coffee, John. C., Jr. 1984. “Market Failure and the Economic Case for a Mandatory Disclosure System.” Virginia Law Review 70, pp. 717–​753. Cornes, Richard and Sandler, Todd. 1996. The Theory of Externalities, Public Goods, and Club Goods. Cambridge, MA: Cambridge University Press. Dam, Kenneth W. 1999. “Self-​ Help in the Digital Jungle.” Journal of Legal Studies 28, pp. 393–​412. Evans, David S. 2013. Attention Rivalry among Online Platforms. University of Chicago Institute for Law & Economics Online Research Paper No. 627. Farber, Daniel A. 1991. “Free Speech without Romance:  Public Choice and the First Amendment.” Harvard Law Review 105, pp. 554–​583. Fitzpatrick, Thomas J. IV, and Sagers, Chris. 2009. “Faith Based Financial Regulation: A Primer on Oversight of Credit Rating Organizations.” Administrative Law Review 61, pp. 557–​610. Frischmann, Brett M. 2009. “The Pull of Patents.” Fordham Law Review 77, pp. 2143–​2167. Frischmann, Brett M. and Lemley, Mark A. 2007. “Spillovers.” Columbia Law Review 107, pp. 257–​302. Fung, Archon, Graham, Mary, and Weil, David. 2007. Full Disclosure: The Perils and Promise of Transparency. New York: Cambridge University Press. Galbraith, John K. 1958. The Affluent Society. Boston, MA: Houghton Mifflin Harcourt. Gilson, Ronald J. and Kraakman, Reinier H. 1984. “The Mechanisms of Market Efficiency.” Virginia Law Review 70, pp. 549–​644. Gleick, James, 2011. The Information: A History, a Theory, a Flood. New York: Pantheon Books. Goldstein, Paul. 1994. Copyright’s Highway:  from Gutenberg to the Celestial Jukebox. New York: Hill and Wang. Gordon, Wendy. 1992. “On Owning Information: Intellectual Property and the Restitutionary Impulse.” Virginia Law Review 78, pp. 149–​282. Hasen, Richard L. 1996. “Clipping Coupons for Democracy:  An Egalitarian/​Public Choice Defense of Campaign Finance Vouchers.” California Law Review 84, pp. 1–​59. Hemphill, C. Scott and Suk, Jeannie. 2009. “The Law, Culture, and Economics of Fashion.” Stanford Law Review 61, pp. 1147–​1200. International New Service v. Associated Press, 248 U.S. 215 (1918).

 

254   TIM WU Jefferson, Thomas. 1813. “Letter to Isaac McPherson, Monticello, August 13 1813.” In: Andrew Adgate Lipscomb, ed., The Writings of Thomas Jefferson. Washington, DC: Thomas Jefferson Memorial Association of the United States. Judge, Kathryn. 2016. “Information Gaps and Shadow Banking.” Draft, 2016, on file with author. Kapczynski, Amy and Syed, Talha. 2013. “The Continuum of Excludability and the Limits of Patents.” Yale Law Journal 122, pp. 1900–​1963. Kieff, F. Scott. 2001. “Property Rights and Property Rules for Commercializing Inventions.” Minnesota Law Review 85, pp. 697–​754. Kitch, Edmund. 1977. “The Nature and Function of the Patent System.” Journal of Law and Economics 20, pp. 265–​290. Kovarsky, Lee. 2006. “A Technological Theory of the Arms Race.” Indiana Law Journal 81, pp. 917–​970. Krawiec, Kimberly D. 2001. “Fairness Efficiency, and Insider Trading: Deconstructing the Coin of the Realm in the Information Age.” Northwestern University Law Review 95, pp. 443–​503. Landes, William M. and Posner, Richard A. 2003. “Indefinitely Renewable Copyright.” University of Chicago Law Review 70, pp. 471–​518. Lemley, Mark A. 1997. “The Economics of Improvement in Intellectual Property Law.” Texas Law Review 75, pp. 989–​1084. Lemley, Mark A. 2004. “Ex Ante versus Ex Post Justifications for Intellectual Property.” University of Chicago Law Review 71, pp. 129–​150. Lemley, Mark A. 2005. “Property, Intellectual Property, and Free Riding.” Texas Law Review 83, pp. 1031–​1076. Lichtman, Douglas. 2004. How the Law Responds to Self-​Help. John M. Olin Law & Economics Working Paper No. 232, University of Chicago Law School. Losee, Robert. 1998. “A Discipline Independent Definition of Information.” Journal of American Social Information Science 48, pp. 254–​269. Lyndon, Mary L. 1989. “Information Economics and Chemical Toxicity: Designing Laws to Produce and Use Data.” Michigan Law Review 87, pp. 1795–​1861. Macaulay, Lord Thomas Babington. 1841. “Speech Delivered in the House of Commons.” Magat, Wesley A. and Viscusi, W. Kip. 1992. Informational Approaches to Regulation. Cambridge, MA: The MIT Press. Magliocca, Gerard N. 2001. “One and Inseparable: Dilution and Infringement in Trademark Law.” Minnesota Law Review 85, pp. 949–​1036. Menell, Peter S. 1988. “An Analysis of the Scope of Copyright Protection for Application Programs.” Stanford Law Review 41, pp. 1045–​1104. Mill, John Stuart. 1848. Principles of Political Economy with Some of Their Applications to Social Philosophy. London: John W. Parker, West Strand. Moglen, Eben. 2003. The dotCommunist Manifesto. http://​emoglen.law.columbia.edu/​my_​ pubs/​dcm.pdf [Accessed 21 August 2016]. Nachbar, Thomas B. 2007. “The Comedy of the Market.” Columbia Journal of Law & the Arts 30, pp. 453–​466. Palmer, Tom G. 1989. “Intellectual Property: A Non-​Posnerian Law and Economics Approach.” Hamline Law Review 12, pp. 261–​304. Pierce, John, 1980. An Introduction to Information Theory:  Symbols, Signals and Noise. New York: Dover Publications.

 

LAW AND ECONOMICS OF INFORMATION    255 Raustiala, Kal and Sprigman, Christopher. 2012. The Knockoff Economy: How Imitation Sparks Innovation. New York: Oxford University Press. Rose, Carol M. 2003. “Romans, Roads, and Romantic Creators: Traditions of Public Property in the Information Age.” Law and Contemporary Problems 66, pp. 89–​110. Sage, William M. 1999. “Regulating Through Information:  Disclosure Laws and American Health Care.” Columbia Law Review 99, pp. 1701–​1829. Samuelson, Paul A. 1954. “The Pure Theory of Public Expenditure.” Review of Economics and Statistics 36, pp. 387–​389. Samuelson, Paul A. 1955. “Diagrammatic Exposition of a Theory of Public Expenditure.” Review of Economics and Statistics 37, pp. 350–​356. Shavell, Steven and van Ypersele, Tangay. 2001. “Rewards versus Intellectual Property Rights.” Journal of Law & Economics 44, pp. 525–​547. Sony Corp. of America v Universal City Studio, Inc., 464 U.S. 417 (1984). Sunstein, Cass R. 1999. “Informational Regulation and Informational Standing:  Akins and Beyond.” University of Pennsylvania Law Review 147, pp. 613–​674. Sunstein, Cass R. and Ullmann-​Margalit, Edna. 2001. “Political Goods.” Journal Political Philosophy 9, pp. 129–​149. Valuck, Tom. 2004. “Keeping Dietary Supplement Regulations Slim and Fit: Finding a Healthy Balance between Paternalism and Consumer Choice.” Georgetown Journal of Law & Public Policy 2, pp. 285–​314. Wheeler, John Archibald. 1990. “Information, Physics, Quantum:  The Search for Links.” In: Wojciech H. Zurek, ed., Complexity, Entropy, and the Physics of Information. Boulder, CO: Westview Press. White, Lawrence J. 2002. “The Credit Rating Industry: An Industrial Organization Analysis.” In: Richard M. Levich et al., eds., Ratings, Rating Agencies, and the Global Financial System. New York: Springer Publishing Company. 41–​63. Yoo, Christopher S. 2007. “Copyright and Public Good Economics:  A  Misunderstood Relation.” University of Pennsylvania Law Review 155, pp. 635–​7 15.

 

Chapter 11

OPEN-​A CCESS AND INFORMATION COMMONS Yochai Benkler

Open-​access commons are a family of institutional arrangements that are far more pervasive in modern complex economies than usually recognized in the economic literature. Core resources necessary for communications, innovation, trade, transportation, and energy are managed based on symmetric use privileges open to all, deploying nondiscriminatory allocation based on queuing where congestion occurs, rather than on exclusive proprietary control used to achieve price clearance. Highways, roads, sidewalks, navigable waterways, and open squares are central to intercity and urban commerce. The public domain in knowledge, data, information, and culture forms the foundation of innovation, markets, and creativity. Open standards, the core Internet protocols, unlicensed wireless spectrum, and the privately created open-​access commons in Free and Open Source Software (FOSS) runs most Internet infrastructure. More ambiguously, common carriage and public utilities that characterize basic infrastructures for energy and wired communications exhibit full or partial characteristics of open-​access commons. The defining characteristic of open-​access commons, by comparison to property, whether individual or collective, is their utilization of (a) symmetric use privileges for (b) an open, undefined set of users in the general public, rather than (a′) asymmetric exclusive control rights located in the hands of (b′) an individual legal entity or defined group (club) use, and (c) their primary reliance on queuing and some form of governance-​based allocation, rather than (c′) price-​cleared models, for congestion-​clearance and management. Far from being necessarily less efficient or unsustainable, for substantial classes of resources, we have observed many critical resources migrating from provisioning based on a reasonably well-​developed market in private exclusive rights to open-​access commons. These migrations have not occurred through regulatory intervention, but rather through private actions of users and producers. Carol Rose documented this transition in roads and squares in the nineteenth century;1 and it was 1 

See Rose (1986).

 

OPEN-ACCESS AND INFORMATION COMMONS    257 the case of open-​access Internet, which displaced proprietary services like CompuServe and Prodigy, in Wi-​Fi and similar open-​access wireless commons, which now carry the majority of wireless data communications despite early dominance of proprietary wireless carriage; it has been the case in software, where FOSS, in competition with proprietary substitutes, now accounts for much of the basic software for using the Internet; and it is developing in diverse models of open-​access publication, both in “net native” sites like Wikipedia and many hundreds of thousands of lesser forums, and in more traditional publication sectors, primarily in the scientific and educational fields. Despite their ubiquity, an apparently critical role in the growth-​critical domains of innovation, transportation, and infrastructures, and competitive successes in modern economies, little economic theory addresses itself to the emergence and resilience of open-​access commons. The baseline assumption is, instead, that open-​access commons are tragic:2 rational actors pursuing their self-​interest under an open-​access regime will suffer congestion and disinvestment. Public goods theory explains state or public ownership of some classes of resources—​like lighthouses. These resources are still owned as property, usually by the government or a publicly created body, and access to them may be open, where they are strictly nonrivalrous, as with lighthouses or national security, or may be allocated by some other mechanism of public decision making, whether democratic or authoritarian, rational or corrupt. We have theories for group ownership of certain resources, initially club goods theory,3 and more recently prominent, the Ostrom School of commons theory.4 Both theoretical approaches, however, require exclusion of nonmembers or noncommoners from the resource set owned as a club or a participants in the common property regime. A defining feature of both theories is that, by their own terms, they would converge with standard economic theory in predicting that, for example, open-​access wireless spectrum would fail, and certainly underperform a market in spectrum clearance rights. Yet, over the past 15 years, Wi-​Fi and similar open-​ spectrum approaches have outpaced property-​like wireless carriage and now carry the majority of data communications. They would similarly predict that a protocol capable of auctioning or otherwise prioritizing clearance slots for congestible data-​carriage networks such as IBM’s Token Ring for local area networks or some network protocols that competed with the Internet protocol would be more efficient and would outperform protocols based on a simple first-​come, first-​served protocol, with no limitations on who can use the system, such as Ethernet or the Internet Protocol, TCP/​IP. Yet the history of network technology in the past 30 years has seen protocols based on an open-​ access commons model of management (Ethernet and TCP/​IP) outcompete protocols able to achieve price clearance, and gain dominance as the core standards of network communications.

2 

See Hardin (1968, 1244–​1245). See Buchanan (1965, 1–​14); Olson (1965); Berglas (1976, 116–​121). See, generally, Cornes and Sandler (1996). 4  See Ostrom (1990). 3 

 

258   YOCHAI BENKLER Section 11.1 of this chapter offers a brief overview of the commons literature, emphasizing the distinction between Ostrom commons and open access. Section 11.2 offers thumbnail case studies of the emergence of open-​access commons in the digitally networked environment. The emergence of unlicensed wireless in physical infrastructure space; the rise of TCP/​IP and Ethernet in networking protocol space; the emergence of FOSS; the emergence of commons-​based production of content on the Net, and of open-​ access publishing in scientific and educational materials. Section 11.3 suggests that the emergence of open-​access commons reflects the combined effect of innovation economics under conditions of high uncertainty and the diversity of human motivations (generally studied in economics as a branch of behavioural economics). It concludes with a brief typology of open-​access commons and their proprietary parallels, organized along the dimensions of the models of provisioning the resource and models of governing the resource once provisioned. For all its richness, the work stimulated by the emergence of the Internet over the past quarter century has not yet caused a revision of property theory. This chapter is intended, in part, to help stimulate a reimportation of theory from what we have been learning at the unstable edge, to the core of traditional theory.

11.1.  Two Tales of all Commons: An Intellectual History Garrett Hardin’s parable of the Tragedy of the Commons set the terms of the debate over the commons for the following two generations. Following closely on the heels of Mancur Olson’s Logic of Collective Action, it laid the intellectual foundations for an abiding scepticism about the feasibility of open-​access commons. Resources to which anyone had a right of access would be overused and underinvested. Every extracted unit provided its full benefits to the extractor, while sharing its disinvestment costs with all other potential and future extractors; by contrast, every invested unit imposed its full costs on the investor, but the benefits it produced were shared with all other and future extractors. To avoid overextraction and underinvestment under these conditions, the resource had to be owned and managed—​regulated either by the state or by private owners. Demsetz’s theory of property rights followed these basic insights, arguing that property rights would be introduced as soon as the marginal increase in the value of the resource gained by converting it from commons to property became larger than the transactions costs of creating and maintaining a property regime in the commons.

11.1.1. The Ostrom School Two schools of work on the commons developed in response to this baseline story. The first, anchored in the work of Elinor and Vincent Ostrom at the Workshop in Political

 

OPEN-ACCESS AND INFORMATION COMMONS    259 Theory and Policy Analysis at Indiana University was primarily a response to Olson. Over decades of painstaking field research, the Ostrom School showed that groups could solve the problems of collective action without relying on the state for either of the two then-​dominant models: directly regulating behaviour or defining and enforcing private property rights. The work emphasized detailed studies of a carefully delineated set of institutions—​limited common property regimes (CPRs)—​applicable to a carefully defined class of physical resources:  common-​pool resources.5 Using highly context-​specific, detail-​rich case studies of these settings, under the Institutional Analysis and Development (IAD) framework Elinor Ostrom developed,6 and abstracting from them to the mainstream game theory and public choice theory, Ostrom was able to carve out a distinct and robust field that had enormous real-​world implications for development policy. It played a critical role as a major intellectual critique of the dominant model that privileged property rights as the core solution to collective action problems.7 CPRs range from the lobster gangs of Maine,8 through Spanish irrigation districts,9 to Japanese fisheries.10 CPRs are not open-​access commons. Indeed, Ostrom insisted on “the difference between property regimes that are open-​access, where no one has the legal right to exclude anyone from using a resource, and common property, where members of a clearly defined group have a bundle of legal rights including the right to exclude nonmembers from using that resource.”11 This definition would exclude congestible open commons like roads and highways, Wi-​Fi, or the Internet. The Ostrom School focused not on open access, but on the fact that groups could solve their collective actions problems without the state or exclusive property as among the members of the group. Nowhere is this clearer than in Ostrom’s description of the irrigation districts in Alicante, which used a CPR-​specific system of tradeable, divisible scrip-​ denoted rights in fractions of minutes of water. Such a fluid market was “a commons” in Ostrom’s framework, because it derived from a collectively created, non-​state, non-​ state-​defined-​property system. The critical policy claim of the Ostrom School was that these systems embodied local knowledge, and were superior both to state regula­ tion and standardized property rights systems, in that both of the latter abstracted too greatly from the diverse and distinct features of the resource set governed by the CPR. The primary policy implication was that rationalized modernization programmes, whether implemented as regulatory interventions or state-​sponsored public works, or as “privatization” through parcelling the CPR into individualized property rights, were likely to cause greater disruption and loss of local knowledge

5 

See E. Ostrom (1990). See Elinor Ostrom (2011, 9–​11). 7  See E. Ostrom (1990). 8  See Schlager and E. Ostrom (1992, 249, 257–​259). 9  See E. Ostrom (1990, 69–​82). 10  See Satria, Matsuda, and Sano (2006, 226, 233–​34). 11  See E. Ostrom (1990, 121). 6 

 

260   YOCHAI BENKLER about proper management of the common-​pool resource than leaving the existing CPR in place.12

11.1.2. Open Commons The majority of the work on open commons in the past quarter century has revolved around information and the Internet. But the first work to challenge the idea that open-​access commons were systematically tragic was Carol Rose, The Comedy of the Commons.13 Rose examined common law doctrines under which private property came to be declared open to the public as a whole: where the set of individuals who have the right is open and undefined. She discussed, in particular, roads and navigable waterways, as well as open squares or fields where gatherings (both social and market) were traditional. Rose’s primary explanation was an early version of network economics—​ demand-​side increasing returns to scale made it so that opening these resources to public use substantially increased usage, which, in turn, produced substantial enough positive externalities to dominate congestion costs caused by making the road or navigable waterway an open-​access commons. Most of the work on open commons has occurred in the relatively “easy” case of noncongestible information goods and the public domain, as well as in the “harder” case of congestible network goods: Internet and wireless communications. Information is nonrivalous and partially nonexcludable, which means that to the extent that proprietary mechanisms succeed in reducing the nonexcludability, they systematically lead to underutilization of information relative to optimal (the nonrivalry means the marginal cost of information, once produced, is zero, and any positive price leads to some deadweight loss),14 and because existing information is a core input into the production of new information (e.g., established scientific facts as a basis for new investigation, past innovations leading to new ones, and news reports input into analyses), treating information as property also increases the cost of new information production.15 So much is well established and thoroughly modeled, and it is commonplace that intellectual property sets up a tradeoff between the incentives it creates for innovators and creators through enabling them to extract rents from the products of their investment, and the underutilization of the information by users and second-​ generation information goods producers that result from the nonrivalrous nature of information.16

12 

See Hess and Ostrom (2003) p. 123. See Rose (1986, 778–​780). 14  This has been a standard argument since Nelson (1959). For another discussion of the perverse effect on incentives of open rights to information, see Arrow (1962, 616–​617). 15  See Scotchmer (1991). 16  See Boyle (2008, 17–​41); Lerner (2002, 221–​222). 13 

 

OPEN-ACCESS AND INFORMATION COMMONS    261 In the early 1990s, Litman published an early analysis of how copyright systematically preserved a substantial public domain, by design, as a fundamental resource set for works subject to copyright,17 and Pamela Samuelson investigated the critical role of open access to the incremental development process at the heart of software development.18 Boyle then began to expand this view and locate it in a political economy, framing the tension over property in information, knowledge, and culture as one between producers who depended on access to existing information, such as software developers, journalists, or rap artists, and producers who depended on control over stocks of cultural goods.19 Lemley criticized efforts to strengthen intellectual property rights based on endemic market failures in information production, as well as the “on-​the-​ shoulders-​of-​giants” effect and the significance of positive externalities in innovation,20 and Cohen underscored the unique economics of information to negate the growing use of the analogy of physical property to support stronger intellectual property rights.21 My own work built on these insights and extended them in two ways. First, by analyzing open-​spectrum commons, I expanded the analysis from the domain of strictly nonrival public goods (information, knowledge, and culture) to rival or congestible goods where open innovation effects dominated congestion-​clearance efficiency effects.22 Second, I explained the shared institutional form of the public domain and other open commons in terms of a shift in the institutional foundation of the industrial organization: decentralization of innovation.23 A shift from asymmetric exclusive rights to symmetric use privileges underwrote a decentralization of innovation, creativity, production, and exchange, and thereby permitted greater experimentation and diversity.24 Lessig combined these insights into a broad argument for preserving commons at every layer of the Internet: at the level of physical and logical infrastructures, and the level of the creative content people exchange over it.25 Frischmann then tied the work on Internet, wireless, and information to the work Rose did by developing a more general theory of commons in infrastructure.26 He developed an approach based on demand-​ side failures. Defining “infrastructure” as a broad range of goods that are important in the downstream creation of other goods, particularly in a broad range of public goods and “social goods” like rule of law or basic capabilities that a society’s moral commitments require that everyone have, and which “may be consumed non-​rivalrously for some appreciable range of demand,” Frischmann argued that failures in demand to express the full social value of these infrastructure goods will be systematic, and will 17 

Litman (1990, 965). Samuelson, (1990a, 1025; 1990b, 23). Her work clearly influenced the thinking of leaders in the software developer community: see Garfinkel, Stallman, and Kapor (1991, 50–​53). 19  See Boyle (1996, 174–​184). 20  Lemley (1997, 1049–​1057). 21  See Cohen, (1998, 462–​466). 22  See Benkler (1998, 287–​359; 2002). 23  See Benkler (1998, 1999, 354–​424). 24  See Benkler (2001, 84–​88). 25  See Lessig (Random House 2001, 147–​233). See, also, Benkler (2000, 561). 26  See Frischmann (2005, 917). 18 

 

262   YOCHAI BENKLER systematically lead to underprovisioning of the infrastructure good if left as a private property model.27

11.2.  Open-​Access Emerging in the Presence of Proprietary Alternatives: Cases from the Networked Environment Over the past 25 years, open-​access models repeatedly have emerged and become stable, sometimes dominant, models for provisioning and managing critical segments of all layers of the information environment. The repeated success of these practices suggests that, at a minimum, open-​access commons are more stable and sustainable than the standard tragedy of the commons model permits. The fact that they were chosen by agents in market and social settings rather than through regulatory fiat, and succeeded in terms of market adoption by consumers or firms in the presence of well-​developed proprietary alternatives, suggests further that they provide some affirmative advantages over proprietary or closed-​commons alternatives with which they compete.

11.2.1. Unlicensed Spectrum No core resource in contemporary society better reflects the intellectual and institutional history of thinking about rationalized regulation of public goods, the shift to privatization and price-​cleared markets, and, finally, the emergence of commons, than spectrum regulation.28 Ubiquitous connected computing would simply be impossible without extensive use of wireless communications. From the now-​mundane smartphone to the exotic driverless car, through heart monitors, smart grids, or inventory management and shipping, the major innovations in early twenty-​first century information technology, built on tiny computers embedded in everything, could not develop if they were limited to communicating through wires. From the early 1910s until the 1990s, “spectrum,” the range of frequencies usable for wireless radio communications, was treated as a regulated public good, subject to administrative rationing and regulation. It was the subject of public ownership and funding in most of the world, and the subject of licensing and close federal regulation in the public interest in the United States. For half that period, spectrum regulation was also the subject of a sustained intellectual effort to explain that clear definition of exclusive property rights, initial allocation through 27 

28 

See Frischmann (2012). For a more complete intellectual history with citations, see Benkler (2012b, 76–​100).

 

OPEN-ACCESS AND INFORMATION COMMONS    263 auction, and subsequent allocation through flexible secondary markets would be a far superior alternative to the command and control regulation that was the exclusive model used throughout the world to regulate spectrum. Indeed, it was in developing his argument for spectrum auctions in a 1959 paper entitled the Federal Communications Commission that Ronald Coase first developed the argument that became The Problem of Social Cost a year later. By the early 1990s, the superiority of a property-​in-​spectrum market had become the orthodoxy among economists working on wireless regulation, and the private property approach gained partial acceptance in institutional practice. Over the course of the 1990s, spectrum auctions became the norm, and by the early 2000s, secondary markets, particularly in the United States and Australia, were made substantially more flexible. By the late 1990s, however, a technological alternative had developed that utilized “junk bands” that had been set aside as open-​access commons for the emissions of industrial, scientific, and medical radio signals. In 1998, the precursor to the Wi-​Fi standard was adopted, and in 1999, the first Wi-​Fi standard 802.11b was adopted. Initially treated as a regulatory backwater, and intellectually rejected by mainstream economic thinking on the subject, the unlicensed wireless spectrum drew innovation from a wider range of companies and amateurs than those involved in the proprietary spectrum. Investing in computation-​intensive cooperative architectures to manage congestion, rather than on clearing competing bids for exclusive pricing, the wireless capacity of the unlicensed spectrum began to roughly double every 20 months, roughly parallel to Moore’s Law for computation capacity. By 2012, entire industries that had been projected as major areas of growth for proprietary wireless carriers—​mobile health applications, smart-​grid communications, mobile payments, and inventory management—​had come to be dominated by a range of unlicensed wireless technologies, leaving proprietary spectrum-​ based applications niche markets. Even the most obvious success of cellular proprietary architecture, mobile Internet access data, had come to mix Wi-​Fi and cellular, and, over time, the majority of data, even to smartphones, came to be carried over Wi-​Fi.29 Wi-​Fi and similar bands that have become the predominate infrastructure for wireless data communications are open-​access commons with precisely the characteristics that the tragedy of the commons predicted would lead to tragedy, under conditions that attracted substantial orthodox scholarship that predicted precisely this failure. Reality has gravitated in favour of a true open-​access commons. This outcome was the product of two competing dynamics. One dynamic was that at the margin, an owner of any given slice of spectrum could clear competing uses and deliver more reliable communications capacity in that band. The other dynamic was that an open-​access band permitted any device, manufactured by any manufacturer and deployed by any consumer for any purpose, to be deployed, tried, and adopted or abandoned based on its effectiveness for the task required. In the open-​access bands no entity has exclusive control to regulate who deploys what device where. That openness created a sufficient level of innovation by diverse producers, innovation in using computation or coordination to solve 29 

See Benkler (2012a), for detailed analysis of these sectors.

 

264   YOCHAI BENKLER “noise” and innovation in services and architectures, that it has resulted in greater carrying capacity for the commons than is available in proprietary bands. As a practical matter, the open, decentralized innovation permitted in open-​access spectrum dominated whatever higher efficiency was obtainable from centralizing decisions about allocation and assignment in proprietary bands in most classes of communication. Proprietary bands retain their advantage in certain important types of communications, particularly communications that move very fast and need continuous coverage, but have been overtaken by commons-​based models in most sectors that require wireless data communications capacity.

11.2.2.  TCP/​IP vs. ATM In 1985, TCP/​IP was adopted by the Internet Advisory Board (an informal collection of engineers working on the Internet problem) as the Internet protocol. TCP/​IP is an open-​access commons, in the sense that it treats all packets identically, and requires the developers of end applications to design their applications so they are robust to any likely delay that results from queuing being the congestion management protocol. It developed and was adopted as an informal protocol, by volunteers who claimed no proprietary interest in it, even though there were both proprietary firm-​developed alternatives from IBM and DEC (Digital Equipment Corp.), and formal standard body alternatives, the International Organization for Standardization (ISO) and the International Telecommunications Union (ITU). Most pertinent from our perspective here was the effort, primarily in the 1990s, to develop a protocol that would allow telecommunications carriers to differentiate between packets and provide priority to some packets, which, in turn, would permit price clearance over queuing. The Asynchronous Transmission Protocol (ATM) was touted by telephone companies as the next generation of IP, but in fact failed to outcompete its open-​access competitor. The rate of innovation enabled by the fully open standard, with its commitment to end-​to-​end open innovation outcompeted those applications developed to take advantage of a more controlled set of network resources.30

11.2.3. Free and Open-​Source Software Moving from physical infrastructure and standards to software, the well-​known story of FOSS has served as a poster child for the success of commons-​based strategies for over a decade.31 FOSS reflects a licensing practice that voluntarily “contracts out” of a proprietary regime and instead adopts an open-​access commons. All FOSS licenses create an open-​access regime for the software developed. Anyone can copy the code, modify 30  31 

See van Schewick (2010). See (Benkler 2002); Kelty (2008); Schweick and English (2012).

 

OPEN-ACCESS AND INFORMATION COMMONS    265 it, use it, and redistribute modifications if they so choose. The major division among the various licenses is that some licenses, most prominently the BSD (Berklely Software Distribution) licenses create a simple open-​access regime. The other class, most prominently the GPL (General Public License), imposes a reciprocity condition on the rights of any user who modifies and distributes the software. That is, any modified software under the GPL must be released under the same open-​access terms that the modifier received it. But even the GPL is open access (a) with regard to use, redistribution, and modification for own use; and (b) imposes a nondiscriminatory reciprocity requirement on all, essentially a requirement to reseed the commons as a condition for making certain, more intensive uses of it. It is decidedly not a common property regime that is based on exclusion from the shared resource of all but a defined set of commoners. By the end of the first decade of the twenty-​first century, FOSS had come to account for between 65% and 70% of the web-​server software market; about 80% of server-​side scripting languages; an undocumented but large portion of embedded computing running Linux, as well as forming the kernel of the handheld Android operating system; and accounting for about one third of the web browser market, in the form of Firefox. By one account, about 40% of firms engaged in software development engaged at least in some of their work in FOSS development.32 FOSS has certainly not driven proprietary software development out of the market, but considering that it is based on a development model in which no one exerts exclusive rights over the final project, and about half the people involved in any significant extent are not paid for their contributions, the growth, success, and sheer technical excellence of FOSS defies explanation under traditional models that privilege proprietary and firm-​based development. There are aspects of FOSS that go directly to organization theory, but are beyond the scope of this chapter.33 For our purposes here, it is enough to note that one of the most dynamic, growing areas of innovation and production has seen a wide-​scale, sustained, and effective adoption of an open-​access commons in its core resources, both inputs and outputs, even on the background of a well-​developed property system and a well-​developed set of firms that were developing software on a proprietary model before FOSS burst on the scene as a major organizational and institutional alternative.

11.2.4. Wikipedia and Commons-​Based Peer Production of Content More Generally Paralleling FOSS, Wikipedia is one of the handful of most visited sites on the Internet, and it has established itself as one of the most important general knowledge utilities on the Web. It is edited by thousands of volunteers who manage their affairs internally without contracts, property, or state fiat, and without payment. Its inputs and outputs are all open-​access commons, licensed under a Creative Commons Attribution ShareAlike 32  33 

Lerner and Schankerman (2010). For a review chapter, see Benkler, (2016).

 

266   YOCHAI BENKLER license, which shares its core features with the GPL described previously, applied to cultural creations as opposed to software. Comparative studies over the years have mostly found Wikipedia to be of reasonable quality: imperfect, but not more so than other encyclopedias, including the standard-​setter, Britannica. Studies oriented in particular towards scientific entries found Wikipedia to be reliable. The National Cancer Institute study in 2010 was a particularly powerful example, where Wikipedia articles on various common cancers were found to be of equivalent accuracy, though less user-​friendly and readable, than the National Cancer Institute’s professionally produced explanations for patients.34 In terms of formal institutional framework, Wikipedia is an open-​access commons. Moreover, organizationally and technically, it is designed to permit anyone to edit it, whether they log in as a user or not, although no one is paid to do so. Lacking contract, exclusive property, or fiat, Wikipedia is the most complex and successful instance of large-​scale sustained self-​governance that we have observed on the Net, and quite possibly anywhere. This self-​governance process is best understood through the prism of the IAD and common property regime literature, since while formally there are no constraints on membership, and institutionally there are no exclusive rights, the social practice revolves around a well-​articulated social-​norms structure governing this vast community. For close to a decade, as of this writing, the number of editors who contributed more than five edits per month to Wikipedia in all languages has floated between 75 and 85 thousand, and the number of editors who contributed more than 100 edits per month has floated between 10.5 and 11.5 thousand; the English-​language Wikipedia has about 33% to 40% of those numbers, respectively. By any account, that is a very large number of active contributors who are managed in a complex, vague system of overlapping elements, none of which quite fit any crisp, well-​defined model of governance. As Wales put it, “Wikipedia is not an anarchy, though it has anarchistic features. Wikipedia is not a democracy, though it has democratic features. Wikipedia is not an aristocracy, though it has aristocratic features. Wikipedia is not a monarchy, though it has monarchical features.”35 A particularly insightful analysis of this set of overlapping features is developed in three chapters of Joseph Reagle, Good Faith Collaboration,36 although the work on Wikipedia governance is extensive, and a substantial portion of it is more criti­ cal of one or many aspects of the community’s governance processes and practices.37 While Wikipedia’s position as the leading instance of commons-​based peer production is clear, smaller-​scale projects that rely on open-​access commons for cultural production are legion. Stack Overflow or Quora are likely best known, but Wikia, the company founded by Jimmy Wales to host Wikis, hosts several hundreds of thousands of Wikis. The P2PValue project, funded by the EU, is building a large database of 34 

See Rajagopalan et al. (2010). See Wales (2007). 36  See Reagle (2010, Chap. 4–​6). 37  An excellent bibliography is found in Morell (2011); the volume generally collects a substantial amount of recent work that develops a critique of the more optimistic interpretations of Wikipedia. 35 

 

OPEN-ACCESS AND INFORMATION COMMONS    267 hundreds of case studies of peer production projects.38 Rather than an exception or a quirk, building knowledge bases using commons-​based, rather than proprietary models has become a standard approach in the menu of possible models. Wikipedia and FOSS are the most visible and successful examples of an alternative production model that has developed online: commons-​based peer production.39 The focus of this chapter is on commons, and largely excludes discussion of the economics of distributed innovation or peer production specifically. Briefly, the simplest model of peer production focuses on transactions costs. Social exchange is a transactional framework parallel to price-​cleared, managerial, and government transactional frameworks. The Coasean transactions costs explanation of the firm can then be extended to social transactional frameworks. In particular, where human capabilities and motivations are diverse and therefore hard to specify and contract, where tasks are complex and require diverse forms of human capital and insight, and where resources that could go into an information production task are similarly diverse, and may be possessed by different people, the transactions costs associated with a proprietary information production project—​including contracting both for the necessary information inputs and the necessary human resources, can be very high. Social production allows people to self-​assign, explore a large opportunity space of information resources in the commons and potential collaborators, and get together without the associated contracting costs, and without the monitoring and compensation system costs associated with firm-​based, proprietary production. Where information inputs that are nonrivalrous can be combined with practices that require little capital or capital already in service in households (e.g., computers and communications capacity), and human time that would otherwise be focused on consumption can be refocused on production that treats the tasks as play, social production can emerge as the most efficient model.40 Similarly, collaborative user innovation is particularly effective where communication costs are low and the design task can be rendered modular but would be very expensive if borne by a central actor.41

11.2.5. Open-​Access Publication and Creative Commons Beyond peer production, we are observing substantial efforts to shift practices that, in the past, have emphasized proprietary control to commons-​based models. Academic publication in particular has seen a significant shift towards open-​access publication.42 In some disciplines, most prominently physics and computer science, academic publication is almost exclusively open access. That is, the research outputs published are available under an open-​access license. In other disciplines with more well-​established, 38 See http://​directory.p2pvalue.eu/​home. 39 

See Benkler (2002, 369). See Benkler (2002). 41  See Baldwin and von Hippel (2010). 42  For an extensive review of the history, types, and progression of open access, see Suber (2012). 40 

 

268   YOCHAI BENKLER dominant publishers, most importantly biology and medicine, where the dominance of proprietary publications is difficult to surmount because of the importance of publication in those venues for authors’ professional advancement, open-​access publishing has developed more slowly. Nonetheless, even in these areas, the emergence of the PLoS (Public Library of Science) journals has created a significant venue for high-​quality scientific papers even in the presence of these extremely high-​impact proprietary journals. At the time of this writing, PLoSOne is the largest scientific publisher in the world. Open-​access scholarly communication has its roots in several efforts beginning in a 2000 petition called for by Harold Varmus, Patrick O. Brown, and Michael Eisen, calling on senior scientists to commit to publish only in open-​access journals. In late 2001 early 2002, many of the aspirations of the movement were set in the Budapest Open Access Initiative. The core idea was that scientific publication has never been driven by royalty payments to authors or reviewers, and while the cost of professional production could be significant in some journals, the pricing of journals by publishers reflected monopoly power over access to knowledge that was generated by scientists funded through public and philanthropic funding, who had interest in the widest possible dissemination of their work, rather than high royalties, which they themselves did not enjoy. Over the 15 years of its development, open-​access publication has increased, several major universities have undertaken to have at least the prepublication version of their faculty’s work available in open-​access repositories (often called Green Open Access repositories), and several major government and philanthropic funding agencies have mandated, or at least supported, open-​access publication fees, which go to publishers in lieu of royalties to fund the professional editing aspect of the work while keeping the works available for downloading by anyone, anywhere, free of charge. Of all other forms of successful open-​access practices, open-​access publishing of academic work is the least puzzling. Basic science is a public good that enjoys public and philanthropic funding, and so separates the production price and the consumption price in a way that overcomes some of the standard problems with private provisioning of public goods using proprietary exclusion. Academic scientists likely self-​select because of a preference profile that is happy to trade off money income for a range of nonmonetized desiderata, from status to freedom to be creative. Nonetheless, it offers a valuable example of a practice that is a critical element of growth in market societies that has moved away from an exclusively proprietary model, towards an open-​access model over the past 15 years.

11.2.6. Open-​Access Case Studies: Conclusion In all, the diverse case studies, from spectrum and standards to software, general knowledge, cultural production, and academic publication are intended to underscore the extent to which in the digitally networked information environment we have seen, repeatedly and significantly, the voluntary adoption of open-​access commons-​based practices in the presence of pre-​existing proprietary models. This has happened not

 

OPEN-ACCESS AND INFORMATION COMMONS    269 as holdovers from preindustrialization cultural practices in the global market periphery, but at the heart of the most advanced economic sectors in the most advanced economies.

11.3.  Theories of Commons Open-​access commons are a family of institutional solutions that respond to three practical problems under certain resource conditions. The three practical problems are (a) high persistent positive externalities, of which nonrivalry in information goods is an extreme case; (b) uncertainty, under which exploration trumps appropriation and has its primary impact in innovation; and (c) social disembeddedness, or the risk that markets will drive resource utilization in ways that will lead to social instability or political intervention. This latter set of problems, following from Karl Polanyi’s definition rather than the more recent usage, must await treatment in a different publication, owing to space constraints and placing greater demands on law and economics literature as it stands. Pursuing the former two in a narrower, new institutional economics framework will have to suffice for this chapter. In terms of characteristics of the resource set, open access is most feasible in the case of resources that are either nonrivalrous (information, knowledge, and standards) or partially congestible, with variable loads over time such that for substantial ranges of their operation their use is not congested—​roads, electricity, and spectrum have this characteristic. The extent to which the resource is depleted by use or renewable also contributes to its amenability to open-​access management. The less congestible the resource is, the less benefit is gained from introducing asymmetric excludability except as a solution to initial provisioning. The more prominent the periods of noncongestion in the total utilization range, the less benefit there is for instituting an asymmetric exclusivity regime to clear peak demand periods. The more a partially congestible resource is renewable, like spectrum, the less significant the problem of disinvestment, or cumulative congestion over time, is. The more the resource requires continuous reinvestment, such as with roads or the electricity grid, the more we see members of the open-​access family that are integrated with public provisioning or some other form of payment for use that nonetheless retains the symmetric use privileges but attaches it to use payments. Open access can be required in a society even where all these conditions are absent, where the social implications of exclusion dominate the efficiency concerns of nonexclusion. Emergency room care is an obvious example. As Kapczynski and Syed have shown, there are classes of rules of intellectual property best explained by this form of deep nonexcludability.43

43 

See Kapzcynski and Syed (2013, 1900).

 

270   YOCHAI BENKLER

11.3.1. Positive Externalities Beginning with Rose’s Comedy of the Commons, which explored the emergence of open-​access commons in roads and navigable waterways as a function of the positive returns to scale that travel provided a growing continental commercial system,44 a core explanation of the emergence and success of open-​access commons has been their utility in providing the resources necessary to support high positive externality activities. Frischmann then emphasized these “spillovers” as central to a wider range of “infrastructure” goods.45 Information goods are a particular subset of this problem, in that (a) the nonrivalry means that efforts to internalize the positive externalities by creating enough exclusivity to support appropriation through charging a price will necessarily result in deadweight loss;46 and (b) high exclusion leads to higher costs for downstream innovators or creators, because of the “shoulders of giants” effect (innovation is both input and output of its production; proprietary exclusion therefore increases both costs and expected benefits). As a result, the property-​like solutions represented by patents and copyrights suffer from the well-​known limitations and imperfections, while the public domain plays a critical role in seeding innovation and creative expression. Open access to academic publication is an example. The understanding of the role academic science plays in early-​stage research and investigation as producing high positive spillovers that cannot be captured through intellectual property is longstanding. The basic idea is that investigation that tries to internalize all its social value will necessarily focus on appropriable innovation, and, therefore, will necessarily be more narrowly focused. Given that early innovation is critical to later innovation, that it is a cumulative process, and that it is critical to growth, a proper growth-​oriented policy will seek to assure that there is some level of public funding for “basic” research—​that is, research usable as input in a wide range of research projects. Open access to that basic science as input for follow-​on innovation and investigation maximizes its spillovers. Debates over patenting of university innovation occur precisely along the lines of whether some degree of exclusivity will lead to greater effort to convert the basic science into usable technology, as compared with the risk that this exclusivity will lead to a narrowing of focus and a gain, in terms of appropriable investment, that is outweighed by the loss in focus on basic, high-​positive-​spillover science.47 The open-​access publication movement of the past 15 years takes this basic logic and applies it to the area where the argument in favour of appropriation is even weaker than the patent, because the investment necessary to convert a finished research product into a published paper is much smaller than the investment necessary to bring a science innovation to a product market, and the majority of the labour is done in peer review, as professional activity attendant to 44 

See Rose (1986, 768). See Frischmann, supra (2005, 2012). 46  For the original statement of the trade-​off, see Arrow (1962), supra; for an overview of the problem, see Bracha and Syed (2014, 1841). 47  Mowery, Nelson, Sampat, and Ziedonis (2004); Owen-​Smith and Powell (2001, 109). 45 

 

OPEN-ACCESS AND INFORMATION COMMONS    271 publication. Similarly, because science is incremental, the on-​the-​shoulders-​of-​giants effect is pronounced, further supporting the open-​access models. This also explains in large measure why software, where innovation is widely seen as incremental, is a field where we see open-​access commons in the form of FOSS licensing being chosen by both market and nonmarket actors. Roads, in the nineteenth and twentieth centuries, and the Internet and spectrum, in the twenty-​first, are examples of congestible goods associated with very high positive externalities. The more people use roads to travel to a city or between homes and workplaces; or use the Internet or spectrum to connect to services and social practices, the more congested the shared resource becomes, but also the more valuable the dependent activities. The city centre becomes more valuable as a trade centre the more potential trading partners there are; the application development market grows and becomes more valuable to all users when there are more users who use the Internet or wireless communications more often. Efforts to perfectly calibrate the price of using the infrastructure so as to maximize both (a) the efficient utilization of the infrastructure at any point, including congestion peaks, and (b)  the positive externalities associated with high usage require enormous amounts of information, about all users, and about all possible combinations of users and uses that might benefit from meeting each other. Given imperfect information and transactions costs, it is practically impossible to maxi­ mize on both dimensions. Where we have seen infrastructures with very large positive externalities, like roads and navigable waters or the Internet, we have seen that tension resolved in favour of growth in the system as a whole, through symmetric universal open access to the infrastructure resource, rather than in favour of efficiency of utilization of that resource. Depending on the cost of provisioning and the risk of disinvestment, we have seen these symmetrically managed resources range from simple open access and minimal-​use rules, like navigable waters, unlicensed spectrum, or the Internet protocol, to owned and priced symmetric use models like common carriage in telephony or public utilities in electricity distribution.

11.3.2. Uncertainty, Freedom to Operate, and Exploration Open-​access commons and property can also be interpreted as institutional mechanisms that represent significantly different information and motivation models. Property centralizes the point at which information and incentives necessary to determine the access, use, management, and disposition of a given resource in a single entity by giving that entity asymmetric power to determine who will get to access or use the resource, at what time, and for what purposes. The defining feature of commons is that there is no such asymmetric power. Instead, the resource is subject to a set of symmetric rules concerning access, use, extraction, and management. The absence of asymmetry removes the owner as a focal point for transactions and as the coordinating mechanism

 

272   YOCHAI BENKLER for competing claims on the resource. The symmetry allows diverse users the freedom to operate without transacting, within the symmetric constraints and subject to the congestion characteristics of the resource. As in the case of property and unlike regulatory decisions, information is gathered and processed by decentralized actors. Unlike the case of property, information gathered by these decentralized actors is not collated in a single decision point. Rather, diverse actors act upon information they have or exchange without the need to translate it into a universally understood expression (currency, e.g.) that compares competing uses and clears them. Where the level of uncertainty is such that freedom of action (to adapt to changed circumstances) is an important desideratum, in some cases, more than security in holdings (whose value and utility are part of the uncertainty) and power to appropriate outputs directly through exclusion (whose coming into being is part of the uncertainty)—​we need, and find ubiquitously around us, both commons and property. On this analysis, with perfectly frictionless markets under perfect information, we wouldn’t need commons. But this is no more relevant than saying that with perfectly selfless individuals under perfect information and frictionless social exchange we wouldn’t need property. Given imperfect markets, imperfect information, diversely motivated individuals, and imperfect systems of social cooperation and exchange, some mix of property and commons is necessary for reasonable planning and pursuit of goals. This is from the private-​returns perspective, setting aside collective goals such as efficiency and growth, and explaining the widespread adoption of commons-​based practices (like FOSS) even in the presence of property-​based alternatives. From an individual agent’s perspective, having a mix of resources—​ some commons, some property—​will increase his or her utility over time, given imperfect markets, persistent uncertainty, and change. The histories of spectrum commons and the Internet protocol offer nice illustrations. The combination of doubling of computation capacity every 18 months for decades, coupled with the global reach of the innovation system and its escape from the confines of a few well-​known labs, like Bell Labs, created a rate and range of change that led to true uncertainty (as opposed to risk, where we know the range of outcomes and distribution of probabilities) in innovation practices that depended on computation (whose innovation rate caused uncertainty, but was not itself uncertain, and has not been managed in a commons) and communication as core resources. TCP/​IP, the core Internet protocol, implemented an “end-​to-​end” design principle that effectively refused to optimize for any particular function within the network, and required all applications to take care of themselves—​that is, solve whatever higher-​level functions and optimization they required without making any demands on the network design itself. This design choice sacrificed optimization and efficiency of a known set of applications (e.g., voice or real-​time streaming) in exchange for high flexibility and decentralization of the capacity to innovate. It meant that when four clever Israeli programmers figured out instant messaging, or four Estonian programmers figured out a better voice codec, they did not need to ask permission from a network operator, they did not require the change

 

OPEN-ACCESS AND INFORMATION COMMONS    273 of network design that would still have to accommodate hundreds of other applications developed by others, but instead could simply design ICQ, the grandfather of instant messaging, or Skype, respectively, to do all of its work on the end-​user devices, and send through the network only the minimal simple packets the network was designed to receive and route. ICQ launched the Israeli high-​tech startup culture, but at the time, came out of nowhere. As for Skype, while the idea of video telephony had been around for decades, Skype’s solution used a modified peer-​to-​peer network that was built initially on an architecture that its creators had originally developed for the KaZaa peer-​to-​peer file-​sharing network. It used end-​user nodes to relay packets that had no quality of service assurance in the network. The approach would have been treated as a pipe dream within the telephony engineering system before it was successfully introduced. Indeed, Internet telephony was the most prominent driver of efforts to replace the Internet protocol so that carriers could distinguish packets and sell priority (quality of service commitments) to voice packets. Instead, the end-​to-​end, open-​access architecture of the Internet allowed for hundreds, or thousands, of low-​cost experiments in this and related fields to be run, implemented, and fail in a fully decentralized form until one or a few of them resulted in a superior solution. The same can be said of all the major innovations on the Internet—​from Berners Lee’s innovation of the World Wide Web, through the browser, the search engine, to the social network and the cloud storage company—​these were all the results of extensive experimentation that depended on the open-​access commons model of the Internet and came out as the winning solution among many parallel efforts of exploration in the face of a rapidly changing and highly uncertain innovation challenge. Similarly, in open-​access spectrum, we saw diverse companies develop diverse products to take advantage of open-​access spectrum bands, mostly Wi-​Fi but also other standards in diverse unlicensed bands, in a way that dramatically outpaced innovation by those few carriers who owned spectrum. In areas as diverse as smart-​grid communications systems, medical device wireless communications, or inventory management, the more cumbersome carriers that depended on proprietary spectrum allocations failed to keep up with the diverse range of innovative companies that relied on the commons.48 Ultimately, even the carriers themselves ended up turning to the commons to carry a majority of their wireless data requirements. When presented with major spikes in its network after introduction of the iPhone, AT&T had major congestion problems with its mobile data network. It could have gone to the secondary spectrum markets set up by the Federal Communications Commission (FCC) a few years earlier, where it could have leased the additional capacity in a spot market. It did not. Instead, it combined a long-​term proprietary strategy—​seeking to purchase licenses from Qualcomm—​with a short-​term, more dynamic solution that was based on the commons. AT&T invested in Wi-​Fi hotspots and encouraged users to off-​load traffic to their home and public Wi-​Fi

48 

See Benkler (2012b).

 

274   YOCHAI BENKLER spots. SFR in France, the second-​largest mobile provider and third-​largest home broadband provider, went one further and harnessed all of its home broadband subscribers—​ about 22% of the French market—​to become Wi-​Fi load-​balancing points for all their mobile data subscribers. Wi-​Fi off-​loading by carriers has become the norm, carrying anywhere from 35% to 65% of mobile data.49 More generally, we can say that the more diverse, uncertain, and rapidly changing the environment, the harder it is to codify the value of resources, uses, and outcomes, and the more attractive the freedom of action associated with having a resource in the commons is to these users. The symmetric constraints coupled with a general privilege to use the resource under these constraints mean that the need for transactions at the margin is eliminated, and with it transaction-​cost barriers: strategic behaviour of platform or essential-​facilities owners, imperfect information with its widespread risk of unmatched offer–​ask differences as a user seeks to obtain a sufficient flow of the resource, and so forth. The commons can be said to have a private option value to users whose price is (a) the reduced certainty of availability of a stated quantity of the resource as is available in markets, itself a function of how perfect or imperfect the relevant market is; (b) the lost appropriation opportunity from not having the resource controlled in a proprietary form, relative to nonexclusion-​based forms of appropriation that remain available without exclusion from the resource; and (c) the cost differential between the desired use in the market, given its imperfections and the cost of using the commons. The greater the background uncertainty as to the required quantity or quality of the resource and the market imperfections, the higher the option value—​that is, the more of the benefits of property an agent would be willing to forgo in exchange for the greater flexibility offered by commons, within its known constraints. Uncertainty is connected to one additional dimension of the economic advantage of open-​access commons. Different tasks are more or less amenable to the diverse motivations individuals bring to their actions. The better defined, more routine a task, the easier it is to specify the desired level and quality of effort, to monitor the outcome and connect it to performance and, therefore, to subject the behaviour to reward and punishment on a standard incentives model. The more a desired outcome depends on initia­ tive, tacit knowledge, insight, or creativity, the more uncertain a task environment, and the more the worker needs to continuously examine, explore, innovate, adapt, and apply diverse forms of effort to the task, the harder it is to subject performance to monitoring, or to price effort accurately. As a result, intrinsic motivations become more important, and price-​driven performance is harder to apply well. This difference helps explain why Mertonian science takes over from managerial models as the explored knowledge space becomes less known; why industrial labs that are oriented towards generating big innovation steps create organizational bubbles relatively protected from managerial control (e.g., Bell Labs and Xerox Labs), and why entrepreneurial firms tend to cluster around 49 

See ibid (103). The scale and scope of use, rather than the precise numbers, are what is important for purposes of this review.

 

OPEN-ACCESS AND INFORMATION COMMONS    275 universities, which are excellent institutions for harnessing a range of motivations, from the pleasure of inquiry, through status, to freedom and flexibility over time and area of application. Where resources are subject to open-​access commons, they more readily lend themselves to models that do not tie use directly to payment. Agents who seek to operate on non-​priced motivations can access the resources without concern for the ways in which their use could be translated into enough revenue to secure continued access to the resource. The success of commons-​based strategies in areas like software development, consumer reviews, video creativity, or factual writing reflects precisely the freedom to operate on nonmonetary motivations permitting the development of highly diverse creative and innovative practices.

11.4.  Types of Open-​Access Commons The family of institutional arrangements that fall under the category of open-​access commons is defined by its use of symmetric use privileges, rather than asymmetric exclusive rights, as the core allocation mechanism. The primary branches in the family tree depend on the provisioning of the resource and the governance of the symmetric use privileges. Table 11.1 offers an overview of the members of the open commons family and their exclusive property parallels. The table reflects four major provisioning systems (government, market, social, and natural) and four major governance approaches (state, property and contract, social norms, and no constraint). Each cell is divided into two: a light-​grey shaded subcell, where access to the resource is available to an open class on nondiscriminatory terms, and a black-​shaded subcell, where asymmetric exclusion is the organizing principle. The traditional antipodes (market and state) are represented by the categories of market provisioned, property and contract-​governed, asymmetric exclusivity subcell (hot dogs, homes, and so on), and the state-​provisioned, state-​ regulated, asymmetric exclusivity subcell (military bases and food stamps). Classic public goods are represented in the state-​provisioning, no constraint cell (lighthouses). The dominant modes of commons that serve as the foundation of commercial, industrial economies fall in the nonexclusivity subcells of the state-​and market-​provisioning cells. These can be subject to state regulation (highways, public utilities, mass transit when state provisioned, or common carriers, privately held utilities, or unlicensed wireless bands when market provisioned), or no constraint (open government data, or formerly IP protected materials now in the public domain). The more exotic phenomena that have developed in networked society—​free software, both commercial and purely socially produced—​occupy the subcells of social provisioning, mostly with no asymmetric exclusivity, while many of the CPRs studied by the Ostrom School occupy both the symmetric nonexclusivity (for uses within the CPR) and asymmetric exclusivity (for the relations between insiders and outsiders in CPRs) subcells of social norms-​ organized, socially produced goods.

 

Table 11.1  Types of Open Access Commons by Governance and Provisioning Model Governance/ Provisioning

State regulation

State: tax, bonds, Highways, and fees streets; public utilities; water; mass transit

Military bases; food stamps Markets: direct Common payment, indirect carriers; “private” appropriation public utilities; unlicensed wireless bands

Property and contract

Social-​cultural norms

No constraint

Null (if universal symmetric access right, then law, not contract, allocates)

Peer review for publicly funded science not patented; parks; city squares; sidewalks Publicly funded science that results in patents

Lighthouses; government data: weather, labour/​GDP measurements

Street performers; online musicians; voluntary compliance systems

Cultural materials and innovation originally commercial now in the public domain

Government contracts Broadcast reception (provision in market, but equal privilege to use); GPL/​BSD software by firms (for example, Android)

Automobile Hot dogs; Effort in high-​ safety standards; homes; personal commitment zoning computers; IP organizations goods in coverage Social: labor and Solid organ goods; donations donations

Nature

Contractually reconstructed commons; BSD, GPL? CC-​BY; CC-​ SA?; CC-​NC

Null

Null

CPRs inside, if need provisioning: for example, a dam; von Hippel innovation; Wikipedia editing; much CBPP; GalaxyZoo; Foldit; culturally constructed commons

TCP/​IP; the web; Wi-​Fi standards; much CBPP outputs; Wikipedia reading

Health regulation Enrollment applied to church in socially day care provisioned services

CPRs on the outside; Alicante irrigation system

Null

Pollution Privately created controls; national open nature parks; fisheries preserves

CPRs that require Air inhalation; open allocation: for ocean transit example, pastures

Tradeable permits Private recreation CPRs from the parks: for outside example, hunting lodges

Null

 

OPEN-ACCESS AND INFORMATION COMMONS    277

11.5. Conclusion This chapter was intended to familiarize readers with the literature on open-​access commons and the factual of prevalence open-​access commons in contemporary advanced economies. Contrary to the tragedy of the commons fable, open-​access commons are in fact ubiquitous in modern, complex economies, and play a critical role in making market economies function. Open-​access commons is not a single institution, but a family of institutional arrangements. The core-​defining feature of the family is that its subtypes all apply an institutional model that provides symmetric use privileges to an open general class of users, rather than assigning an asymmetric exclusion right to an individual or known class of individuals as do individual private property, club goods, or CPRs. Open-​access commons have emerged through choice in markets, social arrangements, or public policy, even where earlier property-​based institutions already existed. This has largely happened where use of the resource involved high positive externalities that cannot be internalized without substantial loss of total welfare; where innovation and exploration using the resource as input is particularly valuable, so that the innovation effects of permitting everyone to explore with productive uses of the resource dominate the efficiency effects of maintaining more controlled use for congestion avoidance; and where the resource is useful for a range of uses, including socially motivated use, which is unlikely to be able fully to express its social value if forced to be monetized. The economic theory of open-​access commons as a general theoretical problem is still in its infancy. Substantial work has been done on CPRs, on information commons, or the public domain versus patents and copyrights, on the Internet protocol and end-​ to-​end innovation, and on wireless spectrum regulation. There nonetheless remains substantial work to be done to synthesize these diverse forms of open-​access commons and explain at a more general level how these diverse commons interact with property to offer a more comprehensive theory of market economies and societies’ use of these two families of institutions. Even if the outline of the theoretical explanations available to date is unpersuasive to the reader, the fact of the large role of open-​access commons demands that we offer better theories. Economists cannot ignore the commons and continue to imagine that property is the interesting core, and commons a negligible periphery, in the face of large-​scale, critical elements of growth that adopt commons by choice and sustain them over time in preference to available proprietary alternatives.

References Baldwin, Carliss, and von Hippel, Eric. 2010. Modeling a Paradigm Shift:  From Producer Innovation to User and Open Collaborative Innovation. Working Paper, Harvard Business School. Benkler, Yochai. 1998a. “Overcoming Agoraphobia: Building the Commons of the Digitally Networked Environment.” Harvard Journal of Law and Technology 11, pp. 287–​400.

 

278   YOCHAI BENKLER Benkler, Yochai. 1998b. “The Commons as a Neglected Factor of Information Policy.” Presentation at the 26th Annual Telecommunications Research Conference. Alexandria, VA (October 3–​5). Benkler, Yochai. 1999. “Free as the Air to Common Use: First Amendment Constraints on Enclosure of the Public Domain.” New York University Law Review 74, pp. 354–​446. Benkler, Yochai. 2000. “From Consumers to Users:  Shifting the Deeper Structures of Regulation towards Sustainable Commons and User Access.” Federal Communications Law Journal 52, pp. 561–​579. Benkler, Yochai. 2002. “Coase’s Penguin, or Linux and the Nature of the Firm.” Yale Law Journal 112, pp. 369–​446. Benkler, Yochai. 2012. “Open Wireless vs. Licensed Spectrum:  Evidence from Market Adoption.” Harvard Journal of Law and Technology 26(Fall), pp. 69–​163. Benkler, Yochai. 2016. “Peer Production and Cooperation.” In: J. M. Bauer and M. Latzer, eds., Handbook on the Economics of the Internet. Cheltenham: Edward Elgar. 91–​119. Berglas, Eitan. 1976. “On the Theory of Clubs.” American Economic Review 66, pp. 116–​121. Boyle, James. 1996. Shamans, Software, and Spleens:  Law and the Construction of the Information Society. Cambridge, MA: Harvard University Press. Boyle, James. 2008. The Public Domain:  Enclosing the Commons of the Mind. New Haven, CT: Yale University Press. Bracha, Oren and Syed, Talha. 2014. “Beyond the Incentive-​ Access Paradigm:  Product Differentiation and Copyright Revisited.” Texas Law Review 92, pp. 1841–​1920. Buchanan, James. 1965. “An Economic Theory of Clubs.” Economica 32, pp. 1–​14. Cohen, Julie.E. 1998. “Lochner in Cyberspace:  The New Economic Orthodoxy of ‘Rights Management.’” Michigan Law Review 97, pp. 462–​563. Cornes, Richard and Sandler, Todd. 1996. The Theory of Externalities, Public Goods, and Club Goods. New York: Cambridge University Press. Frischmann, Brett, M. 2005. “An Economic Theory of Infrastructure and Commons Management.” Minnesota Law Review 89, pp. 917–​1030. Frischmann, Brett, M. 2012. Infrastructure:  The Social Value of Shared Resources. New York: Oxford University Press. Garfinkel, Simson L., Stallman, Richard M., and Kapor, Mitchell. 1991. “Why Patents Are Bad for Software” Issues in Science and Technology 8(Fall), pp. 50–​55. Hardin, Garrett. 1968. “The Tragedy of the Commons.” Science 162, pp. 1243–​1248. Hess, Charlotte, and Ostrom Elinor. 2003. “Ideas, Artifacts, and Facilities: Information as a Common-​Pool Resource the Public Domain.” Law and Contemporary Problems 66(Winter/​ Spring), pp. 111–​145. Kapzcynski, A. and Syed, Talha. 2013. “The Continuum of Excludability and the Limits of Patents.” Yale Law Journal 122, pp. 1900–​1963. Kelty, Christopher. 2008. Two Bits:  The Cultural Significance of Free Software. Durham, NC: Duke University Press. Lemley, Mark A. 1997. “The Economics of Improvement in Intellectual Property Law.” Texas Law Review 75, pp. 989–​1084. Lerner, Josh. 2002. “150 Years of Patent Protection.” American Economic Review 92(May), pp. 221–​225. Lessig, Lawrence. 2001. The Future of Ideas: The Fate of the Commons in a Connected World. New York: Random House. Litman, Jessica. 1990. “The Public Domain.” Emory Law Journal 39, pp. 965–​1023.

 

OPEN-ACCESS AND INFORMATION COMMONS    279 Moody, Glenn. 2002. Rebel Code: Linux and the Open Source Revolution. New York: Basic Books. Morell, Mayo F. 2011. “The Wikimedia Foundation and the Governance of Wikipedia’s Infrastructure, Historical Trajectories and its Hybrid Culture.” In:  Geert Lovnik and Nathaniel Tkacz, eds., Critical Point of View. Amsterdam: Institute of Networked Cultures. Mowery, David C., Nelson, Richard R., Sampat, Bhaven N., and Ziedonis, Ardvis. 2004. Ivory Tower and Industrial Innovation, University-​Industry Technology Transfer Before and After the Bayh-​Dole Act. Palo Alto, CA: Stanford University Press. Nelson, Richard R. 1959. “The Simple Economics of Basic Scientific Research.” Journal of Political Economy 67, pp. 297–​306. Olson, Mancur. 1965. The Theory of Collective Action. Cambridge, MA:  Harvard University Press. Ostrom, Elinor. 1990. Governing the Commons:  The Evolution of Institutions for Collective Action. New York: Cambridge University Press. Ostrom, Elinor. 2011. “Background on the Institutional Analysis and Development Framework.” Policy Studies Journal 39(February), pp. 7–​27. Owen-​ Smith, Jason, and Powell, Walter W. 2001. “Career and Contradictions:  Faculty Responses to the Transformation of Knowledge and its Uses in the Life Sciences.” Research in the Sociology of Work 10, pp. 109–​140. Rajagopalan, M.S., Khanna, V., Stott, M., Leiter, Y., Showalter, T., Dicker, A., and Lawrence, Y. 2010. “Accuracy of Cancer Information on the Internet: A Comparison of a Wiki with a Professionally Maintained Database.” Journal of Clinical Oncology 28, p. 6058. Reagle, Joseph, M., Jr. 2010. Good Faith Collaboration: The Culture of Wikipedia. Cambridge, MA: MIT Press. Rose, Carol. 1986. “The Comedy of the Commons: Custom, Commerce, and Inherently Public Property.” University of Chicago Law Review 53, pp. 711–​781. Samuelson, Pamela. 1990a. “Benson Revisited:  The Case against Patent Protection for Algorithms and Other Computer Program-​Related Inventions.” Emory Law Journal 39, pp. 1025–​1154. Samuelson, Pamela. 1990b. “Legally Speaking:  Should Program Algorithms Be Patented?” Communications of the ACM 33, pp. 23–​27. Satria, Arif, Matsuda, Yoshiaki, and Sano, Masaaki. 2006. “Contractual Solution to the Tragedy of Property Right in Coastal Fisheries.” Marine Policy 30, pp. 226–​236. Schankerman, M., and Lerner, Josh. 2010. The Comingled Code: Open Source and Economic Development. Cambridge, MA: MIT Press. Schlager, Edella, and Ostrom, Elinor. 1992. “Property-​ Rights Regimes and Natural Resources: A Conceptual Analysis.” Land Economics 68, pp. 249–​262. Schweick, Carles M., and English, Robert C. 2012. Internet Success: A Study of Open-​Source Software Commons. Cambridge, MA: MIT Press. Scotchmer, Suzanne. 1991. “Standing on the Shoulders of Giants: Cumulative Research and the Patent Law.” Journal of Economic Perspectives 5(Winter), pp. 29–​41. Suber, Peter. 2012. Open Access. Cambridge, MA: MIT Press. van Schewick, Barbara. 2010. Internet Architecture and Innovation. Cambridge, MA: MIT Press. Wales, Jimmy. “Talk: Benevolent Dictator.” Wikimedia. March 16, 2007. http://​meta.wikimedia. org/​?oldid=544462 [Accessed 21 August 2016].

 

Chapter 12

FAM ILY AND H OU SE H OL D EC ONOMI C S Amy Wax

The past decade has seen a dramatic surge in women into the labor force, accompanied by significant changes in gender roles within the family, the workplace, and society as a whole. These developments have elicited growing academic interest and prompted proposals for legal and policy reforms designed to improve outcomes for women, families, and everyone else (Blau, Ferber, and Winkler 2011). The purpose of this chapter is to explore some aspects of recent work in this area, with emphasis on the economic analysis of the interplay between labor markets and family roles.

12.1. Household Decision-​M aking Models Research by economists and others has revealed that family well-​being, and the economic fate of men and women within families, is a complex, interactive function of social and economic conditions, relationships within households, and individual choices. Gary Becker, in Treatise on the Family (1981), starting from the analysis of the family as a single decision-​making unit, pioneered the insight that models for household behavior needed to take into account how family members with differing preferences make decisions under the constraints imposed by others in the family and the economy as a whole. In the wake of Gary Becker’s groundbreaking work, the analysis of household decision making has developed from a simple unitary model toward more complex and nuanced understandings of the diversity of interests and the dynamic interactions that take place within families (Himmelweit et al. 2013). The unitary model of household functioning, which regards the family as a single decision-​making unit, assumes that household members agree by consensus to

 

FAMILY AND HOUSEHOLD ECONOMICS    281 maximize a single utility function. That function is subject to a pooled budget constraint, composed of the sum of all family members’ income (Vermeulen 2002). If total income is held constant, the unitary model predicts that individual contributions to the pooled household budget, or changes in those contributions, are independent of each person’s influence over how the budget is allocated (Vermeulen 2002). Although the unitary model assumes that individual preferences and resources within the household could be combined through consensus between the household members, it does not indicate how such a consensus could be reached (Samuelson 1956; Alderman et al. 1995). Becker (1974) sought to improve on the model by positing a benevolent head of the family who took into account the preferences of all household members, but also adjusted allocations in response to family members’ behavior (Becker 1981). Thus, if a family member—​for example, a “rotten kid”—​took actions to raise his or her own consumption, thereby lowering the consumption of others, the head of the household could reduce transfers to try to induce the “rotten kid” to behave less selfishly. Becker predicted that this sort of response by the head of household would cause individual preferences and behavior within the household to converge. The unitary model’s approach to family resources has come under fire repeatedly as overly simplistic about the distributive effects of a diversity of preferences and interests among family members (Doss 2011). For example, further analysis of the “rotten kid” theorem, which echoes criticisms leveled at the unitary model generally, has found that the theorem only holds under restrictive circumstances (Alderman et  al. 1995; Bergstrom 2008). Other models that seek to incorporate a more dynamic approach to how family decision making affects household allocations have had more predictive success. For example, nonunitary models predict that reallocating income from fathers to mothers tends to increase children’s consumption, nutrition, and well-​being. These are outcomes unitary models do not predict (Himmelweit et al. 2013; Alderman et al. 1995; Vermeulen 2002). The validity of these predictions has received empirical support. A 1997 study of UK government policy found that redistributing child benefits from husbands to wives resulted in greater expenditures on women’s and children’s clothing (Lundberg et al. 1997) Likewise, a higher income share for wives in rural Mexico was associated with greater expenditures on food and children’s needs, and lower expenditures on services and alcohol, a result not predicted by a simple income-​pooling method (Lechene and Attansio 2002). Bargaining models offer the most significant advantage over unitary models in explaining intrahousehold interactions among individuals with disparate preferences (Himmelweit et  al. 2013). These models represent the application of game-​theoretic approaches, developed and refined by economists working in various fields, which analyze how individuals make decisions when their fate depends on what other individuals do. The models recognize that the income and non-​monetary resources available to families are not independent of the interactive dynamics of the unit, which are in turn crucially affected by the individual, distinct utility functions of each member. An important insight of bargaining models is that interactions among family members determine both the total resources generated by the unit and the allocation of those

 

282   AMY WAX resources. Thus, on some assumptions, household members might make decisions that generate suboptimal well-​being for individuals within the unit or the family as a whole. Household bargaining models have been subdivided into cooperative and non-​ cooperative models. In cooperative models, household members are assumed to act together in order to reach a Pareto-​efficient result, defined as one where no person can achieve greater utility without the utility of the others being reduced (Doss 2011). Non-​ cooperative models drop the assumption that household members enter into binding, costlessly enforceable agreements. This allows for possible inefficient, non-​Pareto optimal situations (dubbed “burnt toast” options) as each individual household member acts to maximize his or her own utility at others’ expense in light of a budget constraint and other household members’ decisions (Lundberg and Pollack 1996). Evidence of inefficient forms of behavior in actual marriages and families, such as child abuse, domestic violence, and economically suboptimal geographic relocations and labor market choices, are most consistent with non-​cooperative models (Lundberg and Pollack 1996; Doss 2011; McPeak and Doss 2006; Udry 1996). According to bargaining models, the bargaining power of each family member is determined by his or her “threat point”—​the utility level that each individual would achieve if cooperation broke down (Mahony 1995; Wax 1998). Threat-​point analysis has generally focused on married couples by analyzing the interactions between husbands and wives. In the divorce-​threat model, the threat point is determined by the situation each member of the couple would face if the marriage dissolved (Himmelweit et al. 2013; Lundberg and Pollack 1993; Chiappori et al. 2002). This model predicts that the bargaining power of each spouse within the marriage, as well as the likelihood that a spouse will seek or resist divorce under different legal regimes, is a function of the resources each spouse can generate and retain for him or herself as a single person. Thus, an increase in the wife’s share of the total household income will give her greater bargaining power within the relationship, and vice versa (Blundell et al. 2007; Wax 1998). This prediction is consistent with the finding (discussed further later in the chapter) that women decrease their share of the housework as their income increases up to a 50–​50 split (Bittman et al. 2003). Using a divorce-​threat model, Wax has posited that, because a number of key factors combine to give husbands an average extramarital threat-​point advantage over their wives, men will tend to receive the lion’s share of marital resources and egalitarian marriage will be rare (Wax 1998; see, also, Mahony 1994). According to Wax the most critical male advantages are a longer reproductive life and a greater potential to remarry someone younger and have more children. These factors greatly enhance men’s utility relative to women’s in the event of a divorce. In addition, it can be shown through game-​theoretic modeling that women’s stronger preferences for domestic order and investments in “quality” children (because of limited reproductive potential), along with men’s greater earning power, tend to boost men’s bargaining advantage within marriage. This enables men to shift domestic responsibilities to women even in the face of women’s preference for equal sharing of domestic and childcare tasks (Wax 1998). That men tend to enjoy a large share of the marital gains, or “surplus,” is confirmed by the observation

 

FAMILY AND HOUSEHOLD ECONOMICS    283 that married men enjoy better health and well-​being than single men do, with the gains for married over single women being much smaller (Wax 1998). Positing a strong, average intramarital bargaining advantage for men also helps explain the paradox that most divorces are initiated by women, despite women having poorer extramarital prospects. In accordance with a threat-​point model, Margaret Brinig observes that a woman will leave a marriage if its value approaches or falls below the value of her next-​best alterna­ tive. It is suggested that this can happen when the husband appropriates most of the marital gains for himself, which may result in his “overreaching” and making his wife worse off than she would be without him (Brinig and Allen 2000; Brinig and Crafton 1994; Wax 1998). Under the alternative, non-​cooperative bargaining model of marital interaction, sometimes referred to as the “separate spheres model” (Lundberg and Pollack 1993), the option of marital dissolution is considered unavailable, and the threat point is represented by the couple staying together even after cooperation between them breaks down (Bennett 2013). Under this model, bargaining power is increased for the spouse with more resources that can be withheld from the other within the marriage (Bittman et al. 2003). For example, a breadwinner husband can withhold income from a nonworking wife. Or a homemaker wife can reduce her level of household services (Lundberg and Pollack 1993). With the advent of no-​fault divorce and the substantial likelihood that spouses will terminate non-​cooperative relationships, this model’s ambit may be limited. However, it retains vitality for couples concerned about the high costs of divorce, including well-​documented harms to children—​a concern that some economists have observed tends to predominate among the upper middle class (Wax 2014). Because spouses’ circumstances and threat points are so individualized within this model, it’s validity has been difficult to prove (Himmelweit et al. 2013).

12.2.  Division of Labor Within Households Housework can be defined as “the set of unpaid tasks performed to satisfy the needs of family members or to maintain the home and the family’s possessions” (Lachance-​ Grzela and Bouchard 2010). Because it is customarily unpaid and exists outside the market, housework is difficult to observe, measure, and quantify (Shelton and John 1996). This presents an empirical challenge, and researchers have often responded by ignoring or excluding less visible or overlapping types of effort (such as child minding or passive “babysitting,” household management, and various kinds of emotional labor) from direct examination (Shelton and John 1996). Despite these limitations, research on time-​use patterns within families reveals a recurring constant. As stated by two prominent investigators of family time use, “[t]‌he most notable characteristic of

 

284   AMY WAX the current division of household labor is that, whether employed or not, women continue to do the majority of housework” (Shelton and John 1996). Although women’s and men’s time spent doing housework has gradually converged (Bianchi et al. 2000), the most recent data from an Organization for Economic Cooperation and Development (OECD 2013) study show that men spend 30% more time on paid work and 50% less time on unpaid work than women do. Also, men and women tend to spend their time on different sorts of tasks. Women do more time-​consuming, routine housework, including meal preparation and cooking, housecleaning, shopping for groceries and household goods, washing dishes and cleaning up after meals, and laundry. Men’s efforts are directed at household tasks that require attention only intermittently, such as household repairs, yard care, driving other people, managing finances, and paying bills (Lachance-​Grzela and Bouchard 2010; Coltrane 2000). Bargaining theory predicts that increasing female involvement in the workplace will lead to greater bargaining power at home and reduced time spent on housework. Consistent with this theory, women’s on housework time has been observed to decline over time as their workplace experience has increased. Nonetheless, complete convergence has not been achieved. Female labor market gains have not translated into equality at home (Lachance-​Grzela and Bouchard 2010), with women continuing to perform a larger share of unpaid home labor (Pinto and Coltrane 2009). Several models have been developed to explain these patterns and explore the factors thought to influence how much housework each spouse performs. Each of the major models makes the simplifying assumption that housework is undesirable and therefore each spouse will tend to avoid it—​an assumption that might be questionable in some cases (Greenstein 2000).

12.2.1. The Relative-​Resources Model The relative-​resources approach, sometimes also referred to as the economic-​exchange hypothesis or the economic-​dependence model, builds on broader insights of bargaining models that predict the allocations of benefits and burdens within families. Like other assignments of value generated within a marriage, who does the housework as opposed to who enjoys its fruits is a function of the alternatives available outside the relationship. Divorce-​threat and internal allocation bargaining models are thus relevant to understanding the division of housework responsibility. A key insight of these models is that a partner’s individual resources and endowment, such as income, education, and the value of extramarital options (including economic, marital, and reproductive alternatives) (Wax 1998), provide decision-​making power within the relationship, which in turn affects the allocation of household labor (Mannino and Deutsch 2007). Since housework is presumed to be undesirable and requires the expenditure of energy for the benefit of others, family members with more resources and, therefore, more power, will tend to bargain their way out of performing housework (Knudson and Wærness 2008). These assumptions predict that wives’ relative paucity of individual resources compared

 

FAMILY AND HOUSEHOLD ECONOMICS    285 with husbands’ puts women in a weaker negotiating position and explains the chronic housework “gap” between men and women (Greenstein 2000). In general, the research literature provides some support for the relative-​resources model as an explanation for observed patterns. There are data showing that the secular trend in increased earnings for women, and rising income relative to men, helped cause the growth over a 31-​year period in men’s participation in housework (Cunningham 2007). Other studies have found that wives’ contribution to outside household income is inversely related to the allocation of household labor, even when other individual characteristics are held constant (Knudson and Wærness 2008; Parkman 2004). The relative education of spouses also correlates with the division of household labor, with data indicating that couples in which wives’ education exceeds their husbands’ have smaller gender gaps in the quantity of household labor performed (Bianchi et al. 2000). Finally, couples who share the breadwinner role appear to have the closest to an equal distribution of housework, although not to the point of strict equality (Davis and Greenstein 2004). One notable shortcoming of the relative-​resources approach has been its inability to explain the persistent gap in housework despite women’s steadily improving currency in the workforce and even in couples where the wife’s earnings equal or exceed the husband’s. The relative-​resources model would suggest that parity in the workplace would produce equality at home, but the evidence instead indicates that women who have comparable resources to their partners still do most of the housework (Evertsson and Nermo 2007). A number of scholars have noted the data’s failure to confirm the linear relationship between the partners’ earning differentials and the allocation of housework as predicted by the relative-​resources model. They propose instead that the actual relationship is curvilinear, with more traditional labor allocations seen in households where women’s earnings exceed or fall short of their spouses’, and more equal divisions in those where the spouses’ incomes are more closely matched (Bittman et al. 2003; Greenstein 2000). This curvilinear relationship is arguably in tension with the suggestion that women’s share of housework decreases when their economic independence increases (Knudsen and Wærness 2008; Fuwa 2004), as well as with other research suggesting that only a woman’s absolute earnings, not her relative earnings, matter in predicting her time spent doing housework (Gupta 2006, 2007). The observation that women who earn more compared with their husbands do more housework than in households with equal earnings remains a puzzle that straightforward relative-​resources models fail to explain.

12.2.2. The Time-​Availability Model The time-​availability model is based on the premise that the amount of time each partner spends on paid labor affects the amount of time that he or she has avail­ able to perform housework (Artis and Pavalko 2003). Because men are traditionally more involved in the labor force, and husbands invest more hours in paid labor even

 

286   AMY WAX when both spouses work either part time or full time, this model predicts that men will have less time available to perform housework and women will do the greater share (Lachance-​Grzela and Bouchard 2010). The model also predicts that rising female labor-​force participation will result in a reallocation of the housework burden toward men because of women’s decreased availability to perform housework (Robinson and Hunter 2008), but that parity will be hard to achieve without gender equality in hours of paid work. The time-​availability model has received some support from the data on the relationship between the partners’ paid work patterns and their work at home. As a general matter, both full-​time and part-​time employed men and women perform less housework than the unemployed of either sex do (Bianchi et al. 2000). Studies also confirm a fairly robust correlation between the household members’ hours of employment and the distribution of housework within the family (Cunningham 2007), with a woman’s share of housework decreasing as her hours of paid employment increase (Knudson and Wærness 2008; Artis and Pavalko 2003). Qualitative elements arguably related to the intensity and demands of paid work that could distract attention from household tasks (including length of employment history and earnings trajectory) also have been shown to correlate with both partners’ involvement in housework, although women’s employment status has a greater effect than does men’s (Cunningham 2007). Some studies of the relationship of housework and time availability have revealed that women’s employment seems to lead to a more equal distribution of housework through the mechanism of exposing women to workplace environments that are supportive of gender equality (Bolzendahl and Myers 2004). It is also possible, however, that this link is due to selection, with employed women tending to have more egalitarian gender views from the start (Fan and Marini 2000). Like the resource-​allocation hypothesis, the time-​availability model falls short in explaining some aspects of the gender gap in household responsibility, including the finding that working women sometimes do more housework than their employed husbands do, even when they work the same hours at jobs with similar status (Bartley et al. 2005). One study showed that, in a sample of full-​time male and female workers with approximately equal working hours, women spent the equivalent of 80% as much of their paid-​work time doing housework, whereas men spent the equivalent of only 40% (Lincoln 2008), with the result that the women worked more hours overall. Another study suggests, however, that when time spent in both paid employment and unpaid domestic work are combined, there is an equal split of hours invested between partners (Gershuny and Sullivan 2003). The variations in the findings of the relationship between spouses’ paid​and domestic work hours counsels caution. Accurate evidence on working hours is essential to any proper empirical test of the time-​availability model, but it is hard to come by. As discussed more fully later in the chapter, the designations of full time and part time are imprecise and may fail to capture actual hours worked, which can differ by gender even within the same job categories (Hymowitz 2011a, 2011b, 2012). Another shortcoming of the time-​availability model is that it does not answer the question of whether women’s greater responsibility for housework is a cause or an

 

FAMILY AND HOUSEHOLD ECONOMICS    287 effect of devoting fewer hours to paid work. Implicit in some discussions of the time-​ availability model is the assumption that each spouse chooses how much time to work for pay according to individual preferences, with the housework responsibility falling into place in response to those choices. The problem is that choices about paid work may be dependent on household expectations. Some women may feel forced to reduce their work hours because of weighty household responsibilities imposed by other factors—​ such as the type of power imbalances identified by the resource constraint model, or the pressures of gender ideology as discussed in Section 12.2.3. Thus, the mere fact that the hours of paid and unpaid work are inversely related for each member of the couple does not necessarily settle the question of why a particular balance of paid and unpaid work is observed and, thus, whether the time-​availability model offers a complete causal explanation of household divisions of labor.

12.2.3. Gender-​Ideology Model Gender ideology is defined as “how a person identifies [himself or herself] with regard to marital and family roles traditionally linked to gender” (Greenstein 2000). Notions about proper male–​female roles in society and within relationships are positioned on a spectrum ranging from traditional ideas (favoring distinct spheres and a strict male-​ breadwinner-​and-​female-​homemaker structure) to more egalitarian norms (which embrace a vision of both partners participating more equally at home and at work) (Lachance-​Grzela and Bouchard 2010). According to the gender-​ideology model, ideas matter. People’s views about gender roles, and their desire to represent and fulfill those roles, are as important as economic concerns in their decisions about how to divide responsibility for earning income and running the household. On this assumption, couples with views closer to the egalitarian end of the spectrum would be predicted to more equally divide housework, whereas those with more traditional attitudes would show a lopsided assignment of paid and unpaid labor between spouses, with the performance of more traditional female tasks by wives and male tasks by husbands (Davis et al. 2007). Although gender-​related perceptions and social norms are elusive and difficult to measure directly (De Henau and Himmelweit 2013), some studies suggest that gender ideology has an independent influence on men’s and women’s behavior. Compared with more traditional women, women with strong egalitarian gender attitudes are likely to report doing less household labor, whereas more egalitarian men tend to perform more hours of housework compared with men subscribing to more traditional norms (Davis et al. 2007; Fuwa 2004; Parkman 2004). Some empirical observations suggest that women’s behavior is more sensitive to the couple’s gender attitudes than is men’s. For example, men’s egalitarian attitudes tend to correlate with less labor time for their female partners without producing an absolute increase in their own housework hours. Also, although women with attitudes that are more egalitarian do less work than traditional women do, egalitarian women’s partners do not show a significant increase in household labor relative to the partners of more conventional women (Bianchi et al. 2000).

 

288   AMY WAX Other research indicates, however, that men with higher levels of education do a greater share of the housework than do men with less education (Gershuny and Sullivan 2003), an observation that may be explained by the strong correlation between high economic status and egalitarian gender ideologies (Cha and Thébaud 2009). Indeed, because men who are more educated would tend to command greater resources and higher earnings that would relieve them of household duties, their willingness to do a greater share of housework, if robust, supports the hypothesis that gender attitudes do have some effect on men’s domestic behavior. As a general matter, there is evidence that gender ideology evolves in the direction of egalitarian viewpoints, with individuals increasing their support of egalitarian perspectives over time (Fan and Marini 2000). In light of these observations, the gender-​ideology model predicts that the societal trend toward widespread adoption of egalitarian attitudes “should translate into a more equal division of household labor between men and women,” even controlling for other factors (Lachance-​Grzela and Bouchard 2010; Davis and Greenstein 2004; Artis and Pavalko 2003). The overall direction has indeed been toward divisions of labor that are equal, but it remains to be seen whether actual convergence is ultimately achieved or whether women continue to do the lion’s share of unpaid work.

12.2.4. The Economic-​Dependency Model and the Gender-​Construction Model As a variant on the relative-​resources model, Julia Brines (1994) initially posited that economic dependency would be a decisive influence in the allocation of household labor. The model predicts that, as economically dependent wives—​that is, those who rely on their husbands for basic financial support—​increase their share of the household earnings, their portion of domestic labor will decrease. This prediction follows from a conventional notion of economic exchange, which posits that a wife swaps her unpaid labor for a share of the household income, with her need to gain access to her husband’s income decreasing as her earnings rise. Based on empirical time-​use studies, however, Brines observed that the economic-​exchange model could not be so straightforwardly applied to couples where husbands are economically dependent on wives. Although exchange theory predicts that the husband would assume responsibility for most of the domestic work under those circumstances, Brines discovered that economically depen­ dent men’s share of the housework actually declines. Brines’ conclusion is that men and women appear to respond differently to economic dependence on their spouses. Brines hypothesized that couples who violate the traditional structure of a breadwinner husband with a dependent wife feel constrained to respond to this “role reversal” by enacting a form of gender display. Reallocating housework back to the woman counterbalances the man’s compromised breadwinner role and mitigates the resulting threat to the husband’s masculine identity. By having the husband

 

FAMILY AND HOUSEHOLD ECONOMICS    289 do less housework, the couple “does gender” and achieves “gender accountability” in the eyes of themselves, their spouses, and their friends. Brines’ findings led to the elaboration of the gender-​construction hypothesis, which builds on the gender-​ideology model to identify gender as not only a distinct aspect of couple’s self-​definition but also something that is dynamically created and recreated in interactions with others (Potuchek 1992). According to Coltrane (2000), “gender construction theories suggest that women and men perform different tasks because such practices affirm and reproduce gendered selves, thus reproducing a gendered interaction order.” Brines’ application argues that housework is a key activity through which men and women display or produce gender (Bianchi et al. 2000; Brines 1994). Since household labor is widely perceived as expressing the caring and nurturing aspects of femininity (Badr and Acitelli 2008), women may perform more housework to reinforce their feminine gender identities, and men may resist performing housework to protect their male gender identities (Knudson and Wærness 2008; Erickson 2005). In keeping with this observation, there is evidence that American men who face challenges to their masculinity in the workplace tend to avoid housework (Arrighi and Maume Jr. 2000). Likewise, Greenstein (2000) found that, regardless of gender ideology, couples with non-​normative earner roles engage in “gender deviance neutralization” by distorting the amount of housework they report for each spouse in a direction that appears consistent with gender expectations. In sum, the focus on the function of norm and identity reinforcement, and the inclusion of gender as a “product” of housework, helps make sense of some seemingly irrational, or at least economically perplexing, aspects of the household division of labor (Shelton and John 1996).

12.2.5. Other Aspects of the Division of Household Labor In addition to those mentioned already, other factors have been found to predict the division of household labor. These include the couple’s marital status and race, and the contributions of children.

12.2.5.1. Marital Status Studies have indicated that married women spend significantly more time on housework than cohabitating women do, even after controlling for other demographic characteristics (South and Spitze 1994). Research also consistently shows that cohabitating couples have a closer to equal distribution of household labor than do married couples (Baxter 2005; Batalova and Cohen 2002). This is mostly a function of each partner spending less time on traditionally gender-​specific tasks, resulting in a more dramatic reduction of housework time for women and a convergence of unpaid work time between partners (Domínguez-​Folgueras 2013). While some studies report no significant difference in housework performed by married and cohabiting men, a few have found that marriage

 

290   AMY WAX decreases men’s share of housework, which is consistent with married men spending longer hours at paid work (Gupta 1999; Shelton and John 1993).

12.2.5.2. Race The few studies that have focused on race’s role in the division of household labor have yielded mixed results. Although research indicates that African-​American males, net of other predictors, do a larger proportion of the housework than white men do, African-​ American women still do twice as much as their partners (Shelton and John 1996; Kamo and Cohen 1998). Also, white husbands were significantly less likely than black husbands to perform traditionally feminine household tasks (Orbuch and Eyster 1997). In contrast, wives in dual-​earner Mexican-​American families expect their husbands to be involved in all aspects of household labor (Herrera and DelCampo 1995). Overall, white husbands and wives perform significantly fewer hours of household labor compared with non-​white husbands and wives (Bianchi et al. 2000).

12.2.5.3. Contributions of Children The findings are equivocal on whether children perform a significant amount of household labor (Bianchi et al. 2000), but researchers have found that children’s housework is divided by gender, with boys often performing traditionally “male” tasks, and girls performing traditionally “female” tasks (Coltrane 2000). An area worth investigating is whether, given lower birth rates, smaller families, and increased emphasis on developing children’s human capital, children’s participation in household maintenance has undergone a secular decline in recent years. This could increase the relative burden that adults in the home are required to bear.

12.2.6. Fairness in Labor Distribution, the Meaning of Full Time, and the Leisure Gap This section addresses a number of topics important to both the division of household labor and the issue of work–life balance. It reviews research into how fairness in the distribution of household labor is viewed by spouses. It then considers the “gender leisure gap,” which refers to data indicating that women’s average combined hours of paid and unpaid work exceed men’s. Finally, it elaborates on the problem that assertions concerning the gender division of labor, as well as gaps in pay, may be distorted by a lack of precision in measurements of “full-​time” and “part-​time” work, with those terms having different meanings across genders.

12.2.6.1. Fairness One interesting consequence of the division of household labor is that even though women perform the majority of household labor, only 20% to 30% of women perceive this distribution as unfair (Mikulka 1998). Research has found that there is a high

 

FAMILY AND HOUSEHOLD ECONOMICS    291 degree of agreement between married men and women on what is equitable and that most couples do not use a 50–​50 split of housework as an “equality point.” Men believe the division of labor is fair when they contribute 36% of the time devoted to household tasks, whereas women designate their performance of 66% of the work as fair (Lennon and Rosenfeld 1994). Nonetheless, not all men and women are satisfied with the specific allocation within their own marriage. There is evidence that women who view the distribution of household labor as unfair are more likely to experience depression (Bird 1999; Lennon and Rosenfeld 1994) and that a perception of inequity decreases marital satisfaction for both men and women and increases women’s (but not men’s) likelihood of divorce (Frisco and Williams 2003). Yet other research has found that a woman is more likely to perceive an unequal housework division as inequitable when she encounters low time availability (usually because of working long hours in the labor market), is not highly dependent on the partner’s income, and adheres to a non-​traditional gender ideology (Braun et al. 2008). Another strand of research has focused on the existence of a “gender leisure gap,” a term referring to the finding that women’s hours of paid plus unpaid work generally exceed those of men, thus allowing men more leisure time (Bianchi and Milkie 2010). Estimates of this gap vary from men having more than 30 more minutes per day of leisure (Mattingly and Sayer 2006) to 3 hours per week (Wang 2013). Research has also found that while leisure time is more meaningful to women, it is also more stressful and less refreshing, possibly because of more frequent interruptions and attempts at multitasking during nonworking periods (Wang 2013; Bianchi et al. 2006; Offer and Schneider 2011). Alison Wolf (2013) has disputed the existence of a gender leisure gap, claiming that recent evidence shows that the gap is closing, albeit with some variation between countries and over the life course. She also questions the importance of the leisure gap in women’s quest to achieve work–life balance, asserting that its role has been exaggerated relative to other factors more critical to women’s status and well-​being. One important aspect of research on the gendered leisure gap has to do with methodology. Are tallies of working hours, whether at home or in the paid workplace, accurate? Leisure gap reports are sometimes based on time-​diary studies, which are subject to individual distortions in reporting. But data about working hours, especially in official government reports, are especially prone to imprecision. Kay Hymowitz (2013) has confronted this problem in analyzing the purported “gender pay gap,” revealed by statistical reports that full-​time working women earn between 75 and 81 cents for every dollar men earn. She has questioned those numbers by arguing that full time does not designate the same duration of work for men and women. Hymowitz points out that the definition of full time often includes anyone who works more than 35 hours per week. Within that category, the evidence indicates that men as a group work significantly longer hours than women do. In 2007, 27% of male full-​time workers worked 41 hours or more per week, compared with only 15% of female full-​time workers. At the opposite end of the spectrum, 12% of women working full time put in between 35 and 39 hours, whereas only 4% of men did (Hymowitz 2011a, 2011b). Based on these statistics, the gender pay gap could well be a function of men working longer hours. This would not betoken pay discrimination

 

292   AMY WAX but rather lower compensation for women based on fewer hours at work. Hymowitz also attacks the frequent claim that men make more money than women who perform the same job. For example, it has been reported that female physicians and surgeons earn 64.2% as much as male physicians and surgeons do. But Hymowitz argues that these numbers ignore important differences. Males are disproportionately more likely to choose medical specialties that require longer hours and that offer higher compensa­ tion than those chosen by women (Hymowitz 2011a, 2012a, 2012b, 2013). All in all, once factors such as education and hours are controlled for, the pay gap between genders shrinks to single digits.

12.3.  Work–​Family Balance The following section discusses several theoretical approaches to explaining why women differ, on average, from men in their choices for balancing paid work and unpaid domestic labor. The landscape can be roughly divided between those who believe that structural and institutional factors are the most important causes of gender divergence, as opposed to those who cite women’s (and men’s) personal preferences, interests, and outlook as driving differences in outcomes. The contribution of externally imposed versus internal preference-​based elements to women’s “choices” is a critical fault line in the debate about gender divergence in labor market participation and time use. One prolific and leading proponent of the external, structural view is Joan Williams (2001). Williams believes that women’s labor market prospects and success are routinely circumscribed by strong institutional and workplace expectations that favor men. She argues that employers envision an ideal worker who has numerous “masculine” traits—​including the ability to work full time, move when required, take little time off, be continuously available on the job, and give paid work absolute priority over domestic responsibilities. The ideal worker is quintessentially “masculine,” Williams asserts, because functioning in that role requires a worker to have a stay-​at-​home spouse to handle childcare and domestic duties. Because women bear the brunt of household responsibilities, they are less able than men to function as ideal workers, and thus reap fewer rewards in the workplace. This pattern is self-​reinforcing, with women often withdrawing from paid work and shouldering greater domestic responsibility because their failure to function as ideal workers results in lower pay and diminished market opportunities. Williams also makes clear her belief that the “ideal worker” structure is contingent and dispensable. Although the “ideal worker” expectation is deeply embedded in the current culture and structure of the workplace, it incorporates arbitrary features that can and must be reformed before women can achieve true equality. Recent work by the economist Claudia Goldin (2014) carries forward some of Joan Williams’s themes. According to Goldin, the “last chapter” of change that is needed to achieve true economic equality between men and women is a radical revision in how jobs are structured and remunerated. Goldin’s focus is primarily on workplace reforms

 

FAMILY AND HOUSEHOLD ECONOMICS    293 and compensation rather than on trying to alter the household division of labor. She emphasizes the goal of allowing women to combine domestic responsibilities with high workplace status and pay. Like Williams, Goldin wants employers to reject the paradigm of the “ideal worker” who is constantly available to fulfill employer demands. She seeks to create a more temporally flexible workplace that de-​emphasizes the need for long, continuous, fixed hours or “face time,” thus leaving more time for the necessary tasks of domestic life. According to her research, family-​friendly workplace restructuring has gained momentum in various sectors, such as technology, science, and health, with beneficial results for women’s workplace status and gender pay parity. Other economic sectors, such as the corporate, financial, and legal worlds, have proved more resistant. Nonetheless, she argues, these areas might be amenable to the type of team approach that gives individual workers more leeway to attend to responsibilities outside the workplace while still maintaining efficiency and continuity within it (Goldin 2014). In contrast to Williams and Goldin, other theorists stress women’s preferences, tastes, and interests as the principal driving forces underlying distinct life roles for men and women. Kingsley Browne (2002) adopts the perspective of evolutionary psychology to explain why women are less successful than men at work and why they tend to be more focused on the home front. According to Browne, existing structures and institutions are neither arbitrary nor pivotal in holding women back, and the existence of a “glass ceiling” is a chimera. Rather, because women are more invested in their offspring, they are naturally inclined to give greater attention to domestic pursuits, and have less of a drive to reach the pinnacles of the workplace. Thus, existing arrangements primarily reflect the average preferences, leanings, and ambitions of men and women, which in turn are based on significant innate differences. A study by Steven and Christopher Rhoads (2012) of gender roles and childcare also urges consideration of “biological and evolutionary” explanations, and the role of deep-​ seated gender-​specific preferences, to explain gender differences in workplace status and success. The Rhoads conducted a study of male and female tenure-​track professors at an elite university to determine what factors were associated with more equal or unequal distributions of childcare duties among similarly educated and ranked junior academics. The Rhoads study found that even male professors who took parental leave and purported to embrace non-​traditional gender roles did not generally share childcare duties equally with their wives, even if both members of the couple were full-​time working academics. In attempting to get at why wives and husbands with similar professorial status and jobs nevertheless performed different amounts of childcare, the authors administered a questionnaire that asked the subjects to report their enjoyment of child-​related tasks on a numerical scale. The women almost uniformly reported a significantly higher average enjoyment of even burdensome tasks associated with their children (like taking care of sick child). The authors conclude that an important reason for the unequal distribution of childcare is that the average female gets more positive utility from childcare than does the average male—​a preference that persists despite otherwise similar professional interests and abilities. The authors also suggest that, because neither gender-​role attitudes nor leave-​taking status were strongly correlated with enjoyment of childcare,

 

294   AMY WAX efforts to change external work–family policies or gender-​role ideology would probably not have a significant effect on the study subjects’ behavior, beyond what had already been achieved. Like Brown, the authors argue that “biological and evolutionary factors” are important drivers of residual gender differentials in domestic behavior, even among sophisticated and highly educated populations, and that these tendencies might be beyond the reach of proposed “family-​friendly” policy changes. Catherine Hakim’s preference theory (2000) also argues that attitudinal factors such as women’s work–lifestyle preferences, motivations, and aspirations help explain observed work and family patterns. Unlike Browne, however, Hakim does not argue from an evolutionary perspective, and she assigns an important role to structural and institutional factors, especially in influencing the behavior of women whose preferences are mixed. According to Hakim, the female population is highly diverse, in that it spans a wide variety of interests and orientations. Strongly work-​centered women anchor one end of the population. These women are characterized by their determination to develop a career and a willingness to subordinate domestic pursuits to achieving workplace goals. The other end of the continuum is occupied by home-​centered women, who place family and domestic priorities at the fore and are relatively indifferent to work and career. Finally, there are women in the middle, whom Hakim refers to as “drifters.” These women are happiest when achieving some mix of workplace and domestic goals. Hakim posits that, at present and historically, women at the extremes of the spectrum are more robust in their preferences, with hard-​core work-​oriented women generally rejecting domesticity, and strongly domestic women opting out of the workforce if possible. Regardless of talent, education, and social expectations, the women in these categories do their best to make good on their preferences, which may be easier or harder to achieve in different eras. In contrast, the behavior and work-​family choices of the “drifters” are more amenable to influence by situational factors and contextual variables. These can include cultural attitudes, social norms, and workplace conventions (such as the existence of part-​time positions and flexible hours), as well as official policies such as the availability of generous parental leave and financial subsidies for families. Hakim estimates that between 40% and 80% of the female population occupies the middle category, while the opposite ends of the spectrum each comprise between 10% and 30% of women. Some researchers have critically analyzed Hakim’s preference theory. One study examined work–​life opportunities across seven European countries to determine whether Hakim’s theory could be substantiated or whether more emphasis should be placed on structural factors (Kangas and Rostgaard 2007). These authors found a significant correlation between home-​centered attitudes and labor-​market status, which was consistent with Hakim’s framework, at least regarding “home-​centered” women. They also found that generous leave schemes and other family support policies, as well as husbands’ attitudes and familial orientation, played a large role in women’s work–​life choices, including hours worked. Although none of these observations would appear inconsistent with Hakim’s theory (because she concedes that the majority of women are influenced by such variables), the authors nonetheless criticize Hakim for giving too

 

FAMILY AND HOUSEHOLD ECONOMICS    295 much weight to “intrinsic preferences” and de-​emphasizing the extent to which con­ textual variables, especially in some societies, can drastically shape both what women prefer and their ability to make good on those preferences.

12.4.  Protections for Caregivers: Mandated Benefits and Antidiscrimination Laws Although, as the discussion so far demonstrates, the reasons for this social fact are in dispute, it is well established that women on average bear more responsibility than men for maintaining the household and caring for children. Necessarily, women’s economic status and prospects in the workplace are intimately related to that caregiving function. This section discusses two important legal protections for American women with caregiving responsibilities—​the Family and Medical Leave Act (FMLA) and Title VII of the Civil Rights Act. It looks at the work of Christine Jolls and Jonathan Gruber, who adopt a neoclassical economic framework to examine the effects of mandatory protections for caregivers, such as parental leave laws, on women’s employment and compensation. It then examines this author’s own game-​theoretic analysis, which argues that some family-​unfriendly workplace conventions might represent a dysfunctional or suboptimal equilibrium that could benefit from selective reforms. Finally, the section reviews some empirical research on the effects of mandated parental and maternity leave worldwide.

12.4.1. The FMLA The FMLA, passed in 1993, guarantees up to 12 weeks of unpaid leave annually to employees who meet designated statutory conditions related to illness or family responsibilities. Individual workers are entitled to leave owing to a serious personal illness or to care for a newborn baby, newly adopted child, or a family member with a serious health condition. See 29 U.S.C. § 2612(a)(1) (2013). An employee returning from an FMLA-​covered leave must be restored to the same job or one with equivalent pay, benefits, and other terms and conditions of employment. See 29 U.S.C. § 2614(a)(1). In protecting the rights of pregnant workers and mothers, the FMLA has several limitations. Only employers with at least 50 workers within a 75-​mile radius of the leave-​taking employee’s workplace are obligated to provide leave, and the employee must have worked for the same employer for 1,250 hours in the previous year, which effectively excludes many part-​time workers (29 U.S.C. § 2611(2)(A)(ii)). A 2000 US Department of Labor study found that only 10.8% of employers in the United States meet the FMLA definition of a “covered” employer, and only 58.3% of employees work for a covered employer (Waldfogel 2001). In addition, many employees eligible to take leave under

 

296   AMY WAX the FMLA fail to do so because they cannot afford a long period without pay (Suk 2010). Paid maternity-​related leave in the United States is fully private and rare, with only 16% of employers offering this benefit as of 2008 (Families and Work Institute 2008). Thus, de facto job and legal protection for pregnant women and new mothers who take time off from work is still exceptional in the United States.

12.4.2. Employment Discrimination Litigation: Title VII and the Pregnancy Discrimination Act of 1978 Given the limitations of the FMLA, female employees with caregiving responsibilities have increasingly turned to employment discrimination litigation under Title VII of the Civil Rights Act of 1964 (42 U.S.C. 2000 et. seq.) to secure job protections in the workplace. The language of Title VII forbids discrimination based on sex, not on maternity or family status. In light of this, most Title VII suits brought by caregivers rely on a “sameness” theory, which holds that Title VII is violated when employers fail to treat pregnant women or mothers in the same manner as other employees (Suk 2010). This theory has been used mainly by women who claim that their work status has been compromised by becoming mothers. The Act was also amended in 1978, by adding the Pregnancy Discrimination Act (PDA), which provides specified types of protections for pregnant women (42 U.S.C. § 2000e(k) [2013]). The general turn to statutory antidiscrimination law and the enactment of the PDA followed the failure of litigants to persuade the courts to extend protection to pregnant women under the US Constitution. The plaintiffs in Geduling v Aiello had alleged that California’s disability insurance system violated the Equal Protection Clause of the United States Constitution by excluding pregnancy-​related disabilities from the system’s coverage. The US Supreme Court disagreed, 417 U.S. 484, 492 (1974), holding that there was no violation because California’s exclusion on the basis of pregnancy could not be equated with an exclusion on the basis of gender. Two years later, the Court rejected a Title VII-​based argument on similar grounds, holding that the exclusion of pregnancy coverage from an employer’s disability plan was a rational, nondiscriminatory decision based on cost considerations (General Electric Co. v Gilbert, 429 U.S. 125, 138–​140 [1976]). In response to these cases, Congress passed the PDA of 1978, which amended Title VII to clarify that discrimination “because of sex” included discrimination “on the basis of pregnancy” (42 U.S.C. § 2000e(k) [2013]). Although the statute does not guarantee job leave for pregnancy or childbirth and does not protect mothers in general, its main effect has been to force employers to treat pregnancy like any other physical disability that requires nonworking time and is entitled to health insurance coverage. The law has also helped to mitigate more general workplace discrimination (such as termination or demotion) based on pregnancy.

 

FAMILY AND HOUSEHOLD ECONOMICS    297 Recent data have indicated a surge in pregnancy discrimination litigation, with pregnancy discrimination lawsuits increasing by 65% between 1992 and 2007 (National Partnership for Women and Families 2008). Increasing numbers of cases go beyond invoking the limited protections of the PDA to assert Title VII claims based on unfair treatment of employees with family responsibilities, a phenomenon referred to as family responsibility discrimination (FRD) (Suk 2010; EEOC 2007). These types of cases increased four-​fold between 1996 and 2005 (Still 2006), and recent data indicate that plaintiffs win more than 50% of the cases—​a much higher rate than the 30% for other types of employment discrimination cases (Clermont and Schwab 2009; Parker 2006). The theory behind FRD cases traces its legal origins to the work of Joan Williams who, as already noted, asserts the quintessentially masculine nature of the “ideal worker” favored in the employment setting. On this view, the time demands and inflexibility institutionalized in workplace “ideal worker” structures routinely operate to the disadvantage of women with children and thus amount to a form of sex discrimination that Title VII is designed to correct. As an extension of this framework, many litigants identify gender stereotypes as a potent source of discrimination, arguing that employers routinely erect a “maternal wall” that blocks women’s advancement based on assumptions that female caregivers cannot be good workers and that men are not caregivers who need parental leave (Suk 2010). In keeping with these arguments, the EEOC’s 2007 Guidance identified gender stereotyping as the most important factor in FRD cases. In practice, the “maternal wall” theory has proved to be a successful strategy in FRD litigation. Some FRD cases involve “loose lips,” where supervisors make blatantly discriminatory remarks that reveal their assumptions about mothers. Others rest on allegations of discriminatory requirements, such as last-​minute travel and long continuous hours, that parents without a stay-​ at-​home spouse (who are mostly mothers) have difficulty meeting (Suk 2010). Victories for plaintiffs in such cases represent a significant extension of Title VII to individuals who claim they are disadvantaged in the workplace for their caretaking responsibilities.

12.4.3. Academic Approaches to Mandatory Benefits Several scholars, including Jonathan Gruber and Christine Jolls, have applied an economic perspective to analyze the pros and cons of so-​called mandated benefits, such as those extended through laws like the FMLA, which requires employers to offer affir­ mative, and often costly, protections to employees. Gruber’s work has focused on the effects of mandatory coverage of childbirth expenses in employer-​provided insurance policies. Gruber has hypothesized that requiring employers to include these benefits would lead to lower wages for women or women of childbearing age because employers would try to recapture the increased cost of employing women by paying them less (Gruber 1994). Empirically, Gruber has claimed that his predictions are validated. According to his data, mandated health coverage on the state and federal level caused the wages of women of childbearing age (between 20 and 40) to fall by at least the cost

 

298   AMY WAX of the mandate, while these women’s levels of employment were essentially unchanged. Gruber argues that these findings “consistently suggest shifting of the costs of the mandates [to the beneficiaries of the mandates] on the order of 100%, with little effect on net labor input.” In other words, the women who were supposed to benefit from coverage were bearing the cost through reductions in their compensation levels without any mea­ surable increase in the labor market participation of this group. According to Gruber, these requirements do not actually make women better off, at least in the short term. Christine Jolls (2000) has also analyzed the possible economic consequences of so-​ called accommodation mandates, such as the requirement of protected maternity leave under the FMLA. She concludes that the answer to the question of who bears the costs of such mandates—​whether the beneficiary class, workers as a whole, or some combination of employer and workers—​is: “it depends.” When occupations are significantly segregated by gender, it is easy for employers selectively to pass on a mandate’s costs by lowering wages only for the beneficiary population or by employing fewer people in that category. That is because antidiscrimination laws only require equal treatment by sex for people in the same job and allow differential pay and hiring rates for men and women in distinct jobs. Under these conditions, Jolls predicts that the FMLA’s accommodation mandates will either depress women’s wages or decrease women’s employment, depending on whether the value of the mandate to the workers exceeds its cost. Where cost is less than value, employees will accept the wage reduction and remain employed. If not, the number of workers in the benefited category will decline as employees voluntarily leave the workforce. When significant occupational segregation is not present, in contrast, the constraints of antidiscrimination laws might limit the employer’s ability to pass on costs selectively to the beneficiary population. If “wage differentials” by gender are restricted (through, e.g., aggressive enforcement of equal-​pay laws), employers might try to effect “employment differentials” by gender—​that is, hiring fewer women. If those steps are restricted (because of strong or easily enforced antidiscrimination laws), employers will have no choice but to spread the costs of mandates to the workforce as a whole, which will result in less compensation for everyone, and also in cross-​subsidization of beneficiary groups by others. Whether or not the costs of the mandates exceed the benefits will also influence its effects, as overly expensive mandates will tend to produce lower employment levels and job losses. In sum, the expected consequences of mandates depend on a number of contingent parameters, including the characteristics of the particular workplace, the legal environment, and the relative value of the mandate. All of those factors are important in determining whether a particular mandate’s effects are positive or negative overall. Amy Wax (2004) questions whether some of the assumptions of the neoclassical approach utilized by Gruber and Jolls are valid in general and true for accommodation mandates in particular. She constructs a game-​theoretic model to demonstrate that long hours and excessive workplace demands can sometimes result in a costly “arms race” that gives a competitive edge to individual strivers but hurts some workers (including those with caregiving responsibilities) and is inefficient for the workplace as a whole. In

 

FAMILY AND HOUSEHOLD ECONOMICS    299 other words, certain “ideal worker” practices might be good for some workers relative to others, but bad for everyone because all workers might be happier with a more family-​ friendly set of workplace conventions (Frank 1995). Because existing job arrangements may not always be optimal, family-​friendly reforms might sometimes have the effect of “jolt[ing] management-​employee interactions out of stable, inefficient equilibria and toward more efficient alternatives.” These changes could come from an external source, such as governmental mandates for parental leave and workplace flexibility. Or they might arise informally and internally, through management directives or the evolution of spontaneous order. Wax cautions that although such reforms have the potential to be self-​sustaining, most will require either “firm direction by management or self-​selection by employees with similar preferences” to avoid erosion through turnover or disruption by employees with less family-​friendly priorities. One problem with implementing family-​friendly reforms, however, is that it is not always easy to know when existing workplace conditions represent an inefficient equilibrium or are necessary to the optimal functioning of a particular enterprise. Recently, as Claudia Goldin has demonstrated and has already been discussed (Goldin 2014), a diversity of practices among different types of workplaces has emerged, with some becoming more flexible and less demanding of long hours and continuous availability. Business, law, and finance have generally held out against these trends. Whether those sectors can be effectively restructured without harming productivity or efficiency remains to be seen. Aside from the issue of whether specific workplace mandates actually help or hurt women, some commentators, including economists, have argued that various steps should be taken to share the burden and cost of raising children more widely throughout society. Those proponents observe that society as a whole reaps economic benefits when its adult members are healthy, productive, and well socialized, and that the type of childrearing that achieves this result requires considerable parental investments (Folbre 1994; Burggraf 1997; Wax 1999; Olsaretti 2013). By taking on a large share of the expensive and time-​consuming burden of childcare, parents, and especially mothers, benefit not only themselves and their children, but everyone. Because the costs of raising children are imposed disproportionately on some members of society, we should adopt policies that reward caretakers by offering extra resources, such as job training and government subsidies. Amy Wax adds to this observation by noting that, because beneficiaries of parental care fail fully to compensate those who bear the burdens and provide the benefits, caregiving activities tend to generate uncompensated positive externalities. Classic economic theory predicts that care giving will therefore tend to be undersupplied relative to its optimal levels. In other words, “hands-​on caring and other ‘women’s work’ is vital to a good society and … potentially in short supply in a free one.” That prediction provides some justification, grounded in economic principles, for “a mix of policies and strategies, formal and informal, that returns to caregivers the rewards they would enjoy if the beneficiaries of their efforts really paid their own way” (Wax 1999). The main drawback of such an approach, however, is that not all parents are equally skilled and effective in socializing their children. Quality controls on parenting are notoriously poor, especially for the growing number of children born to single

 

300   AMY WAX mothers who are ill equipped to support or care for them (Wax 2000, 2003). It is thus unclear whether subsidies for all parents will result in a net benefit to society, especially if targeted to those with a paucity of resources.

12.4.4. Effects of the FMLA and Mandatory Paid Leave on Wages and Employment: Empirical Perspectives Researchers interested in the real-​world consequences of family-​friendly mandates have examined the empirical effects on wages and employment of the FMLA’s unpaid leave requirements, as well as paid leave guarantees, which tend to prevail in Europe. Work by Charles Baum and Jane Waldfogel indicates that, while the FMLA has induced more women to take maternity leaves in the United States, effects on wages and employment have not been significant. Christopher Ruhm’s studies of European family-​leave benefits suggest that extended periods of paid maternity leave can have positive effects on employment but negative effects on wages.

12.4.4.1. Effect of the FMLA on Wages and Employment In his empirical examination of the FMLA’s effects on labor markets in the United States, Charles Baum (2003) failed to find any statistically significant change in employment levels or wages. This result was observed even among the subset of women who worked for employers covered by the FMLA and when various controls for selection bias were introduced. Baum proposed several reasons for the FMLA’s minimal effect. First, he noted that many larger companies, which were most affected by the FMLA, had voluntarily provided some kind of maternity leave benefits before the law was passed. In addition, twelve states and the District of Columbia had already enacted and implemented legislation guaranteeing unpaid maternity leave for in-​state workers before the FMLA was enacted. Finally, Baum hypothesized that the short duration of the FMLA’s leave (less than 3 months) minimized its economic impact, especially since the unpaid status might induce many women to take shorter durations of leave or none at all. Based on these results, Baum argues that strengthening the law—​by, for example, extending coverage to small employers, lowering employee eligibility requirements, or lengthening the leave period somewhat—​would likely have modest to minimal effects on employment and wages. However, his data tell us nothing about whether significantly longer European-​style periods of paid leave would have positive or detrimental effects. Baum’s findings largely coincide with an earlier analysis by Jane Waldfogel (1999), who observed that the FMLA led to increased coverage and usage by eligible women without imposing significant costs in the form of lower employment or wages for women overall. Waldfogel used her study to dispel two “myths” about the FMLA. First, she argued that, despite the FMLA’s purported limitations (in covering a minority of workers, many of whom already had benefits, and in securing only unpaid leave), its effects on coverage

 

FAMILY AND HOUSEHOLD ECONOMICS    301 and leave utilization were not negligible. Although acknowledging that the law’s impact has been limited by some of these factors, she reports a “notable increase in coverage and an even bigger increase in leave-​taking” in the wake of its enactment. Waldfogel points toward two possible reasons for this effect: the modest but measurable increase in the population entitled to leave through the FMLA’s expanded coverage, and more utilization of other available leave benefits resulting from a greater acceptance by employees and employers of leave-​taking for family needs in the wake of the FMLA’s enactment. Waldfogel also disputes the FMLA’s presumed negative effects on worker compensation and participation by observing slightly higher employment levels (in part because of greater retention and lower quit rates among women) and minimal net wage effects post-​FMLA, at least in the short run.

12.4.4.2. Effects of Mandated Parental Leave in Europe Unlike the United States, all Western European countries offer at least 3 months of paid benefits to women after the birth of a child. Christopher Ruhm’s study (1998) argues that these mandates lead to more women going to work but lower women’s relative wages, especially for leaves of longer duration. While short periods of up to 3 months of paid parental leave increase the employment-​to-​population ratios of women by 3% to 4% with little effect on wages, longer periods of up to 9 months raise employment-​to-​ population ratios by 4% but cause hourly earnings to drop by around 3%. Ruhm hypothesized that the rise in women’s employment ratios can be explained by multiple factors, including increased workforce participation and duration, as well as changes in the ways the government and managers categorize women workers. According to Ruhm, approximately 25% to 50% of the change is likely due to more women being designated as “employed but absent from work” while on leave. The remaining change in employment ratios is probably due to increased labor-​force participation by females who would not otherwise be working, including those drawn into jobs by the availability of generous maternity benefits and those returning to work after becoming mothers rather than leaving the workforce entirely. As for wages, Ruhm’s results showed that brief leave entitlements had little effect on women’s earnings, but that longer leave periods resulted in 2% to 3% reductions in relative wages—​a difference he termed “substantial.” Ruhm hypothesized that shorter leave periods impose fewer costs on employers, especially where (as in some countries) the benefits are paid by the government. Longer leave periods, on the other hand, could decrease relative wages through several mechanisms. If more women are induced by the lure of maternity benefits to seek and take employment, the increases in the labor supply alone could lower female earnings. Extended periods of leave could also impose substantial nonwage costs on firms who must find and train temporary replacements. Finally, the pronatalist effect of maternity benefits might encourage women to have more children in a short time frame, resulting in absences stretching into years. Taking such extensive periods away from work could cause a “substantial depreciation of human capital.” However, Ruhm cautioned that his results and their interpretation should be viewed as speculative because of the small sample sizes and incomplete data. Thus, the

 

302   AMY WAX jury is still out on the long-​term effects of generous maternity benefits, and whether their impact on women’s pay, employment, and work status is positive or negative.

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FAMILY AND HOUSEHOLD ECONOMICS    307 Walker v Fred Nesbit Distributing Co., 2004 U.S. Dist. LEXIS 15969 (S.D. Iowa 2004). Wang, Wendy. 2013. “The ‘Leisure Gap’ Between Mothers and Fathers.” Pew Research Center (Oct. 17, 2013). http://​www.pewresearch.org/​fact-​tank/​2013/​10/​17/​the-​leisure-​gap-​between-​ mothers-​and-​fathers/​ [Accessed 21 August 2016]. Wax, Amy. 1998. “Bargaining in the Shadow of the Market: Is There a Future for Egalitarian Marriage?” Virginia Law Review 84(May), p. 509. Wax, Amy. 1999. “Caring Enough:  Sex Roles, Work, and Taxing Women.” Villanova Law Review 44, pp. 495–​524. Wax, Amy. 2000. “Rethinking Welfare Rights: Reciprocity Norms, Reactive Attitudes and the Political Economy of Welfare Reform.” Law & Contemporary Problems 63(Winter/​Spring), p. 257. Wax, Amy. 2003. “Something for Nothing: Liberal Justice and Welfare Work Requirements” Emory Law Journal 52(Winter), p. 1. Wax, Amy. 2004. “Family-​Friendly Workplace Reform: Prospects for Change.” Annals of the Academy of Political and Social Science 596, pp. 36–​61. Wax, Amy. 2014. “Diverging Destinies Redux.” Michigan Law Review 112(April), p. 925. Williams, Joan. 2001. Unbending Gender: Why Family and Work Conflict and What to Do About It. Oxford: Oxford University Press. Wolf, Alison. 2013. The XX Factor: How the Rise of Working Women Has Created a Far Less Equal World. New York: Crown Publishing.

 

Chapter 13

E C ONOMICS OF RE ME DI E S Ariel Porat

13.1. Introduction Analyzing the substantive law without its remedial part is almost meaningless.1 If we knew that the law imposes liability for negligence or for breach of a contract, but knew nothing about the remedies to which the victim is entitled in case his rights are infringed, we would know very little about the impact of the law on the real world. Therefore, in all legal systems, the remedies are interlinked with the substantive law. In civil legal systems, the same code that allocates entitlements among the parties also sets the remedies for protecting those entitlements. In both civil and common law legal systems, it is hard to imagine a court deciding a substantive law dispute without taking into account, explicitly or implicitly, the remedies that are available to victims. Indeed, it is hard to imagine the creation of the substantive law, by either legislatures or courts, without careful consideration of the remedial consequences of its breach. The claim that substantive law and remedies are interlinked with one another might imply that each legal field must have its own unique remedies. If that were the case, remedies would not be an independent topic, but rather a subtopic in each and every substantive field of the law.2 This implication, however, is wrong. Remedies in different legal fields have much in common, and the study of remedies as a topic can teach us a lot, especially when the goals of the substantive legal fields are similar (Cooter 1985). Consider tort law and contract law. Under its efficiency rationale, tort law should minimize social costs, thereby enhancing social welfare. In order to achieve this goal, tort law should provide incentives for both the injurer and the victim to take efficient 1  Ariel Porat is Alain Poher Professor of Law at Tel Aviv University and Fischel-​Neil Distinguished Visiting Professor of Law at the University of Chicago Law School. I thank Hed Kovetz for excellent research assistance. 2  In most law schools in common law jurisdictions, an important part of the Contract Law or the Tort Law class is remedies (for breaching a contract or for wrongfully inflicting harm, respectively), and only a few law schools offer a Remedies class.

 

ECONOMICS OF REMEDIES    309 precautions. Similarly, contract law should also provide the parties with efficient incentives, in order to enable them to maximize the contractual surplus. In both torts and contracts, providing the injurer/​promisor and the victim/​promisee with efficient incentives is done through a combination of substantive and remedial law. It should therefore come as no surprise that the remedies in both legal fields share much in common. This chapter emphasizes the common denominators of the remedies in torts and contracts. Some remedies that are more typical of either contracts or torts are also discussed. While the remedies in both fields are similar, they are not identical, and often are adapted to the legal context to which they apply.

13.2.  Property Rules and Liability Rules 13.2.1. General Framework In a seminal article, Calabresi and Melamed (1972) distinguished between the allocation of entitlements and the remedies for protecting them, as two distinct stages in promoting efficiency. In particular, they argued that once entitlements are allocated, they can be protected by either property or liability rules. Under a property rule, no one is allowed to deprive the owner of his entitlement without his consent; under a liability rule, other people are allowed to do so, but must compensate the owner for his losses. Thus, suppose Polluter inflicts harm on Resident. The law should allocate an entitlement, either to Resident to live without the pollution or to Polluter to pollute without interference. Assume first that the law made the former choice, so that the entitlement is allocated to Resident. Now a second choice must be made: to protect the entitlement with either a property rule or a liability rule. Under a property rule, Resident can sue Polluter in court and get an injunction, prohibiting further pollution (rule 1, in Calabresi and Melamed’s terms); under a liability rule, Resident is entitled to compensation only, so it is Polluter’s choice whether to stop polluting or, instead, pollute and compensate Resident for his losses (rule 2, in Calabresi and Melamed’s terms). Assume next that the law allocated the entitlement to Polluter rather than to Resident. Here, too, Polluter’s entitlement can be protected with either a property or a liability rule. Under a property rule, no one can stop Polluter from polluting without his consent (rule 3); under a liability rule, Resident can stop Polluter from polluting even without his consent, but if she chooses to do so she should compensate Polluter for the harm he suffers by ceasing the pollution (rule 4). The four rules are summarized in Table 13.1. Calabresi and Melamed analyzed the efficiency considerations in making the choices with regard to allocating and protecting the entitlements. First, they argued that when transaction costs are low it does not really matter, from an efficiency (rather than a distributional) perspective, whether the entitlement is allocated to Polluter or Resident: as

 

310   ARIEL PORAT Table 13.1 Allocating and Protecting Entitlements Entitlement

Protection

Rule 1

Resident

Property rule

Rule 2

Resident

Liability rule

Rule 3

Polluter

Property rule

Rule 4

Polluter

Liability rule

the Coase Theorem (1960) teaches us, with low transaction costs the parties would reach the efficient solution regardless of the initial allocation of entitlements. Thus, if Polluter is the cheapest cost avoider and rule 1 applies, he would take measures to prevent the harm (otherwise Resident would get an injunction in court, prohibiting pollution); if rule 3 applies, instead, Resident would offer Polluter a payment to stop polluting and Polluter would accept the offer. The same reasoning applies to the reverse case when Resident is the cheapest cost avoider: Resident would take measures either to avoid the harm (under rule 3) or be paid by Polluter to do the same thing (under rule 1). Things become more complicated when transaction costs are high, which makes contracting between the parties either hard or impossible. Here it is necessary to distinguish between two scenarios: first, when the cheapest cost avoider can be identified, and second, when it is unknown who the cheapest cost avoider is or if there is one at all. In the first scenario, the entitlement should be allocated to the party who is not the cheapest cost avoider. Such an allocation would provide incentives to the cheapest cost avoider to take measures to prevent the harm. Thus, if Polluter is the cheapest cost avoider, allocating the entitlement to Resident and protecting her entitlement with a property rule (rule 1) would incentivize Polluter to prevent the harm. The same logic applies to the reverse case when Resident is the cheapest cost avoider: here, rule 3 would do the work. The second scenario is the more interesting because it calls for liability rules. Assume that it is impossible for either courts or legislatures to know whether stopping pollution is efficient or not. Under those circumstances a property rule would not be an adequate solution, since once such a rule is applied, the parties might be stuck in an inefficient situation. For example, if rule 1 is applied, pollution is prohibited, so even if pollution is efficient, it will be prevented. Indeed, if the court or legislature knew that pollution is efficient, they would apply rule 3 and restore efficiency. But once courts or legislatures cannot know whether pollution is efficient or not, rule 2 could solve the problem. With rule 2, Polluter must decide whether to pollute and bear the resulting harm or stop polluting. Polluter will do whatever is cheaper for him, and that would be cheaper for society. Thus, if the harm is 100 and prevention costs are 50, Polluter will stop polluting, whereas if prevention costs are 150, Polluter will continue to pollute. In both cases Polluter’s interest and the societal interest align. Rule 2 is not the only alternative for solving the problem; rule 4 could be equally effective. Under rule 4, it is Resident rather than Polluter who decides whether to stop the

 

ECONOMICS OF REMEDIES    311 pollution or not. If she decides in the affirmative, she will order Polluter to stop polluting and reimburse him for prevention costs, but if she decides in the negative, she will do nothing and bear the harm. Thus, if the harm is 100 and prevention costs are 50, Resident will order Polluter to stop polluting, but if the costs are 150, Resident will do nothing and bear the harm. It is easy to see that the comparisons between harm and prevention costs under rules 2 and 4 are the same, the only difference being the identity of the party conducting the comparison and making the decision that follows. As with Polluter under rule 2, so too with Resident under rule 4, the interest of the party making the decision aligns with the societal interest. The choice between rules 2 and 4 has redistributive consequences (exactly like the choice between rules 1 and 3): rule 2 (and 1) favours victims (Residents), while rule 4 (and 3) favours injurers (Polluters). But, even if efficiency was the only consideration that matters for the law, the choice between the two rules could make a difference. The main efficiency consideration for choosing between the two rules is the availability of information to the courts applying the rules and the risk of errors that follow. Thus, if courts have better information about the harms to victims than about prevention costs, rule 2 will be more efficient than rule 4 is, and if the reverse is true, rule 4 will be the more efficient rule. To understand why, consider the preceding numerical example when harm is 100 and prevention costs are 50, and assume that rule 2 applies. Efficiency wise, the harm should be prevented because it is greater than prevention costs. But suppose now that the courts underestimate Resident’s harm—​say, because they are unaware of the high value Resident ascribes to her property—​and set damages at 40 instead of 100. Under those circumstances, Polluter will inefficiently pollute, because prevention costs are greater than damages. Applying rule 4 could solve the problem if, but only if, the courts estimate Polluter’s prevention costs accurately enough. Thus, if under rule 4, ordering Polluter to stop polluting would trigger Resident’s liability of 50, Resident will compare his harm of 100 (the realistic assumption here is that Resident accurately estimates her own harm) with expected liability of 50, and decide to stop the pollution. In this way, efficiency would be restored. In our last example, rule 2 leads to underdeterrence; with different numbers and overestimation of Resident’s harm by courts, rule 2 might lead to overdeterrence. In both cases, rule 4 might sometimes—​but not always—​solve the problem. In other cases the reverse might be true: under-​or overestimation of prevention costs by courts may result in inefficiencies under rule 4, which rule 2 might sometimes—​but not always—​ameliorate. In cases where courts’ errors are not solvable under either rule 2 or 4 in a satisfactory manner, the case for a liability rule becomes weaker, and the case for a property rule becomes stronger. With high transaction costs, uncertainty as to whether prevention by Polluter is efficient or not, and a high risk of courts’ errors with respect to both harm and prevention costs, it is hard to choose between a property or liability rule. In the real world, rule 4 is very rarely applied (Chang 2014).3 The main reason seems to be that in cases when transaction costs are high, typically, victims are numerous, 3  For a case where it was applied, see Spur Industries, Inc. v Dell E. Webb Development Co., 494 P. 2d 700 (Ariz. 1972).

 

312   ARIEL PORAT and cooperation between them—​a prerequisite for rule 4’s implementation—​is often implausible because of a free-​riding problem. Thus, when there are many Residents who should decide whether to stop Polluter from polluting in return for monetary payment—​as rule 4 requires—​each Resident might refuse to share the costs, knowing that if other Residents pay, pollution will stop anyway and she will be able to reap the benefit for free. The same problem typically does not arise with rule 2: the injurer needs no one’s cooperation in order to inflict harm on the victim and afterwards compensate him for it (Porat 2009).4

13.2.2. Refinements Calabresi and Melamed’s article has inspired many commentators who developed its original arguments, offered new applications, and criticized some aspects of them. Owing to limitations of space, only a few contributions to the literature will be mentioned in this chapter. Lucian Bebchuk (2001) pointed out that Calabresi and Melamed offered an ex post analysis that takes as a given the costs and benefits that would be generated for the parties with and without externality-​producing actions. This analysis, claimed Bebchuk, does not capture the entire picture. The allocation of entitlements and the way in which they are protected divide values between the parties differently, and this ex post division has a considerable impact on the parties’ ex ante decisions. Ex ante decisions take place before the decisions are made whether to undertake externality-​producing actions, and they influence the parties’ potential payoffs with or without these externality-​producing actions. A full account of the efficiency of any given allocation of entitlements and how they are protected—​Bebchuk’s argument goes—​must consider not only the ex post analysis but also the ex ante analysis. A couple of other articles, one authored by Ronen Avraham and the other by Ian Ayres, have dealt with the situation discussed in subsection 13.2.1, in which the court applying a liability rule lacks information about the values the parties ascribe to their entitlements. Avraham and Ayres suggested sets of rules, constructed on a combination of Calabresi and Melamed’s rules and some additional rules that can potentially encourage parties to reveal their true valuations of their entitlements, thereby facilitating outcomes that are more efficient (Avraham 2004; Ayres 1996). Lastly, Barbara Luppi and Francesco Parisi (2011) addressed the question regarding how remedies should be chosen when there are asymmetric transaction costs. They defined asymmetric transaction costs as situations in which different alternatives for reallocating resources entail different costs, such as when it is less costly to transfer an

4  Sometimes, however, injurers have an interest in directing their injurious activities towards the same victim/​s because marginal harm decreases when more injurers join the existing ones. In such cases, cooperation problems among injurers would emerge (Dillbary 2013).

 

ECONOMICS OF REMEDIES    313 entitlement from one use to another than it is in the reverse direction. Luppi and Parisi consider the possibility of using mixed remedies in such cases; for example, applying a property rule when A is the owner of the entitlement and B is the potential infringer, and a liability rule if the positions of A and B are reversed. Calabresi and Melamed’s framework is very useful in many contexts. In contract law, for example, specific performance could be characterized as a property rule, while damages are described as a liability rule. The next section further elaborates on this point.5

13.3.  Specific Performance, Damages, and Efficient Breach 13.3.1. General Framework There has been extensive debate in the legal literature over which remedy—​specific performance or damages—​should be the primary remedy and which the exception. For many, this debate represents a much broader dispute between law and economics and deontological scholars over the nature and goals of the law (Shiffrin 2009; Shavell 2009; Posner 2009). In the beginning, law and economics scholars argued that damages should be the primary remedy because specific performance, but not damages, discourages efficient and, therefore, desirable, breaches of contract. Later, law and economics scholars developed more nuanced arguments, showing that specific performance is often the more efficient remedy. The following two examples illustrate scenarios of efficient breach, and the discussion that follows clarifies the conditions under which a damages remedy would encourage such breaches and, at the same time, discourage inefficient breaches. Example  1. Gain-​Seeking Breach. Seller undertakes to manufacture a machine for Buyer. Expected costs of production are 80, the price, which is paid up front, is 90, and the value of the machine to Buyer is 100. After the contract is concluded, a second buyer shows up offering Seller 110 for the same machine. Seller can produce only one machine at a time, so he breaches the contract with Buyer and sells the machine to the second buyer. The only loss Buyer suffers is the machine’s lost value. Example 2. Loss-​Avoiding Breach. Seller undertakes to manufacture a machine for Buyer. Expected costs of production are 80, the price, which is paid up front, is 90, and the value of the machine to Buyer is 100. After the contract is concluded, owing 5 

The typical application of Calabresi and Melamed’s framework is intentional infliction of harm, as in nuisance (pollution) cases. Is that framework suitable for accidental harms? Should a negligence rule be characterized as a property or a liability rule? For the argument that negligence law should be characterized as liability rules, see Porat (2009, 199–​200) for the counterargument; also, see Coleman and Kraus (1986); Zipursky (1998, 55–​70).

 

314   ARIEL PORAT to a shortage of labour and materials, costs of production rise to 110. Seller breaches the contract. The only loss Buyer suffers is the machine’s lost value.

In both Examples 1 and 2, the breach of the contract is efficient. Under the assumption of perfect compensation with expectation damages as the measure of recovery, Seller pays damages of 100 to Buyer and reaps a benefit of 10 from the breach. An implicit assumption in the argument that the breach in Examples 1 and 2 is efficient is that, owing to high transaction costs, renegotiation between Seller and Buyer after contracting is too costly, and with Example 1, high transaction costs also preclude the sale of the machine (or assigning the right to the machine) by Buyer to the second buyer. Indeed, damages remedy, like any liability rule (see Section 13.2), could be justified only with high transaction costs because, otherwise, specific performance, like any property rule, would be preferable. With a remedy of specific performance, and with the assumption of high transaction costs, in both examples Seller will perform the contract inefficiently. Similarly, with disgorgement damages (in the amount of the profits made by Seller in Example 1 or in the amount of the savings made by Seller in Example 2), Seller will lack any motivation to breach efficiently because he gains nothing from a breach. Note that if compensation is lower than expectation damages, Seller, in both examples, might breach the contract even if performance is efficient. Thus, if damages are 90 (reliance damages), Seller will breach even if the second buyer in Example 1 offers him 95, or if costs of production in Example 2 rise to 95. In both cases the breach is inefficient, but it creates a benefit of 5 to Seller, which might motivate him to breach. The notion of efficient breach is justified by not only the general notion of promoting social welfare but also the more specific idea of incomplete contracts (Shavell 2009; Markovits and Schwartz 2011, 2012). According to the incomplete contracts idea, contract law provides the parties with default rules that apply to their contracts unless they opt out of those rules. The default rules save the parties transaction costs (in terms of negotiation and drafting costs), which they would have incurred but for the default rules. In order to achieve their goal, the default rules should be compatible with most parties’ interests because, otherwise, most parties would opt out of the defaults, and transaction costs would increase rather than decrease. The default rules will be compatible with most parties’ interests if they are efficient, viz., if they allocate risks and provide the parties with incentives in ways that increase the contractual surplus. The efficient breach idea—​so the incomplete contracts argument goes—​increases the contractual surplus, and is, therefore, compatible with most contractual parties’ interests. Therefore, it should be considered a desirable default rule. Note that increasing the contractual surplus serves not only the promisor’s interest, but also the promisee’s because the expected benefit of the option to breach efficiently will be shared by the two parties through price adjustment when making their contract. Therefore, basing the efficient breach idea on the theory of incomplete contracts might be more effective in defending this idea from deontological (or other nonutilitarian) attacks compared with basing it on the general notion of promoting social welfare.

 

ECONOMICS OF REMEDIES    315

13.3.2. Refinements The efficient breach argument is valid, as long as damages are fully compensatory. When damages are undercompensatory, specific performance often becomes the most efficient remedy. A notable category of cases where specific performance is the primary remedy because damages are typically undercompensatory is the sale of unique goods. In a now classical article, Anthony Kronman proposed a rationale for the willingness of courts to allow specific performance when the contract’s subject matter is a unique, rather than fungible, good. He suggested that with unique goods, far more so than with fungible goods, there is a substantial risk of undercompensation of buyers for two reasons: first, buyers often attach a subjective value to the unique good, and that value is not compensated for in the event of breach. Second, subsequent to breach of unique good contracts by sellers, buyers incur search costs in finding a substitute good, on top of the search costs they incurred when finding the original good, and those additional search costs are not compensated for (Kronman 1978). Since, according to Kronman, the parties would prefer specific performance over damages if the benefit to the seller from having the option to breach and pay damages is less than the costs of the breach to the buyer, and because the costs of the breach to the buyer with unique goods are typically higher than with fungible goods, Kronman concluded that specific performance would more often be preferred by the parties with unique goods than those with fungible goods. Another assumption underlying the efficient breach argument relates to transaction costs. In gain-​seeking breaches, such as in Example  1, the efficient breach argument assumes that transaction costs make it hard, even impossible, for Buyer to find the second buyer who values the subject matter of the contract more, and sell it to her. When this assumption is relaxed, specific performance might be the most efficient remedy. In an article published shortly after Kronman’s article, Alan Schwartz argued for a much broader application of specific performance than that suggested by Kronman. Schwartz claimed that the risk of undercompensation is substantial not only with unique goods, as Kronman suggested, but also with many fungible goods (Schwartz 1979). Furthermore, in contrast to Kronman, Schwartz claimed that the benefit to the seller of having the option to breach and pay damages is often less with fungible goods than with unique goods. Therefore, with fungible goods, the parties’ ex ante preferences would not necessarily warrant damages, rather than specific performance, as their preferred remedy. Further, for Schwartz, the central consideration in the choice between damages and specific performance as a remedy is which one entails lower post-​breach negotiation costs. This depends, according to Schwartz, mostly on whether (in our Example 1) it is easier for the seller or for the first buyer to find the second buyer who values the good more than the first buyer: only if it is the seller could damages be preferable to specific performance. Thomas Ulen took the argument for specific performance a step further, suggesting that specific performance should be the routine remedy for breach. Ulen, like Schwartz, regarded the post-​breach negotiation costs as a central factor in the efficiency of specific performance (Ulen 1984).

 

316   ARIEL PORAT While the first-​generation writings on efficient breach focused on the promisor’s decision to perform or breach, Richard Craswell (1988) analyzed the effects of the contractual remedies on various decisions made by the promisor and promisee. Craswell considered the effect of the remedies on the decisions as to whether to enter into the contract in the first place and what level of precautions to take in order to reduce the probability of breach. Craswell explained that even if post-​breach negotiation costs were zero, the prevailing remedy would still affect the parties’ decisions made before the promisor’s decision whether to perform or breach. In the economic analysis of contract law, it is implicitly assumed that the efficient breach argument is equally valid with respect to both loss-​avoiding and gain-​seeking breaches (Posner 2009). By contrast, lay people’s intuition is different:  experimental studies have indicated that people react more tolerantly to loss-​avoiding breaches than to gain-​seeking breaches (Baron and Wilkinson-​Ryan 2009). Moral philosophers have also distinguished between the two types of breaches, arguing that a breach to pursue a gain is more reprehensible than a breach to avoid a loss (Zamir and Medina 2010, 265). Lastly, behavioural law and economics could explain people’s different reactions to the two types of breach as a reflection of people’s different attitudes to losses as opposed to gains (Cohen and Knetsch 1992; cf. Zamir and Ritov 2010). Recently, Maria Bigoni, Stefania Bortolotti, Francesco Parisi, and Ariel Porat (2014) suggested, also from an economics perspective, that the case for allowing the promisor an option to breach is typically more vital in loss-​avoiding breaches than in gain-​seeking breaches.

13.3.3. The Promisee’s Incentives While the effects of remedies on the incentives of the promisor have been thoroughly analyzed in the literature, only a few scholars have analyzed their effects on the promisee’s incentives.6 A notable exception is Robert Cooter (1985), who pointed out that with full compensation, the victim’s incentives are eroded and overreliance might result. For example, if the promisee knows that there is a high likelihood of a breach, he might rely as if the likelihood of a breach is zero, knowing that he can reap the benefits of reliance if performance takes place but externalizes its costs to the promisee—​who will reimburse him for those costs—​if a breach occurs. Cooter suggested that when damages to the promisee are awarded at a fixed amount, the promisee relies efficiently because he fully internalizes both the costs and benefits of his reliance. Thus, liquidated damages, if they are set at the level of expected harm and remain invariant with respect to actual harm, might solve the overreliance problem.7

6  For an analysis of the mitigation of damages defence, see Goetz and Scott (1983). But the mitigation of damages defence applies only after a breach (or an anticipatory breach) occurs, and it is effective only when the victim’s behaviour is verifiable. 7  But it may create other inefficiencies: see infra Section 13.5.2.

 

ECONOMICS OF REMEDIES    317 Cooter and Porat (2002) discussed the erosion of the victim’s incentives not only with respect to overreliance, but also with respect to noncooperation. They noted that with fully compensatory damages, the promisee who could cooperate with the promisor and reduce the probability of a breach might be unwilling to do so, especially if noncoop­ eration is nonverifiable (otherwise a duty of cooperation or a comparative fault defence could solve the problem [Porat 2009]). Cooter and Porat suggested a novel theoretical solution, which they called “anti-​insurance.” According to their solution, the promisee and promisor make a contract with a third party (“anti-​insurer”), according to which the promisee assigns his right to damages to the anti-​insurer, so that in case of a breach the promisee receives no compensation and the promisor pays fully compensatory damages to the anti-​insurer. Before a breach occurs, the anti-​insurer pays to the promi­ sor and promisee for the valuable right to collect damages in case of a breach. Both the promisor and promisee now have efficient incentives because they fully internalize the costs and benefits of the precautions they will take to reduce the probability of a breach or reduce overreliance. Another more practical solution for improving the promisee’s incentives is to undercompensate her. With the risk of undercompensation, the promisee will be more willing to cooperate or avoid overreliance than with fully compensatory damages. Indeed, with imperfect compensation, the promisor’s incentives are deficient, but once the promisee’s incentives are taken into account, allowing some level of undercompensation could be optimal (Cooter and Porat 2004).

13.4.  Scope of Liability Not all harms are compensable, and not all victims can recover. First, in both torts and contracts, only foreseeable harms are recoverable. Second, in tort law, proximate cause is a limit to liability: if the harm is too remote, liability will not be imposed. Third, in negligence law, liability will be imposed only if the negligent injurer owed a duty of care to the victim. Both proximate cause and duty of care are used by courts as a means to limit liability for policy considerations (Restatement 3d Torts: Liability for Physical and Emotional Harm, § 7, cmt. a, 2010; Dobbs 2000, 448). Section 13.4 discusses several topics, all of which raise questions as to the appropriate scope of liability.

13.4.1. Foreseeability In both torts and contracts, foreseeability of losses is a precondition for the imposition of liability (Dobbs 2000, 443–​470; Farnsworth 2004, 792–​799). There are several efficiency justifications for this requirement. First, if the losses are not foreseeable there is no sense in imposing liability for their materialization, since such liability will not affect the behaviour of the injurer or the

 

318   ARIEL PORAT promisor. That is because if losses are unforeseeable, the costs of taking them into account when deciding which precautions to take are prohibitively high, so the injurer and the promisor will ignore them anyway, with or without liability (Landes and Posner 1987, 246–​247). Second, in negligence, when injury of any kind is unforeseeable—​namely, the probability of an injury is very low—​expected harm is low, and the costs of precautions typically exceed expected harm. When the costs of precautions are higher than expected harm, the injurer is non-​negligent, and liability should not be imposed. According to this justification for the foreseeability requirement, the unforeseeability of any injury is an indicator that there is no negligence on the injurer’s part to begin with. Note that this justification applies to a narrow set of cases where any injury—​as opposed to only the one that resulted in the litigated losses—​is unforeseeable. Third, on many occasions, the unforeseeable losses are foreseeable for the promisee and victim. In such cases the promisee and victim are typically the cheapest cost avoiders of the unforeseeable losses, whereas the injurer and promisor are not. Leaving the unforeseeable losses on the victim’s and promisee’s shoulders motivates them to take measures to avoid those losses, either before or after the wrong or breach takes place. This is especially essential when those measures are nonverifiable, and neither the comparative fault nor the mitigation of damages defence is applicable. Fourth and last, in the contractual context, the foreseeability requirement incentivizes the promisee to disclose private information to the promisor regarding the promisee’s unforeseeable losses, which is vital to the promisor for deciding whether to breach or to perform, as well as what level of precautions to take to avoid a breach. This justification for the foreseeability requirement is relevant, when conveying information from one party to another is possible and when the unforeseeable losses are foreseeable for the promisee (Ayres and Gertner 1989). To better understand this justification, assume that the promisee’s expected losses from a breach are 100 and foreseeable for her, but only a loss of 10 is foreseeable for the promisor. Without the foreseeability requirement, the promisee would not convey to the promisor any information regarding his high potential losses, because if the promisor knew about that, he would charge a higher price for his undertakings. As a result, with only partial information, the promisor would have deficient incentives to perform. In contrast, with the foreseeability requirement, the promisee would convey the information regarding her high potential losses to the promisor in order to make those losses foreseeable for him and, therefore, recoverable by the promisee. Conveying the information would secure the promisor’s efficient incentives, thereby increasing the contractual surplus.

13.4.2. Pure Economic Loss Victims often suffer pure economic losses. In contracts, losses are often purely economic in the sense that the promisee lost profits and nothing else, but as has already

 

ECONOMICS OF REMEDIES    319 been explained, liability is routinely imposed and for good economic reasons.8 In torts, in contrast, courts are commonly reluctant to impose liability for pure economic losses. There are several efficiency considerations that could justify this reluctance. The first consideration is that pure economic losses are often a private rather than a social cost9 (Bishop 1982). Imagine an injurer who created a nuisance to restaurateur 1, who shut down his restaurant for a week and lost profits of 100. Assume that the restaurant’s patrons fully mitigated their losses by dining during that week at another restaurant owned by restaurateur 2. Further, assume that the profits gained by restaurateur 2 from restaurateur 1’s patrons are 100, in addition to the regular profits made from his own regular patrons. From a social perspective—​so goes the economic argument—​no social harm has been done: profits were just transferred from one person to another. With no social harm, injurers should not take any costly precautions, so liability should be nil. This argument, however, has limits. To start with, if restaurateur 1 is a recurring loser and restaurateur 2 a recurring winner, no liability might inefficiently suppress restaurateur 1’s activity (Bishop 1982). Second, with no liability, restaurateur 1 might take costly precautions to avoid the harm; if the injurer, rather than restaurateur 1, is the cheapest cost avoider, liability would save the costs of precautions of restaurateur 1, even if at a cost to the injurer who—​given his expected liability—​would take precautions and prevent the harm (Dari-​Mattiacci and Schäfer 2007). Third, loss of profits—​as in our example—​are not necessarily just transfers of value from one person to another: the destruction of input might increase the marginal cost of production, leading to production decrease and higher prices (Rizzo, 1982a and 1982b). The second consideration against liability for pure economic losses is, that with such losses causation is often hard to prove. Thus, even if we think that those losses should be prevented, there is a risk that with liability the injurer will pay more than what he actually caused and be overdeterred. The reason why causation is harder to prove in pure economic loss cases than in physical injury cases is that those losses are of a type that occurs regularly with no wrongdoing, and, therefore, it is hard to distinguish them from non-​wrongful losses. To illustrate, assume that in the nuisance example, restaurant 1 was not shut down, but restaurateur 1 nonetheless lost profits owing to low attendance by patrons. Low attendance, however, could be caused by many other causes—​most of them non-​wrongful—​and it could be hard, sometimes even impossible, to isolate the effects of the wrongful from those of the non-​wrongful causes. If courts tend to resolve uncertainties in favour of victims—​and they are often so inclined—​they might impose too heavy a liability burden on the injurer (Abraham 2011, 1781–​1783). 8 

Supra Section 13.3. This, however, is not always so. Sometimes pure economic losses are a substitute for physical losses that are not compensated for practical reasons. For example, if the defendant polluted a river with chemical effluents and destroyed the wildlife in a certain area, since no one in particular owns the wildlife, recovery for the physical harm is impossible. Anglers, however, might be able to recover for lost profits even if those are pure economic losses: the lost profits could serve as a proxy for the social value of the lost wildlife. Cf. Pruitt v Allied Chemical Corp., 523 F. supp. 975 (1981). 9 

 

320   ARIEL PORAT The third and last consideration against awarding damages for pure economic losses is that those losses often have two characteristics that make the victim an especially effective cost avoider. The first characteristic is that those losses are accumulated over time, and, therefore, victims have a relatively long period to mitigate them. The second characteristic—​which has already been mentioned—​is that economic losses are of a type that occurs regularly with no wrongdoing; as a result, victims have expertise in handling and reducing them. The nuisance case is not the best example to illustrate these two characteristics, especially if the restaurant is shut down because of the nuisance. So let’s take another example: suppose a person is wrongfully injured in a road accident and has not showed up at work for 2 months. The injured person’s employer argues that he has suffered pure economic losses in terms of lost profits because of his employee’s absence from work. Obviously, the employer will not be able to recover. A  possible justification for this result is that the employer is a very effective cost avoider: her lost profits accumulate from day to day, so she has time to consider how to mitigate them (e.g. by hiring a substitute employee, reducing her activity level, or postponing the performance of some of the work for a few months). Furthermore, the employer is accustomed to handle such losses on a daily basis—​employees are often absent from work for non-​wrongful causes—​and must have expertise in minimizing them. Indeed, even if the employer had been entitled to compensation for her lost profits, she would have been required to mitigate those losses as a precondition for any recovery; however, most of the employer’s failures to mitigate losses are nonverifiable, and, therefore, the most effective way to encourage her to mitigate losses efficiently is just to let her bear them.

13.4.3. Nonpecuniary Loss Nonpecuniary losses are losses that have no economic impact on the victim, such as emotional distress, agony, disappointment, and pain and suffering. In contracts, nonpecuniary losses are compensated almost only when the main interest protected by the contract is nonpecuniary in nature (Farnsworth 2004, 810). Typical examples are tour package contracts,10 contracts to perform cosmetic surgeries,11 and contracts for providing services for weddings or funerals.12 In torts, nonpecuniary losses are typically compensated when accompanied by physical injury, mainly bodily injury, and only rarely when those are standalone losses (Dobbs 2000, 1050–​1053). One objection to the imposition of liability for nonpecuniary losses is that those losses are subjective, and, therefore, the risk of plaintiffs’ bringing frivolous claims is high. If those claims were to be allowed—​so the argument goes—​injurers might pay 10 

Jarvis v Swan Tours EWCA Civ 8 (1972). Sullivan v O’Connor 296 N.E. 2d 183 (1973). 12  Lewis v Holmes 109 La. 1030 (1903). 11 

 

ECONOMICS OF REMEDIES    321 excessive damages and be overdeterred. This objection, however, is less persuasive when there is some objective evidence for the existence of the nonpecuniary losses and their magnitude, such as when the victim suffers pain and suffering accompanied by bodily injury (Bovbjerg et al. 1989). Another objection is that inflicting nonpecuniary losses on the victim typically does not decrease her marginal utility of money, so transferring payments from the injurer to the victim typically does not improve social welfare (cf. Shavell 1987, 228–​231; Danzon 1984, 517, 521). This objection is attenuated, and it even disappears when deterrence is considered, and because nonpecuniary losses are social losses, injurers and promisors should internalize them and be adequately deterred (Rea 1982). The marginal utility of money argument coupled with the countervailing deterrence argument provides a compelling explanation of courts’ willingness to allow compensation for nonpecuniary losses (almost) only when the interest protected by the contract is mainly nonpecuniary. Imagine a construction contract between Builder and Owner, where the parties anticipate when making their contract that with a certain probability performance will be delayed and, as a result, Owner will be disappointed. Would they agree that in case of a breach Owner would be compensated for his disappointment? If yes, liability should be the contractual default rule; otherwise, no liability should be the default rule. Let’s start with the marginal utility of money argument. According to this argument, Owner will never insure against disappointment loss, because suffering this loss will not affect her marginal utility of money. Similarly, Owner will not “insure” against such a loss through the contract (because he will be required to pay a premium through the contract price). The deterrence argument does not change this conclusion, as long as we assume that most of the losses resulting from the breach are pecuniary. Because pecuni­ ary losses are compensated, deterrence is reasonably attained, even if a small fraction of the losses—​those that are nonpecuniary—​are not. Thus, in our example, the marginal utility of money argument seems to overcome the countervailing deterrence argument, and the parties would prefer, ex ante, not to have liability for nonpecuniary losses (cf. Rea 1982). If instead, most of the losses expected to result from the breach are nonpecuniary, the conclusion will be different. Take, for example, a contract made between a travel agency and a traveller for providing a package tour by the former to the latter. Here, the efficient rule, which most contractual parties would prefer, is liability for nonpecuniary losses. Although the traveller would never insure against such losses with an insurer, he would insure against them with the travel agency because such “insurance” would provide the agency with efficient incentives to perform the contract. In this example, as opposed to the previous one, most of the expected losses are nonpecuniary, and no liability for those losses would result in severe underdeterrence.13 13 

For the argument that victims might be willing to insure against nonpecuniary losses, see Croley and Hanson (1995).

 

322   ARIEL PORAT

13.4.4. Caps on Consequential Damages The foreseeability requirement, which has been discussed in Section 13.4.1, caps damages by allowing recovery for foreseeable losses only. Contractual parties, however, often cap damages even further, sometimes precluding liability for any consequential losses altogether (Farnsworth 2004, 799). One reason for contractual parties to cap consequential losses relates to the fact that consequential losses are often unique to the promisee, as when the breach causes the promisee a loss of profits coming from third parties. In such cases the promisee can often take steps to mitigate his consequential losses in nonverifiable ways, and making the promisee bear those losses would incentivize him to do so. At the same time, because of their uniqueness, those losses are often not accurately anticipated by the promisor (even if they are foreseeable enough to pass the foreseeability threshold), and, therefore, capping them promotes certainty. Indeed, without liability the promisor’s incentives to perform efficiently decreases because he externalizes some of the costs of the breach to the promisee, but given the advantages described previously, this flaw might be a price worth paying.14 A second reason, which applies mostly to consumer contracts, is that capping damages is an effective tool for avoiding adverse selection. Take an example used in the literature (Epstein 1989). A shipper ships packages for owners and sometimes the packages are damaged. Some packages are worth more; others worth less. The shipper charges a uniform price (discriminating in prices is either too costly or illegal), and when a package is damaged, he is liable for the full amount of the harm done. Under this liability scheme, owners whose packages are worth less than average subsidize owners whose packages are worth more than average because, by assumption, they all pay a uniform premium through the price. This cross-​subsidization is unjust, especially if owners of high-​ value packages are typically wealthier compared with owners of low-​value packages. Moreover, cross-​subsidization results in inefficient consumption and adverse selection. Specifically, because owners with low-​value packages pay more than what they should have paid given their low expected harm, their consumption level is too low; in contrast, because owners with high-​value packages pay less than what they should have paid given their high expected harm, their consumption level is too high. In addition, in the long run, because fewer owners of low-​value packages will consume the shipping services, prices will go up (as the average expected harm will go up). As a result, even fewer owners of low-​value packages will consume the shipping services; prices will go up again; and so on and so forth. At the end, only consumers with very high-​value packages will consume the shipping services, and, in the extreme case, the shipping ser­ vices will shut down. One way to solve the problem is to cap damages. Thus, the shipper could offer contracts to consumers under which damages are limited to the value of low-​ value packages. This would mitigate the inefficiencies, including the adverse selection 14 

Leaving some losses uncompensated also mitigates the promisee’s moral hazard problem: see Shavell (1979).

 

ECONOMICS OF REMEDIES    323 problem, and would be more just. Consumers with high-​value packages would be able to secure full compensation through first-​party insurance, if they choose to do so.

13.5.  The Measure of Recovery Generally, in both torts and contracts, damages are compensatory. But it may sometimes be unclear what compensatory damages are. First, Section 13.5.1 deals with this question in a very specific tort context: damages for bodily injury, and then, Section 13.5.2 deals with one contractual exception to the compensatory damages principle, which is liquidated damages.

13.5.1. Bodily Injury and Lost Income A major component in any award of damages for bodily injury is lost income. The result is that a high-​income (“rich”) victim receives compensation that is higher—​sometimes much higher—​than what a low-​income (“poor”) victim receives, even if both victims suffer from the same bodily impairment because of the wrongdoing. By contrast, when courts set the standard of care, they do not distinguish between rich and poor victims: the injurer is required to take the same level of care towards the victim regardless of his income, even if his type as rich or poor can be anticipated by the injurer.15 This leads to an inconsistency in tort law: there is a misalignment between the standard of care and damages (Porat 2011). The following example illustrates this point. Example 3. Poor and rich neighborhoods. John drives his car at a speed of 30 mph in a rich neighborhood. Unfortunately, he hits a pedestrian as she is crossing the street. Had John driven a bit more slowly, he would have succeeded in stopping his car in time and preventing the accident. A day later, John drives his car again at the same speed, but this time in a poor neighborhood. Once again, he hits a pedestrian. All driving conditions are the same as they were in the rich neighborhood the day before; therefore, in this case, as well, the accident would have been avoided had John driven his car a bit more slowly. Is it possible that, under a rule of negligence, the same court would find John liable for the first accident but not for the second?

Assuming that in the rich neighborhood, most people have a higher income than the residents of the poor neighborhood do, one could argue that different standards of care should be applied in the two neighborhoods. It is quite possible, even reasonable, then, that the same court would find that: (a) John failed to take due care in the rich

15 

When a victim’s type as rich or poor cannot be anticipated in advance by the injurer, there can be no question that the standard of care should be set according to the average victim.

 

324   ARIEL PORAT neighborhood and, therefore, should be held liable towards his victim; and (b) John took due care in the poor neighborhood and, therefore, should be exempt from all liability. Courts, however, do not set different standards of care for driving in rich and poor neighborhoods. Similarly, they also do not set different standards of care for doctors treating rich and poor patients. If a court were required to explain the application of the same standard of care for the rich and the poor, it would reason that the lives and limbs of the rich and poor have identical social value and, therefore, are deserving of the same level of legal protection. But such reasoning, convincing as it may be, is inconsistent with the practice of awarding higher damages to rich victims. This practice suggests that rich people’s lives and limbs are more highly valued by the law relative to those of poor victims. To be consistent with this practice, so it seems, injurers should take greater care towards the rich than towards the poor, just as they should be more careful in their interactions with high-​value property. Therefore, to restore consistency to the law, courts should have chosen one of two routes: to either apply different standards of care to rich and poor victims (contrary to what they actually do), coupled with different levels of compensation (as they actually do), or, alternatively, to apply the same standard of care to rich and poor victims (as they actually do), coupled with the same level of compensation (contrary to what they actually do). From a social perspective, there is no compelling reason why lost income should be the main criterion for valuing people’s lives and limbs,16 but this question is beyond the scope of this chapter. Therefore, let us assume first that lost income is the right criterion, and consider the efficiency of the law under this assumption. If lost income is the right criterion, and given that the standard of care is set uniformly according to average income but damages are awarded for the victim’s lost income, injurers will comply with the standard of care when they expect a rich victim but undercomply when they expect a poor victim. To see why, assume that the expected harm of rich victims is 15, the expected harm of poor victims is 5, and average expected harm is 10. Further, assume that the standard of care is set at 10, namely, injurers are required to take precautions up to 10 to reduce the risk to either rich or poor victims. With these figures, injurers will take precautions up to 10 towards rich victims (and pay no damages if harm occurs) and up to 5 towards poor victims (and pay damages if harm occurs). As the expected harm for rich victims is 15 and for poor victims is 5, injurers will be underdeterred towards rich victims and optimally deterred towards poor victims. Assume now that lost income is not the right criterion for awarding damages for bodily injury, and that rich and poor people’s lives and limbs have the same value. Further, assume that people’s lives and limbs are determined by average income.17 Now, taking precautions by injurers up to 10 towards rich victims is efficient because their 16  Lost income could be correlated with people’s productivity. It is questionable, however, whether this correlation is strong, and whether productivity is the main value of people’s lives and health. 17  This is a simplifying assumption: a plausible argument is that average income should also not play a major role in valuing victims’ lives and limbs (Friedman 1982; Porat and Tabbach 2011).

 

ECONOMICS OF REMEDIES    325 expected harm is assumed to be 10. Conversely, taking precautions up to 5 towards poor victims is inefficient because 10, rather than 5, is assumed to be their expected harm. The analysis so far has implicitly assumed no courts’ errors in setting the standard of care and awarding damages and no injurers’ errors in anticipating courts’ decisions. With the risk of errors, the analysis becomes more complex (Porat 2011), but it does not change the basic conclusion: efficiency wise,18 the value of people’s lives and limbs should be reflected in both the standard of care and damages in a consistent manner, otherwise inefficiencies will result.

13.5.2. Liquidated Damages While the default rule in contract law is that damages are compensatory, the parties are free to opt out of the default rule by incorporating a liquidated damages clause. If, however, damages are set too high, courts are authorized to strike down the liquidated damages clause as being a penalty, and to award compensatory damages instead. When deciding whether to uphold a liquidated damages clause, courts are instructed to consider the anticipated loss at the time of contracting, the actual loss, and the difficulties of proving the actual loss (Restatement 2d Contracts, §356, [1981]). As liquidated damages are closer to both anticipated and actual losses, and as there are more difficulties in proving actual loss, courts are more willing to uphold the liquidated damages clause. The Uniform Commercial Code (“UCC”) adds a fourth consideration to be taken into account, which is “the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy” (UCC, §2-​7 18). It is puzzling why courts are authorized to scrutinize liquidated damages clauses, while they are generally not authorized to do the same thing with other clauses (Posner 1979, 290). Indeed, at least when the parties are rational and well informed, there is no reason to assume that the liquidated damages clause they incorporated into their contract sets damages too high (Schwartz 1990). In the next paragraphs, both the advantages and disadvantages of liquidated damages are discussed, when the question that arises is whether the disadvantages can justify the wide discretion granted to courts to strike down liquidated damages clauses. Incorporating a liquidated damages clause into their contracts has several advantages for the parties. First, it saves litigation costs. Indeed, since the actual loss is a consider­ ation for the court whether to uphold the clause, the parties might litigate as to the exact magnitude of the actual loss. But that would not be necessary in most cases because as long as the gap between the actual loss and liquidated damages is not large, courts will tend to uphold the clause; on many occasions, the defendant will not even try to argue that the gap is large, and it would not be necessary to litigate about actual losses (Goetz and Scott 1977). 18 

Distributive justice considerations could provide at least a partial explanation for the inconsistency in the law (Porat 2011, 105–​107).

 

326   ARIEL PORAT Second, a liquidated damages clause promotes certainty because, with this clause, the parties can accurately anticipate the amount of damages to be paid by the promisor to the promisee in case of a breach. This advantage is prevalent if the liquidated damages clause sets both a floor and a ceiling, as is the case when the parties have not agreed otherwise. Third, a liquidated damages clause protects interests that otherwise are not adequately protected by contract law. Thus, if the parties anticipate that a breach would result in nonpecuniary losses, or losses that are hard to prove (such as reputational losses), they might incorporate into their contract a liquidated damages clause relating to such losses (Goetz and Scott 1977). Consequently, not only will compensation be secured, but the promisor’s incentives will improve as well.19 Fourth, a liquidated damages clause is a solution to the promisee’s overreliance problem: as has been explained, with liquidated damages, the promisee internalizes both the costs and benefits of his reliance and, therefore, relies efficiently.20 Fifth and last, a liquidated damages clause enables the promisor to signal his credibility to the promisee: by undertaking to pay a large enough amount of damages in case of a breach, he is able to signal to the promisee that the probability of a breach is low (Posner 2011, 160). Thus, a landlord might hesitate to lease his property to a tenant he hardly knows, fearing the latter may damage the property or fail to evacuate it on time. Given that the level of enforcement is lower than 100%, and given litigation costs, the landlord’s entitlement to compensatory damages might not be a satisfactory guarantee for the tenant’s performance, and the landlord will not lease the property to him. If, however, an enforceable liquidated damages clause, stipulating damages in an amount that is much higher than expected losses, is incorporated into the contract, the landlord might be convinced to lease his property to the tenant after all. This advantage, however, is generally unattainable because in order to attain it, the parties must stipulate damages in an amount that is much higher than both expected and actual losses; courts would not enforce such a stipulation and would strike it down as a penalty. Liquidating damages clauses come at a cost: sometimes they might result in inefficiencies. First, they might lead to inefficient breach or inefficient performance (and to inefficient investment in precautions); the former will occur if liquidated damages are lower than actual losses; the latter, if they are higher than actual losses.21 If this were the main disadvantage of liquidated damages clauses, courts’ power to strike them down should have been a default rule. After all, it is for the parties to decide whether the liquidated damages clause should be set aside if it largely deviates from actual losses.

19  However, undercompensating some losses could improve the promisee’s incentives. See Shavell (1979). 20  Supra Section 13.3.3. 21  On the other hand, the promisor who is generally reluctant to breach, even efficiently, for moral reasons, might be willing to breach when damages are stipulated in the contract. Cf. Wilkinson-​Ryan (2010). Thus, liquidated damages clauses might sometimes encourage efficient breaches.

 

ECONOMICS OF REMEDIES    327 Second, if liquidated damages are set too high, the promisee’s expectation for overcompensation might tempt her to induce inefficiently a breach in nonverifiable ways (Clarkson, Miller, and Muris 1978). This risk, however, is not necessarily a reason for courts to intervene in liquidated damages clauses, as long as the parties are assumed aware of such risk when stipulating damages in their contracts. Third, because of lack of information, irrationality, or bounded rationality, the promi­ sor might not be aware of the harsh consequences of a liquidated damages clause, and might agree to set it too high. For example, he might be overly optimistic about his ability to perform the contract, believing he will almost never be subject to the liquidated damages clause. Liquidated damages set too high might encourage the promisor to overinvest in precautions and perform even when a breach is efficient. If this were the main disadvantage of liquidated damages clauses, courts’ power to strike them down should have been limited to cases where asymmetric information or irrationality is a real concern, such as in some consumer contracts. Forth, sometimes, through a liquidated damages clause, the parties might try to externalize costs to third parties by setting damages much higher than what efficiency requires. Thus, suppose that in our previous example, the tenant is under a substantial risk of bankruptcy and the landlord is aware of this. The parties might reach an agreement, setting damages five times higher than anticipated losses, knowing that if the tenant eventually goes bankrupt, part of the costs of the liquidated damages will be borne by his creditors. In such cases, intervention by courts is essential regardless of the parties’ wishes, even if the parties are well informed and fully rational.22

13.6.  Partial Recoveries In this part, two concepts of partial recoveries are discussed: probabilistic recoveries and offsetting risks. The first concept is well known and has been applied by courts in some specific categories of cases, whereas the second is less known and has not been applied by courts so far.

13.6.1. Probabilistic Recoveries In civil cases, the plaintiff succeeds in trial if he proves his case by a preponderance of the evidence. The question that arises is whether in certain cases tort victims should be entitled to a probabilistic recovery if they have failed to prove causation by a preponderance of the evidence. Typical cases where this question emerges are medical malpractice cases when the doctor’s negligence reduced the patient’s chances of recovery and the 22 

A liquidated damages clause that is above expected harm might have anticompetitive effects because it makes the breach for the promisor very costly (Chung 1992; Spier and Whinston 1995).

 

328   ARIEL PORAT patient eventually did not recover (King 1981; Levmore 1990; Porat and Stein 2001, 122–​ 125). For example, suppose that the patient’s chances of recovery were 30%, but because of negligent misdiagnosis by the doctor, those chances were reduced to zero. The probability that the doctor’s negligence caused the patient’s non-​recovery is 30%. Should the patient recover for 30% of his losses because the doctor deprived him of his chances of recovery?23 In some jurisdictions, the answer is yes, while in others the answer is no (Porat and Stein 2001, 74–​76). Does efficiency require compensation in this case? Not necessarily, if we assume that in the specific category of cases doctors handle not only cases of less than 50% chances of recovery, but also cases of more than 50% chances of recovery, and there is symmetry between the two groups of cases. With such symmetry, a doctor’s liability would be the same under both a probabilistic recovery and a preponderance of the evidence rule. To see why, imagine that a patient has either a 30% chance of recovery or a 70% chance of recovery, with equal probabilities. The doctor is negligent and reduces the patient’s chances of recovery to zero. The patient does not recover and suffers harm of H. Under a probabilistic recovery rule, the negligent doctor’s expected liability is 50% × 30% × H + 50% × 70% × H = 50%H.24 Under a preponderance of the evidence rule, the negligent doctor’s expected liability is the same: 50% × 0 + 50% × H = 50%H.25 Liability of 50%H in this example is also efficient because the expected harm of the doctor’s negligence is 50%H.26 Things are different if there is an asymmetry between the two groups of cases. Consider an extreme example where in a certain hospital department all the patients have a less than 50% chance of recovery. Under a preponderance of the evidence rule, those patients would never be entitled to compensation because, in each and every case when harm occurs, the probability that the negligent doctor caused the harm is less than 50%. Therefore, under the latter rule, doctors will not be deterred. In contrast, under the probabilistic recovery rule, patients who suffer harm will always be entitled to compensation from negligent doctors, and the latter’s expected liability will equal expected harm, as required for efficiency. Note that even when there is symmetry between the two groups of cases, probabilistic recovery is essential, as long as the doctor can identify in advance whether her patient has a less than or more than 50% chance of recovery. 23  Suppose that chances of recovery were reduced by the doctor’s negligence from 70% to 40% and the patient has not recovered; under a probabilistic recovery rule the patient should recover 50%—​not 30%—​ of the ultimate harm because the probability that she suffered that harm from the doctor’s negligence is 50% (Porat and Stein 2001, 124; Restatement 3d Torts: Liability for Physical and Emotional Harm, § 26, cmt. n, 2010). 24  There is a probability of 50% that the patient has a 30% chance of recovery, and then liability would be 30%H, and there is a probability of 50% that the patient has a 70% chance of recovery, and then liability would be 70%H. 25  There is a probability of 50% that the patient has a 30% chance of recovery, and then liability would be zero, and there is a probability of 50% that the patient has a 70% chance of recovery, and then liability would be H. 26  There is a probability of 50% that the patient has a 30% chance of recovery, and then expected harm is 30%H, and there is a probability of 50% that the patient has a 70% chance of recovery, and then expected harm is 70%H. Thus, expected harm is 50% × 30% × H + 50% × 70% × H = 50%H.

 

ECONOMICS OF REMEDIES    329 It is important to note that probabilistic recovery is more essential if the typical case is less than 50% chance of recovery rather than more than 50% chance of recovery. When chances are less than 50%, with a preponderance of the evidence rule, underdeterrence will result. When chances are more than 50%, with the same rule, overdeterrence might result, but only if we assume courts’ errors in setting the standard of care and awarding damages or injurers’ errors in anticipating courts’ decisions. (Porat 2011, 112–​114). To see why, suppose that in a certain hospital department all the patients have a 70% chance of recovery, and the harm, if it occurs, is H. Bearing these figures in mind, the patient’s expected harm is 70%H, and the doctor should be required—​efficiency wise—​to take precautions up to 70%H. Would the doctor take higher precautions because if harm occurs, he bears a liability of H? The answer is no: the doctor will take precautions up to 70%H, thereby satisfying the standard of care and bearing no liability. However, the doctor might overcomply if there is a risk of courts’ errors in setting the standard of care and awarding damages or injurers’ errors in anticipating courts’ decisions. Since such risk is common, the probabilistic recovery rule might be superior to a preponderance of the evidence rule, not only in less-​than-​50%-​chance cases, but also in more-​than-​50%-​chance cases. Beyond lost chances of recovery cases, the Market Share Liability doctrine (MSL), which is a form of probabilistic recovery rule, has been applied by courts in some jurisdictions. In one case to which the doctrine was applied, numerous manufacturers produced the same generic drug, which later was found to be defective and harmful. Since in most cases plaintiffs could not tell which manufacturer’s drug caused their harm, a preponderance of the evidence rule allowed all manufacturers in most suits to escape liability. Under MSL, however, each manufacturer was required to bear liability according to his market share at the relevant time with respect to the harmful drug. Thus, if one manufacturer’s market share was 10%, he was required to compensate each and every plaintiff who suffered harm of H, in the amount of 10%H (Porat and Stein 2001, 58–​69). Although MSL does not provide fully efficient incentives to injurers, it is more efficient compared with no liability. Inefficiency might still result because the manufacturers’ behaviours are often nonverifiable, and even with MSL, a manufacturer might refrain from taking costly but efficient precautions because most of the benefits of his precautions would be captured by the other manufacturers (Cooter and Porat 2007).

13.6.2. Offsetting Risks Consider the following example (Porat 2011): Example 4. Choosing between two medical treatments. A doctor must decide between Treatment A and Treatment B for his patient.27 Each treatment entails different risks but produces the same utility if the risks do not materialize. This utility is much 27 

Note that one of the treatments could be an omission, such as not operating on the patient or not administering a certain medicine.

 

330   ARIEL PORAT greater than the respective risks of each treatment. The costs of administering the treatments are the same, and the costs of choosing between them are low. Treatment A entails a risk of 500 to the patient’s left arm (there is a probability of .01 that the treatment will produce harm of 50,000), and Treatment B entails a risk of 400 to the patient’s right arm (there is a probability of .01 that the treatment will produce a harm of 40,000). The risks of Treatments A and B are not correlated: the realization of the risk from one treatment has no bearing on the probability of the realization of the risk from the other treatment. The doctor negligently chooses Treatment A, and a harm of 50,000 materializes. Should the doctor be held liable? If so, in what amount?

Under prevailing tort law, the doctor in Example 4 would be found liable because he was negligent: he could have reduced the total risk to the patient by 100 (500–​400) at a low cost, but failed to do so. The negligent doctor’s liability under prevailing tort law would amount to the entire harm, which is 50,000, because that is the harm caused by his negligence. Thus, while the net risk created by the doctor’s negligence is 100, his expected liability is five times higher:  .01 × 50,000  =  500. The reason for the misalignment between net risk and expected liability is that tort law ignores that the negligent doctor, by choosing treatment A, not only increased the risk to the patient’s left arm (of 500), but also decreased the risk to the patient’s right arm (of 400). If the doctor bears liability for the increased risk (internalizes the negative externalities), without being credited for the decreased risk (does not internalize the positive externalities), his expected liability will be higher, even much higher, than social costs, which are the net rather than the gross risk. Liability for far more than social costs is likely to result in overdeterrence, which in the medical context often takes the form of defensive medicine. Overdeterrence and defensive medicine will result if there are courts’ errors in setting the standard of care and awarding damages or doctors’ errors in anticipating courts’ decisions (nonverifiability of some harms but not others is a typical problem leading to defensive medicine). As doctors pay more in damages, overdeterrence and defensive medicine become more severe (Porat 2007). To restore the alignment between social costs and expected liability, the doctor’s liability in Example 4 should be 10,000 rather than 50,000. Liability of 10,000 would result in this example in expected liability of 100, which is the social cost of the doctor’s negligence. In more general terms, a doctor’s liability should be H(Ra–​Rb)/​Ra, where H stands for the materialized harm, Ra for the risk that was increased by the doctor’s negligence and materialized into harm, and Rb for the risk that was decreased by the doctor’s negligence. The same formula can be applied to other cases where an injurer increased the risks to person A and decreased the risks to person B (Porat 2007) (although such application is expected to raise objections mainly from noneconomic lawyers). In such cases, as long as a restitution claim against person B is legally or practically impossible, there is room for the argument that, efficiency wise, the injurer’s liability towards person A should be decreased in accordance with the risks reduced to person B. A similar

 

ECONOMICS OF REMEDIES    331 argument applies to cases where person B received a certain benefit (as opposed to a probabilistic benefit in terms of decreasing B’s exposure to risks): as long as the benefit is social rather than private, and some other conditions are met, offsetting the benefit from damages awarded to person A would be justified (again, under the assumption that a restitution claim against person B is legally or practically impossible) (Porat and Posner 2014).

References Abraham, Kenneth S. 2011. “Catastrophic Oil Spills and the Problem of Insurance.” Vanderbilt Law Review 64, pp. 1769–​1791. Avraham, Ronen. 2004. “Modular Liability Rules.” International Review of Law and Economics 24, pp. 269–​297. Ayres, Ian. 1996. “Legal Entitlements as Auctions: Property Rules, Liability Rules, and Beyond.” Yale Law Journal 106, pp. 703–​750. Ayres, Ian and Gertner, Robert. 1989. “Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules.” Yale Law Journal 99, pp. 87–​130. Baron, Jonathan and Wilkinson-​Ryan, Tess. 2009. “Moral Judgment and Moral Heuristics in Breach of Contract.” Journal of Empirical Legal Studies 6, pp. 407–​423. Bebchuk, Lucian A. 2001. “Property Rights and Liability Rules:  The Ex Ante View of the Cathedral.” Michigan Law Review 100, pp. 601–​639. Bigoni, Maria, Bortolotti, Stefania, Parisi, Francesco, and Porat, Ariel. 2014. Unbundling Efficient Breach. Chicago:  University of Chicago Law School. http://​ssrn.com/​ abstract=2477973 [Accessed 22 August 2016]. Bishop, William. 1982. “Economic Loss in Tort.” Oxford Journal of Legal Studies 2, pp. 1–​29. Bovbjerg, Randall R., Sloan, Frank A., and Blumstein, James F. 1989. “Valuing Life and Limb in Tort: Scheduling ‘Pain and Suffering.’” Northwestern University Law Review 83, pp. 908–​976. Calabresi, Guido and Melamed, Douglas A. 1972. “Property Rules, Liability Rules, and Inalienability: One View of the Cathedral.” Harvard Law Review 85, pp. 1089–​1128. Chang, Yun-​chien. 2014. Optional Law in Property:  Theoretical Critiques. http://​ssrn.com/​ abstract=2351651 [Accessed 22 August 2016]. Chung, Tai-​Yeong. 1992. “On the Social Optimality of Liquidated Damages Clauses:  An Economic Analysis.” Journal of Law, Economics, and Organization 8, pp. 280–​305. Clarkson, Kenneth W., Miller, Roger L., and Muris, Timothy J. 1978. “Liquidated Damages v. Penalties: Sense or Nonsense?” Wisconsin Law Review 1978, pp. 351–​390. Coase, Ronald H. 1960. “The Problem of Social Costs.” Journal of Law and Economics 3, pp. 1–​44. Cohen, David and Knetsch, Jack L. 1992. “Judicial Choice and Disparities between Measures of Economic Values.” Osgoode Hall Law Journal 30, pp. 737–​770. Coleman, Jules L. and Kraus, Jody. 1986. “Rethinking the Theory of Legal Rights.” Yale Law Review 95, pp. 1335–​1371. Cooter, Robert D. 1985. “Unity in Tort, Contract, and Property: The Model of Precaution.” California Law Review 73, pp. 1–​51. Cooter, Robert D. and Porat, Ariel. 2002. “Anti-​insurance.” Journal of Legal Studies 31, pp. 203–​232.

 

332   ARIEL PORAT Cooter, Robert D. and Porat, Ariel. 2004. “Decreasing Liability Contracts.” Journal of Legal Studies 33, pp. 157–​197. Cooter, Robert D. and Porat, Ariel. 2007. “Total Liability for Excessive Harm.” Journal of Legal Studies 36, pp. 63–​80. Craswell, Richard. 1988. “Contract Remedies, Renegotiation, and the Theory of Efficient Breach.” Southern California Law Review 61, pp. 629–​670. Croley, Steven P. and Hanson, Jon D. 1995. “The Nonpecuniary Costs of Accidents: Pain-​and-​ Suffering Damages in Tort Law.” Harvard Law Review 108, pp. 1785–​1917. Danzon, Patricia M. 1984. “Tort Reform and the Role of Government in Private Insurance Markets.” Journal of Legal Studies 13, pp. 517–​549. Dari-​Mattiacci, Giuseppe and Schäfer, Hans-​Bernd. 2007. “The Core of Pure Economic Loss.” International Review of Law and Economics 27, pp. 8–​28. Dillbary, Shahar. 2013. “Tortfest.” University of Chicago Law Review 80, pp. 953–​1005. Dobbs, Dan B. 2000. The Law of Torts. St. Paul, MN: West Group. Epstein, Richard A. 1989. “Beyond Foreseeability:  Consequential Damages in the Law of Contract.” Journal of Legal Studies 18, pp. 105–​138. Farnsworth, Allan E. 2004. Contracts. 4d ed. New York: Aspen Law & Business. Friedman, David D. 1982. “What is ‘Fair Compensation’ for Death Injury?” International Review of Law and Economics 2, pp. 81–​93. Goetz, Charles J. and Scott, Robert E. 1977. “Liquidated Damages, Penalties, and the Just Compensation Principle: Some Notes on an Enforcement Model and a Theory of Efficient Breach.” Columbia Law Review 77, pp. 554–​594. Goetz, Charles J. and Scott, Robert E. 1983. “The Mitigation Principle:  Toward a General Theory of Contractual Obligation.” Virginia Law Review 69, pp. 967–​1024. King, Joseph H. 1981. “Causation, Valuation, and Chance in Personal Injury Torts Involving Preexisting Conditions and Future Consequences.” Yale Law Journal 90, pp. 1353–​1397. Kronman, Anthony T. 1978. “Specific Performance.” University of Chicago Law Review 45, pp. 351–​382. Landes, William M. and Posner, Richard A. 1987. The Economic Structure of Tort Law. Cambridge, MA: Harvard University Press. Levmore, Saul. 1990. “Probabilistic Recoveries, Restitution, and Recurring Wrongs.” Journal of Legal Studies 19, pp. 691–​726. Luppi, Barbara and Parisi, Francesco. 2011. “Toward an Asymmetric Coase Theorem.” European Journal of Law and Economics 31, pp. 111–​122. Markovits, Daniel and Schwartz, Alan. 2011. “The Myth of Efficient Breach: New Defenses of the Expectation Interest.” Virginia Law Review 97, pp. 1939–​2008. Markovits, Daniel and Schwartz, Alan. 2012. “The Expectation Remedy Revisited.” Virginia Law Review 98, pp. 1093–​1107. Porat, Ariel. 2007. “Offsetting Risks.” Michigan Law Review 106, pp. 243–​276. Porat, Ariel. 2009. “Private Production of Public Goods: Liability for Unrequested Benefits.” Michigan Law Review 108, pp. 189–​227. Porat, Ariel. 2011. “Misalignments in Tort Law.” Yale Law Journal 121, pp. 82–​141. Porat, Ariel and Posner, Eric. 2014. “Offsetting Benefits.” Virginia Law Review 100, pp. 1165-​1209. Porat, Ariel and Stein, Alex. 2001. Tort Liability under Uncertainty. Oxford:  Oxford University Press.

 

ECONOMICS OF REMEDIES    333 Porat, Ariel and Tabbach, Avraham. 2011. “Willingness to Pay, Death, Wealth, and Damages.” American Law and Economics Review 13, pp. 45–​102. Posner, Richard A. 1979. “Some Uses and Abuses of Economics in Law.” University of Chicago Law Review 46, pp. 281–​306. Posner, Richard A. 2009. “Let Us Never Blame A Contract Breaker.” Michigan Law Review 107, pp. 1349–​1363. Posner, Richard A. 2011. Economic Analysis of Law. 8th ed. New York: Aspen. Rea, Samuel A., Jr. 1982. “Nonpecuniary Loss and Breach of Contract.” Journal of Legal Studies 11, pp. 35–​53. Rizzo, Mario J. 1982a. “A Theory of Economic Loss in the Law of Torts.” Journal of Legal Studies 11, pp. 281–​310. Rizzo, Mario J. 1982b. “The Economic Loss Problem: A Comment on Bishop.” Oxford Journal of Legal Studies 2, pp. 197–​206. Schwartz, Alan. 1979. “The Case for Specific Performance.” Yale Law Journal 89, pp. 271–​306. Schwartz, Alan. 1990. “The Myth that Promisees Prefer Supercompensatory Remedies:  An Analysis of Contracting for Damages Measures.” Yale Law Journal 100, pp. 369–​407. Shavell, Steven. 1979. “On Moral Hazard and Insurance.” Quarterly Journal of Economics 93, pp. 541–​562. Shavell, Steven. 1987. Economic Analysis of Accident Law. Cambridge, MA:  Harvard University Press. Shavell, Steven. 2009. “Why Breach of Contract May Not Be Immoral Given the Incompleteness of Contracts.” Michigan Law Review 107, pp. 1569–​1581. Shiffrin, Seana V. 2009. “Could Breach of Contract be Immoral?” Michigan Law Review 107, pp. 1551–​1568. Spier, Kathryn E. and Whinston, Michael D. 1995. “On the Efficiency of Privately Stipulated Damages for Breach of Contract: Entry Barriers, Reliance and Renegotiation.” Rand Journal of Economics 26, pp. 180–​202. Ulen, Thomas S. 1984. “The Efficiency of Specific Performance: Toward a Unified Theory of Contract Remedies.” Michigan Law Review 83, pp. 341–​403. Wilkinson-​Ryan, Tess. 2010. “Do Liquidated Damages Encourage Breach? A  Psychological Experiment.” Michigan Law Review 108, pp. 633–​671. Zamir, Eyal and Medina, Barak. 2010. Law, Economics, and Morality. Oxford:  Oxford University Press. Zamir, Eyal and Ritov, Ilana. 2010. “Revisiting the Debate over Attorney’s Contingent Fees: A Behavioral Analysis.” Journal of Legal Studies 39, pp. 245–​288. Zipursky, Benjamin. 1998. “Rights, Wrongs, and Recourse in the Law of Torts.” Vanderbilt Law Review 51, pp. 1–​100.

 

 

Pa rt  I I

C OR P OR AT E , C OM M E RC IA L , A N D E N V I RON M E N TA L L AW

 

 

Chapter 14

THE EC ONOM IC NAT U RE OF THE C ORP ORAT I ON Lynn Stout

14.1. Introduction Corporations are among the most powerful and economically important institutions in modern society. This chapter examines the nature and structure of corporate entities (a category that includes not only business corporations but also nonprofits and many limited liability companies [LLCs]). It discusses the basic characteristics of corporate entities; surveys different models or theories of the corporation; and explores the question of corporate purpose. The chapter pays special attention to how corporate law allocates economic and control rights to, and among, both the corporate entity itself and the natural persons involved with corporations, such as shareholders, directors, and executive officers.

14.1.1. The Corporation versus the Firm As a preliminary matter, it is essential to note that while the words corporation and firm are often used interchangeably, they refer to very different things. The careless but unfortunately common habit of treating them as synonyms confuses and misleads (Robe 2011). Firm is an economic concept that refers to the organization of economic activity involving more than one person, outside of formal markets. By contrast, corporation is a legal concept that carries important economic consequences. In particular, a corporation is a specific pattern of formal rights and responsibilities created by law and distributed between and among both human persons, and a legislatively created, artificial legal person (the corporate entity).

 

338   LYNN STOUT It is possible to create a firm that is not a corporation. For example, a law firm or an accounting firm organized as a partnership is still (as the name implies) a firm in the economic sense. Similarly, a sole proprietor who hires employees has created a firm, but has not created a corporation. In theory, it is equally possible to create a corporation that is not a firm. Modern corporate codes typically allow a single human person to create a corporate entity, contribute all of its capital, and then serve as that entity’s sole shareholder, director, officer, and employee. Such a corporate entity is just that—​a corporate entity—​but it is not a firm. The existence of a firm is neither necessary nor sufficient for a corporation to exist. A theory of the firm is not a theory of the corporation.

14.1.2. Corporations and Agency Cost Analysis Because the firm and the corporation are so frequently confused, economic analysis of corporations often focuses, almost exclusively, on the so-​called agency cost problem (see, e.g., Ciepley 2013). However, agency costs are an issue whenever economic activity is organized in firms, not only (or always) in corporations. Agency costs also arise in partnerships and indeed in any project involving more than one person. Because most corporate activity requires more than one person (even a corporation with a single shareholder is likely to borrow from creditors), agency costs are common in corporate entities (Rock 2013). However, corporate entities raise interesting economic issues beyond the conventional agency cost problem that has attracted so much attention. Moreover, any discussion of agency costs in corporations must address the critical question of who (or what) is the principal and who is the agent. Many economic theorists and some legal scholars assert that shareholders are principals and directors are shareholder’s agents in corporations (see, e.g., Jensen and Meckling 1976). However, this assumption is incorrect as a matter of law. Corporate law treats directors not as agents of shareholders but as fiduciaries who owe legal duties not only to shareholders, but also to the corporate entity itself (Blair and Stout 1999; Ciepley 2013). Although the trope that shareholders are principals and directors are agents is sometimes a useful simplification, especially in the rare case of a corporation with a single shareholder and no debt, it is more often seriously misleading (see Section 14.3.3, infra).

14.2. Characteristics of Corporate Entities Corporate entities are creatures of law, and they are associated with five important legal characteristics. These are legal personality (meaning the corporate entity can own

 

THE ECONOMIC NATURE OF THE CORPORATION    339 assets and exercise rights in its own name); limited personal liability for shareholders and other natural persons who participate in the corporation; delegated and often professional management; transferable equity shares; and perpetual life (Clark 1986; Stout 2005; Schwartz 2012). Only legal personality and delegated management are always found in the corporate form. A corporation without legal personality is an oxymoron, and as a legal entity, a corporation must delegate and rely on natural persons to make decisions and act in the entity’s name. However, corporations can lack limited liability, professional management, transferable shares, or perpetual life. These latter four characteristics, nevertheless, are common in modern corporations, especially in public corporations.

14.2.1. Legal Personality (Including Entity Shielding and Asset Lock–​In) The most fundamental attribute of a corporate entity is legal personality. Legal personality allows corporate entities to hold property and enter transactions in their own names, including acquiring cash, land, equipment, and other property to be held in the corporation’s name. Legal personality explains a number of otherwise-​puzzling elements of corporate law: for example, the idea that directors can owe fiduciary duties of loyalty and care to an artificial person (Blair and Stout 1999). It also explains why jurisdictions tax the incomes of corporate entities, then also tax corporate distributions to shareholders (so-​called double taxation) (Bank 2006). Legal personality is economically important because it gives corporations “entity shielding” (Hansmann, Kraakman, and Squire 2006). This means that the creditors of a natural person involved in the corporation—​e.g., a shareholder, director, or employee—​ cannot take corporate assets to satisfy the natural person’s debt. A shareholder’s creditors, for example, can enforce their claims against the shareholder’s personal assets, including the shareholder’s equity shares. But the shareholder’s creditors cannot claim the corporation’s assets. Similarly, a director’s creditors can claim any fees that the corporation owes the director, but cannot claim corporate property. A second important economic consequence of legal personhood is that it allows some corporate entities—​especially those controlled by an independent board of directors—​to “lock in” corporate assets. Assets are locked into the entity when natural persons involved with the entity, such as directors, shareholders, or employees, lack the power to extract those assets for themselves at will (Hansmann 1996; Blair 2003; Ciepley 2013). By reducing the risk of opportunistic or ill-​timed demands for distributions, asset lock-in permits corporations to accumulate safely “firm-​specific” assets that would lose much of their value if they did not remain in the firm (Blair and Stout 1999; Blair 2003). This allows corporate entities to pursue uncertain or long-​term projects with less fear of disruption (Hansmann 1996; Stout 2014). It also encourages both equity investors and

 

340   LYNN STOUT other corporate “stakeholders” such as customers and employees to make their own beneficial firm-​specific investments (Blair and Stout 1999). To lock in their assets, many corporate entities rely on independent boards of directors (i.e., boards comprised in part or whole of individuals who are not also employees, major shareholders, or otherwise in a position to personally benefit from extracting corporate assets). (The fiduciary duty of loyalty bars directors from using their director positions to distribute corporate assets to themselves.) Asset lock-in is possible in a board-​controlled corporation because board governance separates “ownership and control” (Blair 1995). Corporate assets remain in the entity’s name unless and until the board of directors decides to distribute those assets, for example by declaring a dividend, raising employees’ salaries, or making charitable corporate contributions. As discussed further in Section 14.3.5, this “separation of ownership and control” raises some economic problems but can also contribute in important ways to corporate success. Unlike entity shielding, which is inherent in the corporate form, asset lock-in depends as a practical matter on the degree to which the corporation’s board can resist the demands of natural persons who want the corporation to distribute its assets (e.g., shareholders seeking dividends, or executives or employees seeking larger salaries). Nonprofit corporations without shareholders typically have a high degree of lock-in, especially when incumbent boards elect their own successors. In business corporations where shareholders have the nominal right to elect directors, asset lock-in depends on share ownership patterns. Publicly traded corporations with disbursed shareholders who face obstacles to collective action usually have high degrees of lock-in. In contrast, a corporation with a controlling shareholder who can easily remove and replace directors does not have much lock-in, because the controlling shareholder can replace any director who refuses the shareholder’s demands for distributions. In both nonprofit and for-​ profit corporations, asset lock-in can be threatened when executives or other employees have the power to extract corporate assets in the form of excessive salaries and perquisites, or through theft or misappropriation.

14.2.2. Limited Liability for Natural Persons Legal personality allows corporate entities to enter contracts and commit torts in their own names. Only the corporation is legally responsible for, and only the corporation’s assets may be used to satisfy liability arising from, these corporate contracts and torts. This phenomenon is often described as limited shareholder liability. However, other natural persons associated with corporations (e.g., directors and executives) also generally are not personally responsible for the corporation’s acts. Thus, directors, executives, and creditors also have “limited liability.” In theory, limited liability for shareholders in particular is important to public corporations because it allows shareholders to invest without needing to monitor closely managers’ behavior or the wealth of other shareholders (Manne 1967; Easterbrook and Fischel 1985). However, business history raises doubts about the importance of

 

THE ECONOMIC NATURE OF THE CORPORATION    341 limited liability in explaining the rise of the public corporation, as many jurisdictions adopted limited liability relatively recently (Weinstein 2005). For example, Great Britain extended limited shareholder liability to companies with more than 25 members with the Limited Liability Act 1855, whereas California corporations did not enjoy limited shareholder liability until 1931 (ibid.). The practical importance of limited shareholder liability is especially questionable in the case of large, well-​capitalized companies with assets more than sufficient to satisfy all likely corporate liabilities. This may be why the adoption of limited shareholder liability in California did not significantly affect the share prices of publicly traded California firms, implying that the market did not perceive limited liability legislation to be a significant event for these companies (ibid.). It should be noted that limited liability for natural persons associated with or acting on behalf of the corporate entity can be defeated in some circumstances. For example, in a corporation with a controlling shareholder, the doctrine of “piercing the corporate veil” in some circumstances allows creditors of the firm to access a controlling shareholder’s personal assets. Similarly, corporate directors, executives, and employees may incur personal liability when they exercise their corporate powers in a negligent or criminal fashion.

14.2.3. Delegated and Professional Management (“Centralized” Management) Because corporate entities are not natural persons, they are incapable of making decisions or taking action except through natural persons. In this sense, delegated management—​meaning management by natural persons, typically a board of directors—​is intrinsic to the corporate form. Corporations can be distinguished in this regard from proprietorships, which can be run by their human proprietors, and partnerships, which can be run by their human partners. Corporations as artificial entities governed by human directors necessarily face agency problems that may not be present, or at least not present to as great a degree, in proprietorships and partnerships. Moreover, corporate boards often further delegate the day-​to-​day operations of the company to teams of employees typically headed by a chief executive officer. This pattern of “centralized” or professional management is common in corporations and certain “management-​managed” LLCs (Clark 1986; Stout 2005). However, professional management also can also be found in partnerships and proprietorships that hire execu­ tive managers. Professional management has advantages, because it allows a firm to be operated by individuals who may have greater expertise, be able to make a larger time commitment, and have better access to information than the firm’s owners or board of directors. However, the decision to hire professional management adds another layer of agency

 

342   LYNN STOUT costs that must be incurred to run the firm, whether the firm is a proprietorship, partnership, or corporate entity.

14.2.4. Transferable Shares Not all corporate entities issue equity shares. Nonprofits often lack shareholders, and nonstock business corporations exist. But most business corporations issue equity shares, and those shares are often “freely transferable,” meaning the shares and all their accompanying rights (e.g., to vote, receive dividends, and inspect documents) can be sold to third parties without restriction. Freely transferable equity shares are particularly associated with public corporations listed for trading on organized exchanges. Listing has important economic consequences for public corporations. Because the listed shares typically carry with them the right to elect directors, it becomes theoretically possible for an acquirer to purchase a majority or even all of the company’s shares, and so become a controlling shareholder. This shifts control of the corporate entity and its assets from a board, to the controlling shareholder. The result has been described as a “market for corporate control” (Manne 1965). A  company with widely disbursed, passive shareholders, whose board enjoys a high degree of independence and insulation from shareholder pressures, can be transformed into a company whose board serves at the controlling shareholder’s pleasure. This limits the corporate entity’s ability to lock in its assets against shareholder demands (Blair 2003). It can also change the nature and magnitude of agency costs. The new controlling shareholder may be better (or worse) than the original board of directors at monitoring and constraining the agency costs associated with professional management (Manne 1965). Having a controlling shareholder may also introduce new agency problems if the controlling shareholder seeks to extract corporate assets at the expense of creditors, employees, or minority shareholders (Rock 2013).

14.2.5. Perpetual Life Perhaps the most fascinating characteristic of the corporation is its potential to outlast its human incorporators. A corporation is “sempiternal”—​once created, it can exist in perpetuity (Ciepley 2014). In contrast, a proprietorship or partnership ends when the proprietor or a partner exits the firm or dies. Business assets must be transferred to a new proprietorship or partnership for the business to continue (Stout 2014). The possibility of perpetual life allows corporate entities to pursue projects over multiple human generations. For example, a corporate entity, the Veneranda Fabricca, has been building and maintaining the Cathedral of Milan for over 600 years (ibid.). The Hudson’s Bay Company, which is still operating, was incorporated in 1670 (Schwartz 2012).

 

THE ECONOMIC NATURE OF THE CORPORATION    343 Not all corporations are so long-​lived, of course. A corporate charter may provide that a corporation will exist only for a certain period. Moreover, corporate entities disappear because they are merged, dissolved, or become insolvent. Nevertheless, the possibility of perpetual life allows both nonprofit and business corporations to pursue long-​term, open-​ended projects of uncertain and possibly perpetual duration.

14.3.  Theories of the Corporation The literature offers several different theories or models of the corporation (Millon 1990; Allen 1992). These theories try to capture the pattern of legal rights, responsibilities, duties, and privileges typically found in corporations in a single readily understandable description. In other words, they attempt to summarize briefly the legal technology that is the corporate entity. Given the complexity of corporations, it is not surprising that multiple models have been offered. The corporation has been described as, among other things: (1) an entity; (2) an aggregate of natural persons; (3) the property of its shareholders; (4) a nexus of contracts; (5) a collection of specific assets; and (6) a political system or “franchise government.” Each of the models—​perhaps they are better described as metaphors—​offers some insight into the corporate form. However, all have limitations, and some have great potential to be misleading.

14.3.1. Entity Theory Perhaps the most solidly grounded theory of the corporation, at least from a legal perspective, holds that the corporation is an independent, artificially created entity. The entity theory of the corporation is captured in Chief Justice Marshall’s famous description in the Dartmouth College case, Trustees of Dartmouth College v Woodward, 17 U.S. 518 (1819), of the corporation as “an artificial being, invisible [and] intangible” (636–​ 637.) Justice Louis Brandeis expressed a similar view in 1933 in Liggett v Lee, when he described the corporation as a “Frankenstein monster which States have created by their corporation laws,” (288 U.S. 517 [1933]). The entity theory of the corporation was widely embraced in the nineteenth century, and it is enjoying a resurgence today (see, e.g., Hayden and Bodie 2011, 1127, “[a]‌ corporation is not a contract. It is a state-​created entity”) (Biondi, Canziani, and Kirat 2007; Keay 2008). This may be because entity theory does an excellent job of explaining and predicting fundamental corporate characteristics, especially legal personality and perpetual life. If the corporation is an entity, it makes sense that corporations own assets in their own names, enter contracts and commit torts, and can sue and be sued. It makes sense that corporations are governed by boards of directors who owe

 

344   LYNN STOUT fiduciary duties to the entity as well as shareholders. It makes sense to tax the entity’s income. It makes sense that corporations can persist beyond the lifetimes of their human incorporators. Entity theory is cognitively challenging, however, as it requires observers to ascribe significance to an institution that is not only artificial but also (as Chief Justice Marshall pointed out) invisible and intangible. Thus, some scholars have dismissed corporations as “not real” (Easterbrook and Fischel 1985, 89). Nevertheless, just as gravity is real (if invisible) and political states are real (if intangible), corporations are real and have real effects (Stout 2012). Because the word person is normally used to describe human beings, it can also be difficult to think of corporate entities as “legal persons.” However, in the case of corporations the word person is being used to describe not an organism, but rather an institution that, acting through its board of directors, can exercise many of the legal rights that natural persons enjoy, including the rights to own property and to enter contracts. The most serious objection to entity theory may be normative rather than positive. This objection centers on the idea that, if we treat corporations as independent entities with rights, they may come to pose a threat to the welfare of human beings that created them (Millon 1990). (Hence, Brandeis’s reference to Frankenstein’s monster.) This normative concern does not detract from entity theory’s strong positive value in realistically describing the nature of corporations and corporate behavior.

14.3.2. Aggregate Theory Another theory of the corporation that crops up occasionally treats corporations as aggregations of natural persons. Thus, cases and commentators sometimes describe corporations as being “composed” of human beings (Millon 1990, 214). The US Supreme Court may have given a nod to aggregation theory in the Hobby Lobby case, Burwell v Hobby Lobby Stores Inc., 134 S. Ct. 2751 (2014), when the majority held that, based on the religious beliefs of its current shareholders, a closely held corporation had freedom of religion rights, and further observed that “a corporation is simply a form of organization used by human beings to achieve desired ends” (2768). Treating corporations as aggregations of natural persons seems, however, to raise more questions than offer answers. For example, which human beings are being aggregated? Only shareholders (some of whom may themselves be trusts or corporations)? Or should we also aggregate the interest of customers, executives, and rank-​and-​file employees, and possibly the community? Perpetual corporate life also poses a serious challenge to aggregation theory. Whether we view corporations as aggregations of shareholders or other humans as well, the pool of humans involved may be constantly shifting, especially in large public corporations, where both employees and shareholders come and go quickly. Is the corporation an aggregation of those who originally founded it or an aggregation those who are involved with it at present? Also, aggregation theory glosses over the difficult reality that natural persons who supposedly “compose” the

 

THE ECONOMIC NATURE OF THE CORPORATION    345 corporate entity often have very different interests and different ideas about what the corporation ought to do. Finally, the aggregate approach fails to distinguish corporate entities from other legal forms such as partnerships or membership associations, and it fails to explain the fundamental characteristics of legal personality and perpetual life. As a result, the aggregation model of the corporation can be criticized as offering relatively little insight into the nature of corporate entities.

14.3.3. Property (“Principal/​Agent”) Theory An influential model of the corporation often associated with economic analysis, which is somewhat related to aggregate theory, is property theory. Property theory treats corporations not as aggregations of natural persons but as aggregations of shareholders’ property (Allen 1992). According to this view, corporations “belong” to their shareholders (see, e.g., Friedman 1970). Managers, including directors, are agents whom the shareholder-​owners hire to manage their property, much as a landowner might hire a property manager. Property theory carries important governance implications. One is that corporations ought to be run in shareholders’ interests, typically interpreted as shareholders’ financial interests (Hansmann and Kraakman 2000). A second implication is that directors ought to do shareholders’ bidding when asked (Hansmann and Kraakman 2000; Bebchuk 2007; but see Bainbridge [2003], adopting property theory but disagreeing with this implication). While many laypersons believe shareholders own corporations, this statement is incorrect as a matter of law. As legal persons, corporations (like natural persons) either own themselves or have no owners (Blair 1995; Robe 2011; Stout 2012). Shareholders do not own corporations, they own shares of stock, a kind of contract between the shareholder and the corporate entity that gives the shareholder limited rights (e.g. to receive any dividends the directors declare, to vote on certain corporate matters, and to inspect certain records). Thus, shareholders are on equal legal footing with bondholders and employees who, like shareholders, also have contracts with the corporate entity that give them limited distribution rights and in some cases, limited voting and inspection rights. Property theory accordingly seems to disregard the formal legal relationship between shareholders and corporations. This seems a serious flaw in property theory, as property rights are defined by law (See Chapter 6 in the Handbook, “Economics of Property Law,” by Henry Smith). Thus, property theory can be criticized as offering an erroneous description of the legal technology that is the corporation (Stout 2012). However, the property model may be a reasonable metaphor in cases where a shareholder enjoys such a high degree of control over the board and corporate policy that the shareholder becomes the functional equivalent of a sole proprietor. Thus, property theory may be useful for analyzing corporations with no debt and a single shareholder who controls the board of directors.

 

346   LYNN STOUT However, in the typical modern public corporations with disbursed shareholders, collective action problems make it extremely difficult for shareholders to influence incumbent boards of directors. Thus, as Adolf Berle and Gardiner Means described nearly a century ago (Berle and Means 1932), share ownership in a public corporation does not as a practical matter typically translate to shareholder control over the corporate entity. Accordingly, the property theory provides a very poor model for describing the typical public corporation. Property theorists often concede that public corporations are characterized by the separation between shareholder “ownership” and actual control of corporate assets that Berle and Means described (Blair 1995). However, they typically view this as a flaw not of property theory, but of public corporations. Thus, property theorists often argue that corporate law and practice should be “reformed” to give disbursed public company shareholders greater influence over boards or to encourage more hostile takeovers in which public companies acquire controlling shareholders (Manne 1965; Bebchuk 2007). In other words, they argue that corporations should be changed to fit the model, rather than changing the model to fit real corporations. This approach disregards and puts at risk the economic benefits generated by asset lock-in and board-​controlled corporations (Blair 2003; Stout 2013; Section 14.3.5).

14.3.4. Nexus of Contracts Theory Another theory of the corporation frequently associated with law and economics is the nexus of contracts theory (Easterbrook and Fischel 1985). This theory views the corporation as a web or “nexus” of explicit and implicit contractual agreements between and among various parties associated with the firm, including shareholders, directors, officers, employees, and creditors (Eisenberg 1999; Hayden and Bodie 2011). The nexus of contracts approach has many strengths. First, it embraces the intricacy of corporate entities, which can rival nation-​states in size, scope, and complexity. It thus avoids the unrealistic reductionism of the property or aggregation theories. Second, nexus theory emphasizes the voluntary nature of most corporate relationships. Third, it highlights corporate diversity and the reality that those who create and participate in corporations can draft customized charters, bylaws, and contracts that depart from the standard “default” rules. For example, while most corporate codes provide that each share of common equity has one vote (“one share, one vote”), they also permit corporations to issue classes of shares with different voting rights. At the same time, the nexus of contracts approach has weaknesses. Many nexus theorists dismiss the corporate entity as irrelevant or even nonexistent. As two pioneers of nexus theory have put it, “the corporation is not real. It is no more than a name for a complex set of contracts among managers, workers, and contributors of capital. It has no existence independent of these relations” (Easterbrook and Fischel 1989, 89; see also Jensen and Meckling [1976, 310–​11], describing the corporation as a “legal fiction”). This

 

THE ECONOMIC NATURE OF THE CORPORATION    347 not only is inconsistent with the corporation’s legal status, it also makes it difficult to determine the corporation’s boundaries. For example, when General Motors sells a car to a dealer, is the sales contract part of the corporation? What if the dealer subsequently sells the car to a retail customer, who then buys car accessories from a department store? Are these purchase contracts also part of the corporation? The question of corporate boundaries under nexus theory can be answered by combining nexus theory with the entity theory, and treating the corporate entity itself as the contracting party at the center of the web of implicit and explicit contracts that makes up a corporation. The corporation can then be defined as including only contracts to which the corporate entity is a party (e.g. the charter and bylaws, as well as contracts, employment agreements, and debt instruments and equity shares issued in the name of the corporation). However, nexus theory has a second limitation in that it glosses over the critical role played by the state in permitting incorporation and limiting how corporations may be organized. Although corporate law allows for a high degree of customization (most corporate law rules are default rules), there are some corporate law rules that are mandatory. For example, the director’s fiduciary duty of loyalty is mandatory and cannot be contracted around.

14.3.5. Team Production Theory The team production theory of the corporation focuses on the role corporate entities play in fostering team production, meaning production that requires contributions from more than one party (Blair and Stout 1999). Team production projects pose a difficult contracting problem when team members’ contributions are project-​specific (they have limited value outside the project) and nonseparable (all contributions are essential to the project’s success, making it impossible to assign any particular portion of the benefits generated by the project to any particular contribution). In such cases ex ante sharing rules invite shirking, while ex post negotiations over the division of rewards encourage opportunistic rent-​seeking. Corporate projects often involve team production, requiring project-​specific contributions from investors, employees, and others and others (Blair and Stout 1999). The team production approach to corporate law posits that the unique corporate characteristic of governance by a board of directors whose members cannot distribute corporate assets to themselves (what Henry Hansmann [1996] has called a “distribution constraint”) can be understood as a second-​best contracting solution to the team production problem. Essential corporate team members (shareholders, employees, and others who make company-​specific investments) give up property rights over the team’s joint output to the corporate entity, which “owns” any surplus generated by team production. The corporate entity in turn is governed by a board of directors whose members cannot keep the surplus for themselves but must choose between keeping the surplus

 

348   LYNN STOUT in the entity’s name or distributing all or part of it to various corporate team members (e.g., paying dividends to shareholders or larger salaries to employees). If the board’s members want to keep the corporate entity viable, which is a prerequisite to their keeping their board positions, they have an incentive to use corporate surplus to reward various team members as necessary to keep those members inside the corporate team. The team production model accordingly views corporate directors not as agents of shareholders, but as a governance mechanism designed to encourage and protect specific investment in corporate team production. This approach explains a number of aspects of corporate law, including the rules of fiduciary duty, shareholders’ limited voting rights, and derivative suit procedure (Blair and Stout 1999). The team production theory of the corporation can be critiqued as applying more clearly to public corporations with disbursed and relatively powerless shareholders than to closely held firms or firms with a single shareholder. This is because directors in companies with a controlling shareholder may find it difficult to act as independent “mediating hierarchs” who control and distribute the corporate surplus (Coates 1999). The property model may be a better model for describing such controlled firms.

14.3.6. Political Theories (Corporations as “Franchise Governments”) Another way to model the corporate entity is to view it as an extension or “franchise” of the political state (Ciepley 2013). This theory recognizes that corporations closely resemble governments in their internal governing authority over their constituents, especially shareholders and employees. Moreover, this internal governing authority exists because it has been expressly granted by state action; it is state law that gives corporate entities legal personhood. Thus, corporations should be viewed not only as aggregations of private contracts or private property but also as quasi-​public institutions. The political theory of the corporation finds support from the fact that many early corporations (e.g., the British East India Company) were chartered by governments for expressly public purposes, not merely for private profit. It also recognizes that corporate entities and political entities have many common characteristics, including the use of voting rules to select representatives and the creation of lines of authority within the entity. Finally, it recognizes that political action is essential for corporate entities to exist, as private contract alone cannot create legal persons with entity shielding (Hansmann, Kraakman, and Squire 2006; Ciepley 2013). But while the political theory of the corporation offers many insights, it does not provide much guidance on what corporate governance structures are most desirable for corporations. To some extent, it also begs the question of why states allow incorporation; that is, the normative question of corporate purpose. To this question we now turn.

 

THE ECONOMIC NATURE OF THE CORPORATION    349

14.4.  Theories of Corporate Purpose A corporate entity must rely on natural persons, especially its board of directors, to make decisions and to take action in the entity’s name. This inevitably raises the question of what goals the natural persons tasked with serving the corporation’s interests should pursue. To qualify for favorable tax treatment, nonprofit corporations must describe their goals and purposes in their charters. In contrast, corporate codes generally allow other corporations (often called “for-​profit” corporations, to highlight their tax status) to be formed “for any lawful purpose.” Moreover, the vast majority of for-​profit corporate entities describe their purpose in their charters by using some variation of the phrase “any lawful purpose” (Stout 2012). It is, therefore, not surprising that, just as different models of the corporate entity have been offered, different theories of corporate purpose have predominated at different times and in different places.

14.4.1. State Interests As a historical matter, most early business corporations were chartered by political states to accomplish specific purposes relating to the state’s interests. For example, the Hudson’s Bay Company was chartered by the English crown for the specific purpose of exploring and developing colonial lands in North America; the Dutch East Indies Company was chartered by the Dutch legislature to do the same in Asia. Each company enjoyed a state-​granted monopoly over trading in its area. These early corporations were clear examples of “franchise corporations,” whose principal purpose was to serve the interests of the chartering government (Ciepley 2013). Today, most states permit “free incorporation,” allowing anyone to create a corporation for any lawful purpose. However, the franchise theory of corporate purpose persists in the form of scholarly arguments that, because state action is required for corporations to exist, corporations should be run in a fashion that contributes broadly to public welfare, not only to generate private profits (see, e.g., Ciepley 2013).

14.4.2. Customer Welfare In the eighteenth and early nineteenth century, many business corporations were created not to serve their investors, but to serve the consumers who relied on the goods and services produced by the corporations (Hansmann and Pargendler 2014). This is most directly evidenced by the voting structures of these corporations, which typically were local monopolies created to provide needed infrastructure (roads and canals) and financial services (banking and insurance). The merchants, farmers, and landowners who

 

350   LYNN STOUT patronized these businesses were also their principal shareholders, and voting rights were allocated in a fashion that favored small shareholders over larger ones (ibid.). The customer welfare theory of corporate purpose finds its modern expression in prominent management scholars who argue that corporations ought to serve “customer capitalism” (Martin 2010). For example, management guru Peter Drucker famously believed, “the purpose of business is to create and keep a customer” (Stern 2011).

14.4.3. Managerialism During most of the twentieth century, the dominant theory of corporate purpose was managerial capitalism or managerialism (Davis 2009, 63). This business philosophy viewed professional managers of public corporations (i.e., directors and executive employees) as stewards or trustees of important economic institutions that ought to be operated to benefit a wide range of constituents, including not only shareholders but also customers, employees, suppliers, the local community, and the nation. Managerialism fell into disfavor at the close of the twentieth century owing to the increasingly widely held belief, perhaps related to the decline of the heavily unionized American auto and steel industries, that it promoted self-​serving managerial behavior and inefficient “empire building.” It is questionable whether the evidence supports the view that managerialism proved uncompetitive (Rock 2013; Stout 2013). Nevertheless, many experts today view managerialism as discredited. However, considerable support remains for stakeholder theory, see Section 14.4.5, which shares many elements of managerialism.

14.4.4. Shareholder Value and Shareholder Primacy Perhaps the dominant theory of corporate purpose today, especially among nonexperts in the United States and UK, might be called shareholder value theory or shareholder primacy. This theory holds that the sole purpose of business corporations is to maximize shareholder wealth or “shareholder value” (Hansmann and Kraakman 2000; see, e.g., Bainbridge 2003). Shareholder value theory is associated with the notion that the corporation is the property of its shareholders, see Section 14.3.4. Like the property model, it implies that corporations exist to serve only shareholders and that directors ought to do shareholders’ collective bidding. Shareholder value theory is also associated with the “fundamental value” version of the efficient capital markets hypothesis, which holds that the price of the company’s shares always reflects the best possible estimate of the company’s fundamental economic value (Hansmann and Kraakman 2000; see, generally, Gilson and Kraakman 1984; Stout 2003). Despite its popularity, the idea that corporations exist to maximize shareholder value rests on questionable intellectual foundations. As a positive matter, it conflicts with modern corporate codes and charters, which typically permit corporations to pursue

 

THE ECONOMIC NATURE OF THE CORPORATION    351 any lawful objective. The business judgment rule similarly gives boards of directors wide latitude to pursue noneconomic objectives and to serve nonshareholder interests (Blair and Stout 1999; Stout 2012). The result, as the US Supreme Court recently stated in the Hobby Lobby case, is that “modern corporate law does not require for-​profit corporations to pursue profit at the expense of everything else, and many do not do so,” Hobby Lobby case, Burwell, 134 S. Ct. at 2771. Many proponents of shareholder value thinking concede its positive limitations. They argue instead that, even if corporate law does not require boards to maximize shareholder value, as a normative matter that is what boards ought to do, because shareholders own corporations and are the corporate entity’s residual claimants (Hansmann and Kraakman 2000; see, e.g., Bainbridge 2003). These last two statements are factually incorrect, however. As discussed in Sections 14.2.1 and 14.3.3, corporations as legal persons either own themselves or are incapable of being owned by anyone. Similarly, the corporate entity holds legal title to all corporate profits and is its own residual claimant; the board of directors, and not the shareholders, has the legal authority to decide what to do with the entity’s residual (Stout 2012). A second intellectual flaw in the normative case for a shareholder value theory of corporate purpose is that it implicitly presumes that a single “shareholder value” exists. In other words, it assumes shareholders are homogeneous. It thus glosses over the reality that shareholders frequently have different and conflicting interests (Greenwood 1996). For example, the pursuit of “shareholder value” in the form of a higher share price today may benefit short-​term shareholders while harming longer-​term shareholders by eroding the company’s long-​run profitability (Stout 2012; Aspen Institute 2014). Finally, the shareholder value theory of the corporation can be critiqued on the grounds that it produces socially inefficient results because it discourages team production, see Section 14.4.6, and encourages corporations to be managed in a fashion that ignores external costs and benefits, see Section 14.4.5.

14.4.5. Stakeholder Welfare Another theory of corporate purpose that enjoys substantial support among contemporary corporate experts, especially outside the United States, is stakeholder welfare theory (Freeman 1984; Freeman et al. 2010). Stakeholder theory, like franchise theory, holds that states permit incorporation so that companies may generate social benefits. Stakeholder theory further argues that, in calculating social benefits from corporate activity, there is no reason to focus only on benefits to equity investors. The welfare of other parties involved with or affected by corporate behavior (e.g., employees, customers, suppliers, and the community) should also be considered. Stakeholder theory is sometimes criticized as failing to explain why shareholders typically elect directors. However, as a matter of logic, the observation that shareholders have voting rights that other stakeholders do not have is not enough to demonstrate that only shareholder welfare should count in setting corporate policy. There may be

 

352   LYNN STOUT other reasons for limiting voting rights (Blair and Stout 1999). For example, minors and noncitizen residents cannot vote in US political elections, but this does not mean US policymakers should ignore their interests. Similarly, case law sometimes seems to give shareholders special treatment by describing directors’ fiduciary duties as being owed to “the corporation and its shareholders.” This critique has led some stakeholder theorists to propose the creation of explicit fiduciary duties to stakeholders (see, e.g., Freeman 1984). However, it can be argued that the existence of fiduciary duties to the corporate entity demonstrates both that shareholder welfare is not the only corporate goal that matters and that corporations can operate to protect stakeholder interests (Blair and Stout 1999). A second common objection to the idea of maximizing stakeholder welfare as a corporate objective is the claim that, as a practical matter, it is difficult to balance the interests of different constituencies against each other, and inviting corporate managers to do so simply gives them discretion to impose more agency costs. While this objection has some merit, it is subject to the qualification that managerial discretion still might be a “second-​best” solution if maximizing shareholder wealth is itself an inefficient objective (e.g., because it discourages team production or because it generates excessive external costs).

14.4.6. Team Production Theory A third contemporary theory of corporate purpose that shares some common elements with stakeholder theory is team production theory (Blair and Stout 1999). Team production theory holds that the purpose of the corporation is to generate economic surplus by protecting the company-​specific investments of various corporate “team members,” such as the equity investors who contribute financial capital used to make specific investments in research or infrastructure, employees who invest in firm-​specific human capital or customers who rely and become dependent upon on the firm’s products. As described in Section 14.3.5, team production theory views the corporate goal as maximizing the surplus generated by the team. Accomplishing this goal requires ensuring that each essential team member receives a large enough share of the benefits from corporate production that the member wants to continue with the team. Team production theory resembles stakeholder theory in supporting the idea that corporations should be run to benefit not only shareholders but also employees, customers, suppliers, and other groups whose specific investments contribute to corporate success. Like stakeholder welfare theory, it recommends that managers seek to balance the interests of several constituencies, and so it is subject to similar criticisms (balancing interests is difficult, can increase agency costs, and so forth). Unlike stakeholder theory, however, team production theory does not address the problem of external corporate costs and benefits to groups that do not participate in corporate production.

 

THE ECONOMIC NATURE OF THE CORPORATION    353

14.4.7. Long-​Term Production Theory A theory of corporate purpose that has recently emerged from several sources might be called long-​term production theory (Schwartz 2012; Stout 2014; Keay 2008). This approach to understanding corporate purpose focuses on what may be the most interesting and unique feature of corporate entities: the possibility of perpetual existence and “immortal investing” (Schwartz 2012). Unlike partnerships and proprietorships, corporations, in theory, can exist in perpetuity. This unique corporate characteristic suggests that an important and perhaps primary economic purpose of at least some corporations is to pursue economically beneficial projects likely to succeed only over very long or uncertain periods of time (Schwartz 2012; Stout 2014). For example, many of the earliest nonprofit corporations were universities, municipalities, and religious organizations pursuing projects over timeframes measured in several human generations (e.g., building and maintaining a cathedral or university) (Stout 2014). Similarly, some contemporary business corporations have been operating for centuries (Schwartz 2012). Among modern business corporations, the public company comes closest to fitting the notion that the primary purpose of corporate entities is to pursue long-​term projects. This is because public corporations whose shares are traded in a somewhat efficient stock market (i.e., a market where prices roughly capture future value) provide incentives for the present generation of investors to pursue projects that may not generate profits for decades—​as long as those future profits can be captured in today’s share price. Public corporations thus help overcome the limits to altruism that might otherwise lead the present generation to underinvest in projects that benefit future generations (Stout 2014). It should be noted that when stock markets are somewhat inefficient, public corporations are more likely to be able to pursue long-​term investments if they are board governed, and so able to keep their corporate assets locked in. This suggests that under conditions of limited market efficiency, “shareholder democracy” of the sort often favored by proponents of the property model and shareholder value theory (see Sections 14.3.3 and 14.4.4) may harm the public corporation’s ability to pursue beneficial long-​ term projects (Stout 2014). The idea that pursuing very long-​term projects is an important economic function of the corporate form raises interesting questions about the best way to measure corporate performance. If the future is foreseeable and the stock market is perfectly efficient, today’s share price may be a reliable measure of the value of the corporation’s future returns to shareholders. But if (as seems far more likely) the future is uncertain or the market is imperfectly efficient, stock price can be unreliable. Indeed, to the extent the future is uncertain, long-​term “shareholder value” becomes fundamentally unobser­ vable. An unobservable variable is useless as a performance metric. In such a case, it might be better to gauge long-​term corporate performance by focusing on whether the corporation is likely to survive into the long term. In other words, entity sustainability

 

354   LYNN STOUT may be a better metric of corporate performance, and a more useful goal, than maximizing today’s profits or share price (Keay 2008; Belinfanti and Stout 2016).

14.5. Conclusion As a positive matter, there is widespread agreement about the basic legal characteristics of corporate entities:  legal personhood, limited liability, delegated management, transferable shares (for stock corporations), and perpetual existence. However, when it comes to models of the corporate entity and to the normative question of proper corporate purpose, we see great diversity and a fair degree of disagreement (Allen 1992; Aspen Institute 2014). As to models, it seems reasonable to suggest that most have insights to offer. Recall the parable of the four blind men and the elephant: the blind man who grasped the trunk compared the elephant to a snake; the man who grasped the leg likened it to a tree; the man who touched the side thought it resembled a wall; and the man who grabbed the tail thought it was like a rope. Just as each of the four blind men had different but useful insights into the nature of the elephant, different models of the corporation may each have some value. However, some models are more useful than others are in particular circumstances. For example, the property model is best applied to firms with a single shareholder, whereas the team production model is typically most applicable to public firms with disbursed shareholders. Regarding theories of proper corporate purpose, commentators sometimes argue that we need a single corporate objective because otherwise, the directors and executive employees who manage corporations will enjoy too much discretion and generate excessive agency costs. As economist Michael Jensen has put it, “any organization must have a single-​valued objective as a precursor to purposeful or rational behavior … [i]‌t is logically impossible to maximize in more than one dimension in the same time” (2002). This perspective overlooks the possibility that it is often rational not to seek to maxi­ mize a single objective, but instead to “satisfice” several important constraining objectives (as Nobel Prize-​winning economist Herbert A. Simon has put it [1978]). Biological organisms and mechanical systems, for example, typically satisfice multiple objectives (e.g., ensuring a minimum required level of energy inputs, maintaining temperatures within an acceptable range, avoiding dangerously stressful forces, and so forth). There seems no reason to assume that organizations like corporations cannot similarly follow Simon’s satisficing principle. Although a goal of satisficing several objectives may leave more room for agency costs than mindlessly pursuing a single objective, satisficing multiple objectives may be preferable if it produces a more successful, resilient, and sustainable organism, mechanism, or organization. Moreover, it may be desirable to permit different corporate entities to pursue different purposes. This is clearly the case for nonprofits; different nonprofits typically describe different purposes in their charters. There seems no reason to assume business

 

THE ECONOMIC NATURE OF THE CORPORATION    355 corporations cannot also be used for diverse purposes. After all, the typical corporate code and the typical corporate charter simply provide the business must be “lawful.” While a certain amount of profitability is necessary to ensure survival, outside that constraint business corporations can pursue a number of objectives, including producing innovative products, providing secure and high-​paying employment opportunities, generating returns for equity and debt investors, and promoting economic growth and stability. Like the Swiss army knife, the corporate entity is an organizational tool that can be put to many uses.

References Allen, William T. 1992. “Our Schizophrenic Conception of the Business Corporation.” Cardozo Law Review 14(2), pp. 261–​281. Aspen Institute, Business & Society Program. 2014. Reopening the Question of Corporate Purpose. New York: Aspen Institute. http://​www.aspeninstitute.org/​sites/​default/​files/​content/​upload/​Unpacking%20Corporate%20Purpose%20May%202014.pdf [Accessed 28 August 2016]. Bainbridge, Stephen M. 2003. “Director Primacy:  The Means and Ends of Corporate Governance.” Northwestern University Law Review 97(2), pp. 547–​606. Bank, Stephen A. 2006. “A Capital Lock-​In Theory of the Corporate Income Tax.” Georgetown Law Journal 94(4), pp. 889–​947. Bebchuk, Lucian. 2007. “The Myth of the Shareholder Franchise.” Virginia Law Review 93(3), pp. 675–​732. Belinfanti, Tamara C. and Stout, Lynn. Forthcoming. Shareholder Value Theory and the Systems Alternative. Draft on file with the authors. Berle, Adolf A. and Means, Gardiner C. 1932. The Modern Corporation and Private Property. New York: Macmillan. Biondi, Yuri, Canziani, Arnaldo, and Kirat, Thierry, eds. 2007. The Firm as an Entity: Implications for Economics, Accounting, and the Law. New York: Routledge. Blair, Margaret M. 1995. Ownership and Control:  Rethinking Corporate Governance for the Twenty-​first Century. Washington, DC: Brookings Institute. Blair, Margaret M. 2003. “Locking In Capital:  What Corporate Law Achieved for Business Organizers in the 19th Century.” UCLA Law Review 51(2), pp. 387–​455. Blair, Margaret M. and Stout, Lynn A. 1999. “A Team Production Theory of Corporate Law.” Virginia Law Review 85(2), pp. 247–​328. Burwell v Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014). Ciepley, David. 2013. “Beyond Public and Private:  Toward a Political Theory of the Corporation.” American Political Science Review 107(1), pp. 139–​158. Ciepley, David. 2014. “The Corporate Roots of the Liberal Democratic State.” Unpublished manuscript, draft on file with the author. Clark, Robert C. 1986. Corporate Law. Boston: Little, Brown. Coates IV, John C. 1999. “Measuring the Domain of Mediating Hierarchy: How Contestable Are U.S. Public Corporations.” Journal Corporation Law 24(4), pp. 837–​867. Davis, Gerald F. 2009. Managed by the Markets:  How Finance Re-​ shaped America. New York: Oxford University Press.

 

356   LYNN STOUT Easterbrook, Frank H. and Fischel, Daniel R. 1985. “Limited Liability and the Corporation.” University of Chicago Law Review 52(1), pp. 89–​117. Eisenberg, Melvin A. 1998. “The Conception That the Corporation Is a Nexus of Contracts, and the Dual Nature of the Firm.” Journal of Corporate Law 24, p. 819. Freeman, R. Edward. 1984. Strategic Management:  A  Stakeholder Approach. Boston, MA: Pitman. Freeman, R. Edward, Harrison, Jeffrey S., Wicks, Andrew C., Parmar, Bidhan L., and de Colle, Simone. 2010. Stakeholder Theory: The State of the Art. Cambridge, MA: Cambridge University Press. Friedman, Milton. 1970. “The Social Responsibility of Business Is to Increase Its Profits.” The New York Times Magazine. Sept. 13. Gilson, Ronald J. and Kraakman, Reinier H. 1984. “The Mechanisms of Market Efficiency.” Virginia Law Review 70(4), pp. 549–​644. Greenwood, Daniel J.H. 1996. “Fictional Shareholders: For Whom Are Corporate Managers Trustees, Revisited.” Southern California Law Review 69(3), pp. 1021–​1104. Hansmann, Henry. 1996. The Ownership of Enterprise. Cambridge, MA:  Belknap Press of Harvard University Press. Hansmann, Henry and Kraakman, Reinier H. 2000. “The End of History for Corporate Law.” Georgetown Law Journal 89(2), pp. 439–​468. Hansmann, Henry and Parglender, Mariana. 2014. “Evolution of Shareholder Voting Rights: Separation of Ownership and Consumption.” Yale Law Journal 123(4), pp. 948–​1013. Hansmann, Henry, Kraakman, Reiner H., and Squire, Richard. 2006. “Law and the Rise of the Firm.” Harvard Law Review 119(5), pp. 1335–​1403. Hayden, Grant M. and Bodie, Matthew T. 2011. “The Uncorporation and the Unraveling of ‘Nexus of Contracts’ Theory.” Michigan Law Review 109(6), pp. 1127–​1144. Jensen, Michael C. 2002. “Value Maximization, Stakeholder Theory, and the Corporate Objective Function.” Business Ethics Quarterly 12(2), pp. 235–​256. Jensen, Michael C. and Meckling, William H. 1976. “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” Journal of Financial Economics 3(4), pp. 305–​360. Keay, Andrew R. 2008. “Ascertaining the Corporate Objective: An Entity Maximization and Sustainability Model.” Modern Law Review 71(5), pp. 663–​698. Liggett v Lee, 288 U.S. 517 (1933). Manne, Henry G. 1965. “Mergers and the Market for Corporate Control.” Journal of Political Economy 73(2), pp. 110–​120. Manne, Henry G. 1967. “Our Two Corporation Systems: Law and Economics.” Virginia Law Review 53(2), pp. 259–​284. Martin, Roger. 2010. “The Age of Customer Capitalism.” Harvard Business Review 88(1/​2), pp. 58–​65. Millon, David. 1990. “Theories of the Corporation.” Duke Law Journal 2, pp. 201–​262. Robe, Jean-​Philippe. 2011. “The Legal Structure of the Firm.” Accounting, Economics and Law 1(1), pp. 1–​86. Rock, Edward B. 2013. “Adapting to the New Shareholder-​Centric Reality.” University Of Pennsylvania Law Review 161(7), pp. 1907–​1988. Schwartz, Andrew A. 2012. “The Perpetual Corporation.” George Washington Law Review 80(3), pp. 764–​830. Simon, Herbert A. 1978. “Rationality as Process and Product of Thought.” American Economic Review 68(2), pp. 1–​16.

 

THE ECONOMIC NATURE OF THE CORPORATION    357 Stern, Stefan. 2011. “The Importance of Creating and Keeping a Customer.” Financial Times, October 10. www.ft.com/​intl/​cms/​s/​2/​88803a36-​f108-​11e0-​b56f-​00144feab49a.html [Accessed 28 August 2016]. Stout, Lynn A. 2003. “The Mechanisms of Market Inefficiency: An Introduction to the New Finance.” Journal of Corporation Law 28(4), pp. 635–​669. Stout, Lynn A. 2005. “On the Nature of Corporations.” University of Illinois Law Review 2005: 253–​267. Stout, Lynn A. 2012. The Shareholder Value Myth:  How Putting Shareholders First Harms Investors, Corporations, and the Public. San Francisco, CA: Berrett-​Koehler. Stout, Lynn A. 2013. “On the Rise of Shareholder Primacy, Signs of Its Fall, and the Return of Managerialism (in the Closet).” Seattle University Law Review 36(2), pp. 1169–​1185. Stout, Lynn A. 2014. “The Corporation as Time Machine:  Intergenerational Equity, Intergenerational Efficiency, and the Corporate Form.” Seattle University Law Review 38(2), pp. 685–​723. Trustees of Dartmouth College v Woodward, 17 U.S. 518 (1819). Weinstein, Mark. 2005. “Limited Liability in California: 1928-​31: It’s the Lawyers.” American Law and Economics Review 7(2), pp. 439–​483.

 

Chapter 15

MARKET FOR C ORP ORAT E L AW REDU X Roberta Romano

15.1. Introduction Corporations operate in numerous markets:  product markets, labor markets, and capital markets. This chapter focuses on the market that is the prerequisite for firms’ successful operation in all other markets, as it is the market that frames their organizational structure and governance: the market for corporate law. In the United States, two features of the legal landscape have informed such a conceptualization of corporate law as a product (Romano 1985): (1) corporate law is the domain of the states rather than the national government; and (2) under the internal affairs doctrine, the state whose corporate law governs a firm is the state of its statutory domicile. This arrangement provides firms with a choice, they can select their governing law from among the states regardless of their physical location; thus, the notion that states offer a product that corporations purchase, by means of incorporation fees (referred to as franchise taxes). For the past century, remarkably, one small state, Delaware, has been the market leader, serving as the domicile for the overwhelming majority of US corporations (e.g. Romano 1985, 244, reincorporations and Fortune top 100; Alva 1990, 885, largest; Daines 2001, 538, initial public offerings (IPOs); Bebchuk and Cohen 2003, 389, Compustat database of public firms). The debate over the market for corporate law has focused, in large part, on whether the phenomenon of Delaware’s dominance is for the better. The first part of the chapter analyzes the dynamics of the US market for corporate law, which can best be characterized as states competing for corporate charters, along with data pertinent to the question of whom this market organization benefits (managers or shareholders) and explanations why Delaware has had a persistent and commanding position. The focus is on the market for public corporations, given their relative importance to the economy, the more extensive literature, and space limitations for this chapter. For analyses of the market for privately held corporations and unincorporated

 

MARKET FOR CORPORATE LAW REDUX    359 firms, in which Delaware is also the most important state actor, although the features of the legal regime that attract firms differ in ways related to the differing needs of their respective clienteles (see Kobayashi and Ribstein 1996, 2011; Damman and Schündeln 2009, 2012). The focus is also on contemporary state competition (i.e., post-​1960s corporation code reforms). For analyses of state competition in the nineteenth and early twentieth centuries, see Butler (1985) and Wells (2009). The second part of the chapter turns to explain Delaware’s persistence as the pre-​ eminent incorporation state. This is a distinctive feature of US corporate law. There are other federal systems of corporate law, but a similar Delaware phenomenon does not exist. For analyses of the market for corporate law in other federal settings see, for Canada, Daniels (1991); Cummings and MacIntosh (2000, 2002). For the European Union, see Enriques (2004); Becht et al. (2008); Enriques and Tröger (2008); Hornuf (2012); Ringe (2013). The chapter concludes with a summary and suggestions for future research.

15.2.  The Market for Corporate Law The US market for corporate law is a function of federalist political arrangements, and the literature that has debated its efficacy is a microcosm of the literature on the broader question of political organization. A federal system of government provides a number of benefits for its citizens. It protects the individual from the coercive power of government, as states can diffuse political authority and thereby provide a counterweight to a national government (de Tocqueville 1835). A federal system can also allocate public goods and services more efficiently than a centralized system can, increasing the utility of its citizens by being able to match specific government programs and policies with diverse citizen preferences, as lower-​level entities (states and municipalities) compete for citizens who choose to reside in the jurisdiction, offering their preferred package of public goods (Tiebout 1956). This theoretical claim accords with the greater trust individuals in the US have in the level of government that is closest to them (e.g., Pew Research Center 2013). Finally, federalism spurs innovation in public policy because of the experimentation afforded by the laboratories of the states, maneuvering, that is, competing, to match the preferences of citizens (New State Ice Co. v Liebmann, 285 U.S. 262, 311, 1932, Brandeis, J, dissenting). But while the benefits of federalism are axiomatic in US politics, so too is the recogni­ tion of costs from the workings of multiple layers of governments, which can impede effective administration and thereby diminish individual welfare. In particular, where the benefits and costs of a government policy or program do not fall squarely within the boundaries of a jurisdiction, the optimal quantity and quality of public goods or services will not be produced. States will tend to overprovide goods and services when they can export the costs to nonresidents, and, conversely, underproduce goods and services whose benefits accrue to both residents and nonresidents (the utility or welfare of

 

360   ROBERTA ROMANO nonresidents not being included in the political calculus). The contention is that because the national government includes all citizens, such jurisdictional spillovers would no longer result in production mismatches as governmental decision makers at the higher level can internalize appropriately all of a program’s costs and benefits. The intellectual state of play, therefore, is an empirical question, and the answer may well vary with the context. How does the broad statement of the benefits and costs of federalism map onto the corporate law setting? Corporate law governs relations between managers and shareholders. As a consequence, although those individuals do not physically reside in the domicile state, the costs and benefits of the corporate contract are borne by them, that is, there are no externalities or interjurisdictional spillovers in corporate law of any significance that would suggest the appropriate authority should be the national government. Accordingly, questions regarding the efficacy of the federal system of corporate law have been directed at whether it furthers the objective of safeguarding the economic interest of shareholders, the residual claimants.1 The data indicate that this arrangement has been shareholder welfare increasing: while certainly not perfect, the competitive pro­ cess in which states seek to retain and attract domestic corporations has tended to result in corporation codes whose content is in accord with investors’ preferences. This is, to be sure, in part a function of incentives brought to bear on managers from the numerous alternative uses to which investors’ funds can be put, as well as from the other markets in which firms operate (see, e.g., Winter 1977), but it is also the product of the incentives of states competing in the market for corporate law.

15.2.1. The State Competition Debate The classic positions in the state competition debate were formulated in the 1970s in two widely cited articles by William Cary (1974) and Ralph Winter (1977). The two sides of the debate share assumptions regarding the behavior of firms and states: (1) firms will seek out the jurisdiction with their preferred corporate law, being able to change domicile (reincorporate) without significant cost; and (2) states will compete to offer laws that attract or retain domestic corporations to increase state coffers (domestic corporations pay franchise fees to incorporate and do business in a state). The disagreement was over whose preferences informed the domicile choice, and thereby found expression in state law. Because Delaware (1) attracts the most corporations, including a majority of the largest publicly traded firms, firms going public for the first time, and firms changing their domicile (Romano 1985; Daines 2002; Moodie 2004); (2) obtains a large fraction of its total tax revenue from incorporations—​an average of 17% over 1966–​2000, which increased to 20% and higher since 1992 (Romano 2002)—​and (3) is either a pioneer or 1  The normative claim for advancing shareholder interests as the objective of corporate law is that operating firms in accordance with the interest of the residual claimant will maximize firm value, which benefits all parties in relationships with the firm (see, e.g., Easterbrook and Fischel 1991, 38).

 

MARKET FOR CORPORATE LAW REDUX    361 early imitator of statutory innovations (Romano 1985, 2002, 2006), the debate over the efficacy of state competition devolves into one over the quality of Delaware law, and correlatively, to whose preferences it is responding when updating its code. Cary (1974, 666) contended that managers’ preferences governed, characterizing Delaware case law as unfavorable to shareholders, and, more famously, the development of state law as a race for the bottom. Winter, however, identified a critical omission in Cary’s analysis that would point the race in the precise opposite direction: firms operating under a legal regime unfavor­ able to shareholder wealth would be outperformed by those operating under a favorable regime, which would put managers’ employment in jeopardy. Namely, a higher cost of capital and correspondingly lower stock price of underperforming firms, would drive them out of business, or subject them to a takeover, and the managers would be replaced by a creditor’s committee or a successful hostile bidder. This omnipresent threat, Winter contended, would result in managers selecting the domicile that was most likely to maximize shareholder wealth, that is, firm value. The many markets in which firms operate, then, align managers’ and shareholders’ interests with regard to domicile choice, leading states to compete toward the top rather than the bottom.

15.2.2. Do States Compete? More recently, some commentators have contended that, given Delaware’s dominant position in the charter market, corporate law in the United States cannot accurately be described as the product of competition (Kahan and Kamar 2002). They advance a number of related claims as evidence that states do not compete: (1) other states have not sought to replicate key features of Delaware’s legal regime by similarly charging high franchise fees and establishing a specialized court to hear corporate law cases;2 (2) excluding Delaware, state officials do not express an active interest in attracting incorporations; and (3) there are not sufficient benefits to other states to compete. The characterization that states do not compete does not accord, however, with the behavior of states and firms that we observe.

15.2.2.1. Defensive Competition States need not copy Delaware institutions to be competing for domestic corporations, nor is active recruitment of incorporations by government officials a prerequ­ isite for competition.3 As I  have previously characterized the competitive process, given Delaware’s dominance, most other states engage in defensive competition, acting to retain domestic corporations, rather than seeking to lure corporations away from 2  The importance of franchise revenues and a specialized court for Delaware’s success is discussed in Section 15.3.2, infra. 3  For a more comprehensive critique of the position that there is no market for corporate law, see Romano (2002, 75–​83; 2005a).

 

362   ROBERTA ROMANO Delaware and unseat it as the market leader (Romano 1985). Defensive competition is an effective strategy because most newly public firms incorporate in either their home state or Delaware (Daines 2002). Most certainly, many, if not nearly all, states do not behave as if they were indifferent to the number of corporations in their jurisdiction: for if that were the case, we would not observe states repeatedly revising their corporation codes in response to changes in Delaware law and loss of local firms to Delaware (Romano 2006; Moodie 2004). Nor would we observe Delaware assiduously responding to revisions in other state codes. It, furthermore, would not make strategic sense for states to compete with Delaware by charging as high a franchise fee,4 whereas in terms of adjudicative strategy, some states, in fact, have created specialized business courts. Alternatively some states, particularly those with a relatively small number of public corporations, such as Connecticut, follow a less expensive strategy, adoption of the bright-​line rule-​based approach of the Model Business Corporation Act (Model Act), instead of Delaware’s standards-​based approach that relies on judicial expertise, diminishing the need for a specialized court (Lotstein and Callo 2000, 10).5 More important, not all states need compete with Delaware for it to behave as if it were an actor in a competitive market. Even if only a few states adapt their corporation codes to changing circumstances, Delaware would ignore that activity at its peril, as sluggishness in adaptation could cause domestic firms to migrate, paralleling the influx of firms into Delaware when their home states did not quickly adopt Delaware’s statutory innovations (Romano 1985; Moodie 2004). As long as there are not significant entry barriers to charter competition (a characterization of market structure that Kahan and Kamar do not question), the potential entry of competitors, without actual competition, could 4  As discussed in Section 15.3.2, infra, the significance of high franchise fees is that when a large proportion of a state’s tax revenues is derived from franchise fees, it attracts corporations by functioning as a commitment device by the state to be responsive to changing business needs, and only a few states, similarly small as Delaware, could, theoretically, benefit from duplicating that aspect of Delaware’s success. But even with considerably lower fees, many states raise in absolute dollars far more revenues from franchise fees than does Delaware (e.g., Romano 1985). Moreover, there is a positive relation between the proportion of total tax revenue states collect from franchise fees and their corporate law responsiveness (Romano 1985), which suggests that even relatively small dollar amounts influence behavior. To the extent, as discussed in Section 15.3.1 infra, that a Delaware domicile is most apt for firms seeking to engage in specific transactions, such as mergers and acquisitions, other states can vie with Delaware by competing on price rather than quality: firms that do not anticipate engaging in transactions to which Delaware law adds value might prefer a package of lower franchise fees and lower quality law (such as no expert court and a less responsive code). 5  There is an economy of scale in the production of legal precedents (see Section 15.3.2, infra), which makes it less cost-​effective to operate a specialized court in a state where there are few corporations that could ever require its services. The Model Act, which enables small states to compensate for the lack of economies of scale, is a product of a subcommittee of the American Bar Association’s Corporate Laws Committee of the Business Law Section, whose members generally are attorneys at large firms with public corporation clients. It provides a template for state corporation codes and has undergone several iterations since the initial draft of 1950. At present, thirty-​two states and the District of Columbia have adopted a version of the Model Act, but most large states have not. For a discussion of its role in the making of state corporate law, see Carney (1998); Romano (2006).

 

MARKET FOR CORPORATE LAW REDUX    363 compel a producer such as Delaware, which otherwise would appear to be a monopolist, to behave as if there were perfect competition (Baumol 2002; Romano 2002, 82–​83). Indeed, a desire to retain existing, and attract additional, corporations is a straightforward explanation why Delaware attentively revises its corporation code. Further, as Baumol notes, innovation in capitalist economies requires constant investment, which results in minimal entry barriers (sunk investments do not matter), because the innovator has continually to expend funds on research and development to maintain its edge, expenditures no different from those that a new entrant must undertake. This feature also characterizes the corporate charter market: Delaware’s costs of maintaining innovative activity through legislative updating and developing and appointing knowledgeable judges, are likewise those that would be borne by an entrant.

15.2.2.2. Role of the Bar in Statutory Innovation The pivotal factor for understanding the working of the charter market is that corporate law initiatives responding to changes in the business or legal environment are brought to legislators’ attention and that legislators respond positively to such appeals. Kahan and Kamar’s contention that the existence of competition is to be gauged by the presence of formal statements and actions of state government officials, misses how lawmaking works on the ground and the modus operandi of state competition: Legislative initiatives in corporate law originate with the corporate bar in Delaware, as well as other states. State officials in Delaware may well express a much more active interest in attracting corporations compared with those of other states, but the more crucial factor in generating competition is legislatures’ responsive updating of corporation codes to changing business circumstances. The corporate bar, as the repository of knowledge and expertise related to those matters is the catalyst for nearly all such legislative activity. In keeping with the fire-​alarm characterization of congressional oversight of agencies in the politi­ cal science literature (McCubbins and Schwartz 1984), the corporate bar monitors and identifies needed legislative changes, no doubt reflecting the needs of their clients (managers and investors), whether owing to a changed business environment, judicial opinions, or laws adopted in other states, and the Delaware legislature in turn responds to the bar’s pulling the fire alarm by enacting the proposed initiatives (e.g., Alva 1990, 900). A good illustration of state competition at work is the diffusion of statutory innovations in response to the crisis in directors’ and officers’ liability (D & O) insurance. By 1984, the market for D & O insurance had changed dramatically from the beginning of the decade, with firms having difficulty obtaining or renewing policies, as premiums skyrocketed, deductions increased, and yet coverage decreased (Romano 1989). While a tight reinsurance market owing to natural disasters contributed to the market dislocation, a 1985 decision of the Delaware Supreme Court, Smith v Van Gorkom, 488 A.2d 858 (1985), held outside directors had violated their duty of care when agreeing to a merger price at a substantial premium without sufficiently informing themselves of the firm’s value. This decision, no doubt, exacerbated managers’ and investors’ anxiety over the market trend: difficulty in obtaining insurance for directors who were confronted with heightened potential liability would render more difficult retention or recruitment of

 

364   ROBERTA ROMANO quality outside directors, individuals whom many institutional investors consider an especially key governance device for monitoring managers. States responded to the perceived D & O insurance crisis by seeking to lower directors’ liability on the view that doing so would mitigate a potential recruitment problem created by inadequate liability insurance. By 1987, thirty-​five states had modified their corporation codes to reduce directors’ exposure to shareholder litigation (Romano 1989, 30). After initial experimentation, with three different approaches adopted by Indiana, Delaware, and Virginia, most states settled on the solution chosen by Delaware, which was not the most aggressive solution, to permit charter amendments that limit or eliminate director liability for monetary damages for breaches of the duty of care (i.e., the liability exposure in Smith v Van Gorkom). Most important, commentaries by practitioners and legislative histories in a number of states upon the enactment of their statutes explicitly stated that they were enacting the statute to deter local firms from reincorporating in Delaware (Romano 2006, 224). Contrary to Kahan and Karmar’s thesis, this behavior can only be coherently explained as evincing states competing for corporations; if states were indifferent to the number of domestic incorporations, they would not be concerned about the content of their corporation codes, and we would not observe the rapid diffusion of limited-​liability statutes across the states, a pattern repeatedly observed of statutory innovations in the corporate context, although the speed of diffusion varies across provisions (Romano 2006). Kahan and Kamar (2002, 705) also contend that the bar’s role as the leading source of legislation indicates an absence of state competition, asserting instead that lawyers are motivated to seek corporation code revisions in order to enhance their reputations, or solve clients’ specific problems, in ways not related to attracting incorporations. But that is a distinction without a difference: the effect of enhancing a reputation (whether for expertise or political connectedness) or solving a client’s problem, through promoting legislation is not only to maintain that client relation but also to attract additional clients. Legislation that addresses one firm’s problem typically resolves a problem confronted by numerous other firms, which will thereby be attracted to the state. Kahan and Kamar would appear implicitly to acknowledge that the alternative explanations for lawyers’ legislative activity that they provide are actually indistinguishable from the financial motive to increase the pool of in-​state domiciled firms (i.e., potential clients). For they seek further to distinguish lawyers’ motives to attract clients from motives to attract corporations to the state, by suggesting lawyers obtain clients by promoting arcane legislation to benefit themselves at the expense of clients and other lawyers (since only the drafter would ostensibly understand such a law’s operation), or laws very different from those of Delaware to limit competition from out-​of-​state lawyers (Kahan and Kamar 2002, 705–​706). But this speculation is inconsistent with State Corporation codes as we know them, as well as the revisions urged by the bar that we observe: corporation codes do not consist of unduly complex or abstruse provisions, in contrast to other business-​related federal statutes and their implementing regulations, of which the federal tax code is paradigmatic. Furthermore, there is substantial unifor­ mity across the states, and the statutory innovations that rapidly course through states

 

MARKET FOR CORPORATE LAW REDUX    365 at the bar’s behest, such as the limited-​liability statute, are quite transparent such that non-​initiating attorneys can readily comprehend them (e.g., Romano 2006). In short, the most parsimonious and compelling explanation of the role of the bar in the making of corporate laws is that it is the motor force of charter competition. By prodding legislatures to innovate or imitate another state’s innovation, in response to exogenous shocks caused by changing business and legal circumstances, they benefit their clients and thereby themselves, by maintaining, if not expanding, their practice, by making their state a more appealing domicile.

15.2.2.3. Evidence of Competition There is additional evidence relating to the diffusion of legislative innovations across the states and flows of reincorporations that is consistent with characterizing the states as competing for corporations. First, corporate law innovations diffuse across the states in an S-​shaped curve—​the proportion of adopters increases with time (Romano 1985, 2006; Carney 1996)—​which is similar to the diffusion of technological innovations in industry and of financial product innovations that is conventionally interpreted as a sign of competition (e.g., Nabseth and Ray 1974; Molyneux and Shamroukh 1999). Second, the revenue that states obtain from the corporate franchise tax is significantly positively related to the responsiveness of a state’s corporate law to firms’ preferences (where responsiveness is measured as a function of the rate and extent to which the state enacts legal innovations considered desirable by reincorporating firms, see Romano [1985]; Moodie [2004]). This phenomenon comports with what, as earlier noted, can be best described as defensive competition, in which states compete with Delaware by seeking to retain local firms rather than attract foreign firms (i.e., by reducing outflows rather than increasing inflows of reincorporating firms) (Romano 1985; Moodie 2004). Third, firms changing domicile tend to move from less to more responsive states, or to put it another way, the more responsive states are less prone to lose in-​state firms to Delaware (Romano 1985; Moodie 2004). In this regard, we also observe spurts of reincorporations to states—​Delaware, in particular—​upon statutory innovations (Romano 1985; Moodie 2004). If states were not seeking to retain corporations, then we would not observe the positive relations between revenues, responsiveness, and reincorporation flows nor would we expect to see the S-​shaped pattern of legal diffusion. Kahan and Kamar’s multiple explanations, dismissing the presence of competition, cannot otherwise account for these pertinent facts. Their thesis would also appear to be premised on the view that the state competition literature is founded on the contention that all states are as vigorous as Delaware in engaging in legislative innovation to attract firms, and that the market for corporate law is one of textbook (perfect) competition. But that is not—​and has not been for some time—​the contention. The claim is more subtle. The definition of competition—​there being a market for corporate law—​is not that states act to win (see Moodie 2004, 10), that is, to unseat Delaware as the market leader, but rather, that states act defensively (which they indeed do) to revise their corporation codes in response to Delaware’s legislative innovations, and for Delaware, in turn, to respond to other states’ innovations (which it does) and for that dynamic

 

366   ROBERTA ROMANO process to affect (which it does) the number of firms incorporated in a state. Moreover, in a comprehensive study of firms’ domicile decisions, discussed in Section 15.2.4.5, infra, Ofer Eldar and Lorenzo Magnolfi (2016: 31) find that Delaware “faces competitive pressure” regarding the maintenance of its legal regime, as they estimate that it would lose a substantial number of firms and revenues to other states were it to change its laws.

15.2.2.4. Competition from Nevada There is one state besides Delaware that indisputably actively seeks to attract corporations from other jurisdictions, Nevada. Historically referred to as the Delaware of the West, it is a state that, like Delaware, has had a net inflow of incorporations (e.g., Romano 1985, 246; Barzuza and Smith 2014, 3599, 3601). It also engages in activity paralleling that of Delaware: state officials actively promote local incorporation, it has established a specialized business court, and it charges a much higher franchise fee—​although lower than Delaware’s—​than that of other states, which it has been increasing over time as its market share of incorporations has increased (Barzuza 2012). These features of corporate law production, as earlier noted, are characterized by Kahan and Kamar to be the sine qua non of state competition. But there is also a distinct difference in the most recent pattern of Nevada’s activity that distinguishes it from the classic state competition story. In recent work, Michal Barzuza (2012) contends that Nevada competes with Delaware by means of product differentiation: evaluating the two states’ statutes, she reports that Nevada offers a code tailored to a clientele quite different from that of Delaware, firms seeking a lax corporate law that provides managers with heightened protection from liability to shareholders when compared with Delaware law. In her analysis, Delaware provides stronger protection to shareholders—​a Winter or race to the top view of Delaware—​while Nevada is the polar opposite, an exemplar of the Cary or race for the bottom characterization. Barzuza (2012, 948, 953) posits that Nevada’s product differentiation of corporate law laxity is a recent competitive strategy, as the reforms to Nevada’s code she identifies as distinctively more lax than Delaware’s were enacted in the 2000s. Although Barzuza considers her hypothesis consistent with an absence of competition, this characterization is at odds with the data that she provides. If states can carve-​out distinctive market niches, then they are, in fact, competing with Delaware by seeking to attract a subset of firms from the pool of all potential reincorporations (that is, firms considering migrating from their home state), reducing the attraction of Delaware or other states, whose products are not so differentiated. Larry Ribstein (2011) questions Barzuza’s assessment of Nevada as the embodiment of the managerialist regime that Cary had contended was Delaware’s trophy. Offering a more benign self-​selection explanation, Ribstein contends that Nevada’s product differentiation can be understood as providing efficient contracting for firms for whom the monitoring and litigation costs they would bear as Delaware corporations would be unduly high and thereby reduce firm value. The idea is that for firms for whom litigation is more likely to be frivolous, diminishing the prospect of liability would be cost effective. This could be particularly true for small firms for whom the additional layer

 

MARKET FOR CORPORATE LAW REDUX    367 of costs of a Delaware domicile (compared with being incorporated in their home state) could lead to financial stress.6 Another feature of Delaware law that could increase litigation costs for some firms, that Barzuza (2012, 982) notes is the emphasis in Delaware jurisprudence on the decisions of independent directors for determining fiduciary liability. The reasoning is that because small firms have historically been less likely to have independent boards than large firms, the doctrine would render it more difficult for them to be absolved from liability, or impose considerable expense by having to increase the number of indepen­ dent directors. This concern is not mere speculation. Such an effect has been observed for small firms from the independent director mandates of the Sarbanes–Oxley Act and stock exchange rules following the Enron accounting scandal (Linck et al. 2009). Barzuza (2012, 982), however, rejects the reduced frivolous litigation-​cost explanation in favor of the managerialist one, by contending that the issues that produce frivolous lawsuits are not related to legal differences between the two states. Barzuza suggests (2012, 936) that were Nevada’s approach to be followed by other states, state competition would indeed be a race for the bottom.7 Research examining the diffusion of state corporate laws up to now has focused solely on innovations by Delaware and the Model Act (Romano 1985, 2006; Carney 1996). Nevada’s competitive presence is a topic where additional research would be quite useful, both to identify whether a similar diffusion pattern exists for innovations by Nevada and to sort out how the characteristics of Nevada firms identified by Barzuza relate to the probability of being subject to frivolous litigation or high litigation costs (versus a propensity to engage in fiduciary misconduct). Key questions, if other states have mimicked the revisions to Nevada’s code that Barzuza stresses include what is the effect on the inflow and outflow of corporations in such states, and do the characteristics of firms incorporating in such states replicate those of Nevada firms?

15.2.3. State Takeover Regulation Takeover regulation in the United States is an area of dual jurisdiction: though most of the contested activity is in the domain of the states, the ground rules for the making of tender offers are set forth in national legislation known as the Williams Act, Pub.L. No. 90–​439, 82 Stat. 454 (2010). Because the Supreme Court (in Schreiber v Burlington Northern, Inc, 472 U.S. 1, 1985) interpreted the federal antifraud provisions to cover only 6 

Seemingly small amounts related to incorporation fees matter even to publicly traded corporations: firms reincorporating out of Delaware to reduce taxes identified annual tax savings ranging between $2,000–​$50,000 (Romano 1985, 257 n 257). 7  The conclusion is derived from data, discussed in Section 15.2.4.2, infra, indicating that Nevada companies have more frequent financial restatements than firms incorporated in other states, as well as her analysis of Nevada’s revised code and the subsequent influx of incorporations. However, as also discussed in that part, there are data indicating that Nevada does not decrease the value of small firms incorporating in the state, and may even increase their value.

 

368   ROBERTA ROMANO disclosure violations and not the fairness of a bid or appropriateness of management actions (matters covered by fiduciary duties at state law), the dual jurisdiction is largely divided such that actions of bidders are principally regulated at the national level while those of management are left for the most part to the states. Starting in the late 1960s, when hostile takeovers emerged as a key acquisitive mechanism for control changes in which incumbent management was replaced, by their avoidance of managerial consent as required for a merger (Manne 1965), and intensifying in the 1980s, when hostile takeovers soared with innovation in financing, states responded by enacting statutes attempting to render such transactions more expensive.

15.2.3.1. The Debate over State Takeover Laws The first generation of takeover statutes, structured similarly to the Williams Act in regulating bids, were struck down by the Supreme Court, as burdens on interstate commerce (in Edgar v MITE, Corp., 467 U.S. 624, 1982), but unfazed, states immediately responded by enacting new statutes (referred to as second-​generation statutes), whose content sought to track more closely subject matter conventionally contained in state corporation codes (by restricting bidder voting rights and merger transactions), and these statutes were upheld as valid exercises of state law (in CTS Corp. v Dynamics Corp. of America, 481 U.S. 69, 1987). Over forty states now have takeover statutes, and most of them have multiple statutes (Romano 2006, 227–​231). In addition, starting in the interval when the constitutional validity of takeover statutes was in flux, but continuing, thereafter, creative lawyering devised self-​help defensive tactics for adoption at the firm level by management, most of which were upheld by courts. There is a large literature on whether the effect of takeover regulation and firm-​level defenses, which are widely perceived as encouraging bidding auctions, benefit shareholders, given a tradeoff between a higher premium conditional on the occurrence of a bid and an unconditional, lower probability of a bid in the first place (as the prospect of an auction deters initial bidders by reducing the return on investment in identifying potential targets). But implicit in that tradeoff regarding investor welfare is an observational problem for shareholders (and for courts’ adjudication): managers have a conflict of interest regarding defenses, shielding their positions versus obtaining a higher premium for shareholders, and it is difficult to disentangle the motives even in a specific transaction context. While the conflict of interest can be mitigated by incentive compensation (such as, accelerated stock option vesting and golden parachutes, which are large severance payments paid upon a change in control), when managers bypass shareholders and seek instead a statutory solution to thwart a bid, it would seem plausible to characterize that behavior as primarily self-​serving. The endgame setting of hostile takeovers, in which the relation between managers and shareholders will end with the termination of the target corporation’s independent existence, undercuts the other market constraints that align managers’ and shareholders’ choice of a corporate law regime. Accordingly, some commentators believe that state takeover activity demonstrates that state charter competition is harmful to shareholders, the implication being that it should be replaced by national regulation (e.g.,

 

MARKET FOR CORPORATE LAW REDUX    369 Bebchuk and Ferrell 1999). But the import of state takeover regulation for an assessment of the efficacy of state competition is not that straightforward, as it depends on the answer to two further questions: (1) are the dynamics of state takeover regulation an anomaly or a paradigm for state competition? and (2) would the political economy of a national law produce a different and superior output from that of state competition?

15.2.3.2. Anomaly or Paradigm? The political process and the pattern of adoption of takeover statutes indicate that they are an anomaly when compared with the ordinary course of corporate law legislation. Whereas the statutory innovations earlier discussed are sponsored by the corporate bar, outside of Delaware, takeover statutes are more typically promoted by managers of a local corporation, or the state chamber of commerce at the behest of a member, which is a target (or anticipates imminently becoming a target) of a hostile offer (Romano 1988, 461). Even more striking, is the disparate pattern of innovation and diffusion of takeover statutes compared with other corporate law provisions. Delaware, invariably an early adopter of corporate law innovations, is a persistent laggard when it comes to takeover statutes. While it has been the first or one of the first states to adopt most statutory innovations over the past several decades, dating from its 1967 code modernization, a dozen states had adopted a first-​generation takeover statute over seven years before Delaware’s enacting such a provision, and over twenty states had enacted second-​generation statutes before it responded, which only followed the Supreme Court’s decision upholding such a law (Romano 2006, 218). In addition to not replicating the typical diffusion process of statutory innovation, Delaware’s takeover statutes have been considerably less restrictive of bids than the prototypes in other states. For example, its first-​generation statute provided greater flexibility and protection to bidders than other statutes by the absence of a hearing requirement—​the prime mechanism by which the early statutes sought to defeat hostile bids by imposing an extensive delay—​and making the statute’s coverage optional (Romano 2002, 95). Delaware’s second-​generation statute, which regulates a successful hostile bidder’s subsequent combinations and transactions with the target, shares those characteristics, providing a mechanism by which a hostile bidder could be exempt from the statute entirely (based on the percentage of shares acquired), reducing substantially the number of years to which the combination restrictions apply, and excluding a post-​moratorium fair-​price requirement. Its legislation would appear to have had a moderating influence on subsequent statutory adoptions: a majority of states, thereafter, enacting the same type of statute as Delaware followed its lead by selecting the shorter interval of applicability and eliminating the post-​moratorium fair-​price requirement (Romano 2006, 232). Several features of Delaware’s legal landscape explain why it would take a more accommodating approach to hostile takeovers than other states. First, Delaware’s corporate bar vets all corporation code revisions and the fact that there are more bidders as well as potential targets incorporated in Delaware than in other states results in a greater variety of perspectives informing the Delaware bar’s deliberations over takeover

 

370   ROBERTA ROMANO regulation, than occurs in other states where the bar principally represents targets. Indeed, in contrast to Delaware’s unvarying legislative practice, in other states, takeover statutes have been enacted bypassing the corporate bar’s input, entirely. Romano (1987) chronicles such an instance in Connecticut. Second, and even more important, given the large number of Delaware-​domiciled (but not physically present) corporations, no one target would have sufficient leverage in the legislature to obtain a specific statute, as occurs in other states, where a major corporation can sway legislators who may have personal relations with management, or may be worried over the potential loss not only of civic support but also of local employment, on the expectation that a successful hostile bidder would move the headquarters, or close down in-​state facilities.8 In sum, the widespread adoption of takeover statutes has been viewed as problematic by commentators on both sides of the state competition debate, but Delaware, with its distinctive corporate law politics, is hardly the source of the problem.

15.2.3.3. Would a National Takeover Regime Be for the Better? Despite the problematic political dynamics of state takeover regulation, there are compelling reasons why a preemptive national regime would not be for the better. First, it is questionable whether the political dynamics of takeover regulation would be any different at the national level than it is in the states. To the extent that the problem with the enactment of takeover statutes is one of asymmetrical collective action—​managers are better organized politically than shareholders—​this holds true regardless of state or national forum. In addition, managers have a greater incentive than shareholders to lobby on takeovers because of greater adverse personal stakes: individuals care more about preventing losses than achieving gains of equal magnitude (e.g., Hardin 1982, 83, 120–​121), and the loss to individual managers from loss of their positions is far more consequential than is the premium gained by individual shareholders who hold small blocks of stock. To the extent that interest groups other than managers and shareholders, and in particular, labor unions, influence state legislators to enact takeover statutes, they tend to be equally, if not better, organized at the national level. For example, the Dodd–Frank Act, Pub. L. No. 111–​203, 124 Stat. 1376 (2010), contains directives to the US Securities and Exchange Commission (SEC) concerning regulations that were high on labor’s legislative agenda, some for years, and tangentially related to the ostensible focus of the law, the financial crisis (e.g., Romano 2005b: 1596 n. 214, labor unions’ initial push for proxy nomination rule referenced in Dodd–​Frank; Romano [2012, 110], union source of statute’s executive pay ratio disclosure rule). 8 

A further factor differentiating the takeover legislative context from other corporate laws is that some states have enacted statutes to assist resistance to a hostile bid by local companies that are domiciled out of state (Romano 1988, 460–​61 n 11), suggesting that legislators considering takeover statutes in states other than Delaware may be motivated more by local employment than the number of in-​state incorporations.

 

MARKET FOR CORPORATE LAW REDUX    371 Second, there is an instructive historical record of congressional activity regarding takeovers, mimicking what occurred in the states. The Williams Act, enacted in 1969, was similar in structure to Virginia’s earlier enacted takeover statute, and, as numerous commentators have noted, tilted the playing field for incumbent managers (e.g., Easterbrook and Fischel 1991, 224–​225). In addition, congressional action on takeovers—​which peaked in the 1980s and consisted of numerous bills and hearings and enactment of tax code provisions increasing the cost of takeovers—​was primarily directed at restricting bids, as was the state legislation being adopted at the time (Romano 1993, 76–​80). Just as many state takeover statutes were enacted at the behest of a local target, congressional bills and hearings were frequently sponsored by legislators of a target’s state (Romano 1988, 482–​484). Furthermore, the sole bill on takeover regulation ever to come out of congressional committee expressly reserved a role for state regulation (Romano 2005a, 228 n. 24), thereby making plain that were legislation to have been enacted, it would surely have been closely aligned with managers’ preferences, which is not what commentators have in mind when advocating national regulation. Congressional activity diminished following the Supreme Court’s decision upholding state takeover statutes, as managers refocused their efforts in state capitals and the Reagan and Bush Administrations made clear, through their selections of SEC chairmen, their opposition to adopting an additional layer of takeover regulation, the Williams Act having been adopted at the urging of the SEC chairman at the time (Romano 1988, 489). But the pattern of congressional activity suggests that had the Supreme Court decided otherwise, Congress would, in all likelihood, have proceeded to enact regulation paralleling states’ second-​generation statutes. Finally, a national takeover regime would provide firms with far less flexibility in their approach to hostile takeovers than state regulation. There would be no safety valve through which firms could avoid restrictive legislation, as there is when takeovers are regulated by the states and firms can choose from among regimes, such as Delaware’s more bidder-​, hence shareholder-​, friendly statute or states with no takeover statutes. In fact, the existence of less restrictive options constrains managers from establishing fortress-​like defenses. An informative example involves the Pennsylvania disgorgement statute. It was considered more Draconian compared with other statutes, and event studies uniformly identify it as having a significant negative stock price effect (Szewczyk and Tsetsekos 1992; Karpoff and Malatesta 1995). Following its enactment, institutional investors pressured managers to opt out of the statute, and a majority of publicly traded firms did so (Romano 1993, 68–​69). By contrast, optionality is not a characteristic of national legislation: the federal security laws are mandatory in nature, as is its component takeover regulation, the Williams Act. The widespread withdrawal by Pennsylvania corporations from inclusion under a value-​decreasing statute makes plain the acuity of Winter’s critique that capital markets discipline managers notwithstanding their best efforts at entrenchment, by placing a floor on deleterious state competition. Additional support for this contention is that in contrast to other innovations in takeover regulation, hardly any states followed Pennsylvania’s lead in adopting a similar statute.

 

372   ROBERTA ROMANO Could we do better than the existing regulatory regime for takeovers? Most certainly. A regime in which firms must opt in to be covered by a takeover statute, following the approach taken by Georgia and Tennessee and patterned after limited-​liability statutes, for instance, rather than the otherwise prevalent opt out formulation, would increase confidence that being subject to a statute meshes with shareholder preferences, as adopting a charter provision requires management initiation, and data suggest that statutory defaults can be sticky (e.g., Listokin 2009). Permitting shareholders to opt out of a takeover statute without management consent through bylaw provisions, which once adopted cannot be reversed by management, as is true for the adoption of bylaws requiring majority voting for directors (see Delaware Gen. Corp. Law 216), would also be a useful improvement. But perfection is not the proper yardstick for measuring the performance of state competition. When commentators contend that a national takeover regime would be superior to the states, they are operating under the illusion that Harold Demsetz (1969, 1–​2) famously referred to as the fallacies of the nirvana approach, assuming that a perfect solution exists to critique real-​world institutions when the appropriate comparison should be between realistic alternatives. State competition is no exception to this admonition: the reality is that it is a pipe dream of commentators to believe that a national law would take the shape of their preferred, takeover-​friendly regulation. There is no plausible reason to expect that takeover regulation at the national level would result in superior institutional arrangements than exist under state competition, while good reason to expect that it could make matters far worse.

15.2.4. Who Benefits from Competition? The existence of a market for corporate law does not of itself provide information regarding to whose preferences, managers’ or shareholders,’ states are responding when they revise their corporation codes and compete for incorporations. The answer to that question requires an empirical inquiry.9 A body of research has sought to address whether state competition for charters benefits manager or shareholders, that is, whether it has led to Cary’s race for the bottom or, in keeping with Winter’s analysis, has tended 9 

Cheffins et al. (2014) seek to demonstrate that US state competition since the nineteenth century has been a race to the bottom, by calculating the change in value of an index to measure the strength of US state laws related to indices used to evaluate shareholder rights across nations in contemporary comparative corporate governance research, first introduced in La Porta et al. (1997). The analysis unfortunately does not demonstrate that state corporate law has, as is contended, been at the bottom for over a century, because the construction of the index defines away the issue: it classifies a statute as harmful to shareholders if it is enabling (as opposed to mandatory) or if it increases managerial discretion. To their way of thinking, the national securities laws, which are mandatory, are the sole component of US law that is at the top. However, to ascertain the direction—​top or bottom—​of state competition, as is the paper’s objective, it is necessary to measure the effect of enabling statutes and statutes increasing discretion on share value. Cheffins et al. assert further that the judgment of commentators who evaluate state competition as toward the top is derived from a style of legislation. To the contrary, the evaluation is informed by the substantial body of empirical research indicating

 

MARKET FOR CORPORATE LAW REDUX    373 toward the top. On balance, the data are most consistent with the latter view, as they indicate that shareholders have benefited from competition.10

15.2.4.1. Event Studies of Reincorporation A good proxy for ascertaining whether the choice of legal regime benefits shareholders is to examine the effect of a change in domicile on share value. If such a move (reincorporation) increases share value, it would then be difficult to maintain that charter competition is harmful to shareholders. The conventional methodology for measuring such a wealth effect is an event study, which examines the stock price effect surrounding an unanticipated event (here, the announcement of a proposal to change domicile). The assumption of the technique is that in an efficient stock market, prices incorporate new information about a firm’s prospects as soon as it is made public. Using a model of expected prices in the absence of the event, the difference between actual and predicted price on the announcement or event date, referred to as the abnormal return or average residual, measures the wealth effect of the event. The methodology is reviewed in Bhagat and Romano (2002). Hundreds of event studies have been undertaken to evaluate the wealth effects of public policies and firm-​level actions, as well as to establish requisite elements of federal securities law violations and the measure of damages, under Supreme Court jurisprudence (Bhagat and Romano 2007). There have been eight event studies of the effect of a change in incorporation state. All of the studies find positive abnormal returns: in five, they are statistically significant, while in two only marginally significant at 10% (Bhagat and Romano 2007, 971).11 These findings are consistent with Winter’s perspective on competition, that it benefits investors. Were Cary’s view correct, the wealth effect would be negative. But because reincorporation is often accompanied by new business plans (see Section 15.3.1), a concern a positive wealth effect. For an assessment of the empirical literature on the impact of the mandatory national securities laws on share value, which tends to be insignificant or negative, see Romano (2002). 10  Macey and Miller (1987) suggest that a third group, corporate lawyers, are the principal beneficiaries of Delaware’s success, noting that Delaware law is more favorable to shareholder lawsuits than that of other states, such as its absence of a security-​for-​expenses statute, a requirement that plaintiffs post a bond to cover defense costs should the lawsuit fail. No empirical research has been undertaken to test the hypothesis that state competition benefits lawyers at shareholders’ expense—​ indeed it would be exceedingly challenging to formulate how such an effect could be measured. While the hypothesis is consistent with lawyers’ key role in the development of corporate law, as has been detailed in Section 15.2.2.2, the evidence detailed in this section indicating positive wealth effects and the superior performance of Delaware firms is more consistent with a regime that on balance benefits shareholders; in other words, whatever lawyers may benefit from Delaware law, it is either consistent with, or swamped by, the benefits accruing to shareholders. In addition, Delaware law is not one-​sidedly in favor of litigation. For example, plaintiffs are restricted by having to meet a strictly applied demand requirement before a shareholder derivative suit can be brought, and many firms, in fact, migrated to Delaware to take advantage of its limited liability statute (Heron and Lewellen 1998; Moodie 2004). 11  The remaining study by Dodd and Leftwich (1980), which is also the earliest and therefore the only one to use monthly data, as daily data were not then available, finds statistically significant positive abnormal returns over 2 years before the reincorporation. Of the five studies reporting statistically significant positive abnormal returns, the significant positive result in one is for a subsample of reincorporations only.

 

374   ROBERTA ROMANO might be that the positive price impact was due to investors’ valuation of the new plan, rather than the new legal regime. This does not appear to be the case, however, as an event study classifying moves by the type of accompanying business plan tested whether the abnormal returns differed significantly across the different classifications of reincorporations and found that they did not (see Romano 1985, 272).12 The average abnormal return across the studies is 1.28%. Critics of state competition have sought to minimize the import of the event study data by describing this figure as rather small or modest (Bebchuk et al. 2002, 1791). But such a depiction is mistaken: as a point of reference, an investment project that generates positive abnormal returns of even 1% is substantial in competitive capital markets. For instance, the magnitude of the price effect of announcements of capital expenditures, joint ventures, product introductions, and acquisitions is less than 1% (Andrade et al. 2001, 119). The most prominent critic of state competition has further sought to minimize the import of reincorporation event studies by contending that state competition may produce some harmful provisions even though the total package of statutes is not (Bebchuk 1992). But this critique misses the point: from the perspective of the efficacy of the output of competition, it is precisely the net wealth effect of state law on investors that is key, and the event studies indicate that the effect is in general positive, and most certainly not negative.

15.2.4.2. Studies of the Effect of Domicile on Performance Another analytical technique that has been used to examine whether shareholders gain from state competition is to compare the effect of a Delaware domicile on a mea­ sure of firm performance. The idea is that if Delaware firms outperform non-​Delaware firms, then that is evidence that the direction of competition is toward the top and not the bottom, given Delaware’s dominant position in the chartering market. The ana­ lytical difficulty with such studies is a well-​recognized problem in empirical corporate finance: the choice of domicile, as with other governance mechanisms, is endogenous, and, therefore, it is difficult to attribute causality to differences in performance, or even to expect to identify differences in performance, in relation to differences across firm characteristics. This is because in equilibrium firms would be expected to have selected the domicile that maximizes their value, such that no performance difference would be uncovered across differently-​domiciled firms, or if a positive (negative) performance difference is identified, it could well be due to the superior (inferior) quality of the firms 12 

In contrast with Romano’s finding, Heron and Lewellen (1998) find positive returns for firms reincorporating to limit directors’ liability but negative returns for firms adopting defensive tactics when reincorporating. The negative returns are statistically significant only on an unconventional event date, the date of the shareholders’ meeting, and not the date of the first public announcement of the reincorporation proposal (proxy mailing date), which is the more appropriate date on which to identify abnormal returns in accordance with the methodology, that is, the first public announcement of the event (Bhagat and Romano 2007, 973). The significance of the finding is therefore problematic. In addition, contrary to Heron and Lewellen, both Romano (1985) and Netter and Poulsen (1989) find insignificant positive abnormal returns for reincorporations undertaken for takeover defensive purposes.

 

MARKET FOR CORPORATE LAW REDUX    375 selecting Delaware and not the other way around. The confounding of results owing to self-​selection is not an issue in reincorporation event studies because all of the sample firms have chosen to move. There have been five studies examining the comparative performance of Delaware firms, three examining the change in several measures of accounting performance of firms before and after incorporating in Delaware, or between reincorporating and non-​reincorporating firms; and two comparing the performance, as measured by Tobin’s Q13 of Delaware firms to non-​Delaware ones (Bhagat and Romano 2007, 981). The accounting performance studies find no significant difference in performance in any comparison, except for a finding that the change in earnings before interest and taxes over the year after the domicile change was higher for firms reincorporating in Delaware than those reincorporating in other states (Wang 1995). The most plausible interpretation of the absence of significant accounting performance differences is that firms select the domicile that optimizes their future performance. The finding of a significant improvement post-​reincorporation in Delaware compared with other domicile changes is consistent with the event study findings, that is, a positive price effect suggests that investors anticipated increased earnings, but it could equally indicate a self-​selection effect, that higher quality firms (those with higher future earnings) relocate in Delaware. The performance results are different when Tobin’s Q is compared across domiciles. Daines (2001) finds that Delaware firms have significantly higher Tobin’s Q values (by 5%), controlling for investment opportunities and other variables known to affect Tobin’s Q, across the pooled 16 years of the sample and in 12 of the 16 years when the effect is estimated separately. The results hold for subsamples of firms: mature firms, IPO firms, and firms that had not reincorporated midstream, further bolstering the contention that a Delaware domicile adds value. Daines suggests the source of the value-​added is either Delaware law’s providing superior protection of public/​minority shareholders from expropriation by managers/​controlling shareholders, or its increasing the likelihood of firms being acquired at a premium. And there is support for the latter explanation, as Delaware firms are, in fact, more likely to be takeover targets (Daines 2001). A subsequent study by Subramanian (2004) examining a different time frame, adding four later years (1997–​2000), and subtracting the first ten years of Daines’ study (1981–​ 1990), reports a reduced, albeit still significantly higher Tobin’s Q value for Delaware firms (2.8%), and that in the most recent years of the sample, the difference between 13 Tobin’s Q is the ratio of a firm’s market value to the replacement cost of its assets, and is

conventionally interpreted as a proxy for a firm’s investment or growth opportunities. In this context, business opportunities added by corporate law rules are considered a component of the value measured by Tobin’s Q. For a discussion of a distinct endogeneity issue in using Tobin’s Q to measure performance in relation to firms’ corporate governance, such as the law of their domicile, because of the correlation between ownership and the inputs into the Tobin’s Q calculation as well as governance choices, see Bhagat and Romano (2007, 982). As a consequence, it is desirable to consider a variety of performance measures when seeking to evaluate the relation among governance, ownership, and performance.

 

376   ROBERTA ROMANO Delaware and non-​Delaware firms is no longer significant.14 The absence of a difference in later years could suggest that other states had caught up with Delaware by amending their codes to eliminate major differences, thereby reducing the value of a Delaware incorporation, or that the decline in the takeover market in the late 1990s was picked up in the Tobin’s Q values.15 Finally, Michal Barzuza and David Smith (2014) investigate a different performance measure to study the effect of a Nevada domicile: the filing of an accounting restatement. They find that Nevada firms have a significantly higher number of accounting restatements than firms in other states, including those in Delaware, consistent with Barzuza’s product differentiation thesis, that managers of Nevada firms sought out its lax laws to exploit shareholders. Namely, because restatements are events that produce significantly negative stock price effects, the claim is that the flow of firms into Nevada evidences an adverse effect of state competition on investors. The Nevada firms are, however, by conventional measures riskier than other firms (they are younger, smaller, and less profitable). Such a difference would seem, intuitively, to contribute to accounting troubles, complicating attributing the higher number of restatements to firms moving into a domicile that facilitates fraud, but an analysis pairing the Nevada firms with Delaware firms of similar characteristics still finds that the Nevada firms have significantly higher restatements. To address the alternative efficient contracting product differentiation explanation of the effect of Nevada’s lax law, Barzuza and Smith examine Tobin’s Q values. Consistent with Daines’ study, the Delaware firms in their sample have significantly higher Tobin’s Q values.16 Nevada firms do not. But as Nevada firms also do not have significantly lower Tobin’s Q values than firms in other states, one cannot readily conclude that the data demonstrate firms select Nevada to engage in misconduct. Ribstein (2011) contends that Barzuza and Smith’s data are entirely consistent with efficient contracting because the firm characteristics (smaller, younger, and less profitable) distinguishing Nevada firms suggest that they are firms that cannot afford the monitoring costs, such as the cost of setting up a complex internal control system, that 14 

One explanation for the disparate results could be a difference in samples that is not simply due to the different time intervals under study: Daines’s study includes only firms for which data are available for at least 5 years, whereas Subramanian’s study has no such data restriction. The directional impact of the difference in the sample is ambiguous; however, as the more liberal selection method of Subramanian’s study would increase the number of both firms that have disappeared owing to financial distress and young firms that have significant growth opportunities. 15  Subramanian (2004, 54–​56) offers further possible explanations of the difference. This is an area where further research is needed to understand better the disparity in the studies’ findings and, accordingly, the import of the phenomenon originally reported by Daines. 16  Barzuza and Smith do not report the time frame over which they analyze Tobin’s Q, but their data set, from 1990–​2011, would indicate that the analysis includes all of Subramanian’s data, which would further suggest that Subramanian’s differential findings from Daines’ study (no Delaware effect over a few years), was a blip. But as Barzuza and Smith do not disaggregate the analysis into groups of years or individual years, as does Subramanian, the explanation for the difference across the studies remains unclear.

 

MARKET FOR CORPORATE LAW REDUX    377 could catch accounting errors or improprieties. Such an explanation would account for the more frequent restatements. Consistent with Ribstein’s benign interpretation of the Nevada incorporation phenomenon, Eldar (2016) finds that small firms with low institutional ownership incorporated in Nevada have higher Tobin’s Q than similar firms incorporated in Delaware (but not larger firms). He also finds that firms reincorporating in Nevada experience insignificantly positive abnormal returns. Because in contrast to Delaware, Nevada’s laws reduce the likelihood of takeovers and shareholder litigation, he interprets these data as evidence that the small firms selecting a Nevada domicile benefit from not being exposed to the corporate governance regime imposed by Delaware law, which disciplines managers through facilitating the market for corporate control and what can be costly shareholder litigation. The evidence bearing on the question whether firms selecting Nevada for its more limited-​liability regime do so for efficiency or expropriation purposes is, therefore, mixed, warranting further empirical investigation.

15.2.4.3. Event Studies of Changes in Delaware Law Event studies of changes in Delaware law have also been undertaken as a means of evaluating state competition. As in the comparative performance studies, the idea is that, because Delaware is the most successful incorporation state, the effect on stock prices of changes in its legal regime is equivalent to the effect of state competition on shareholder welfare. Event studies of legislation are considerably more challenging compared with those of reincorporations, however. Given the nature of the legislative process, it is dif­ ficult to pinpoint a point in time when the event is first publicly announced, yet accurate identification of an unanticipated event is critical to the proper use of the methodology (Bhagat and Romano 2002).17 In addition, a legal rule applicable to all domestic corporations may not affect all firms equally, and in particular may affect some firms positively and others negatively (as well as still others not at all). Analysis of the price effect for a portfolio that does not control for heterogeneity across firms in relation to how they will be impacted by the rule could simply aggregate offsetting effects, and therefore not be able to isolate the rule’s impact.18 That is not an issue when the event study is of a firm-​specific event, such as a reincorporation, because endogeneity is automatically controlled for by the composition of the test portfolio—​it includes only firms experiencing the event. 17 

To manage this problem, researchers typically identify specific key dates in the legislative process, such as a bill’s introduction, approval by the committee with jurisdiction, approval by each of the legislative chambers, and sum abnormal returns across those dates, as uncertainty over adoption is resolved, to determine the wealth effect of a statute. 18  There have also been event studies of Delaware court opinions. These are not reviewed given methodological interpretative difficulties that can confound interpretation of effects, related to the market’s having formed an expectation of a lawsuit’s outcome before the announcement date, and the Delaware legislature’s frequent reversal or clarification of opinions perceived to impact firms adversely or uncertainly (Romano 2006, 225 n. 42). For an evaluation of the studies, see Bhagat and Romano (2007, 980–​981).

 

378   ROBERTA ROMANO Statutory changes in Delaware law that have been investigated are enactment of the limited-​liability statute and the second-​generation takeover statute. As there have been numerous event studies of takeover statutes, those examining Delaware’s take­ over statute are included in the discussion of the studies of all such statutes in Section 15.2.4.4. The three event studies of the limited-​liability statute find that it did not have a significant price effect (Bhagat and Romano 2007, 977). Because firms had to opt into the statute to be covered, the insignificance could be a function of market uncertainty over whether firms would adopt a provision. Event studies of Delaware firms’ adoption of limited-​liability charter amendments address that possibility. The answer, it would appear, is not clear-​cut. Depending on the event window examined or the portfolio of firms, the five such event studies report significantly positive, negative, or insignificant stock price effects (Bhagat and Romano 2007, 979–​980). But as only one of the studies reported a significant negative finding over a single interval (7 days), which was not replicated in the others, all of which report either significantly positive or insignificant results over a variety of intervals, it is most plausible to interpret the data as indicating that these are not shareholder-​wealth-​decreasing provisions. The positive assessment of the impact of the limited-​liability statute is bolstered by two additional factors. First, shareholders voted overwhelmingly to amend charters to include limited-​liability provisions, and this cannot be adduced to shareholders blindly following management because institutional investors who in the same, and subsequent, time frames actively propose eliminating defensive tactics did not propose and have continued not to propose eliminating limited-​liability provisions (Bhagat and Romano 2007, 980). Second, were state competition truly a race to the bottom, then states would have followed Indiana’s more aggressive lead and adopted a statute that eliminated directors’ liability for negligence altogether, rather than leave the choice of eliminating liability to the shareholders, following Delaware’s approach.

15.2.4.4. Event Studies of Takeover Statutes The wealth effects of state takeover statutes have been extensively studied and the findings are less uniform in this context than that of reincorporations. Depending on the statute type, event date, and sample, studies report significantly negative, positive, or insignificant results. For a tabulation, see Romano (1993, 62–​66). Consistent with intuition, statutes that are often characterized as more restrictive of bids are more likely to have significant negative effects (Bhagat and Romano 2007, 976), but even then, except for the Pennsylvania statute discussed in Section 15.2.3, findings of statistical significance are not robust across studies. Moreover, as Karpoff and Wittry (2014, 10), referencing Karpoff and Malatesta (1989) note, even in studies where the price effect of a specific type of statute is statistically significant, it is not significantly different from the stock price reaction of other types of statutes not found to be significant. In addition, there are no consistent results when firms are distinguished by the presence of firm-​level defenses (i.e., whether the statute would have a more substantial impact as being a firm’s primary protection).

 

MARKET FOR CORPORATE LAW REDUX    379 The most comprehensive and influential event study of takeover statutes, by Jonathan Karpoff and Paul Malatesta (1989), includes forty statutes enacted in twenty-​six states and finds that the statutes have a small significantly negative price effect (–​0.4%). The finding of significance occurs only on the event date of a newspaper report concerning legislation; there are no significant abnormal returns on legislative event dates, in keeping with the challenges in using the methodology to evaluate legislation. But given the comprehensiveness of the data set, commentators view the Karpoff and Malatesta results as a credible measure of the overall impact of takeover statutes, although no doubt this view also accords with the belief that any action decreasing the possibility of a successful takeover, owing to the loss of a potential takeover premium, would be shareholder-​wealth decreasing. When the impact of the Delaware statute is separately examined, the stock price effects are insignificant or depending on the interval and sample, significantly positive (Karpoff and Malatesta 1989; Jahera and Pugh 1991). The different wealth effect of the Delaware statute compared with that of other states’ statutes is consistent with a difference in the political economy in the making of takeover statutes between Delaware and other states that produced its less restrictive statute (as recounted in Section 15.2.3). The nonnegative impact of the Delaware takeover statute is also consistent with the characterization in the comparative performance studies that Delaware is more shareholder-​friendly than other states (see Section 15.2.4.2). The takeover-​statute event studies provide the most compelling evidence against state competition, given the finding of negative stock price effects in aggregate and for individual statutes, which diffused rapidly across the states although Delaware’s behavior has not contributed to the problem. A fair conclusion is that state competition is not working well in this context because for at least some firms in some states, legislative initiatives to make takeovers more difficult were shareholder-​wealth-​decreasing events. The irony is that from the Cary perspective the data adverse to state competition also cast Delaware in a most positive light.

15.2.4.5. Studies of Firms’ Domicile Decisions A further body of research examines firms’ domicile decisions to shed light on the competition debate. Four studies compare the domicile and physical location of firms to draw insights into state competition that may not be apparent when examining reincorporations. The implicit idea of these four studies is that a firm’s domicile decision is a nested one, first it considers whether it should take as its domicile the state in which it is physically located and then, if it decides not to do that, it considers where to relocate. Because the vast majority of firms not domiciled in their state of physical presence are incorporated in Delaware, the two steps are often collapsed into deciding whether to stay home or go to Delaware. With this working assumption, the studies then examine characteristics of state corporate laws to see which states are more successful in retaining firms, that is which states have a higher ratio of headquartered firms also domiciled therein, a measure consistent with states engaging in defensive competition (see Section

 

380   ROBERTA ROMANO 15.2.2.1).19 The comparison is expected to shed light on who benefits from state competition, by determining whether the more (or less) successful states are also states with codes thought to be more likely to benefit shareholders. Of the four studies taking this approach, two focus on the number of takeover statutes in the headquarters state, as the determinant of states’ success in local company domicile retention (Subramanian 2002; Bebchuk and Cohen 2003). They focus on takeover statutes because they consider obstruction of takeovers as adverse to shareholders’ welfare. The authors count the number of takeover statutes enacted in a state, with the sum referred to as an antitakeover index. (Bebchuk and Cohen use a subset of five possible statutes; Subramanian tallies six statutes but emphasizes an analysis treating each statute separately.) Both studies find that the more takeover statutes a state has, the more firms it retains (i.e., the less likely firms headquartered in the state are incorporated in Delaware). In addition, when firms are incorporated in a state different from the headquarters state but not in Delaware, the domicile state has a higher antitakeover index than the headquarters state. They interpret these two pieces of data as evidence supporting Cary’s position that state competition is a race for the bottom, harming shareholders. In contrast to Bebchuk and Cohen’s (2003) study, Subramanian’s analysis (2002, 1840) finds that states with the most egregiously restrictive takeover statutes (i.e., those for which event study data are significantly negative, Ohio’s and Pennsylvania’s disgorgement statute and Massachusetts’ staggered board mandate) have a lower retention rate compared with states with less restrictive statutes. That finding is at odds with a race for the bottom story. If managers are selecting a domicile that expropriates shareholders, then they should not avoid but rather seek out states with the most effective statutes for blocking takeovers (just as noted earlier, the race to the bottom thesis would expect all states to adopt the most lax liability rule, yet, curiously, they do not). It is also wholly unrealistic to assume that a firm’s choice of domicile is so unidimensional as to consider only a state’s takeover statutes. Research on reincorporation decisions indicates that in selecting a domicile, firms are attentive to numerous features of state codes along with a states’ corporate law environment, such as the legislature’s ‘responsiveness to changing business circumstances, the quality of the judiciary, and rules related to acquisitions and to directors’ and officers’ liability and indemnification (Romano 1985; Moodie 2004). For example, although Bebchuk and Cohen and Subramanian contend the absence of a takeover statute in California explains why a large proportion of California-​ headquartered firms are incorporated in Delaware, there is another, more compelling explanation for the phenomenon: California corporate law is viewed as quite uncertain, which creates uncertainty for business planning. Corporate law cases in California can

19  A corporation’s domicile for US federal jurisdictional purposes is either its statutory domicile or the state in which its headquarters is located, and the state of physical presence of corporations identified in these studies (and its referent when the term is used in the text), is the headquarters state. I also on occasion refer to the headquarters state as the home state for ease of exposition.

 

MARKET FOR CORPORATE LAW REDUX    381 come before any of a multitude of state trial judges who often have minimal expertise in corporate law and business practices, in contrast to the Delaware chancery court. In fact, California attorneys surveyed in the early 1980s, well before the Supreme Court had upheld state takeover laws, before Delaware had a second-​generation takeover statute and before Delaware courts had validated poison pill takeover defenses, stated that they recommended reincorporating in Delaware because they could comfortably provide legal opinions about transactions under Delaware law but not so much under California law (Romano 1985). The survey responses tracked firm behavior: there was a large outflow of firms from that state well before hostile takeovers and state takeover laws became prevalent (Romano 1985). Some firms did adopt takeover defenses upon reincorporating, but the numbers were small—​only 11% of the Romano (1985, 252) sample, a figure that aggregates firms migrating from and to all states, not solely California and Delaware, respectively. Accordingly, the ahistorical thesis (Bebchuk and Cohen’s and Subramanian’s) does not explain California’s long history of corporate migration to Delaware, which predates takeover statutes. The multiple dimensions of state law relevant to firm decisions are incorporated in the design of the other two headquarters-​domicile studies by Daines (2002) and Kahan (2006). When variables used to proxy for state law features known to matter to reincorporating firms are included in the econometric analysis, the statistical significance of the number of takeover statutes in determining states’ retention rate vanishes. Daines, whose sample consists of IPO firms, rather than the broader set of public companies used in the other studies, finds that following the Model Act, and in some formulations, the responsiveness to statutory innovations measure of Romano (1985), explain states’ retention rates; takeover statutes do not. Kahan finds that states offering more flexible statutes (where the flexibility provisions are unrelated to takeover defenses) and higher quality judicial systems (identified by rankings in a 2001 survey of 824 in-​house counsel and other senior litigators at large companies) have higher retention rates, while, again, takeover statutes do not. One might have contended that the difference in studies could be a function of sample differences (Daines examines IPO firms, while Bebchuk and Cohen and Subramanian study established firms), but Kahan’s findings hold for both IPO firms and for the same data set of public firms used by Bebchuk and Cohen and Subramanian. This suggests that the difference in findings is most likely due to model specification, that is, omitted state law variables in the models of Bebchuk and Cohen and Subramanian resulted in a spurious finding of significance for the number of takeover statutes. Daines further finds that whether the IPO corporation is advised by a national or local law firm is a significant predictor of whether the firm goes public with a Delaware domicile. This finding is consistent with earlier survey data of reincorporating firms indicating that the move was suggested by outside counsel (Romano 1985, 275). Daines views these findings as suggestive of a lawyer–client agency problem, given his finding that Delaware firms have higher Tobin’s Q values (Daines 2001, 1585, 1595). The reasoning is that local lawyers would advise their clients to retain a local domicile because they would be unable to provide counsel regarding Delaware law, or would face heightened

 

382   ROBERTA ROMANO competition (the many lawyers in Delaware and other states knowledgeable about Delaware law). Daines’ hypothesis that local lawyers who do not recommend Delaware are unfaithful agents may be correct. But an alternative efficiency explanation is that firms with local counsel are not likely to be those that would benefit from a Delaware domicile, which entails higher operating costs. (Delaware franchise taxes are not only higher than those of other states but also impose an additional layer of tax because firms must pay taxes in their home state where they are doing business regardless of statutory domicile.) For instance, they could be firms not planning to engage in transactions for which a Delaware domicile adds value, such as mergers and acquisitions (see Section 15.3.1). Alternatively, they may be firms whose future profitability is highly uncertain, making the need to conserve cash essential. Correlatively, firms with such characteristics would also not be likely to hire national law firms whose fees would be considerably higher than those of local counsel. Daines does estimate a model that controls for the endogeneity of choice of attorney and of domicile, by a two-​stage regression modeling law firm choice and then domicile choice and reports the results regarding the significant impact of a national law firm are unchanged.20 But while the model includes a variable for subsequent acquisitions (one possible alternative explanation), it does not include a proxy measure for future profitability (another one). The extent to which lawyers affect the choice of domicile, more specifically, the direction of the effect—​whether failure to incorporate a firm in Delaware is a value-​decreasing decision, or more pointedly, a decision benefiting counsel at the firm’s expense—​is an area where further empirical work would be fruitful. The fifth and most recent study, by Ofer Eldar and Lorenzo Magnolfi (2016), of firm domicile decisions, develops a sophisticated empirical model of firms’ choice of domicile, based on firm and state-​law characteristics. In the model, firms’ decisions are subject to “rational” inertia, that is, because reconsideration of one’s domicile state every year would be costly, firms reconsider the decision each year with only some probability (estimated from the data) that depends upon changes in the law that are particularly attractive to the firms’ characteristics and economic conditions. The estimation uses the incorporation decisions of all publicly traded firms over 1995–​2013 and characterizes state laws on two dimensions, the number of takeover statutes, as in the four domicile-​ headquarters state studies, and states’ permissiveness regarding limiting directors’ and officers’ liability and allowing indemnification. Eldar and Magnolfi find that most firms “dislike” the states with the most antitakeover statutes and permissive liability-​limiting statutess, that is, firms’ preferences are contrary to the Cary view of competition as a race for the bottom to states catering to managers. These preferences are, in fact, stronger, in an instrumental variables specification for high institutional shareholding, consistent with shareholder preferences dictating the 20  Daines does not specify the instruments used to identify the variables or report tests of the effectiveness of the instruments, or the results of the first stage, so it is not possible to assess how well the two-​stage model addresses the endogeneity concern.

 

MARKET FOR CORPORATE LAW REDUX    383 decision. Most important, the model permits the construction of counterfactuals, such as, what would happen to the pattern of incorporations were a state to change its laws. In this simulation, they estimate, for instance that Delaware would lose significant market share (close to 12%) and revenues (between $35 million and $70 million) if it were to alter its code to be less shareholder-​friendly regarding takeovers, and correspondingly, many firms would move back to their home states.21 In sum, the findings of these five studies of firms’ domicile choices provide further evidence that it is shareholders, not managers, who benefit most from state competition.

15.2.5. Is the National Government a Competitor? A master proposition of the US Constitution is that the national government is supreme when there is a conflict with the states and, under the contemporary understanding of the commerce clause, it can pre-​empt most state law. Mark Roe has asserted that because of this fundamental arrangement, the national government, not other states, is Delaware’s competition and that it dictates the content of corporate law by enacting laws or threatening to do so, leaving to Delaware only those matters that it considers unimportant or those of which it approves of what Delaware has done (e.g., Roe 2003, 2005). Although variations of the thesis that Delaware responds to threats of pre-​emption have episodically appeared in the state competition literature (e.g., Gordon 1991), in a set of recent papers Roe has developed the most full-​throated elaboration of the proposition. From Roe’s perspective, Delaware law exists at the whim of the federal government, either because Delaware officials serve as its instrument, owing to fear of pre-​emption, or because it would be pre-​empted were Delaware officials not to hew to the law the national government desired. Such a thesis is inherently not testable, because it would be confirmed by whatever occurs. If, for example, a particular Delaware law were not pre-​empted, then the claim would be it is because Delaware is doing what the national government wants it to do, regardless of what national or Delaware officials might say or do, or whether there is any data suggesting that any member of Congress was even dimly aware of the matter. It is true that Delaware officials, on occasion, do comment on the possibility of pre-​emption in statements outside of their judicial or legislative rulemaking function, as would any sentient state actor in a federal system. But Roe does not explain why the existence of such comments demonstrates that the national government is master-​like determining the content of state corporate law in the absence of specific pre-​emptive decisions, or that those state actors actually alter their decisions in order to please the national government. 21  They also estimate that were Delaware to alter its code to be closer to Nevada’s permissive liability regime, it would lose most large firms (over $100 million in assets with more institutional owners), although it would gain small firms reincorporating out of Nevada. When they consider corporation codes as bundles, that is, combining the takeover and liability measures, they conclude that gains and losses would offset such that Delaware has “limited incentives to shift to a protectionist regime” (Eldar and Magnolfi 2016, 26).

 

384   ROBERTA ROMANO Roe, for instance, does not acknowledge Delaware officials’ more frequent expressions of anxiety over the possibility of losing corporations to other states, were the state not to act, as evidence that Delaware’s most pressing focus is other states rather than the national government. More to the point, ascertaining the perspective of the national government, particularly when it has not acted pre-​emptively, is not at all self-​evident, as Roe’s thesis would have it. The difficulty of divining the intent of a collective entity, such as Congress, even when it has enacted legislation, let alone a more amorphous national government that has not taken any explicit action on a matter, is a well-​recognized analytical problem in the literature (e.g., Shepsle 1992; Easterbrook 1994, 68), which Roe does not address. Yet this goes to the heart of his thesis, for if Delaware officials are to behave as he posits, they must be able to intuit what the national government desires so as to avoid pre-​emption. Moreover, as I have elaborated elsewhere (Romano 2005a), except for the contention that Congress could theoretically pre-​empt nearly all state law, Roe's thesis is not convincing: it has not done so, and could not, as it would necessitate something akin to a political revolution to do so. A good example of the difficulty with Roe’s notion that Delaware officials act in constant apprehension of pre-​emption is one of Roe’s own, the enactment of Delaware’s second-​generation takeover statute. Contrary to his thesis, the statute was enacted despite SEC officials’ explicit communications to the Delaware legislature of their opposition to the statute and assertion that if enacted it would be pre-​empted (Romano 2005a, 225). Moreover, numerous individuals participating in the hearings on the bill, as well as the press coverage, referred to other states’ takeover laws, and potential reincorporations elsewhere, hence reduced franchise taxes, were no statute to be enacted (Romano 2005a, 224). Therefore, the focus of debate was other states and not the federal government. Only one Delaware attorney referred to concern over federal pre-​emption, and that was late in the legislative process. Yet Roe cites only that reference, overlooking all statements inconsistent with his thesis, as well as expressly rejecting the role of the distinctive factors related to Delaware’s legislative process (see Section 15.2.3) in shaping the statute’s more moderate form, to assert instead that it was generated by fear of pre-​emption. Further, to make his case about the importance of the federal government in corporate law, Roe contends the national government is constantly enacting legislation in the area. But, to the contrary, Congress’s attentiveness to corporate law is rare and episodic. It has enacted amendments to the federal securities laws once every decade or two, primarily in the wake of a collapsing stock market and financial crisis (e.g., Romano, 2005b, 1591–​1593), whereas Delaware updates its code on virtually an annual basis. Given the remote probability of pre-​emption, the responsiveness of states to the activities of one another, along with Delaware’s continual statutory tweaking, it strains plausibility to describe Delaware as “looking over its shoulder [at the federal government] … when it crafts its corporate law” (Roe 2003, 605). Indeed, in subsequent work, Roe appears to recognize the problematic posture of the facts for his thesis, as he notes (2005, 238) that states “have much room to maneuver”,

 

MARKET FOR CORPORATE LAW REDUX    385 suggesting that the best the national government can do is “weaken the mechanisms of the state-​to-​state race.”22 If this were the thesis, it would be difficult to characterize it as identifying the national government, and not other states, as Delaware’s principal competitor. Roe seeks to bolster his thesis by contending that the national government has consistently acted on the most important issues of the day. This contention is mistaken. Since the 1980s, the most active and important area of state corporate law has concerned acquisitions, and in particular, management’s conduct in response to both friendly and hostile offers. Yet Congress has engaged in no substantive regulation of such transactions, while leaving standing the Supreme Court decision eliminating such conduct from the scope of private litigation under the federal securities laws.23 In addition, the corporate law-​related provisions of the Dodd–Frank statute are certainly not related to important issues: requiring disclosure of conflict minerals and the ratio of the CEO’s pay to that of the median employee are trivial matters, though costly to compute, that are not of great moment to shareholders. The Act included no provisions related to management’s fiduciary obligations, the core of state law, which implicate critical issues raised by the financial crisis, such as responsibility for the risk management of financial institutions; those matters remain to be determined by state law. Moreover, when Congress pre-​empted private lawsuits under state securities laws in order to prevent the circumvention of restrictions it had enacted on private rights of action under the federal securities laws, it explicitly excluded state law fiduciary claims, in a provision known as the Delaware carve-​out (Romano 2005a, 229). This is not the behavior of an entity that perceives itself to be Delaware’s competitor. The inclusion of the Delaware carve-​out highlights another factor missing from Roe’s analysis that undercuts the claim regarding the potency of pre-​ emption. Congress is constituted by representatives of states, and those individuals shape what Congress will and will not pre-​empt. The states, in other words, collectively through their representatives, have leverage in the making of legislation, and federal lawmaking is not a one-​way street. Delaware elects two senators, who, in a coalition with other like-​minded legislators, can engage in a variety of blocking strategies were proposed legislation to jeopardize its domain. Because pre-​empting a lawmaking activity of one state often has implications for a number of states, typically more than a few legislators’ interests are at stake on any particular issue. Moreover, even legislators in states 22  There are occasional sentences in which Roe seeks to add a caveat to the article’s vision of Delaware as dancing to the national government’s tune. But they are at odds with the overall tone of the piece, as the import of each caveat is undercut in subsequent passages asserting the national government’s determinative role. 23  Roe (2003, 615) also contends that the SEC’s disclosure requirements (which include disclosures for going-​private transactions) dictate the substance of corporate law because they control what transactions are undertaken. This assertion is inaccurate: disclosure rules do not prevent transactions from occurring, nor state courts from adjudicating transactions’ fairness or appropriateness. And because disclosure requirements do not dictate what state courts consider in evaluating a transaction, state law has an immediate and far greater impact upon managers’ and firms’ behavior than national disclosure requirements.

 

386   ROBERTA ROMANO having no specific stake in an area may not be favorably disposed to pre-​emption as legislation is a game of repeated play and their state might be similarly situated in the near future and could need the support of the legislators of the states whose domain is currently at risk. Finally, Roe (2005, 235) asserts that the national government has made rules on the “central legal institution”, shareholder voting rights, but that claim is overstated. Congress has not, in fact, attempted to enact rules regarding corporations’ substantive voting rights, nor has it expanded the SEC’s authority in the area beyond the authority granted in the New Deal legislation, to regulate the proxy voting process and to regulate mutual funds. The SEC has used that authority to require mutual funds to disclose their votes and voting policies (which Roe references), but this regulation has had no discernible impact on state corporate law (mutual funds having been regulated by the SEC since 1940), nor would it appear to have had much of an impact on mutual fund voting and hence firm policy (see Cremers and Romano 2011). This is not to say that there has been no impact on corporations’ substantive rights at state law by SEC action. The agency has used its authority over stock exchanges to compel them voluntarily to adopt a listing requirement prohibiting firms already listed from creating dual class stock, which is a substantive rule.24 But again this has not had any meaningful impact on corporate law: neither Delaware nor any other state of which I am aware revised its statutes or judicial doctrine regarding voting rights in response to those rules, to elimi­ nate the ability of companies to adopt such voting shares, nor, of course, was there any necessity to do so. Understanding that state competition is the motor force of state corporate law does not imply, as Roe would seem to do, that Congress, the SEC and the stock exchanges are not integral components of the body of law governing corporations, along with state law—​that is Corporate Law 101, and no advocate of state competition would deny the ability, in principle, of those actors to impose restrictions on corporations. Rather, in generating a positive explanation of what informs Delaware lawmaking, one cannot look, as Roe seeks to do, to the national government, as the best available data indicate that the determinative influences are the preferences of corporations—​their managers and investors—​and the responses of other states to those preferences, not an apprehension of federal pre-​emption.

24 

The SEC’s prodding was not in response to any state action of which it disapproved, but rather, a response to stock exchanges under its jurisdiction, which had sought to alter one-​share one-​vote listing requirements to permit midstream restructuring of voting rights by already-​listed firms. More to the point, the SEC initially sought to regulate voting rights directly, requiring the exchanges to prohibit the listing of firms that did not follow the norm of one-​share one-​vote. That rule was invalidated by the federal court of appeals as beyond the agency’s authority, as a matter left to the states in Business Roundtable v SEC, 905 F. 2d 406 (D.C. Cir. 1990). Yet again, Congress did not, in response, overturn the decision and provide the agency with authority to regulate voting rights, which would be expected were the national government to ensure that it, and not states, would be making rules for, as Roe puts it, the “central legal institution”.

 

MARKET FOR CORPORATE LAW REDUX    387

15.3.  Why Is Delaware the Pre-​E minent Incorporation State? The key to Delaware’s sustained market share can be extrapolated from the revealed preferences of the marginal consumers in the market for corporate law, which are reincorporating firms. Those firms, in general, seek two key features in a legal regime: (1) a reduction in the cost and uncertainty of doing business and (2) assurance that the domi­ cile state will maintain, and not welch, on the desirability of its corporate law, which led the firm to locate there in the first place. Delaware’s legal regime is uniquely favorable on both dimensions.

15.3.1. Why Do Firms Reincorporate? Most firms do not change domicile over their corporate lives. Given that there are costs to undertaking a domicile change (e.g., costs to organize a new corporation and merge the two), a firm must expect to increase firm value by operating under the new legal regime. In particular, a firm anticipating undertaking new activities may conclude that it can reduce the cost of doing business were it to be subject to a different regime. A legal regime can directly reduce transaction costs (e.g., different rules governing acquisitions, such as shareholder voting requirements, impose differential costs on transactions). It can also influence transaction costs indirectly, by its impact on the cost, or likelihood of litigation over transactions (e.g., varying levels of clarity regarding how a board can meet its fiduciary duty in considering a takeover offer). The most comprehensive study of why firms reincorporate, which examined the reincorporations of over 500 public corporations from 1960 to 1982, through surveying firms and collecting public information, found that the motivation for nearly three-​quarters could be grouped into three transactional categories, undertaking public offerings, mergers and acquisitions, or takeover defenses, and over 85% of these reincorporations were into Delaware (Romano, 1985, 250–​251, 256). The fourth-​largest category consisted of firms seeking tax savings through a domicile change, and most of those firms (74%) were migrating out of Delaware to avoid the higher, as well as an additional layer of, Delaware franchise taxes (Romano 1985, 255–​258). A more recent study identified a large flow of reincorporations in Delaware in the late 1980s, to take advantage of the limited-​ liability statute, as firms migrated from states that had not yet enacted such a provision (Moodie 2004). The three largest categories in the Romano study comprising reincorporations in Delaware all involve activities that increase the likelihood of a firm’s being subject to a shareholder suit, and suggest a straightforward explanation why domicile choice and reincorporation types are paired. When managers expect a change in corporate activities that increase the probability of shareholder litigation, specific characteristics

 

388   ROBERTA ROMANO of a legal regime become important, such as a well-​developed case law, which facilitates obtaining legal opinions on the validity of transactions, along with clearly specified indemnification rules, because such a regime provides greater predictability for structuring transactions, reducing the probability of litigation (or costs of defending). Concern over transaction uncertainty and litigation costs is also the explanation why firms reincorporated in Delaware take advantage of the limited-​liability statute.

15.3.2. Why Delaware Is the Domicile of Choice: Corporate Charter as Relational Contract A corporate charter is a relational contract, an association between parties that lasts over a long period, over which numerous exchanges occur (here, the firm selects a domi­ cile, and pays franchise taxes over time, and, thereafter, as conditions change, the state revises—​or fails to revise—​the laws governing the contract accordingly). Because in such contracts, one side’s performance is not simultaneous with the other’s, unforeseen contingencies are likely to occur over the life of the contract, making it difficult to specify in advance all of the parties’ rights and obligations, a situation creating possibilities for opportunistic breach. The problem is exacerbated when one party is the state, given its additional role as contract enforcer. That is to say, a party entering into a long-​term contract with the state must consider the additional difficulty that there may be no legal recourse against an opportunistic breach by the state. Delaware’s pre-​eminence in the market for corporate law follows from its ability to resolve credibly such a commitment problem in relational contracting.

15.3.2.1. Credible Commitments An important mechanism for resolving the opportunistic breach problem of relational contracts is the parties’ investment in assets, referred to as transaction-​specific assets, whose value is highest when used in a specific relation rather than in any other use (Williamson 1983). In the corporate chartering context, for example, the state must invest in assets whose return is highest when used to procure incorporations and to ser­ vice the needs of domestic firms. This investment protects firms from a state’s collecting franchise fees and then opportunistically repealing desirable code provisions or not attentively updating its code, as the firm anticipated it would when it initially relocated in the state. Similar investments by firms’ counsel in mastering the domicile’s law, along with the additional out-​of-​pocket costs that would be incurred from reincorporating, protect the state’s investments. Delaware’s most important transaction-​specific asset is an intangible one, its reputation for responsiveness to corporations’ concerns. This reputation is derived not simply from its pioneering role in statutory innovation, but also from the substantial revenues that Delaware obtains from corporate franchise taxes. The large proportion of its bud­ get financed by such taxes renders the state responsive to firms’ preferences because it

 

MARKET FOR CORPORATE LAW REDUX    389 has so much to lose were firms to be dissatisfied and migrate (or new firms dissuaded from locating there). It would be extremely difficult, if not impossible, for Delaware to maintain the services it provides to its citizens with an alternative revenue source, given its small size, were its franchise tax collections to decline. Delaware’s high ratio of franchise taxes to total revenues is an intangible asset that precommits it not to renege on contracts with its corporate customers, for it renders the state vulnerable to breach. Delaware is, in short, a hostage to its success in the chartering market. The hostage-​like dependence on franchise tax revenues is not the only investment that serves as a credible commitment to firms. Its comprehensive body of case law, judicial expertise in corporate law, at both the Chancery Court and Supreme Court levels, along with administrative expertise in the expeditious processing of corporate filings in the Office of the Secretary of State, are assets that have no use outside of the chartering business. These nonredeployable assets are of considerable value to firms: the stock of precedents and specialized court of original jurisdiction, along with experienced business lawyers on the Supreme Court (the sole appellate court) facilitate business planning, which is key for the reduction in transaction costs sought by reincorporating firms. They are also related to the transaction-​specific asset on the corporation side—​counsels specializing in Delaware corporate law have an incentive to maintain the Delaware domicile, as that preserves the return on their human-​capital investment. Delaware also facilitates attorneys’ ability to maintain the value of that investment by circulating unpublished opinions and hearing transcripts, and consulting prominent members of the bar, outside as well as within the state, on corporate law revisions. These advantages for attorneys also benefit shareholders, by reducing the cost of legal services. The final, rather unique, institutional arrangement fostering credible commitments, by which Delaware maintains its dominant market position, is a constitutional provision that requires a supermajority vote of two-​thirds of both houses of the legislature to revise the corporation code.25 This provision makes it difficult for Delaware to renege on the direction of its code, as occurred in New Jersey toward the outset of the twentieth century, which enabled Delaware to replace it as the leading incorporation state (Romano 1993, 42–​43) and, therefore, increases the likelihood that the legal environment can be no worse than it was at the time of a firm’s initial incorporation in the state. This is a desirable feature if corporations are risk averse, and seek a statutory domicile that minimizes the worst-​case scenario. The supermajority requirement also preserves the personal investments in expertise of Delaware citizens who service corporations, by requiring what would be a critical election, revolutionizing state politics, to alter the character of the code and reverse the flow of corporate revenues in the state on which those citizens depend. While the supermajority provision could slow the updating of 25  Article IX section 1 of the Delaware Constitution is derived from a provision in the state’s Constitution of 1831, when a legislative grant of a special charter was required for a firm to do business, but the provision was retained in the Constitution of 1897 despite the enactment of a general incorporation statute. Besides Delaware, Iowa is the only other state that has such a constitutional provision (Article 8, section 12).

 

390   ROBERTA ROMANO the corporation code, in practice, that has not been the case, as Delaware has been a persistent innovator over the years. Rather, the supermajority provision and Delaware’s dependence on franchise taxes are complementary mechanisms functioning to ensure a responsive code: the former is backward-​looking, as a reversal of policy is difficult, while the latter is forward-​looking, incentivizing the state to be responsive to changing business circumstances in order to retain and expand in-​state corporations. Delaware’s successful creation of a credible commitment is exceedingly difficult for other states to replicate. Only a relatively small state could be in a position where franchise fee collections could be substantial enough compared with total tax revenue to have hostage-​like qualities. In addition, in contrast to statutory innovations, it would be difficult to duplicate Delaware’s legal capital. Although specialized courts can be established, and states can incorporate, legislatively or judicially, the existing stock of Delaware law as their own precedents, the dynamic nature of corporate law adjudication requires the development of in-​state judicial expertise, and a small state is not likely to have at the ready a pool of judges having the requisite familiarity with business law and practices. But the essential problem for another state to unseat Delaware in attracting reincorporating firms (compared with retaining local firms) stems from what can be described as a first mover advantage. Once Delaware established its dominant position, it became cheaper for it to maintain a commanding lead over a newcomer because there is value in numbers. As I have put it previously (Romano 1993, 44), “[t]‌he more firms there are in Delaware, the more franchise tax receipts it receives and the more it will rely on its charter business, making it even more important to be responsive. In addition, the more firms there are in Delaware, the more legal precedents will be produced, further providing a sounder basis for business planning, which attracts even more firms to that state. Finally, the more corporate law cases that are brought, the greater will be the expertise of the Delaware judges, as will be the value to an individual from developing such expertise as a member of the judiciary.” This competitive advantage is the reason why the most effective strategy of other states is to engage in defensive competition, to induce local firms to remain domiciled in state, rather than seek to attract firms away from Delaware (see Section 15.2.2.1).

15.3.2.2. Network Externalities Michael Klausner (1995) identified the description of Delaware’s first mover advantage as equivalent to the economics of networks. This economic theory applies to a product that becomes more valuable as its use becomes more widespread, the paradigmatic example being the telephone. Like the telephone, Delaware law is a product whose market exhibits, then, what is referred to as a network externality. That is, each user of the product confers a benefit on other users; a telephone is more useful, the more individuals have one, and the more firms incorporate in Delaware, as already noted, the more value there will be in a Delaware domicile, as there will be greater legal certainty from precedents on more matters, and greater responsiveness, as there will be more revenue for Delaware to lose.

 

MARKET FOR CORPORATE LAW REDUX    391 The benefit of use of the product in a network is independent of the merit or benefit of the product itself,26 and Klausner contends that a network can have adverse lock-​in effects. There may be a superior corporation code in a state other than Delaware, but firms would not relocate out of Delaware, despite its inferiority because of the benefit of being part of its larger network of legal precedents (which is due to the presence of many firms). Similarly, there may be a superior code that has yet to be enacted by any state, but a network lock-​in effect would discourage innovation. It is, however, analytically difficult to characterize Delaware’s successful legal network as producing inferior (inefficient) laws, which are then subject to lock-​in. Indeed, there are compelling reasons not to expect there to be a significant, adverse lock-​in effect in this context. As S. J. Leibowitz and Stephen Margolis (1998) have suggested, network effects produce negative externalities, such that a more efficient network will not replace an inferior less efficient one, only when market participants cannot internalize those effects. But as they explain (Leibowitz and Margolis 1994), if the dominant network is inefficient compared with a competing one, the owner of the superior network will internalize the network costs and with a more efficient product can subsidize switchers. While a single corporation cannot internalize the costs of a corporate law regime, a legislating state can. Moreover, there are well-​informed specialists—​attorneys and investment bankers—​who are repeat players in the charter market and advise many firms.27 These experts also can internalize the cost of becoming informed about inefficient choices and encourage a state with the leading network to revise an inefficient provision or advise clients to switch to a more efficient regime. These features of the 26  Bebchuk et al. (2002) contend, for instance, that the positive price effects of reincorporation event studies (see Section 15.2.4.1) are due to a network effect unrelated to the content of Delaware law, i.e., investors value being in a network, even if its precedents are harmful to their interest, favoring managers (for if the precedents benefited shareholders, the network effect would work in the same direction as the quality of the substantive law, and it would be of no import for evaluating the price effects). It is difficult to imagine that the positive value of a network could outweigh the negative value of precedents benefiting managers at shareholders’ expense over time, as we would expect to see either a negative price effect in later event studies or a decrease in the number of reincorporations or IPOs in Delaware, or a negative performance effect, none of which are observed (see Section 15.2.4). 27  Some commentators contend that the quality of Delaware law is irrelevant to firm choices because private start-​up firms incorporated in Delaware have more out-​of-​state investors than those incorporated in a home state, interpreting that datum as evidence that investors choose a state that they are familiar with independent of the quality of law. These commentators therefore speculate that Delaware law may be suboptimal, or become suboptimal, but investors will continue to demand firms to locate there. E.g., Broughman and Ibrahim (2015). Yet, there is a straightforward explanation of the finding on which the claim depends, which is consistent with the reason firms reincorporate and the explanation of Delaware’s success offered in Sections 15.3.1 and 15.3.2.1. The larger the number of out-​of-​ state investors, the more distant they are from the firm’s operations, attenuating their ability to monitor management, and accordingly, the greater the probability of litigation over fiduciary claims. In this circumstance, both the quality and predictability of the legal regime matters. Hence, for those firms, selecting a Delaware domicile because of “familiarity” with the law is identical to the value-​enhancing transaction cost explanation of Delaware’s success offered by Romano (1985, 1993). Where there are mostly local investors who can more readily monitor management, then the fiduciary regime would be of less import. Indeed these commentators recognize that familiarity reduces transaction costs, but fail to connect the dots to the actual value Delaware’s legal regime offers. In sum, the sophisticated investors

 

392   ROBERTA ROMANO corporate law market would displace an inefficient network, whether the lock-​in problem is thought to be due to imperfect information (early adopters, i.e., reincorporators, lack information regarding superior law), or the size of the network (later adopters join a known inefficient market because of the many early adopters).

15.3.2.3. Evidence of Network Effects There has been limited research exploring the presence of network effects in corporate law. In his study of IPO firms’ domicile choice, Daines (2001, 1596) finds only mixed evidence in support of the presence of such effects. He finds that retention rates are higher for states with large numbers of firms, as well as for Model Act states (this assumes that the act functions as a network because one state’s precedents can be used by all Model Act states). However, the significance of these findings is not robust, dependent on the model specification. In addition, as he notes, the analysis cannot distinguish a network benefit from an alternative explanation, that firms value the Model Act’s substantive rules, an alternative that could also explain why the number of in-​state incorporations is positively related to retention rates (i.e., those states also have more valuable corporate laws).28 There are data on the question whether a corporate law network would exhibit lock-​in effects, suggesting that a dominant corporate law network can, indeed, be replaced by a more efficient one (i.e., no lock-​in effect). A study of Australian corporate law (Whincop 2003) studying competing clusters or networks of indemnification and liability release provisions in corporate charters found that a new mix of the provisions emerged and came to predominate despite the existence of a substantial older network. This research parallels what casual empiricism would suggest about US corporation codes. Delaware is attentively revising and refining its code as business conditions change, despite its large stock of precedents that under a network externality or lock-​in analysis, should discourage, if not prevent, the state from updating to superior provisions. In addition, Ribstein and Kobayashi (2001) examined the choice of form decisions of small businesses to investigate whether there are network externalities that could result in inefficient organizational choices. They compare the choice of organizing as a limited-​ liability company (LLC) or a limited-​liability partnership (LLP). The idea is that because LLPs can take advantage of an existing stock of precedents of partnership law, whereas, as an entirely new business form, there is no comparable stock of precedents usable by LLCs, if network effects mattered for firms, then the LLP should be the preferred form. They find instead that the LLC dominates the LLP, which is at odds with a network being an impediment to the development of alternative organizational forms (or to put it who fund start-​ups would not be willing to have their financial interest governed by a law with which they were simply “familiar” unless they had a rational expectation that the law would not decrease their wealth or otherwise provide little benefit to the business in which they were investing. 28  For additional problems involving interpretation of a statistical effect of the Model Act on retention rates, see Kahan (2006, 347). In contrast to Daines, neither Bebchuk and Cohen (2003) nor Kahan (2006) found the Model Act significant.

 

MARKET FOR CORPORATE LAW REDUX    393 another way, at odds with there being value in a network, compared with other substantive law factors, such as state tax implications), at least with respect to small businesses. Whether Ribstein and Kobayashi’s finding can be extrapolated to the choices of public corporations is an open question. Investigating the presence of network effects and their relation to firm value is another important area for future research.

15.4. Conclusion Under US law, firms’ governing law depends on a statutory domicile, rather than their physical location, which permits them to select their corporate law regime from among the states. This institutional arrangement has led commentators to conceptualize corporate law as a product states offer (with franchise fees the purchase price). This market has been dominated by one state, Delaware, and its large number of incorporations has given it a competitive edge, leading to the development of a large stock of precedents providing legal certainty and a financial dependence on its incorporation business, which create a credible commitment that it will maintain a responsive corporate law environment, thereby attracting even more firms, a phenomenon also referred to as a network effect. Individual firms tend to choose between their state of physical presence and Delaware, and as a result, the competitive strategy of most other states is a defensive one, which seeks to retain local firms rather than attract firms away from Delaware. States respond to statutory innovations by Delaware and the loss or potential loss of incorporations by similarly revising their codes, and Delaware, when not the innovator, is quick to follow other states’ innovations, as the business environment changes. Nevada is an exception to that pattern, as it attracts an inflow of firms headquartered in other states. Contemporary research suggests that Nevada is competing with Delaware by developing a differentiated niche offering reduced liability of managers for shareholder lawsuits, valued most by small firms. The market for corporate law raises several questions, which can be addressed empirically. The classic debate is over whose preferences in the firm, managers or shareholders, are driving the making of state law, famously phrased as whether state competition is a race for the bottom or to the top. The empirical research on this issue suggests that, for the most part, the direction is to the top. More recently, commentators have questioned whether states compete at all, and whether it is the national government, given its pre-​emptive authority, and not the states, with whom Delaware is competing. While there has been less empirical work investigating these latter questions, insofar as they can be tested, the available evidence indicates that states do compete and that they, not the national government, are the competitors to which Delaware assiduously responds. The national government’s activity in the corporate law domain is rare and episodic, and not only has Congress not pre-​empted the core of state law, managers’ fiduciary duties, but it also has even carved those actions out of its pre-​emption of private litigation under state securities laws.

 

394   ROBERTA ROMANO There are questions in the state competition discourse for which further empirical research would be quite valuable. These include resolving conflicting findings regarding whether the valuation of Delaware’s firms is higher than that of firms in other states; updating reincorporation event studies to see if the positive effect found in studies now decades old persists, and if it is due to the content of the law, or a network effect; determining whether Nevada attracts firms with a propensity to engage in accounting misconduct or firms with high litigation costs seeking to avoid frivolous lawsuits, and whether its competitive strategy is being followed by other states; and developing a better understanding of the role of the bar in firms’ domicile selections. Although state competition has now been examined empirically for decades, as a central theme in US corporate law, it remains a remarkably open area of research.

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MARKET FOR CORPORATE LAW REDUX    397 McCubbins, Mathew D. and Schwartz, Thomas. 1984. “Congressional Oversight Overlooked: Police Patrols versus Fire Alarms.” American Journal of Political Science 28, pp. 16–​79. Moodie, Gordon. 2004. “Forty Years of Charter Competition: A Race to Protect Directors from Liability?” Harvard Law School, John M. Olin Center for Law, Economics, and Business Fellows’ Discussion Paper Series, Discussion Paper No. 1. www.law.harvard.edu/​programs/​ olin_​center/​fellows_​papers/​1_​Moodie.php [Accessed 30 August 2016]. Molyneux, Philip and Shamroukh, Nidal. 1999. Financial Innovation. New York: John Wiley & Sons. Nabseth, Lars and Ray, George F. 1974. The Diffusion of New Industrial Processes. Cambridge, MA: Cambridge University Press. Netter, Jeffry and Poulsen, Annette. 1989. “State Corporation Laws and Shareholders:  The Recent Experience.” Financial Management 18, pp. 29–​40. Pew Research Center. 2013. “Views of Government: Key Data Points.” Available at http://​www. pewresearch.org/​key-​data-​points/​views-​of-​government-​key-​data-​points/​ [Accessed 22 October 2016]. Ribstein, Larry. 2011. “Nevada and the Market for Corporate Law.” Truth on the Market Blog (27 May). Ribstein, Larry and Kobayashi, Bruce. 2001. “Choice of Form and Network Externalities.” William & Mary Law Review 43, pp. 79–​140. Ringe, Wolf-​Georg. 2013. “Corporate Mobility in the European Union—​A Flash in the Pan? An Empirical Study on the Success of Lawmaking and Regulatory Competition.” European Company and Financial Law Review 10, pp. 230–​267. Roe, Mark J. 2003. “Delaware’s Competition.” Harvard Law Review 117, pp. 588–​646. Roe, Mark J. 2005. “Regulatory Competition in Making Corporate Law in the United States and Its Limits.” Oxford Review of Economic Policy 21, pp. 232–​242. Romano, Roberta. 1985. “Law as a Product: Some Pieces of the Incorporation Puzzle.” Journal of Law, Economics and Organization 1, pp. 225–​283. Romano, Roberta. 1988. “The Future of Hostile Takeovers: Legislation and Public Opinion.” University of Cincinnati Law Review 57, pp. 457–​505. Romano, Roberta. 1989. “What Went Wrong with Directors’ and Officers’ Liability Insurance?” Delaware Journal of Corporate Law 14, pp. 1–​33. Romano, Roberta. 1993. The Genius of American Corporate Law. Washington, DC: AEI Press. Romano, Roberta. 2002. The Advantage of Competitive Federalism for Securities Regulation. Washington, DC: AEI Press. Romano, Roberta. 2005a. “Is Regulatory Competition a Problem or Irrelevant for Corporate Governance?” Oxford Review of Economic Policy 21, pp. 212–​231. Romano, Roberta. 2005b. “The Sarbanes-​Oxley Act and the Making of Quack Corporate Governance.” Yale Law Journal 114, pp. 1521–​1611. Romano, Roberta. 2006. “The States as a Laboratory: Legal Innovation and State Competition for Corporate Charters.” Yale Journal on Regulation 23, pp. 209–​247. Romano, Roberta. 2012. “Regulating in the Dark.” In:  Cary Coglianese, ed., Regulatory Breakdown:  The Crisis of Confidence in U.S. Regulation. Philadelphia, PA:  University of Pennsylvania Press. 86–​117. Shepsle, Kenneth A. 1992. “Congress Is a ‘They,’ Not an ‘It’: Legislative Intent as Oxymoron.” International Review of Law and Economics 12, pp. 239–​256. Subramanian, Guhan. 2002. “The Influence of Antitakeover Statutes on Incorporation Choice:  Evidence on the ‘Race’ Debate and Antitakeover Overreaching.” University of Pennsylvania Law Review 150, pp. 1795–​1873.

 

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Chapter 16

L AW AND EC ON OMI C S OF AGE NCY AND PA RT NE RSH I P George M. Cohen

16.1. Introduction Agency and the general partnership are the intermediate steps between contract and complex business organization. This chapter offers an economic theory of how the law of agency and partnership facilitates economic transactions using these two devices. Law and economics scholarship has generally paid less attention to agency and partnership than to contract and the corporation, the paradigmatic business organization. In part, this focus follows the framework established by Coase. Coase’s two famous papers involved contract and the business firm. His key insight tying the two together is the concept of transaction costs. When transaction costs are low, contract flourishes and, as Coase famously recognized, can involve the rearrangement of legal rights as well as the exchange of goods or services for money. When transaction costs are high, firms may become superior to contracts for certain types of transactions. In the simplified Coasian dichotomy, then, we find contract in conditions of low transaction costs and firms in conditions of high transaction costs. What that framework omits is the bridge between the two. One way to bridge the gap is to focus on “agency costs.” Contract becomes more costly when one party has either greater expertise or knowledge than the other (asymmetric information) or exercises discretion because it is difficult for the other party to monitor and verify the first party’s conduct. The economic problem thus becomes how the “principal” can structure the contractual relationship with the “agent” to get the agent to do what the principal wants when their interests are not perfectly aligned. From this perspective, “agency” is merely a special type of contract, and agency costs are an important reason for the existence of firms, which “internalize” certain types of relationships such as employment. The agency cost approach leads economists to think of agency and the firm as fundamentally about two-​party problems, or an interconnected group of such problems (the “nexus of contracts” view).

 

400   GEORGE M. COHEN From a legal point of view, however, what fundamentally distinguishes agency from contract is that agency involves relationships among three parties: the principal, the agent, and the third party. A principal is an owner of property: an asset or a collection of assets. Assets can be physical, but in many cases they are intangible, such as information (e.g., intellectual property), a legal right or interest (e.g., contracts or financial assets), or reputation (good will). Property owners have two important legal rights: the exclusive right to control the use of their assets and the right to any increase in value of the assets less the costs of obtaining and using them (i.e., profit). As defined in agency law, an agent is a person who acts on behalf of a principal, with the consent of both, and subject to the principal’s control. The principal consents to the agent’s use of the principal’s property, which the principal has the right to control, for the purpose of increasing or maintaining the value of that property for the benefit of (on behalf of) the principal. The third party is someone with whom the agent interacts, whether voluntarily or involuntarily, while working on behalf of the principal. Interactions between the agent and the third party, in which the agent uses and puts at risk the principal’s assets, and over which the principal has the right of control, are the primary concerns of agency law. Agency serves two different, though often overlapping economic purposes. In the first type of agency, “transactional agency,” agents serve as contractual intermediaries. Contracting through personal contact may be costly. The cost may arise from distance, from time, from differential knowledge or expertise, or from the existence of multiple principals on one or both sides of the transaction. The most important thing the law of transactional agency does is to bind a principal to authorized contracts with third parties made by an agent acting on behalf of the principal, without making the agent personally liable on those contracts. Enabling a principal to bind itself through an intermediary facilitates transactions and reduces transaction costs to the principal. In addition, absolving the agent from liability on authorized contracts reduces the costs of participation to the agent, who does not need to “own” the property that is the subject of the transaction. The second type of agency, “employment,” reduces transaction costs in a different way. Contracting with independent service providers may be costly. Independent service providers may lack the specialized training, experience, expertise, or knowledge of firm culture necessary to do an effective job for a particular business. They may lack loyalty to the business, and be too willing to abandon that business for more lucrative opportunities. And they may turn out to be judgment-​proof and therefore not subject to liability if they do a poor job. The employment relationship reduces these costs. The employer benefits because it can invest in job-​specific training, or otherwise expose the employee to job-​specific and sensitive information, and recoup the benefits of these investments by maintaining a long-​term relationship and requiring that the employee work exclusively or predominantly for the employer. The employer can also afford to hire judgment-​proof employees by using bonding devices, such as the prospect of advancement within the company, as incentives, which employees who perform poorly risk losing. Employees benefit from the employment arrangement because it relieves them of the risks and burdens of ownership, such as the need to maintain a sufficient capital stock and the risks of insufficient or uncertain demand for their services. In return, employees give up the

 

LAW AND ECONOMICS OF AGENCY AND PARTNERSHIP    401 potential benefits of ownership, namely profit, and take the risk that their employer will go bankrupt or fire them if the employer needs to respond to changing economic conditions. All employees are agents, though not all employees are transactional agents (e.g. receptionists), and not all transactional agents are employees (e.g., outside counsel). Whereas transactional agents are defined by the authority the principal gives them to contract with third parties, employees are defined by their status, that is, by the type of relationship they have with their employers. Employers typically control how employees do their job, decide what particular job the employee must do and when, and require that employees work exclusively or predominantly for the employer. What employees and transactional agents have in common, however, is that they both interact (or have the potential to interact) with third parties in ways that the principal has the right to control, and that have the primary purpose and potential to facilitate transactions between the employer and the third parties, and to enhance the value of the employer’s assets. Even if employees do not have authority to make contracts for their employers, they often interact with third parties in the course of doing their jobs. They may communicate with, receive information from, make deliveries to, or receive goods from third parties. The most important thing the agency law of employment does, however, is to protect third parties from unwanted, harmful interactions with employees, namely torts. The rule of vicarious liability makes an employer liable, in addition to the employee, for torts that the employee commits within the scope of employment. Thus, the key to agency law is the shift from the two-​party relationship of contract to a three-​party relationship. The reason this shift matters for agency law is that the agency relationship simultaneously creates unique benefits that increase the value of economic activity beyond simple contracts between principals, and creates unique costs that the law must address. In particular, the tripartite nature of the agency relationship (principal, agent, third party) enables any two of those parties to collude against the other. The primary economic purpose of agency law is to enhance the benefits of agency by deterring such collusion. The law of partnership takes a step beyond agency because it involves multiple principals who jointly own assets. A partnership, the default form of business with more than one owner, is defined as an association of two or more persons to carry on as co-​owners of a business for profit. People create partnerships when they believe that by combining assets, including human capital, as well as jointly controlling those assets, they can provide superior goods and services and earn greater profits relative to what they could do separately. Partnerships involve a combination of several contractual relationships: the contract among the principals to establish co-​ownership (the “association,” usually captured in a partnership agreement) and contracts between the partnership and third parties to increase the value of the jointly owned assets (the “carrying on of a business,” which is what distinguishes partnership from the mere joint ownership of property). Economists have long recognized the nature of business entities as essentially contractual—​the most prominent example being the characterization of a corporation as a “nexus of contracts.” But this approach parallels the standard economic approach to agency by framing the firm as merely a series of two-​party interactions.

 

402   GEORGE M. COHEN The focus here differs from the standard approach by emphasizing once again the multiparty nature of partnership transactions. These relationships provide the key link between agency and partnership. Instead of the principal, the agent, and the third party, however, partnerships involve the relationships among two or more partners, non-​ partner agents of the partnership, and third parties. To some extent, partnership law mitigates and masks the multiparty nature of partnership by recognizing the partnership as an entity. One benefit of recognizing a partnership as an entity is that doing so facilitates transactions between the partnership enterprise and third parties. Requiring third parties to contract with all the partners and sue all the partners in the event of a breach could be excessively costly. Recognizing the partnership as an entity that can make contracts, as well as sue and be sued on those contracts, reduces those transactions costs. If the partnership is considered a unified principal, and only non-​partners act as agents of the partnership, then agency law and the doctrines discussed above apply straightforwardly to partnership. In fact, the partnership statute explicitly makes agency law applicable to partnerships if not displaced by specific provisions of the statute. What makes partnership law meaningfully different from agency law, however, is that co-​ownership by multiple partners creates different and more complex problems, which cannot all be solved by recognizing the partnership as an entity. The traditional debate in partnership law about whether to view a partnership as an entity (the view that has ultimately prevailed) or an aggregate of the partners reflects this more complex and complete picture. For example, how exactly does a partnership entity make contracts? More specifically, what role do the partners play in this activity? Partnership law recognizes all partners as agents of the partnership and recognizes their apparent authority to make contracts in the ordinary course of partnership business. Partners entering and leaving the partnership create further complexity, as does the ending of the partnership. A primary economic purpose of partnership law, parallel to transactional agency, is to facilitate partnership transactions with third parties by reducing the transaction costs created by these uncertainties. Multiple ownership also creates a different set of problems, involving the relationship of the partners to each other and to their shared property. These problems also go beyond those created by a standard two-​party contract and simple agency, which involves a unified principal. First, shared ownership of property implies shared control over that property, and because people do not always agree, partnership law requires internal governance or management rules for exercising this shared control. Thus, an additional purpose of recognizing the partnership as an entity is to provide a mechanism of joint control and an efficient means for partners to resolve disputes among themselves. Second, shared ownership creates the possibility of misappropriation of partnership property by one or more partners. Although agents can misappropriate a principal’s property, a risk that explains the existence of fiduciary duties, co-​ownership creates special problems. There may be uncertainty about what counts as joint property rather than individual property, or about how and for what purposes co-​owners can legitimately use jointly owned property. Much of partnership law aims to resolve these uncertainties and to preserve and protect partnership property from various kinds of

 

LAW AND ECONOMICS OF AGENCY AND PARTNERSHIP    403 misappropriation. For example, yet another purpose of recognizing the partnership as an entity is to facilitate the creation, preservation, and transfer of jointly owned (partnership) property, separate from the individual property of the partners, and to protect against both the misappropriation of partnership property and its improper use. Finally, partnership creates collusive possibilities beyond those in simple agency. First, when there are more than two partners, two or more partners could collude against the interests of other partners or the partnership entity. Moreover, one or more partners could collude with a third party against the interests of the partnership. Finally, multiple partners could collude against a third party. Like agency law, partnership law aims to deter collusive behavior, including collusive behavior unique to the partnership relationship. The following two sections elaborate on this theory, and provide examples from agency law and partnership law respectively.

16.2.  Agency Law and the Problem of Collusion As discussed in the previous section, an economic theory of agency law can explain and justify the basic contours of that law by focusing on the three collusive possibilities presented by the agency relationship: principal–agent collusion, agent–​third-​party collusion, and principal–​third-​party collusion. This section explores these aspects of agency law in turn.

16.2.1.  Principal–​Agent Collusion The most important type of collusion addressed by agency law is that between the principal and the agent. Agency law recognizes and addresses at least seven different ways that a principal can collude with its agent to the detriment of third parties. First, a principal can use an agent to mislead a third party about the principal’s desire to contract with the third party through the agent. This danger is the subject of the doctrines of actual and apparent authority. Second, the principal can collude with insolvent agents to shift risks of harm from the principal’s business onto third parties. This problem is the subject of vicarious tort liability for physical injury. Third, a principal can use an agent to mislead a third party about the nature of a transaction. This is the subject of vicarious liability for fraud. Fourth, a principal can use a fake agent to mislead a third party into thinking that it is dealing with an actual agent. This problem is the subject of apparent or ostensible agency, or vicarious liability by estoppel. Fifth, a principal can use an agent to mislead a third party into thinking its transacting partner is a principal and not an agent. This problem gives rise to the rules governing the undisclosed principal. Interestingly, the

 

404   GEORGE M. COHEN undisclosed principal device is the one form of principal–​agent collusion that agency law permits, albeit for limited purposes. Sixth, an undisclosed principal can use an agent to mislead the third party about the agent’s solvency. This problem gives rise to an undisclosed principal’s liability for certain unauthorized transactions by the agent. Seventh, a principal can use an agent to shield the principal from the consequences of unwelcome information. This problem is the subject of the doctrine of imputed knowledge.

16.2.1.1.  C  ollusion to Mislead the Third Party about the Principal’s Intention to Contract (Actual and Apparent Authority) One of the main functions of agency law is to deter principals from colluding with their agents to mislead third parties about their intention to contract. Suppose a principal would like to bind the third party to a contract but give himself a secret option to escape contractual liability if circumstances change in a way that makes the contract disadvantageous to the principal. Of course, a principal could do this expressly by adjusting the contract terms or by acquiring an express option, but those approaches are likely to be costly to the principal. Instead, an opportunistic principal, in the absence of agency law, could collude with an agent to acquire, in effect, a free option. The principal could expressly tell the agent, orally or in writing, that the agent is not authorized to make the contract. At the same time, the principal might hint, or the agent might simply understand, that the principal in fact wants the agent to make the contract, and the principal might misleadingly suggest to the third party that the agent is authorized, for example, by putting the agent in a certain position or providing other “trappings” of authority. Suppose the agent then makes the “unauthorized” contract. If the contract turns out well, the principal is happy to enforce it. If it turns out poorly, the principal claims that he does not have to perform because the agent was not authorized—​a free option. Courts developed the doctrine of apparent authority to deter such conduct. Under the doctrine of apparent authority, if a principal “manifests” to a third party that an agent is authorized, and based on this manifestation the third party reasonably believes the agent is authorized, then the principal will be bound by a contract the agent makes with that third party even if the agent is not “actually authorized.” By the same token, agency law does not permit the principal to collude with the agent to acquire a free option by misleading the third party into thinking that the agent is not authorized, while simultaneously telling the agent that the agent is authorized. The agency law rule that effectuates this result is the doctrine of actual authority. Under agency law, actual authority is sufficient to bind the principal to a contract with the agent, even if the third party was unreasonable in believing that the agent was autho­ rized. Otherwise, the principal could again have his cake and eat it by enforcing the contract if it suited him and avoiding it if it became disadvantageous by asserting that the third party acted unreasonably in contracting with the agent. Of course, in either situation, if the third party could specifically prove that the principal and agent were colluding against him, the third party could prevail in a dispute against the principal without the help of specific agency law rules. What agency law

 

LAW AND ECONOMICS OF AGENCY AND PARTNERSHIP    405 provides is a presumption of collusive behavior that reduces the costs imposed on third parties by a principal’s use of an agent by reducing the risk that the principal is using the agent in a collusive way.

16.2.1.2.  C  ollusion to Shield the Principal from Tort Liability (Vicarious Liability) A second key function of agency law is to deter principals from using agents unreason­ ably to shield themselves from tort liability resulting from physical harm to third parties caused by activities related to the principal’s business. Vicarious liability is the doctrine that accomplishes this goal. Absent vicarious liability, a principal could use agents to shift these risks to third parties by hiring judgment-​proof agents to engage in risky conduct related to the agents’ employment and then fail to adequately monitor and control the agents’ conduct. As is well known in the law and economics literature, judgment-​ proof parties have insufficient incentives to take efficient levels of precautions. Principals who hire agents as employees are generally in a good position to monitor the conduct of these agents and require them to take reasonable precautions that they might otherwise not have sufficient incentive to take. Employer principals have an advantage over the tort system in encouraging desirable behavior because they can use devices such as bonding to ensure that agents conform to the principal’s requirements, including precaution taking. Agency law characterizes principals who have the ability to monitor agents and require precaution taking as possessing “physical” control over the agents, meaning control over the means of doing the work, as opposed to control over just the result. Principals who did not face the prospect of vicarious liability for their employees’ torts would not have sufficient incentive to exercise this kind of control. By avoiding costs associated with paying or insuring against tort liability as well as those associated with monitoring and precaution taking, principals could collude with judgment-​proof agents by hiring them and offering them higher wages out of the saved tort liability costs. Because judgment-​proof employees would be valuable to their principals for their liability-​reducing characteristics, rather than solely for their productivity, principals would hire too many of them relative to the socially optimal amount, and those employees would cause too many accidents. True, apart from vicarious liability, employers who negligently supervise their employees are directly liable to victims of their employees’ torts. Courts, however, do not usually interpret negligent supervision to encompass a simple lack of monitoring or failure to demand that employees take certain precautions (though of course if vicarious liability did not exist, courts might expand the scope of negligent supervision to include such omissions). Moreover, there are aspects of control not usually captured by the negligence standard that are important in the agency context. Economic scholars starting with Shavell have referred to conduct that may increase the risk of accidents but that the negligence standard does not usually take into account as “activity level” effects. The classic example is the amount of driving someone does. The more driving that occurs, the greater the likelihood of an accident, but driving over a certain amount is not usually

 

406   GEORGE M. COHEN thought to be “negligent.” Employers generally control the activity level of their enterprises (including how often, and when, their employees perform certain tasks) and not simply the details of the employees’ work. The activity level effect helps explain why employers are vicariously liable for their employees’ vehicle accidents within the scope of employment, probably the most common situation of vicarious liability. Employers do not generally monitor their employees’ driving or issue directives about how to drive or impose safety requirements (though they may in some cases). They do, however, generally decide, whether an employee will take an additional vehicle trip, where and when the employees will travel, and under what circumstances. The employer’s decisions about these matters do not generally give rise to direct negligence claims against the employer, though they can have a significant impact on the risk of accidents to third parties. The collusion theory helps explain some of the key features of vicarious liability. First, vicarious liability is a form of strict liability, but only in part. Vicarious liability requires that the employee be negligent (or in some cases commit an intentional tort), and then holds the employer strictly liable for the employee’s tortious conduct. Thus, vicarious liability focuses on the relationship between the principal and the agent, not simply on the principal’s choice of activity. Recall that vicarious liability aims to deter the employer from unreasonably shifting risk by hiring judgment-​proof agents to engage in unduly risky activities and then not monitoring or controlling those employees. If, however, an employee non-​negligently causes harm to a third party in the course of doing the principal’s business, then although the employer’s business may in some sense have caused the harm, a collusive bargain between the employer and employee does not. That is, if the employee would not be potentially liable anyway, there is no particular advantage to the employer to hiring judgment-​proof employees and then failing to engage in cost-​effective monitoring of those employees. The law does impose full strict liability on employers for certain activities, most notably “inherently dangerous” activities and could decide to impose full strict liability (“enterprise liability”), but that is a separate question from whether to impose vicarious liability as a matter of agency law. Second, vicarious liability does not attach to all agency relationships, but only those between employers and employees (or masters and servants in the older terminology). The factors that go into distinguishing employer–​employee relationships from transactional agency relationships, such as attorney–client, generally have to do with the likelihood that the agent is judgment-​proof as well as the ability of the principal to monitor the agent and require the agent to take cost-​effective precautions, or to control the employee’s activity level. That is, the factors relate to the degree of collusive risk. Third, vicarious liability applies only when the employee-​agent is acting within the scope of her employment. Only activities within the scope of employment are within the employer’s reasonable control. More relevant to the theory here, an employer would have no incentive to collude with employees to have them engage in unduly risky activities if they are outside the employees’ normal work responsibilities.

 

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16.2.1.3. Collusion to Mislead the Third Party about the Transaction (Vicarious Liability for Fraud) A principal is vicariously liable for an agent’s fraud if the agent acts with apparent authority, even if the agent is a transactional agent and not an employee. This doctrine seems like a curious amalgam of the doctrines of apparent authority for contract and vicarious liability for physical injury. Like apparent authority, vicarious liability for fraud generally arises in cases where the agent seeks to make a contract with a third party on behalf of the principal. Like vicarious liability for physical torts, vicarious liability for fraud holds a principal accountable along with the agent for the agent’s wrongful behavior toward the third party. But unlike apparent authority, the consequence of vicarious liability for fraud is tort damages, not enforcement of the contract the agent sought to make. And unlike vicarious liability for physical torts, vicarious liability for fraud is not limited to employee agents. Of course, the fact that fraud itself can give rise to both contract and tort claims accounts for part of this different treatment, but does not provide a complete explanation. Under the collusion theory, the explanation for the separate and unique treatment of vicarious liability for fraud is that the nature of the collusive behavior is different in fraud cases. In fraud cases, the principal uses an agent to mislead the third party about the nature of the transaction the agent is making on the principal’s behalf. By contrast, in contract cases involving apparent authority, the concern is with the principal misleading the third party about the principal’s desire to enter into the transaction. Moreover, the principal’s ability to use agents to commit fraud is not limited to agents who are judgment-​proof, or agents who engage in unduly risky activity that can harm third-​party strangers. Thus, there is no justification for limiting vicarious liability to employee agents, as there is for vicarious liability for physical torts. Agency can facilitate fraud because agents can use the principal’s good name and reputation to lead a third party to have confidence in the legitimacy of a transaction. Absent vicarious liability for fraud, a principal would have too great an incentive either to look the other way (fail to monitor) when its agents commit frauds, or encourage its agents to commit frauds, that benefit the principal but enable the principal to deny having made any false statements itself. Courts are more willing to find vicarious liability for fraud than vicarious liability for intentional physical torts, which courts often find to be outside the “scope of employment.” One reason for that difference may be a suspicion that if the agent is acting with “apparent authority,” there is too much of a risk of potential gain (collusive benefit) to the principal to allow the principal to claim that the agent was committing fraud solely out of self-​interest. On the other hand, the claim that an agent committed an intentional tort solely for his own benefit and not in collusion with the principal is often (though not always) more plausible. Of course, if a court believes that an agent commits a fraud solely to benefit the agent and not the principal in any way, the court can find that the agent was not acting with apparent authority, and deny vicarious liability. In some well-​ known cases, for example, an agent makes some fraudulent side deal with the third party

 

408   GEORGE M. COHEN that the court finds too remote from the contract the agent is authorized to make to hold the principal vicariously liable. In those cases, collusion between the agent and the third party is more likely than collusion between the agent and the principal.

16.2.1.4. Collusion to Mislead the Third Party into Thinking that an Agency Relationship Exists (Apparent Agency) Closely related to vicarious liability for fraud is the doctrine of apparent agency, which holds a principal responsible for the conduct of someone the principal holds out to be an agent even though there is no actual agency relationship. Unlike vicarious liability for fraud, however, apparent agency is really two separate doctrines, one for contractual liability and one for tort liability (sometimes called vicarious liability by estoppel). Nevertheless, the collusion problem is essentially the same: principals and agents together mislead third parties into reasonably believing that an agency relationship exists when it does not. The difference between the contract and tort doctrines of apparent agency reflects the consequence of the agency relationship in the two contexts. In the contractual context, the same conduct that leads a third party to think there is an agency relation­ ship also leads the third party to think that the agent is acting with authority, and therefore that the principal wishes to be bound by the agent’s conduct. The doctrine of apparent agency relieves the third party of the cost of investigating the legitimacy and authority of the agent (in the absence of suspicious circumstances). In the tort context, the same conduct that leads the third party to think that there is an agency relationship also leads the third party to think that the agent is an employee acting within the scope of employment. That would lead the third party not to worry about investigating the quality or creditworthiness of the ostensible agent, assuming that the ostensible employer would be responsible for ensuring these things. Thus, for example, a law firm holding out a nonlawyer to a client as a lawyer would be responsible for that person’s malpractice (a contract violation as well as a tort). On the other hand, the firm would not be vicariously liable to a third party driver for a car accident the nonlawyer had on the way to see the client about her case. For the principal to be held liable, the nature of the collusive misleading must be connected to the harm caused by that misleading conduct.

16.2.1.5. Collusion to Mislead the Third Party into Thinking an Agency Relationship Does not Exist (Rights of Undisclosed Principal and Liability of an Undisclosed Principal’s Agent) Agency law has long allowed a principal to hide its identity in certain situations and then, after the agent makes a contract on the undisclosed principal’s behalf with a third party, to reveal the principal’s identity and claim that the third party has a contract with the principal as well as with the agent. On its face, the undisclosed principal rule seems to run counter to the collusion theory, under which agency law seeks to discourage principal–agent collusion to disadvantage the third party. The undisclosed principal device is in fact a form of principal–agent collusion to deceive the third party about the

 

LAW AND ECONOMICS OF AGENCY AND PARTNERSHIP    409 principal’s existence and identity, but agency law permits this collusive conduct because the benefits may outweigh its costs. Contract law allows one contracting party to withhold certain information from the other, in part to encourage and reward investment in information and expertise. In particular, one party need not truthfully disclose his reservation price to his contracting partner. In some cases, a contracting party’s identity itself conveys material information about how much that party values the contract, so that party would prefer to keep his identity secret. The classic example is a land assemblage situation, such as Disney buying up land in an area to build a theme park. The most effective way to give the contracting party a property right in his identity is to allow that party to make secret use of an agent intermediary. Thus, agency law allows the undisclosed principal device, despite its collusive nature, when the principal’s purpose is simply to capture more of the contractual surplus, and thereby protect its investments in information and expertise. On the other hand, if a principal and agent collude to hide the principal’s identity for other, illegitimate purposes, agency law steps in to protect the third party. For example, the undisclosed principal does not become a part of the contract, and so cannot sue the third party, if either the principal or the agent knew that the third party would not have dealt with the principal at all (as opposed to at a different price) if the third party had known the principal’s identity. A classic example of this rule would be a mediocre singer contracting as an undisclosed principal through an agent who is a talented signer, to perform for a third-​party customer.

16.2.1.6. Collusion to Mislead the Third Party about an Agent’s Solvency (Liabilities of Undisclosed Principal) Not only does agency law make third parties liable to undisclosed principals, but the law also makes undisclosed principals liable to third parties. Because, as noted above, the agent is liable on any contract made with a third party on behalf of an undisclosed principal, the main concern here is that the undisclosed principal may use an insolvent agent to make the contract with the third party. If the undisclosed principal were not on the hook for the contract made by the secret agent, the principal would be too tempted to use insolvent agents to make its contracts because it (as well as the agent) could escape liability if the contracts turned out poorly. Thus, the rationale for the liability of the undisclosed principal parallels the rationales for both the authority doctrine (collusion to prevent a free option in the principal) and the vicarious liability doctrine (collusion to have an insolvent agent commit wrongs against a third parry). The more controversial cases occur when the undisclosed principal claims that the alleged agent was in fact not an agent at all, and when the undisclosed principal claims that the agent acted without authority. One might think that the third party should bear the risk of the agent’s insolvency in this situation, for two reasons. First, because the undisclosed principal makes no manifestations to the third party, the undisclosed principal could not have deceived the third party about the undisclosed principal’s intentions to contract, as happens in cases involving apparent authority and apparent agency. Second, the third party dealt with the agent believing that the agent was a principal and

 

410   GEORGE M. COHEN so arguably should be responsible for investigating the agent’s financial circumstances. In some cases, however, the conduct of undisclosed principals can in fact mislead third parties about the agents’ solvency. In these cases, agency law steps in to protect third parties, even if they were negligent in failing to investigate the agent’s creditworthiness on their own. Perhaps the best-​known case in which a court found an undisclosed principal relationship despite the claim by the alleged undisclosed principal that there was no such relationship is A. Gay Jenson Farms v Cargill. In that case, Warren, a grain elevator, was an intermediary between Cargill and wheat-​growing farmers. The farmers sold their wheat on credit to Warren, which in turn sold the wheat to Cargill. Cargill also provided all the financing for Warren. Despite the fact that Warren was a poorly managed company (a fact recognized by Cargill), Cargill continued to finance Warren because it “wanted the grain.” Eventually, Warren filed for bankruptcy and the farmers, who as unsecured creditors stood to lose money on all their unpaid contracts, sued Cargill, claiming it had acted as Warren’s undisclosed principal. Although the farmers might have been able to make out a claim of apparent agency, the suit alleged only actual agency and the Minnesota Supreme Court upheld a judgment for the farmers. The court’s analysis is unsatisfying, though in my view its intuition was correct. The court found an agency relationship existed based on two provisions of the Restatement (Second) of Agency. The first, § 14O, says that a creditor can become a principal if it exercises sufficient control over its debtor. In this case, however, Cargill seemed to exercise too little control over Warren, not too much. Cargill did threaten to exercise control at various times, but the court pointed to no concrete evidence that Cargill ever actually exercised the kind of control that an owner would exercise. Moreover, the control that Cargill did exercise involved standard activities that creditors often undertake to help ensure that their loans are repaid. Unsurprisingly, the banking community was alarmed by the prospect of expansive “creditor liability” for everyday creditor conduct, and filed an amicus brief urging reversal of judgment for the farmers. The court attempted to assuage the banks by saying the case was unusual because Cargill was not merely acting as a creditor, but also as a buyer (in fact, Warren’s primary buyer), a role most banks do not play. In this part of its opinion, the court relied on Restatement § 14K, which says a buyer is a principal of the seller if the seller is acting on behalf of the buyer. The key question here is whether Warren operated an independent business, and from all appearances, it did, as Cargill emphasized in its brief. In particular, Warren seemed to earn profits and losses based on the difference between the price it paid farmers for the wheat (which Warren controlled) and the price it resold the wheat to Cargill. The court was correct to focus on the dual role of creditor and purchaser played by Cargill, but was not able to articulate exactly why this dual role mattered. In my view, the dual role might have enabled Cargill to collude with Warren (more precisely with Warren’s corrupt managers) against the farmers by manipulating (and therefore controlling) Warren’s profits. To see how this collusion could occur, consider the fact that the relations among Cargill, Warren, and the farmers involved three transactions: Warren’s purchase from the farmers, Cargill’s loan to Warren, and Cargill’s purchase from

 

LAW AND ECONOMICS OF AGENCY AND PARTNERSHIP    411 Warren. Suppose that Warren paid $1000 to a farmer for wheat, and that Cargill lent Warren the $1000 to buy the wheat. Cargill would presumably charge some interest rate, i, to Warren for the loan. Cargill would then pay Warren some amount for the wheat, presumably with some markup, π over the $1000 Warren paid. Thus, Warren’s real profit on the deal (ignoring other costs) as not simply the markup, but π – i: that is, unless Warren’s markup exceeded its interest costs, it was not making any real profit on the transaction. Because Cargill was Warren’s sole lender (no bank would lend money to Warren given its poor management and prospects for repayment) as well as its primary purchaser (Cargill also had a right of first refusal on all grain sold by Warren), Cargill effectively controlled both the resale price and the interest rate on the loan. Therefore Cargill completely controlled Warren’s profit. Given this ability to control Warren’s profit, Cargill could have colluded with Warren’s managers to the detriment of the farmers. To ensure a supply of grain, Cargill could have told Warren to pay the farmers more than the market price on condition that Cargill would fully finance the overpayment. Under the previous example, suppose the market price was only $900 rather than $1000. The above-​market price would induce the farmers to sell to Warren. If 10% was a competitive markup, and Cargill paid a $100 markup to Warren (i.e., $1100), Cargill would lose money because the competitive price for the wheat in the resale transaction would be only $990 (a 10% markup over the $900 wholesale market price). If, however, Cargill charged Warren 11% interest on its $1000 “loan,” or $110, Cargill would effectively be buying the wheat for the resale market price ($110 – $1100 = –$990). Only the ability to collude with an unrevealed agent makes this scheme possible. If Warren were an ordinary agent working for a disclosed principal, Cargill would be liable for the full $1000 (above-​market) price that Warren agreed to pay the farmers. If Cargill were merely a creditor, even a secured creditor, it would not be lending $1000 to Warren so that it could buy goods worth only $900. Finally, if Cargill were merely a buyer on resale, it would not be paying $1100 for goods worth only $990. Holding Cargill liable sent a message that courts would not allow a principal to use the undisclosed principal device to collude with an agent to mislead third parties about the agent’s solvency. An equally well-​known case that resembles Cargill (and is as infrequently relied upon by courts), though it involves the liability of an undisclosed principal for the unauthorized acts of an actual agent, is the old English case, Watteau v Fenwick. In Watteau, a man who appeared to be the owner of a tavern but was in fact the agent of an undisclosed principal, purchased supplies for the tavern from a third party and then did not make payment. The court held that the third party could recover from the undisclosed principal. The Watteau rule discourages undisclosed principals from hiring insolvent agents to make contracts on their behalf, while creating the impression that the agent owns the assets of the business. Absent the rule, the undisclosed principal could later claim the contracts were “unauthorized,” either to get a free option to avoid contracts that turned out poorly or simply to split the saved expenses secretly with the agent. Although Watteau does in some sense excuse a third party’s negligent failure to investigate the agent’s creditworthiness, putting a greater priority on deterring collusive behavior by the undisclosed principal and the agent is defensible. By deciding to hide

 

412   GEORGE M. COHEN its identity, the undisclosed principal deliberately increases the costs to the third party of determining the true ownership of the assets. Because the whole point of the undisclosed principal device is to discourage third party investigation, the principal who uses the device should not then be able to claim that it was harmed because the device worked exactly as it was supposed to.

16.2.1.7. Collusion to Mislead the Third Party about the Principal’s Solvency (Undisclosed Principal, Warranty of Authority) Another way agency law discourages illegitimate collusion in the undisclosed principal context is to bind the agent as well as the undisclosed principal to the contract the agent makes with the third party. This rule contrasts with the rule of agency authority, under which if the agent for a disclosed principal binds the principal to a contract with a third party, only the principal is bound, and not the agent. In the disclosed principal situation, if the principal is bound, the third party gets exactly what it contracted for and there is no reason to think the parties intended to have the agent act as guarantor of the contract unless the agent expressly agreed to do so. The difference between the undisclosed and disclosed principal situations is that in the undisclosed principal situation there is a risk of collusion to mislead the third party about the solvency of its contracting partner. If the third party thinks that the principal is its contracting partner, as in the disclosed principal case, the third party will likely investigate the principal’s creditworthiness. By contrast, in the case of an undisclosed principal, if not for the rule that the agent is contractually bound as well as the undisclosed principal, an insolvent undisclosed principal could contract using a creditworthy agent to buy on credit from a third party, who necessarily relies on the agent’s good credit to make the contract. The undisclosed principal case also contrasts with the disclosed principal situation in the event that the agent for a disclosed principal purports to act with authority, and attempts to contract with a third party, but in fact leaks actual or apparent authority. In this case, the agent is personally liable to the third party for breach of the agent’s implied warranty of authority, but the principal is not liable on the contract. The third party cannot recover against even the agent under this theory, however, if the principal is insolvent. The key to the implied warranty of authority is the absence of collusion. If the agent acts without actual or apparent authority, then that suggests the agent has not colluded with the principal to mislead the third party, whether about authority or about the principal’s solvency, but has acted unilaterally. Hence, the agent should be liable, but not the principal. Moreover, if the principal is disclosed, the third party should be investigating the principal’s creditworthiness, so even if the agent breaches its warranty of authority, the liability should be limited to the amount the third party would have been able to recover from the principal had the agent been authorized. Of course, if the third party can prove that the agent is in a position to control the principal (e.g., if the agent is the CEO of a close corporation) and caused the principal’s insolvency, the third party would presumably be able to recover. That would be a case of actual collusion rather than presumed collusion.

 

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16.2.1.8. Collusion to Shield the Principal from Harmful Information (Notification and Imputed Knowledge) A final way a principal can collude with an agent to impose costs on third parties is to use the agent to shield the principal from harmful information. Many legal obligations and liabilities are triggered by a person’s either having received a notification of some fact or subjectively knowing some fact. To avoid such consequences, a principal might be tempted to direct an agent to receive notifications sent to the principal, or to learn relevant information, and then not convey the notification or information to the principal. Once again, agency law rules discourage this type of collusive conduct, in this case by imputing an agent’s knowledge to the principal if that knowledge is within the scope of the agent’s responsibilities, and by deeming notifications to an agent sufficient if an agent is either actually or apparently authorized to receive them.

16.2.2.  Agent–Third Party Collusion Agents can decide to throw in their lot with third parties rather than collude with the principal against third parties. Because agents often have advantages over the principal in terms of expertise, control over the principal’s assets, and the difficulties of being monitored, this collusive possibility raises obvious problems. The possibility of agent–​ third-​party collusion is the main reason that the law imposes fiduciary duties, most notably the duty of loyalty, on agents. But the possibility of agent–third-​party collusion also explains a number of limits on the doctrines discussed in the previous section. Under apparent authority, for example, third parties must reasonably believe, based on some manifestation from the principal, that the agent is authorized. The less reasonable the third party’s belief, the more likely it is that the third party is really colluding with the agent against the principal’s interests rather than that principal and agent are colluding to mislead the third party. Similarly, if the agent is acting with the third party against the interests of the principal, the doctrine of imputed knowledge does not apply under the “adverse interest” exception.

16.2.3.  Principal–Third Party Collusion It may seem odd to think that principals can collude with third parties, since the whole point of transactional agency is to relieve the need for principals to have to deal directly with third parties. Although it is true that principal–third-​party collusion is probably the least common of the three collusive possibilities, this type of collusion does explain some aspects of agency law. Most notably, agency law protects against the possibility of the principal and the third party cutting the agent out of his commission once the agent expends the effort to find the third party and make the principal aware of its interest in contracting.

 

414   GEORGE M. COHEN More generally, agency law imposes some duties on principals in their relationships with agents that go beyond ordinary contract duties. For example, principals owe a duty of indemnity to agents who incur certain costs and liabilities in the course of doing their work. This duty makes sense if one thinks about the possibility of principal collusion with the third party. The contract that the principal and third party ultimately make could impose costs and risks on the agent that the agent may be unaware of and may find it difficult to protect against. In some sense, the duty of indemnity parallels vicarious liability in that the ability of the principal to control certain risks justifies putting the liability on the principal instead of allowing the principal to shift the risk to someone else (here the agent rather than the third party). Another duty owed by the principal is the duty to act in good faith toward the agent. Absent this duty, the principal could unfairly collude with the third party to shift the blame for poor service from the principal to the agent and thus unreasonably harm the agent’s reputation in the market.

16.3.  Partnership Law and the Problems of Shared Ownership and Control Partnership law differs from agency because it involves multiple owners. The partnership device facilitates transactions by promoting the pooling of resources. At the same time, the partnership relationship poses unique risks. It is useful to group these risks into two categories: partners acting together on behalf of the partnership against the interest of third parties; and partners acting with third parties against the interests of the partnership. This section considers these possibilities in turn.

16.3.1. Partnership Transactions, Interactions with Third Parties, and Interpartner Collusion One of partnership law’s primary concerns is the regulation of interactions between the partnership and third parties. As in agency, the interactions may generally be divided into the beneficial ones (contracts) and harmful ones (torts). Recognizing the partnership as an entity and making the partnership entity responsible for both types of interactions reduces the overall costs of these interactions. Nevertheless, much of what makes partnership law in this area unique is its focus on the role of, and problems created by, divided ownership and control.

 

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16.3.1.1. Partner Authority to Contract with Third Parties The existence of multiple owners creates potentially more complicated questions of authority than those in agency law, and additional collusive possibilities, because partners can collude with each other, as well as with non-​partner agents of the partnership, to mislead third parties about the partnership’s intention to contract. Partnership law, like agency law, deters collusive behavior through its rules determining which partners have authority to bind the partnership or authorize other non-​partner agents to bind the partnership. First, the current version of the Uniform Partnership Act makes all partners agents of the partnership and gives them apparent authority to bind the partnership so long as the partner is “apparently carrying on in the ordinary course the partnership business or business of the kind carried on by the partnership.” The apparent authority of a partner is generally broader than that of an agent, and is similar to agency law’s inherent agency power doctrine, under which agents placed in general managerial positions can bind their principals even in the absence of apparent authority. Unlike apparent authority in agency, which requires a principal to “manifest” to a third party that the agent has authority (though manifestation can include putting the agent in a position that normally includes certain authority), the only manifestation necessary for a partner to have apparent authority is the partner’s position as a partner. Moreover, partnership apparent authority does not require a “reasonable belief ” by the third party in the partner’s authority, as agency law does. Nor does it impose any duty of inquiry on third parties. Instead, partnership law entitles third parties to presume that all partners have the right of full control over the business. One explanation for the broader rule of apparent authority in partnership law than in agency law is the possibility of collusion among partners, who co-​own the business and share in its control, to mislead third parties about a contracting partner’s authority. Absent the partnership apparent authority doctrine, partners, for example, could secretly agree to limit a contracting partner’s actual authority while knowingly permitting that partner to represent to third parties that he is authorized to bind the partnership. Or a contracting partner could insist to the third party that he is acting with authority while another partner asserts the opposite. In either case, if the contracting partner were deemed to lack authority, the partnership would have the free option described in the agency section of this chapter. Although these problems resemble principal–​agent collusion in agency law, agency law treats the principal as a unity, and does not deal with the additional risks imposed on a third party who deals with a divided principal. Broadening apparent authority beyond that in agency law is one way to discourage the additional collusive technique present in partnership. The broader partnership apparent authority rule acts as a penalty or information-​forcing default to induce the partnership to disclose to third parties any limitations on an individual partner’s authority rather than keep those limitations secret. Moreover, the partnership apparent authority rule relieves the third party not only from having to investigate such

 

416   GEORGE M. COHEN limitations, which defeats the cost-​saving purpose of transactional agency, but also from having to resolve inter-​partner disputes (whether real or feigned) over authority. Partnership law does protect the partnership against partner–third-​party collusion by denying the third party the right to enforce a contract when the risk of partner–​third-​ party collusion is great. Thus, a third party cannot claim that a partner acted with apparent authority if the contract was outside the ordinary course of the partnership business, if the third party had actual knowledge of the partner’s lack of actual authority, or if the partnership sent a notification to the third party stating that the partner lacks authority. In the case of a partner acting outside the ordinary course of partnership business, a third party can still prevail if it can prove that the contracting partner acted with actual authority. As in agency law, allowing the third party the right to enforce the contract against the partnership if the contracting partner acts with actual authority, even if there was no apparent authority, prevents collusive misleading of the third party. In the absence of this rule, the other partners could hide the contracting partner’s authority and so preserve the free option to decide whether to accept the contract after its formation. Nevertheless, the scope of actual authority in partnership for acts outside the ordinary course of partnership business is relatively limited because partnership law requires the partners to agree unanimously to any such act. The ability of a person who never was or no longer is a partner to bind a partnership is more limited than the broad apparent authority rule for an actual, current partner. With respect to transactions made by an apparent partner (partner by estoppel), only those partners consenting to the representation of authority by the apparent partner are bound, and the partnership is bound only if the actual partners unanimously consent. When a third party contracts with a non-​partner, there is a greater risk of collusion between the apparent partner and the third party than in the case where the third party contracts with an actual partner, where inter-​partner collusion against the third party is the greater risk. Thus, in the apparent partner situation, partnership law switches the presumption and requires the third party to prove actual collusion (consent) by the other partners to mislead the third party before the partners will be bound. In addition, with respect to a former (dissociated) partner, although the partnership statute provides a limited term of “lingering apparent authority” to protect third parties who deal with the dissociated partner, the statute imposes a reasonable belief requirement on third parties, including a duty of inquiry into the partner’s departure. The Revised Uniform Partnership Act also permits the partnership to protect itself against lingering apparent authority by filing a statement of dissociation, which third parties are deemed to know about after a certain time. Again, once a partner leaves the partnership, the law is more hesitant to presume that the former partner is colluding with the remaining partners, at least after a certain period of time. The increased risk of the former partner colluding with the third party against the partnership justifies the greater responsibility placed on the third party to learn of the partner’s departure.

 

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16.3.1.2. Partner Torts and Vicarious Partnership Liability Just as a partnership entity can make contracts through non-​partner agents, a partnership entity is vicariously liable for the torts of its employees. In both cases, agency law applies and there is no special role for partnership law beyond a rule recognizing the partnership as an entity. What is unique about the partnership law of vicarious tort liability, however, is that it extends to torts committed by partners, even though the law distinguishes partners, who are co-​owners, from employees, who are not. One reason for this extension of vicarious liability is that from the perspective of the purposes of vicarious liability, the distinction between partners and employees who commit torts does not matter. It is true that the default rule of partnership law is that all partners, unlike employees, share equally in the profits of the business, and therefore the insolvency concern appears at first glance weaker than in the case of employees. Absent vicarious liability for partner torts, however, partnerships would have an incentive to admit into the partnership insolvent partners to engage in the partnership’s activities creating the greatest risk of tort liability. Moreover, because partnership law gives each partner equal rights to control the business (as a default), the partners as a collective, and thus the partnership as an entity, can exercise significant control over an individual partner’s behavior. That control includes not only control over how a partner exercises his responsibilities as a partner but also control over whether, how often, and under what conditions, the partner undertakes potentially risky conduct, as well as control over the partnership’s investments in precaution taking. Thus, the concern that partners might collude against third parties by agreeing to shift control over and responsibility for risky activities to only a subset of insolvent partners justifies extending vicarious tort liability of the partnership to partner torts.

16.3.1.3. Vicarious Partner Liability for Contracts and Torts A big issue in partnership law is the vicarious personal liability of partners for the contracts and torts of a general partnership. Although partners are agents of the partnership, non-​partner agents have only personal liability for their own torts and no liability for authorized contracts they make on behalf of their principals. Principals are liable for authorized contracts made by their agents as well as for the torts of their employees committed in the scope of employment. But if the partnership is an entity and the entity is the principal, the question naturally arises why partners should bear personal vicarious liability for acts of the partnership in which they were not involved. In fact, the general partnership is unique among business entities in imposing such personal liability, and the modern trend in entity law is the development of new entity forms that keep all or some aspects of partnership law, but discard personal vicarious liability for co-​owners. Is there a justification for personal vicarious liability for general partners? The basic problem is that absent vicarious partner liability, the partners could collude to undercapitalize the partnership entity ex ante, or have the partners drain the partnership of assets ex post (i.e., after some liability arises). Non-​partner agents generally do not have similar ability to deplete the principal’s assets, apart from managerial agents who would generally

 

418   GEORGE M. COHEN face personal liability for any asset depletion that occurs. If the partnership entity lacks sufficient partnership property to satisfy contract and tort judgments, and only the entity is liable, the partners will have insufficient incentives to honor the partnership’s contract obligations and take reasonable precautions to avoid partnership torts against third parties, and hence provide proper incentives for reasonable behavior. The problem is analogous to the undisclosed principal problem in agency: agency law keeps the agent on the hook for contracts made on behalf of an undisclosed principal because of the danger that the agent could be shilling for a shell principal, albeit a disclosed one. Here the partners are the relevant agents and the partnership is the potential shell principal. To combat this collusive concern, the law of general partnership (the default business entity for multiple owners) makes all partners personally liable for all the debts of the business, whether arising out of contracts or torts. Of course, in contractual situations, partnership creditors could protect themselves even in the absence of personal partner liability by investigating the partnership assets, by insisting on restrictions on distributions of partnership property to the partners, or by requiring personal guarantees of partners. The law of general partnership essentially relieves partnership creditors of the cost and expense of taking these actions, or of pursuing separate claims against partners who wrongfully deplete the partnership coffers. By contrast, in tort cases involving victims not in a contractual relationship with the partnership, the stranger victims have no ability to make such bargains, so the case for personal partner liability is stronger. The traditional alternative entity to the general partnership that maintains many of the attributes of the general partners but restricts personal liability is the limited partnership. A limited partnership has at least one general partner, who remains personally liable, and at least one limited partner, who does not incur vicarious personal liability. The tradeoff for eliminating personal liability for limited partners is that the limited partners do not get to participate in the control of the business. Thus, limited partners do not contract on behalf of the firm, nor can they act to affect the likelihood of risky conduct by the partnership, nor do they have the ability to undercapitalize the firm. In fact, allowing limited partnerships may actually increase the likelihood that the firm would be sufficiently capitalized, as the limited partners, who are in effect passive investors, contribute additional capital to the firm that the firm might not otherwise have. Moreover, third-​ party contract creditors have an additional layer of protection because they can rely on the assets of the general partner as well as the assets of the limited partnership. More recently, the law has recognized limited liability partnerships, limited liability companies, and other similar entities, which offer all co-​owners limited liability, without restricting their ability to share in the control of the business. To secure the benefits of limited liability, however, these entities must (like limited partnerships) provide some kind of notice to third-​party contractors of their status. As a result, contracting parties can attempt to protect themselves by demanding personal guarantees from members of the limited liability entity. Tort cases involving third-​party victims not in a contractual relationship with the entity present a bigger concern, though the law applicable to these entities attempts to respond to this concern in several ways. First, all co-​owners remain liable for their own torts, which include torts such as negligent supervision of co-​owners

 

LAW AND ECONOMICS OF AGENCY AND PARTNERSHIP    419 and other agents for co-​owners that exercise managerial authority. This direct liability could extent broadly in smaller organizations in which all or a large percentage of co-​ owners are often involved in management. Second, limited liability statutes may require that the entity maintain a minimum amount of liability insurance. Third, courts may apply the doctrine of “veil piercing” in some cases (such as fraud) to defeat the limited liability shield. Given the relative novelty of these entities in the United States, the jury is still out on how effective these protections are.

16.3.2. Misappropriation of Partnership Property and Partner Collusion with Third Parties Apart from partner interactions with third parties, the other key feature of partnership law that distinguishes it from ordinary agency is the fact of co-​ownership of partnership property. As is the case with third-​party interactions, the entity theory of partnership plays an important role here because making the partnership entity the nominal holder of partnership property reduces transaction costs. Once again, however, addressing the problems created by multiple ownership is also important. As already noted in the previous section, general partners typically have a greater ability than non-​partner agents (apart from managerial agents) to control partnership property. But the power to control is the power to abuse that control. Whereas the previous section focused on the danger of partners acting jointly on behalf of the partnership in ways that harm third parties, the concern in this section is that partners may collude with third parties (or with other partners) against the partnership with respect to the partnership property. Unlike the rules designed to protect third parties against collusive inter-​partner behavior, however, the rules designed to deter collusion against the partnership are generally defaults. The partners can decide, in the partnership agreement or at the time the conduct is proposed, whether specific conduct in fact poses a serious collusive risk. Partnership law has a number of features that protect partnership property from misappropriation by partners. Specifically, the fiduciary duties of partners aim to deter partners from failing to enhance partnership property by depriving the partners of opportunities rightfully belonging to the partnership; from diminishing existing partnership property by acting on behalf of a party with an adverse interest to the partnership; and from reducing the returns to partnership property by competing against the partnership business. Although some fiduciary duty breaches involve a partner acting unilaterally (e.g., self-​dealing), in many cases, the partner acts in combination with some third party, or with another partner. Even if partner conduct does not amount to a breach of fiduciary duty, the partnership statute forbids partner conduct that threatens to harm, interfere with, or otherwise adversely affect partnership property. First, the statute provides that partnership property belongs to the partnership entity, and not to the individual partners. Second, partners may use partnership property only for the benefit of the partnership, and not for their

 

420   GEORGE M. COHEN own purposes or the purposes of others. Third, a partner has no right to receive, and cannot be forced to accept, a distribution “in kind,” that is, of nonmonetary partnership property. Fourth, a specific application of rule prohibiting in-​kind distributions is that even on dissolution of the partnership, in-​kind distributions are forbidden without partner consent. Instead, the partnership property is to be “liquidated” and the proceeds distributed to the partners. Together, these rules send a message to partners that once property becomes partnership property, any non-​partnership use by partners of partnership property is effectively deemed a misappropriation in the absence of ex ante or ex post partner­ ship consent. That is, to encourage partners to focus their energies on investing in the partnership, partnership law requires partners to use partnership property only to benefit the partnership as a whole, including satisfying partnership debts, not to benefit any particular partner or group of partners. In general, benefiting the partnership as a whole means keeping the partnership property whole, to maximize its ongoing value either for internal partnership use, or for potential sale to others. Finally, partners cannot use partnership property to satisfy their own personal debts and other non-​partnership obligations. The only property the creditors of individual partners can access is the partner’s “interest in the partnership,” that is, the monetary distributions the partner is entitled to get as a partner. Creditors of individual partners cannot—​by virtue of their relationship with the debtor partner—​exercise any control over the partnership property. Professors Hansmann and Kraakman have argued that this rule, which they call asset partitioning, is one of the prime benefits of recognizing legal entities. But the rule is also of a piece with the other partnership rules designed to protect the co-​owned property from misappropriation by one or more partners acting in combination with a third party, in this case the creditor of an individual partner, against the interests of the partnership. The rule is also a specific application of the more general rule that requires (again as a default) all partners to consent to the admission of a new partner into the partnership. New partners who enjoy broad support of the existing partners may be less likely to collude with one or a group of partners against the interests of the partnership, or to collude with third parties, and more likely to act to maximize the value of the partnership property.

16.4. Conclusion This chapter has attempted to explain how agency and partnership bridge the gap between contract and the firm. Both agency and partnership facilitate contracting, the first by enabling contractual intermediation, and the second by enabling the pooling of resources in the joint pursuit of an enterprise. The main concern of agency law, however, is to address the problems caused by moving from the two-​party contractual relations to three-​party relationships, which creates the potential for any two parties to collude against the interests of the third. Partnership differs from agency in that it involves multiple owners who have the right and ability to exercise control over shared partnership

 

LAW AND ECONOMICS OF AGENCY AND PARTNERSHIP    421 property. That fact creates a need for partnership law to address additional collusive possibilities involving partners, whether acting on behalf of the partnership in dealing with third parties or acting against the interest of the partnership by misappropriating the partnership property.

References A. Gay Jenson Farms Co v Cargill, Inc, 309 N.W.2d 285 (Minn. 1981). Alchian, Armen and Demsetz, Harold. 1972. “Production, Information Costs, and Economic Organization.” American Economic Review 62, pp. 777–​795. American Law Institute. 1959. Restatement of the Law Second: Agency. St. Paul, MN: American Law Institute Publishers. American Law Institute. 2006. Restatement of the Law Third: Agency. St. Paul, MN: American Law Institute Publishers. Ayotte, Kenneth and Hansmann, Henry. 2013. “Legal Entities as Transferable Bundles of Contracts.” Michigan Law Review 111, pp. 715–​758. Ayotte, Kenneth and Hansmann, Henry. 2015. “A Nexus of Contracts Theory of Legal Entities.” International Review of Law and Economics 42, pp. 1–​12. Barnett, Randy E. 1987. “Squaring Undisclosed Agency Law with Contract Theory.” California Law Review 75, pp. 1969–​2003. Coase, R. H. 1937. “The Nature of the Firm.” Economica 4, pp. 386–​405. Coase, R. H. 1960. “The Problem of Social Cost.” Journal of Law and Economics 3, pp. 1–​44. Cohen, George M. 1998. “When Law and Economics Met Professional Responsibility.” Fordham Law Review 67, pp. 273–​299. Cohen, George M. 2015. “Liability of Insurers for Defense Counsel Malpractice.” Rutgers Law Review 68, pp. 119–​153. Cooter, Robert and Freedman, Bradley J. 1991. “The Fiduciary Relationship:  Its Economic Character and Legal Consequences.” New York University Law Review 66, pp. 1045–​1075. De Mott, Deborah A. 1995. “Our Partners’ Keepers? Agency Dimensions of Partnership Relationships.” Law and Contemporary Problems 58, pp. 109–​134. Easterbrook, Frank H. and Fischel, Daniel R. 1993. “Contract and Fiduciary Duty.” Journal of Law and Economics 36, pp. 425–​446. Garoupa, Nuno and Ulen, Thomas S. (2013). “The Economics of Activity Levels in Tort Liability and Regulation.” In: Thomas J. Miceli and Jatthey J. Baker, eds., Research Handbook on Economic Models of Law. Northampton, MA: Edward Elgar Publishing. Hansmann, Henry. 1996. The Ownership of Enterprise. Cambridge, MA: Belknap Press. Hansmann, Henry and Kraakman, Reinier. 2000. “The Essential Role of Organizational Law.” Yale Law Journal 110, pp. 387–​440. Holmes, Oliver Wendell, Jr. 1891a. “Agency II.” Harvard Law Review 5, pp. 1–​23. Holmes, Oliver Wendell, Jr. 1891b. “Agency.” Harvard Law Review 4, pp. 345–​364. Hynes, J. Dennis. 1991. “Lender Liability: The Dilemma of the Controlling Creditor.” Tennessee Law Review 58, pp. 635–​668. Hynes, J. Dennis and Loewenstein, Mark J. 2015. Agency, Partnership, and the LLC: The Law of Unincorporated Business Enterprises: Cases, Materials, Problems. 9th ed. New Providence, NJ: LexisNexis.

 

422   GEORGE M. COHEN Jensen, Michael and Meckling, William. 1976. “Theory of the Firm:  Managerial Behavior, Agency Costs and Ownership Structure.” Journal of Financial Economics 3, pp. 305–​360. Kornhauser, Lewis. 1982. “An Economic Analysis of the Choice Between Enterprise and Personal Liability for Accidents.” California Law Review 70, pp. 1345–​1392. Laffont Jean-​Jacques and Tirole, Jean. 1990. “Cost Padding, Auditing and Collusion.” Annals of Economics and Statistics 25/​26, pp. 205–​226. Landes, William M. and Posner, Richard A. 1987. The Economic Structure of Tort Law. Cambridge, MA: Harvard University Press. Mercuro, Nicholas and Medema, Steven G. 1997. Economics and the Law:  From Posner to Postmodernism. Princeton: Princeton University Press. National Conference of Commissioners on Uniform State Laws, Uniform Partnership Act (1997). Orts, Eric W. 1998. “Shirking and Sharking: A Legal Theory of the Firm.” Yale Law and Policy Review 16, pp. 265–​329. Posner, Richard A. 2011. Economic Analysis of Law. 8th ed. New York: Aspen Publishers. Rasmusen, Eric. 2004. “Agency Law and Contract Formation.” American Law and Economics Review 6, pp. 369–​409. Seavey, Warren A. 1949. Studies in Agency. New York: West Publishing Company. Shavell, Steven. 1987. Economic Analysis of Accident Law. Cambridge, MA:  Harvard University Press. Spulber, Daniel F. 1999. Market Microstructure:  Intermediaries and the Theory of the Firm. Cambridge: Cambridge University Press. Sykes, Alan O. 1984. “The Economics of Vicarious Liability.” Yale Law Journal 93, pp. 1231–​1280. Sykes, Alan O. 1988. “The Boundaries of Vicarious Liability:  An Economic Analysis of the Scope of Employment Rule and Related Legal Doctrines.” Harvard Law Review 101, pp. 563–​609. Tirole, Jean. 1986. “Hierarchies and Bureaucracies: On the Role of Collusion in Organizations.” Journal of Law, Economics and Organization 2, pp. 181–​214. Tirole, Jean. 1988. “The Multicontract Corporation.” Canadian Journal of Economics 21, pp. 459–​466. Tirole, Jean. 1992. “Collusion and the Theory of Organizations” In: Jean-​Jacques Laffont, ed., Advances in Economic Theory: Sixth World Congress. Vol. 2. New York: Cambridge University Press. 151–206. Watteau v Fenwick, 1 Q.B. 346 (1893). Westerfield, Ray Bert. 1915. Middlemen in English Business 1670-​1730. New Haven, CT: Yale University Press. Whincop, Michael J. 1997. “Nexuses of Contracts, the Authority of Corporate Agents, and Doctrinal Indeterminacy: From Formalism to Law and Economics.” University of New South Wales Law Journal 20, pp. 274–​310. Williamson, Oliver E. 1985. The Economic Institutions of Capitalism. New York: The Free Press.

 

Chapter 17

BANKING AND FI NA NC IA L REGUL AT I ON Steven L. Schwarcz

17.1. Introduction Banking and financial regulation (which, hereafter, I will refer to simply as financial regulation) is needed because the financial system provides functions that are essential to economic development.1 The principal function is the aggregation of moneys and the allocation thereof for productive projects. Although each nation regulates banking and finance in its own ways, the universal nature of finance drives a natural convergence in the nature of financial regulation. This chapter thus focuses on the universal principles of financial regulation.

17.1.1. Banking Traditionally, financial regulation focused on banking because banks historically have been the primary entities that have aggregated moneys—​primarily by taking deposits from customers—​and then allocated such monies—​primarily by making loans—​to borrowers to invest in productive projects, such as factories. Traditional financial regu­ lation, therefore, is geared to ensuring that deposit-​taking banks can continue to perform these functions efficiently. 1 

Steven L. Schwarcz is Stanley A. Star Professor of Law & Business, Duke University School of Law; Founding Director, Duke Global Financial Markets Center. E-​mail: [email protected]. I thank Lorna Knick, Duke Law School Class of 2015, for excellent research assistance, and gratefully acknowledge support that has been provided in part by a gift to Duke Law School from the Eugene T. Bost, Jr. Research Professorship of The Cannon Charitable Trust No. 3. Portions of this chapter are based in part on my forthcoming article, “Regulating Financial Change: A Functional Approach,” 100 Minnesota Law Review 1441 (2016), also available at http://​ssrn.com/​abstract=2469467.

 

424   STEVEN L. SCHWARCZ

17.1.2. Shadow Banking In recent years, non-​banks have increasingly begun replacing (“disintermediating”) traditional banks as the intermediaries of funds—​that is, the entities that aggregate moneys and then allocate such monies to firms to invest in productive projects. Shadow banking is a loose term that refers to this process of disintermediation.2 The size of the shadow-​ banking sector—​which includes securitization, money-​market mutual funds, hedge funds, securities lending, asset-​backed commercial paper (“ABCP”) conduits, structured investment vehicles (“SIVs”), and repo financing—​was estimated at $60 trillion worldwide in December 2011.3 Estimates that are more recent suggest an even higher number.4 Several reasons, including efficiency and regulatory arbitrage, account for the rapid rise of shadow banking. Shadow banking can be efficient because disintermediation removes traditional banks as the “middleman” of funding, thereby avoiding the profit mark-​up that banks charge on their loans. Furthermore, in markets where traditional banks cannot flexibly operate owing to overly restrictive regulation, shadow banks can help to fund unmet demands.5 The response to Regulation Q in the US is but one example of this. Regulation Q imposed limits on the interest rates that banks could pay to depositors, creating an unmet demand—​especially by institutional depositors—​for higher returns. That demand sparked the rise of money-​market mutual funds, which offered much higher rates of return than bank deposits.6 Regardless of the reasons for the rise of shadow banking, the failure of financial regulation to address adequately that rise “is widely believed to have contributed to the buildup of risks in the financial system in the period leading up to” the 2008 global financial crisis (the “financial crisis”).7 Financial regulation must also focus on shadow banking.

2 

See Schwarcz (2012, “Regulating Shadow Banking” 619). Halstrick (2011). 4  See Fin. Stability Bd., Global Shadow Banking Monitoring Report. 2012. http://​www. financialstabilityboard.org/​publications/​r_​121118c.pdf [Accessed 29 September 2016] (estimating shadow banking’s worldwide assets as $67 trillion in 2011). Cf. Prasso (2014), reporting that the Financial Stability Board believes that shadow banking grew by $5 trillion in 2012 to $71 trillion. 5  Lane (2013). 6  Macey (2011, 131 and 138). Sometimes, however, shadow banking can result from pure regulatory arbitrage, without efficiency considerations. For example, in the context of mortgage lending, bank holding companies (BHCs) can lend through affiliated depository institutions (ADIs) or affiliated mortgage companies (AMCs). Whereas ADIs are chartered and subject to banking regulations, including capital requirements, underwriting requirements, and strict accounting practices, AMCs are not subject to any such regulation. See Demyanyk and Loutskina (2014). By using an AMC instead of an ADI, BHCs can avoid regulation and can engage in riskier lending practices, ibid. 7  Anabtawi and Schwarcz (2013, 75 and 85). See also Bernanke (2012), arguing that mortgage lending through AMCs, discussed supra footnote 6, encouraged risky lending practices that contributed to the financial crisis. 3 

 

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17.1.3. Some Fundamentals Actual financial regulation tends to be imperfect. Policymakers and regulators tend to respond to the media, which can create distortions by emphasizing what journalists find accessible. Furthermore, after a financial crisis, people naturally want to prevent the next crisis. Regulators, who are themselves usually subject to political short-​termism, typically respond by focusing on preventative regulation, or at least regulation aimed at preventing the next financial meltdown. But that focus is insufficient because it is impossible to always predict the cause of the next financial crisis. Moreover, financial regulation is often tethered to the financial architecture—​the particular design and structure of financial firms, markets, and other related institutions—​ at the time the regulation is promulgated. Ongoing monitoring and updating of that regulation can be costly, however, and is subject to political interference at each updating stage. Notwithstanding these distortions, financial regulation is enacted. In discussing such regulation, it is useful to distinguish what economists sometimes call microprudential and macroprudential regulation. Financial regulation of the components of the financial system—​fundamentally firms and markets—​to ensure that they can efficiently perform their underlying economic functions is called microprudential regulation. Financial regula­ tion of the financial system’s ability to function as a network within which its components can operate is called macroprudential regulation, and thus the goal of macroprudential regulation is to prevent “systemic” risk. As will be discussed, there is some overlap in these terms.

17.2.  Microprudential Regulation As mentioned, microprudential regulation focuses on ensuring that firms and markets, the components of the financial system, can efficiently perform their underlying economic functions. In general, firms and markets operate efficiently absent “market” failures; hence, the goal of microprudential financial regulation is to correct market failures.

17.2.1. Correcting Market Failures 17.2.1.1. Information Failure A key market failure is information failure, which can undermine the reliability of pricing. Funding depends on reliable pricing. Regulation could therefore improve funding by correcting this market failure. The principal information failure is information asymmetry, referring to parties to a transaction having different amounts of relevant information. For example, an issuer

 

426   STEVEN L. SCHWARCZ of financial securities usually has more (and better) information than investors in the securities about the risks. Increasing financial complexity is exacerbating this failure, by undermining disclosure, which since the securities laws of the 1930s has been the chief regulatory tool to reduce information asymmetry. Securities laws generally rely on disclosure, but some financial structures are getting so complex that they are effectively incomprehensible. It may even be rational sometimes for an investor to invest in high-​yield complex securities without fully understanding them. There may be many reasons for this. For example, the investor simply may not have the staffing to evaluate the securities, whereas failure in invest would appear to—​and in fact could—​competitively prejudice the investor vis-​à-​vis others who invest.8 Thus, many institutional investors—​including even the largest, most sophisticated, firms—​bought complex mortgage-​backed securities prior to the financial crisis without fully understanding them.9 Financial complexity is inevitable. Profit opportunities are inherent in complexity, in part owing to investor demand for securities that more precisely match their risk and reward preferences. Regulatory arbitrage increases complexity as market participants take advantage of inconsistent regulatory regimes both within and across national borders. And new technologies continue to add complexity not only to financial products but also to financial markets. Complexity may well be the greatest future challenge for financial regulation.

17.2.1.2. Rationality Failure Another market failure is rationality failure, which can also undermine the reliability of pricing. Even in financial markets, humans have bounded rationality. In areas of complexity, for example, we tend to overrely on heuristics—​broadly defined as simplifications of reality that allow us to make decisions in spite of our limited ability to process information. Modern finance has become so complex that the financial community routinely relies on heuristic-​based customs, such as determining creditworthiness of securities by relying on formalistic credit ratings and assessing risk on financial products by relying on simplified mathematical models. Market participants also follow the herd in their investment choices and are prone to panic. Furthermore, they are unrealistically optimistic when thinking about extreme events with which they have no recent experience, devaluing the likelihood and potential consequences of those events. Because human nature cannot be easily changed, there are limited regulatory solutions to the problem of rationality failure.

17.2.1.3. Agency Failure This market failure generally refers to the misalignment of the interests of principals and their agents. Scholars have long studied inefficiencies resulting from conflicts of interest between managers and owners of firms. There also is a much more insidious 8 

9 

See Schwarcz (2008, 1113–​115). ibid. p. 1110.

 

BANKING AND FINANCIAL REGULATION    427 principal–​agent failure: the intrafirm problem of secondary-​management conflicts. The nub of the problem is that secondary managers are usually paid under short-​term compensation schemes, misaligning their interests with the long-​term interests of the firm. Complexity exacerbates this problem by increasing information asymmetry between technically sophisticated secondary managers and the senior managers to whom they report. For example, with limited technical expertise and limited time available to devote to risk assessment, a firm’s senior managers often want risk to be modeled and reduced to usable numbers.10 Models, however, can be manipulated. For example, VaR, or value-​at-​ risk, has been the most widely used model for reducing investment risk to a number.11 As the VaR model became more accepted, banks began compensating analysts not only for generating profits but also for generating profits with low risks, measured by VaR. Analysts therefore began to refocus investment portfolios to concentrate more on securities (e.g. mortgage-​backed securities and credit-​default swaps) that generate gains but only rarely have losses.12 Because the likelihood of these losses was less than the risk percentages taken into account under VaR modeling—​which typically excludes losses that have less than a 1% (or, in some cases, 5%) likelihood of occurring within the model’s limited time frame—​such losses were not included in the VaR computations.13 Analysts knew but did not always make clear to senior management that in the rare cases where such losses occurred, they would be huge.14 In theory, firms can solve this principal–​agent failure by paying managers, including secondary managers, under longer-​term compensation schemes (e.g., compensation subject to clawbacks or deferred compensation based on long-​term results). In practice, however, that solution would confront a collective action problem: firms that offer their secondary managers longer-​term compensation might not be able to hire as competitively as firms that offer more immediate compensation. Regulation can solve the collective action problem, and thus correct the principal–​ agent failure, by requiring financial firms—​or at least those that meet relevant criteria of materiality—​to pay managers, including secondary managers, under longer-​term compensation schemes. However, because good secondary managers can work in financial centers worldwide, international regulation may be needed to help fully solve the collective action problem.

10 

Nocera (2009, 24).

11 ibid, p. 26.

12  ibid. In a credit-​default swap, one party (the credit “seller”) agrees, in exchange for the payment to it of a fee by a second party (the credit “buyer”), to assume the credit risk of certain debt obligations of a specified borrower or other obligor. If a “credit event” (e.g., default or bankruptcy) occurs in respect of that obligor, the credit seller will either (a) pay the credit buyer an amount calculated by reference to post-​default value of the debt obligations or (b) buy the debt obligations (or other eligible debt obligations of the obligor) for their full face value from the credit buyer. See Schwarcz (2009/​2010, 211, 235 n. 131). 13  Nocera, supra footnote 10, p. 46. 14 ibid.

 

428   STEVEN L. SCHWARCZ

17.2.1.4. Risk Marginalization Risk dispersion is intended to reduce risk from the standpoint of any given investor through investment diversification and more efficient allocation of risk. But if risk is spread too widely, it can become marginalized such that rational market participants individually lack the incentive to monitor it and important correlations between risks can be obscured.15 Furthermore, because the human brain’s ability to correlate accurately perceived and actual risk is limited,16 we tend to ignore or undervalue risk below a minimum threshold level.17 For these and other reasons, investors and other market participants sometimes underestimate and underprotect against risk, with few worrying about where dispersed risk goes or whether risk dispersion can impact the stability of financial markets.18 Marginalization of risk can have both microprudential and macroprudential consequences. The first—​which is the subject of this section—​occurs when the marginalization harms only the market participants (and their investors) that underestimate and underprotect against the risk. The second—​which is the subject of Section 17.3 (discussing macroprudential regulation)—​occurs when the marginalization also harms the financial system itself, as happened in the financial crisis.19 Macroprudential consequences are especially likely to occur when marginalization of risk is coupled with collective action problems. For example, the benefits of exploiting finite capital resources might accrue to individual market participants, each of whom is motivated to maximize use of the resources, whereas the costs of exploitation may be distributed more widely.20 Absent regulatory intervention, market participants will individually pursue their self-​interests to the detriment of other market participants (not to mention the financial system and the real economy).21 Moreover, market participants—​especially those who are investors—​may act as free riders, assuming that other investors have more significant amounts at stake and, therefore, must be engaging in due diligence and monitoring.22

15 

Schwarcz (2012, “Marginalizing Risk” 487). See, e.g., Slovic (2004, 311 and 315). 17  See, e.g., Herring (2009); Cf. (observing the human tendency to ignore details when overwhelmed by complexity) Rapaport (1998). 18   Supra footnote 15. 19 ibid. 20 ibid. 21 ibid. 22  ibid. Cf. De Brouwer (2001). Hedge Funds in Emerging Markets 150. (noting that “even rational market participants may at times ignore their own private information and follow the actions of earlier participants because the [perceived] information in other people’s collective actions overwhelms the individual’s private information.”). More crassly, an investor may rationalize that it will be in no worse position than its competitors, who are making these same kinds of investments, if the investment fails—​especially given the investment’s relatively small size. Even if that rationalization is justified at the outset, however, continuing competitive pressures may motivate the investor to increase the investment, especially where approval of the initial investment sets an institutional precedent that makes further approvals easier. Supra footnote 15. 16 

 

BANKING AND FINANCIAL REGULATION    429 Regulating risk dispersion that causes only microprudential consequences would likely be inefficient because market participants themselves should want to protect against those consequences. But regulating risk dispersion that causes macroprudential consequences could well be appropriate, and indeed, it parallels the traditional regulatory focus of government.23

17.2.  Broader Regulatory Approaches The discussion so far has addressed how microprudential regulation can mitigate market failures. Microprudential regulation can also address market failures more broadly by ensuring that firms can resist the adverse impact of market failures.

17.2.1. Capital Requirements The most common way that regulation accomplishes this is by imposing “capital” requirements, which are intended to protect financial institutions against unexpected losses. Capital requirements in their modern form—​based on ratios rather than fixed dollar amounts—​ were introduced into banking regulation in the 1980s.24 In that form, the requirements are expressed as capital-​adequacy ratios: the minimum ratio of equity (including equity-​like securities) that a bank must hold as a percentage of risk-​weighted assets. The imposition of capital requirements at the national level created a collective action problem:  banks subject to those requirements might become less competitive, at least from a cost standpoint, than banks in nations that did not impose such requirements (or that imposed less strict requirements). In response, bank regulators around the world began to work together, through the Basel Committee on Banking Supervision (hereinafter, BCBS),25 to try to develop uniform capital requirements.26 23 

For a discussion of how to design that regulation, see ibid (arguing that although regulatory responses may be second best, imperfect regulation may well be preferable to limiting risk dispersion because the latter could inadvertently increase the potential for regulatory arbitrage, increase financial instability, and impair the ability of parties to achieve negotiated market efficiencies). 24  Elliott, Feldberg, and Lehnert (2013, 34), discussing how bank regulators switched from using capital requirements based on fixed dollar amounts to capital requirements based on the ratio of capital to total assets, and how the Basel I Accord spread that latter regulatory approach internationally. 25  Established in 1974 by the central bank governors of the Group of Ten, the BCBS “provides a forum for regular cooperation on banking supervisory matters” and its objective is to “enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide.” The BCBS has no formal authority; it leaves the implementation of recommendations to individual countries. See Basel Committee on Banking Supervision, http://​www.bis.org/​bcbs/​. [Accessed 22 July 2014]. 26  Tarullo (2008). Banking on Basel 29 & 45.

 

430   STEVEN L. SCHWARCZ In 1988, the BCBS released the Basel Capital Accord (hereinafter, “Basel I”), which set minimum capital-​adequacy ratios for international banks in countries enacting Basel I into law. Over 100 countries enacted Basel I or at least principles based on Basel I.27 Basel I took a two-​tiered approach to defining capital. Tier 1 capital included widely recognized forms of equity, such as shareholder’s equity and retained earnings. Tier 2 included forms of equity that are more controversial, such as undisclosed reserves, asset-​ revaluation reserves, general loan-​loss reserves, subordinated debt, and certain hybrid (debt/​equity) capital instruments. Basel I required internationally active banks to maintain “total” capital—​restricted to Tier 1 capital and a potentially discounted amount of Tier 2 capital28—​equal to at least 8% of their risk-​weighted assets. Assets—​which in the case of banks are primarily loans payable to the banks—​were risk-​weighted according to five categories, depending on the generic type of the asset (and not, e.g., the particular creditworthiness of the borrower on a loan).29 Less than 10  years after the release of Basel I, the BCBS began rethinking how to improve capital-​adequacy ratios. Basel I’s weaknesses included the bluntness of its risk weighting of assets and its exclusive focus on credit risk.30 Experience also showed that Basel I encouraged regulatory arbitrage, such as banks engaging in securitization transactions instead of making loans.31 The result was the release in 2004 of the Revised Basel Capital Accord (hereinafter, “Basel II”). Basel II retained some elements of Basel I, including the definition of capital and the 8% requirement. However, it took a broader view of risk, including not only credit risk (the risk that a borrower will not repay its loan) but also market risk (the risk that the market value of an asset will decline) and operational risk (the “risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”).32 Further, Basel II introduced a three-​pillar regulatory structure, explained below, based on (1) minimum capital requirements, (2) supervisory review, and (3) market discipline. The first pillar—​minimum capital requirements—​addressed credit, market, and operational risk. Banks had to take all of these risks into account when calculating their minimum capital requirement. Unlike Basel I, however, Basel II gave banks the option of assessing credit risks through one of two internal ratings-​based procedures or under a standardized approach using external credit rating agencies.33 The second 27

  ibid, pp. 64–​65. The amount of Tier 2 capital included in total capital could not exceed the amount of Tier 1 capital. 29  Supra footnote 26, p. 57. 30  Market risk was included in Basel I, however, under the 1996 Market Risk Amendment. ibid, p. 61. 31  “Capital Standards for Banks: The Evolving Basel Accord.” 2003. Board of Governors of the Federal Reserve System 396(Sept.). http://​www.federalreserve.gov/​pubs/​bulletin/​2003/​0903lead.pdf. 32  Basel Committee on Banking Supervision. 2001. Consultative Document Operational Risk 2. http://​ www.bis.org/​publ/​bcbsca07.pdf. The goal of incorporating operational risk into the capital requirements was to reward banks with sophisticated risk management systems. ibid, pp. 1–​2. 33  Supra footnote 26, pp. 124–​5. Banks could use three different methods to calculate operational risk: the basic indicator approach, the standardized approach, and the advanced/​internal measurement approach. Market risk should be determined by the value at risk approach. 28 

 

BANKING AND FINANCIAL REGULATION    431 pillar—​supervisory review—​set forth guidelines for how banks should engage in risk assessment, emphasizing monitoring, early intervention, and prompt remedial action to prevent the capital-​adequacy ratio from slipping below the 8% minimum.34 The third pillar—​market discipline—​focused on requiring banks to formally disclose their risks to the marketplace, thereby providing other banks and market participants with information needed to negotiate contract terms that, effectively, should reward healthy banks and penalize risky banks.35 Basel II was “available for implementation” at the end of 2007, but countries’ implementation timelines varied widely. The European Union fully implemented Basel II within a year, whereas Botswana and Gambia planned on full implementation by 2015.36 The financial crisis, however, soon highlighted the need for capital-​adequacy ratios that are less vulnerable to human error and bias.37 The result is Basel III,38 which has been agreed to by members of the BCBS but is not slated for full implementation until January 2019.39 Basel III reforms Basel II,40 including by improving the inputs for banks’ internal ratings-​based (sometimes called “IRB”) risk-​assessment approaches. Basel III also more strictly defines what is included in Tier I capital41 and sets a minimum capital-​adequacy

34 

Miller and Cafaggi (2013, 175–​6). Basel Committee on Banking Supervision 1. 2011. Pillar 3 Disclosure Requirements for Remuneration. (July) http://​www.bis.org/​publ/​bcbs197.pdf. 36  Supra footnote 26, pp. 126–​7; Financial Stability Institute 4 & 8. 2012. Basel II, 2.5, and III Implementation (July). http://​www.bis.org/​fsi/​fsiop2012.pdf. 37  Supra footnote 34, pp. 180–​1. 38  “Basel III” collectively refers to “Basel III: A global regulatory framework for more resilient banks and banking systems,” “Basel III: International framework for liquidity risk measurement, standards and monitoring,” and “Annex: Minimum requirements to ensure loss absorbency at the point of non-​ viability.” See Basel Committee on Banking Supervision. 2010. Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems. (Dec.). http://​www.bis.org/​publ/​bcbs189_​dec2010.pdf [hereinafter, Basel III: A Global Regulatory Framework]; Basel Committee on Banking Supervision. 2010. Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring. (Dec.). http://​www.bis.org/​publ/​bcbs188.pdf; Basel Committee on Banking Supervision. 2011. Annex: Minimum Requirements to Ensure Loss Absorbency at the Point of Non-​Viability (Jan.). http://​www.bis.org/​press/​ p110113.pdf. 39  The European Union and the US enacted final sets of Basel III regulations in June and July of 2013. According to an August 2013 BCBS report, “internationally active banks continue to build capital, and appear well placed to meet the full set of fully phased-​in minimum Basel III capital requirements ahead of the 2019 deadline.” Basel Committee on Banking Supervision. 2013. Report to G20 Leaders on Monitoring Implementation of Basel III Regulatory Reforms (Aug.). http://​www.bis.org/​publ/​bcbs260.pdf. 40  Basel III modifies and builds on existing Basel capital accords, including Basel II. International regulatory framework for banks (Basel III). Bank for Int’l Settlements. http://​www.bis.org/​bcbs/​basel3. htm [Accessed 3 August 2014]. 41  “The concept of Tier 1 that we are familiar with will continue to exist and will include common equity and other instruments that have a loss-​absorbing capacity on a “going concern” basis, for example certain preference shares. Innovative capital instruments which were permitted in limited amount as part of Tier 1 capital will no longer be permitted and those currently in existence will be phased out.” Hannoun, Hervé, Gen. Manager, Bank for Int’l Settlements. 2010. The Basel III Capital Framework: A Decisive Breakthrough, BoJ-​BIS High Level Seminar on Financial Regulatory 35 

 

432   STEVEN L. SCHWARCZ requirement for Tier 1 capital itself (in addition to the minimum capital-​adequacy requirement for total capital).42 Basel III also introduces greater disclosure requirements, a liquidity requirement, a leverage requirement, and two buffers—​a 2.5% capital conservation buffer and a countercyclical capital buffer. The capital conservation buffer is mandatory, intended to ensure that banks build up capital reserves that can be drawn down in periods of stress to avoid breaches of the capital requirement minimum.43 The countercyclical capital buffer is discretionary, allowing national regulators to require banks to maintain an additional 2.5% of capital during periods of high credit growth.44 As traditional bank lending contracted during the financial crisis, shadow banking expanded and filled part of the vacuum.45 In response, Basel III also imposes capital requirements on some shadow-​banking activities. For example, it extends capital requirements to certain commitments to provide credit (loss protection) or liquidity (protection on the timing of payments, where ultimate losses are not expected). It also imposes capital requirements on short-​term off-​balance sheet commitments.46

17.2.2. Ring-​Fencing Another broad regulatory approach is ring-​fencing, which can be understood as legally deconstructing a firm in order to more optimally reallocate and reduce risk.47 The deconstruction can occur in various ways: by separating risky assets from the firm; by preventing the firm itself from engaging in risky activities or investing in risky assets; or by protecting the firm from affiliate and bankruptcy risks. Two forms of ring-​fencing are commonly used for banks. One is to protect a bank from being taken advantage of by its affiliated firms—​essentially preserving the business and assets of the ring-​fenced bank. Regulation may require, for example, that transactions between a bank and its affiliates be arm’s length. This is exemplified by Section

Reform: Implications for Asia and the Pacific Hong Kong SAR. (Nov. 22). http://​www.bis.org/​speeches/​ sp101125a.pdf. 42  The total capital minimum remains at 8%, but Basel III requires that “Common Equity Tier 1 must be at least 4.5% of risk-​weighted assets at all times,” and that “Tier 1 Capital must be at least 6.0% of risk-​ weighted assets at all times.” Supra footnote 38, para. 49. 43  Supra footnote 38, para. 122. 44  ibid, paras 18–​22. 45  See supra footnotes 2–​7 and accompanying text (discussing shadow banking). 46  Tarullo (2013). In the US, the Dodd–Frank Act imposes additional possible capital requirements. Section 171 of that Act, for example, requires regulators to establish minimum leverage and risk-​based capital requirements for “banks, bank holding companies, and nonbank financial firms identified by the [Financial Stability Oversight Council] for enhanced Fed supervision.” Pappenfus (2014, 253 and 262) (emphasis added). See also Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action, 77 Fed. Reg. 52,791 (proposed Aug. 30, 2012) (to be codified in scattered parts of 12 C.F.R.). 47  Schwarcz (2013, 9).

 

BANKING AND FINANCIAL REGULATION    433 23A of the US Federal Reserve Act and by the recommendations of the report of the UK Independent Commission on Banking (often called the “Vickers Report”).48 The Vickers Report recommends, for example, that interactions by UK retail banks with their affiliates must be at arm’s length.49 Ring-​fencing is also commonly used to limit a bank’s risky activities and investments. This use of ring-​fencing had been the focus of the Glass–Steagall Act in the US,50 and is currently exemplified by the Volcker Rule,51 as well as by the UK Financial Services (Banking Reform) Act of 2013 and the Liikanen Report.52 The Volcker Rule, for example, limits proprietary trading by banks, which was thought to be a cause contributing to the financial crisis.53 As codified, proprietary trading is defined as “engaging as a principal for the trading account of [a bank] in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such … [aforementioned] financial instrument.”54 This definition, however, has been criticized as raising questions, and the Volcker Rule itself has been criticized as reducing the economic efficiency of banks that profited from proprietary trading.55

48  Independent Commission on Banking, Final Report Recommendations. 2011. (often called the “Vickers Report” after Sir John Vickers, the Commission’s chair). 49 ibid, p. 12. 50  The Glass–Steagall Act ring-​fenced deposit-​taking banks by prohibiting them from engaging in the securities business, which was perceived as risky. The Glass–​Steagall Act’s ring-​fencing was repealed in November 12, 1999, by the passage of the Gramm–Leach–Bliley Act of 1999. Ch. 89, 48 Stat. 162 (1933) (codified as amended in scattered sections of 12 U.S.C.). Glass-​Steagall refers to sections 16, 20, 21, and 32 of the Banking Act of 1933. Section 16 was codified as 12 U.S.C. § 24 (Seventh). Section 20 was codified as 12 U.S.C. §377. Section 21 was codified as 12 U.S.C. §378(a)(1). Section 32 was codified as 12 U.S.C. § 78. Repealed by the Gramm–​Leach–​Bliley Act, the Financial Services Modernization Act of 1999, (Pub. L. 106-​102, 113 Stat. 1338, enacted Nov. 12, 1999). http://​www.gpo.gov/​fdsys/​pkg/​PLAW-​106publ102/​html/​ PLAW-​106publ102.htm. 51  This rule is named after former Federal Reserve Chairman Paul Volcker—​often cited as its principal designer. It is being codified pursuant to the Dodd–​Frank Act, 12 U.S.C. §§ 619 & 1851. 52  The “Liikanen Report” was promulgated by a European Commission-​appointed panel of experts, chaired by Bank of Finland governor Erkki Liikanen. Although the Liikanen Report does not refer to ring-​fencing directly, it recommends that banks separate certain of their risky activities from deposit-​ taking. Final Report of the High-​level Expert Group on Reforming the Structure of the EU Banking Sector, chaired by Erkki Liikanen (Oct. 2, 2012). 53  Section 4 of the UK Banking Reform Act similarly prohibits retail banks from “dealing in securities as a principal.” The UK is also considering imposing a ban on proprietary trading by affiliates of UK retail banks—​presumably to make it less likely that such affiliates could fail, which might imperil the retail banks. See Parliamentary Commission on Banking Standards, Proprietary Trading, 2012–​13, H.C. 1034, pp.15–​19. 54  12 U.S.C. § 1851(h)(4). 55  See, e.g., Whitehead (2011, 40). Other criticisms include the argument that the Volcker Rule is motivating proprietary traders to leave commercial banks for firms like hedge funds and investment banks. See, e.g., 2010. “Deutsche Bank Loses Option Trader Saiers to Hedge Fund Alphabet Management.” Bloomberg (July 15, 10:33 a.m.) http://​www.bloomberg.com/​news/​2010-​07-​14/​deutsche-​ bank-​loses-​option-​trader-​saiers-​to-​hedge-​fund-​alphabet-​management.html; 2013. “Top JPMorgan

 

434   STEVEN L. SCHWARCZ Another common use of ring-​fencing is to protect a firm from becoming subject to liabilities and other risks associated with bankruptcy—​usually called making the firm “bankruptcy remote.”56 Although this use of ring-​fencing is standard for securitization and covered bond transactions, it is not typically used in banking.57 The reason is path dependent: at least in the US, banks have not historically been subject to bankruptcy law.58

17.2.3. Monitoring Through Stress Testing Another broader regulatory approach is stress testing, which is effectively a form of monitoring.59 Stress testing has long been used in diverse fields, including engineering and medicine, to gauge the stability of something through rigorous testing beyond normal operating conditions. In a banking context, stress testing examines how banks would be likely to fare under hypothetical negative economic conditions, including financial market crashes, high unemployment and high default rates, failures of other large financial institutions, and liquidity shortages.60 Although some banks have earlier used stress testing in their internal risk management, it has been required since 1996 by an amendment to Basel I.61 Since the financial crisis, regulators have expanded the use of stress testing.62 In the US, for example, the Dodd–Frank Act requires stress testing not only for banks but also for non-​bank systematically important financial institutions.63 Stress testing is a form of monitoring because it gauges the health of financial institutions but does not directly offer a remedy should those institutions fail the test. Prop Trader Leaves to Launch Hedge Fund.” Forbes (Feb. 15, 12:48 p.m.). http://​www.forbes.com/​sites/​ halahtouryalai/​2013/​02/​15/​top-​jpmorgan-​prop-​trader-​leaves-​to-​launch-​hedge-​fund/​. These firms are poorer at absorbing losses than commercial banks, which tend to have much larger equity cushions, thus shifting the risk of proprietary trading to a frailer part of the financial system. 56 

Schwarcz (2011). Ring-​fencing can also be used to help ensure that a firm is able to operate on a standalone basis even if its affiliated firms fail, but this form of ring-​fencing has limited application to financial regulation. It is more commonly used by utility companies that need to ensure the public’s uninterrupted access to an important public service. See supra footnote 47. 58  See 11 U.S.C. § 109 (excluding deposit-​taking banks and domestic insurance companies from federal bankruptcy law). 59   See infra footnotes 63–​4 and accompanying text. This contrasts with the other regulation discussed, which is intended to correct market failures. 60  Weber (2014, 2236 and 2239). 61  Quagliariello (2009). 62  Notably, this was sparked by the 2009 stress tests performed by the US Federal Reserve on nineteen of the country’s largest banks in an attempt to stave off future losses and ensure that those banks could continue lending despite the deepening recession. See Geithner (2009), explaining the motivation of the stress testing program was to “help replace uncertainty with transparency” as well as outlining the stress testing process. 63  Supra footnote 60, at 2292. Banks with more than $10 billion (previously the threshold was $50 billion) in assets are now required to have two stress tests performed annually, one done internally and one conducted by regulators. 57 

 

BANKING AND FINANCIAL REGULATION    435 In the event a bank fails a stress test, regulators must decide on the next steps. The European Central Bank, for example, has been conducting stress tests on EU banks; a bank that fails the test will have two weeks to submit its proposed corrective measures and capital plans.64

17.3.  Macroprudential Regulation Macroprudential regulation refers to financial regulation of the financial system’s ability to function as a network, within which firms and markets can operate. As discussed, its primary goal is to prevent systemic risk. Ideal macroprudential regulation would therefore act ex ante, limiting the triggers of systemic shocks.

17.3.1. Limiting the Triggers of Systemic Shocks 17.3.1.1. Maturity Transformation Several vulnerabilities of the financial system can trigger systemic shocks. The classic vulnerability is maturity transformation: the asset–​liability mismatch that results from the short-​term funding of long-​term projects. This mismatch creates a “liquidity default risk” that borrowers will be unable to repay their lenders. According to some scholars, illiquidity is the fundamental source of financial failure. A bank “run” is the typical (though far from the only) example of maturity transformation leading to a liquidity default. In a bank run, panicked depositors will collectively demand their money. If, as is usual, the long-​term maturities of the bank’s assets cannot generate cash quickly enough to pay the current depositor demands, the bank will default. And if (again, as is usual) the defaulting bank is interconnected with other banks, the defaulting bank’s failure to pay its obligations to those other banks can, in turn, deprive those other banks of money to pay their creditors—​with the chain spreading. Maturity transformation was also at the core of the financial crisis, such as the well-​ known shadow-​banking example, discussed below, of money-​market mutual funds that used short-​term loans by investors, essentially withdrawable on demand, to fund long-​ term projects. In mid-​September 2008, a money-​market mutual fund in the US “broke the buck” for the first time in 14 years.65 This meant that the fund’s price per share, or net asset value (“NAV”), fell below $1.00—​the point at which fund investors would begin losing money. 64 

Black and Sirletti (2014), describing the European Central Bank’s plan to conduct stress tests of euro-​area lenders. 65  Condon (2008). See supra footnote 4 and accompanying text for a discussion of money-​market mutual funds. See, also, infra footnote 79 and accompanying text for discussion of proposed regulatory solutions.

 

436   STEVEN L. SCHWARCZ Because shares in mutual funds were not then US government insured,66 fund investors industrywide raced to try to withdraw their investments from any remaining short-​ term assets—​the effective equivalent of a bank run—​before other investors depleted those assets.67 To mitigate potential systemic consequences, the US government stepped in to guarantee money-​market mutual fund share prices, thereby calming investors and quelling the run.68 Maturity transformation is thus a vulnerability of the financial system, but it is also a benefit. Using short-​term debt to fund long-​term projects is attractive because, if it managed to avoid a default, it tends to lower the cost of borrowing. The interest rate on short-​term debt is usually lower than that on long-​term debt because, other things being equal, it is easier to assess a borrower’s ability to repay in the short term than in the long term, and long-​term debt carries greater interest-​rate risk. Regulation, therefore, should not attempt to prohibit maturity transformation per se. In a banking context, for example, the standard regulatory solution is not to require banks to match-​fund their assets. Rather, governments often provide deposit insurance that limits the likelihood that depositors will panic.69 In other contexts, however, maturity transformation may well remain a real vulnerability. Because many shadow-​banking sources of funding, such as short-​term commercial paper, are not payable on demand—​and thus are not subject to the same type of “run” risk as traditional deposits—​deposit insurance is not a solution. And other regula­ tory solutions are likely to be imperfect.70 Depending on how it is designed, regulation protecting the financial system against maturity-​transformation risk can increase moral hazard, which in turn can motivate risky actions by shadow banks. For example, regulation that protects the shadow-​bank issuer of short-​term securities against its own risky actions would almost certainly increase moral hazard. Regulation that limits incentives for shadow banks to engage in maturity transformation—​such as imposing higher capital requirements on firms that engage in maturity transformation—​would reduce moral hazard but would also reduce the economic efficiency achieved by maturity transformation.71

66 

This contrasts with bank deposits, which are guaranteed up to specified limits by the US Federal Deposit Insurance Corporation. 67  Gordon and Gandia (2014, 313, 317), (also noting that the money-​market mutual funds were unable to secure short-​term credit to meet the sudden demand). 68 ibid. 69  See supra footnotes 66–​8 and accompanying text. 70  In the context of money-​market mutual funds, for example, regulators have been debating potential reforms for years. In July 2014, the US Securities and Exchange Commission (SEC) announced regulatory reforms to be implemented in 2 years, but the regulation remains controversial. See Lynch (2014). See, also, supra footnotes 3, 6, and 65–​8 and accompanying text for a discussion of money-​market mutual funds and shadow banking. 71  A possible compromise might be regulation that protects not individual shadow banks but the overall markets for short-​term securities, such as the Commercial Paper Funding Facility put into place by the US Federal Reserve during the financial crisis to protect the commercial paper market. I later discuss this in Section 17.3.3.2.

 

BANKING AND FINANCIAL REGULATION    437 Thus, the liquidity default risk that inevitably remains can trigger systemic shocks. Indeed, the failure of pre-​financial-​crisis regulation to adequately address liquidity default risk resulting from shadow banking’s maturity transformation “is widely believed to have contributed to the buildup of risks in the financial system in the period leading up to” that crisis.72

17.3.1.2. Limited Liability and Corporate Governance Another vulnerability is the financial system’s failure to require market participants to internalize fully their harm. As a result, they are economically motivated to engage in risky but profitable transactions because much of the harm from a possible systemic collapse would be externalized onto other market participants, as well as onto ordinary citizens impacted by an economic collapse. The most direct regulatory solution should therefore be to require market participants to internalize that harm. For various reasons, including the longstanding limited liability accorded corporate shareholders throughout the world, that may not be feasible. With the rise of shadow banking, limited liability is becoming especially problematic. For the small and decentralized firms (such as hedge funds) that dominate the shadow-​banking sector, equity investors tend to be active managers. Limited liability gives these investor-​managers strong incentives to take risks that could generate out-​ sized personal profits, even if that greatly increases systemic risk. Notwithstanding these incentives, regulation could reduce systemic risk by requiring the managers of systemically important firms—​that is, the agents who run the firm for the shareholder principals—​to also take systemic externalities into account in their corporate governance decision making.73 Such a radical change to traditional corporate governance, in which managers are responsible only to the firm and its investors, should be made only if it does not weaken overall corporate wealth production.74

17.3.1.3. Other Vulnerabilities The very nature of the financial system also subjects it to other systemic vulnerabilities that cannot be regulated away.75 Because the financial system exhibits the characteristics of—​and effectively comprises—​a high-​risk system that is susceptible to “normal accidents,” regulators cannot predict, and, therefore, cannot eliminate, all the triggers of systemic shocks. Another reason why regulators cannot realistically eliminate all of the triggers of systemic shocks is that certain of the market failures that are the subject of imperfect microprudential regulation could even trigger systemic failures. For example, information failure, rationality failure, agency failure, and risk marginalization could, individually or in combination, cause one or more large financial firms to overinvest, 72 

Regulating Ex Post, supra footnote 7, p. 85. See Schwarcz (2016). 74 See ibid. 75  Cf. supra footnotes 19–​23 and accompanying text (observing that marginalization of risk can also have macroprudential consequences, and that regulatory solutions are all second best). 73 

 

438   STEVEN L. SCHWARCZ leading to bankruptcy, and the bankruptcy of a large, interconnected financial firm could lead to a systemic collapse. It therefore is virtually certain that the financial system will face systemic shocks from time to time.

17.3.1.4. Existing Macroprudential Regulatory Approaches Since the financial crisis, policymakers and regulators generally recognized the need for macroprudential regulation. However, they tend to approach it as constituting a loose assortment of “tools” in their “toolkit.” The macroprudential “toolkit” generally comprises cross-​sectoral leverage ceilings, credit and credit-​growth ceilings, reserve and capital buffer requirements, liquidity minima and maturity mismatch maxima, dynamic countercyclical provisioning, and surveillance and data collection.76 It is still unclear, though, which “tools” should be used in which circumstances and how the tools should be calibrated. That itself creates risk because the misapplication of these tools—​such as imposing excessively restrictive leverage or credit and credit-​growth ceilings—​may be as likely to cause financial problems as to solve them. For example, because economic growth is strongly tied to the availability of credit,77 overly restrictive credit or credit-​growth ceilings could cause the economy to contract. Yet the very justification for these ceilings—​the “compelling evidence that credit booms tend to precede particularly severe and prolonged downturns”78—​is questionable. Evidence of the mere tendency for credit booms to precede severe economic downturns does not prove a causal relationship. And even if that causal relationship were proved, the evidence does not yet appear to provide a clear basis for quantifying a limitation on credit growth. The misapplication of capital requirements could also backfire. The regulatory reform dialogue increasingly is focusing on a countercyclical and flexible approach to capital requirements.79 Finance, and especially banking, is by nature procyclical: the increased availability of capital stimulates economic growth.80 Historically, financial regulation has tended to be procyclical as well—​loosening during booms and becoming stricter after crises.81 The rationale for countercyclical capital requirements is that they would 76 

Hockett (2013, 12–​13). See, e.g., Cooper (2008). 78  Elliott, Feldberg, and Lehnert, supra footnote 24, p. 2 (observing this justification for the “growing support for the view that policymakers should use a variety of tools to minimize … excessive credit growth” that could fuel asset bubbles). They also observe, that some economists even conclude from this evidence that the “primary purpose” of macroprudential tools should be “controlling credit growth.” 79   See Johnson (2013, 881, 916), discussing flexible capital requirements as a macroprudential tool; Berner (2013), identifying countercyclical capital requirements as a tool to reduce or neutralize “threats to financial stability”. 80  Ren, Haocong. 2011. Countercyclical Financial Regulation 3. Working Paper No. 5823, The World Bank. http://​elibrary.worldbank.org/​doi/​pdf/​10.1596/​1813-​9450-​5823 (also observing that during economic booms and bubbles, credit expansion outpaces economic growth; and that during economic downturns, lending contracts, further worsening economic prospects). 81  McDonnell (2013, 123), noting that the same factors that cause cycles in the financial markets, cause financial regulations to reinforce the cycles, and discussing how capital requirements are procyclical when they force banks to cut back on lending owing to faltering capital positions because of decreasing credit quality and increasing losses, further deteriorating economic performance and resulting in even more credit losses. 77 

 

BANKING AND FINANCIAL REGULATION    439 help to moderate economic growth, discouraging the buildup of imbalances during economic booms and bubbles (by reducing excessive risk-​taking and credit expansion).82 But countercyclical capital requirements are only as good as the accuracy of the indicators that determine their application and timing. Potential indicators include GDP growth, credit conditions, asset prices, banking performance and soundness indicators, leverage ratios, and credit and liquidity spreads.83 There has been debate, however, about whether countercyclical regulation is actually feasible given that it is virtually impossible to know, ex ante, whether a financial cycle is rational or merely a bubble.84 Furthermore, countercyclical regulation’s effectiveness could be undermined by regulatory arbitrage if the measures are not analogously applied to relevant shadow-​banking activities.85 Accuracy is critical because the misapplication or mistiming of countercyclical regu­ lation can have unintended adverse consequences, as illustrated by the notorious savings and loan (“S&L”) crisis of the 1980s in the US. S&L institutions faced a period in which rising interest rates made lending less attractive to borrowers.86 To avoid having to commit government funds to bail out financially stressed institutions, regulators relieved the stress by engaging in a type of countercyclicality: they eased the capital ratios in order to “help banks muddle through [that] difficult period.”87 However, the result of that forbearance, in conjunction with other regulatory-​relief steps, was to rapidly expand the size of the S&L industry—​from $686 billion in 1982 to $1.1 trillion 1985.88 When the S&L industry eventually collapsed, its increased size led to the largest federal bailout in US history up to that time.89

17.3.2. Alternative Macroprudential Regulatory Approaches It therefore is clear that, notwithstanding the best efforts of regulators, the financial system will inevitably face systemic shocks. Accordingly, macroprudential regulation should also work ex post—​after a systemic shock is triggered—​to break the transmission of the shock and limit its impact. This approach accords with chaos theory, which

82

  Supra footnote 78, at 4–​5. Supra footnote 78, p. 6. 84  McCoy (2013), arguing that even for real estate bubbles, no one has adequate information ex ante to know for sure whether the price increases are rationale or merely a bubble. 85  Supra footnote 78, p. 8. 86  Supra footnote 24, p. 34. 87  ibid (observing that this countercyclicality was imprecisely implemented). 88  ibid. The eased capital ratios enabled rapid growth. For example, a $2 million dollar investment in a new S&L could be leveraged into $1.3 billion in assets. See 1 Div. Of Research And Statistics, Fed. Deposit Ins. Corp., 1997. History of the 80s–​Lessons for the Future. pp. 172–​3.http://​www.fdic.gov/​bank/​historical/​ history/​index.html. 89  See Cunningham and Zaring (2009, 51). 83 

 

440   STEVEN L. SCHWARCZ addresses the problem of inevitable systemic shocks in complex engineering systems. The most successful (complex) systems are those in which the consequences of failures are limited.

17.3.2.1. Breaking the Transmission of Systemic Shocks In examining how macroprudential regulation could break the transmission of systemic shocks and limit their impact, consider three factors that the International Monetary Fund and the international Financial Stability Board have identified as determinants of systemic risk: interconnectedness, size, and substitutability. In reality, these factors relate not to vulnerability but to the transmission of systemic shocks and their impact. These factors implicitly assume that the financial system is subject to vulnerabilities that could trigger systemic shocks. To break the transmission of systemic failures in the financial system would require that the transmission mechanisms all be identifiable. It is probably not feasible, however, to identify all those mechanisms in advance. Ring-​fencing can be useful as a crude barrier, however.90 This is the primary regulatory approach taken in the UK for example, to protect so-​called retail banking, such as basic lending and deposit taking.91

17.3.2.2. Stabilizing Systemically Important Firms and Markets Because regulation cannot completely break the transmission of systemic shocks, regulators must also focus on trying to stabilize systemically important firms and financial markets impacted by the shocks. There are at least two ways that regulation could accomplish that: by requiring those firms and markets to be more internally robust, and/​ or by providing appropriate liquidity to those firms and markets. Regulation could help to stabilize systemically important firms and markets by requiring them to be more internally robust. Financial regulation has long focused on requiring traditional deposit-​taking banks to be robust, usually through capi­ tal and solvency requirements. Since the financial crisis, the US, the European Union, and other jurisdictions are beginning also to subject “systemically important” non-​bank financial firms (SIFIs) to a range of capital, solvency, and similar requirements. This approach is imperfect, however, because it mixes the goals of macroprudential and microprudential regulation. The microprudential goal is to assure that individual firms can continue operating. By subjecting banks and SIFIs to rigorous capital, solvency, and similar requirements (to assure that they can continue operating), that microprudential goal inadvertently becomes a goal of the macroprudential regulation. The flaw in this mixed approach is that macroprudential regulation’s only goal should be to protect the financial system’s overall capacity to function as a network. Macroprudential regulation, therefore, need not impose capital or solvency requirements on individual firms—​even those that are systemically important—​so long as it otherwise achieves that 90  91 

See supra footnotes 47–​58 and accompanying text (discussing ring-​fencing). See supra footnote 53 and accompanying text.

 

BANKING AND FINANCIAL REGULATION    441 goal. This regulatory flexibility is important because capital and solvency requirements do not always efficiently reduce systemic risk.92 Other potential approaches to make systemically important firms more internally robust include requiring at least some portion of the firm’s debt to be in the form of so-​ called contingent capital. Contingent capital debt would automatically convert to equity upon the occurrence of preagreed events. As a parallel to stabilizing systemically important firms by requiring them to be more internally robust, regulation could help to stabilize systemically important financial markets by requiring them also to be more internally robust. For example, increased speed in data transmission is generally associated with market efficiency, but the extreme speeds at which algorithmic trading takes place creates a danger of market collapse. In response, securities market regulators have been proposing the adoption of circuit-​breaker rules to halt, at least temporarily, trading under specified circumstances. Regulation could also help to stabilize systemically important firms and markets by providing appropriate liquidity. Liquidity has traditionally been used, especially by government central banks acting as lenders of last resort, to help prevent financial firms from defaulting. Ensuring liquidity to stabilize systemically important firms could follow this pattern, except that the source of the liquidity could at least be partly privatized by taxing those firms to create a systemic risk fund. Privatizing the source of liquidity would likewise help to internalize externalities, thereby not only offsetting the cost to taxpayers of liquidity advances that are not repaid but also, if structured appropriately, reducing moral hazard by discouraging fund contributors—​including those that believe they are “too big to fail”—​from engaging in financially risky activities.93 Because financial markets can also be triggers and transmitters of systemic shocks, liquidity should be used to stabilize systemically important financial markets. For example, in response to the post-​Lehman collapse of the commercial paper market, the US Federal Reserve created the Commercial Paper Funding Facility (CPFF) to act as a lender of last resort for that market, with the goal of addressing “temporary liquidity distortions” by purchasing commercial paper from highly rated issuers that could not otherwise sell their paper. The CPFF helped to stabilize the commercial paper market.

92 

Regulating Financial Change, supra footnote 1, 1465–​67. Cf. Pistor (2012), observing that “imposing capital or reserve requirements can push market participants to find ways [including the use of derivatives] to formally comply while making sure that their disposable assets are in fact not much curtailed,” thereby creating “additional sources of liquidity risk [that can] remain[] largely unrecognized by financial intermediaries and regulators alike”. This chapter does not address derivatives per se, because they will be addressed elsewhere in the Handbook. For a brief introduction to derivatives and financial regulation, see Schwarcz (2015). 93  For a thoughtful perspective on banks getting too big to manage, see Baxter (2012, 765, 879).

 

442   STEVEN L. SCHWARCZ

17.4. Conclusion Banking and financial regulation is needed to protect the financial system, which provides functions that are essential to economic development. Traditionally, financial regulation focused on banking because banks historically have aggregated moneys (primarily by taking deposits from customers) and then allocated those monies (by making loans to borrowers). Traditional financial regulation is geared to ensuring that deposit-​ taking banks can continue to perform these functions efficiently. In recent years, however, shadow banking has begun to overtake traditional banking. Financial regulation, therefore, must also address shadow banking. Regardless of whether it addresses traditional or shadow banking, financial regulation has two overall goals to ensure: the components of the financial system (firms and markets) can efficiently perform their underlying economic functions and the financial system’s ability to itself function as a network within which those components can operate. Regarding the first goal, firms and markets generally operate efficiently absent market failures. Financial regulation thus should help to correct those market failures, including information and rationality failure, which can undermine the reliability of pricing, and agency failure, in which conflicts can distort decision making. The other goal of financial regulation is to protect against the risk—​usually called systemic risk—​that the financial system will fail to function as a network within which firms and markets can operate. Although this regulation ideally would prevent systemic risk, several vulnerabilities of the financial system (such as maturity transformation and limited corporate liability) can trigger systemic shocks. It therefore is virtually certain, notwithstanding the best efforts of regulators, that the financial system will face systemic shocks from time to time. Accordingly, financial regulation should also be designed to work after systemic shocks are triggered, by breaking the transmission of the shocks and limiting their impact.

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BANKING AND FINANCIAL REGULATION    443 Basel III:  A  Global Regulatory Framework for more Resilient Banks and Banking Systems. Basel Committee on Banking Supervision. (Dec. 2010). http://​www.bis.org/​publ/​bcbs189_​ dec2010.pdf [Accessed 28 September 2016]. Basel III: International Framework for Liquidity Risk Measurement, Standards and Monitoring. Basel Committee on Banking Supervision. (Dec. 2010). http://​www.bis.org/​publ/​bcbs188. pdf [Accessed 28 September 2016]. Basel Committee on Banking Supervision. http://​www.bis.org/​bcbs/​ [Accessed 22 July 2014]. Baxter, Lawrence G. 2012. “Betting Big: Value, Caution and Accountability in an Era of Ultra Large Banking.” Review of Banking & Financial 31, p. 765. Bernanke, Ben S. 2012. Chairman, Speech at the Russell Sage Foundation and the Century Foundation Conference on Rethinking Finance. (April 13). http://​www.federalreserve.gov/​ newsevents/​speech/​bernanke20120413a.htm [Accessed 28 September 2016]. Berner, Richard. 2013. “Using the Tools, Finding the Data.” Director of Office of Financial Research, Remarks at the Joint Conference of the Federal Reserve Bank of Cleveland and Office of Financial Research, Financial Stability Analysis. (May 30). Black, Jeff and Sirletti, Sonia. 2014. “ECB Plans to Limit Stress-​Test Inputs in Bank Checks.” Bloomberg. (July 11, 11:09 a.m.). http://​www.bloomberg.com/​news/​2014-​07-​11/​ecb-​plans-​to-​ limit-​stress-​test-​inputs-​in-​bank-​checks.html [Accessed 28 September 2016]. De Brouwer, Gordon. 2001. “Hedge Funds in Emerging Markets.” 150. Capital Standards for Banks: The Evolving Basel Accord, Boards of Governors of the Federal Reserve System. 396 (Sept. 2003). http://​www.federalreserve.gov/​pubs/​bulletin/​2003/​ 0903lead.pdf. Condon, Christopher. 2008. “Reserve Primary Money Fund Falls below $1 a Share.” Bloomberg (Sept. 16, 9:41 p.m.) http://​www.bloomberg.com/​apps/​news?pid=newsarchive&sid=a5O2y1 go1GRU [Accessed 28 September 2016]. Consultative Document Operational Risk Basel Committee on Banking Supervision, Consultative Document Operational Risk 2. (2001). http://​www.bis.org/​publ/​bcbsca07.pdf [Accessed 28 September 2016]. Cooper, George. 2008. The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market. New York: Vintage Books. 121. Cunningham, Lawrence A. and Zaring, David. 2009. “Three or Four Approaches to Financial Regulation:  A  Cautionary Analysis against Exuberance in Crisis Response.” George Washington Law Review 78, pp. 39–​51. Demyanyk, Yuliya and Loutskina, Elena. 2014. Mortgage Companies and Regulatory Arbitrage 2. Working Paper No. 12-​20R 2014, Fed. Res. Bank of Cleveland. http://​www.clevelandfed. org/​research/​workpaper/​2012/​wp1220r.pdf [Accessed 28 September 2016]. Division of Research and Statistics, Federal Deposit Insurance Corporation. 1997. “History of the 80’s—Lessons for the Future.” pp. 172–​173. http://​www.fdic.gov/​bank/​historical/​history/​ index.html [Accessed 28 September 2016]. Dodd–Frank Act, 12 U.S.C. §§ 619 & 1851. Elliott, Douglas J., Feldberg, Greg, and Lehnert, Andreas. 2013. “The History of Cyclical Macroprudential Policy in the United States.” Fed. Reserve Bd., Finance and Economics Discussion Series No. 2013-​29, p. 34 Final Report of the High-​level Expert Group on Reforming the Structure of the EU Banking Sector, chaired by Erkki Liikanen (Oct. 2, 2012). Financial Stability BD. 2012. Global Shadow Banking Monitoring Report. http://​www.financialstabilityboard.org/​publications/​r_​121118c.pdf [Accessed 28 September 2016].

 

444   STEVEN L. SCHWARCZ Geithner, Timothy. “How We Tested the Big Banks.” The New  York Times, May 7, 2009, at A33. http://​www.nytimes.com/​2009/​05/​07/​opinion/​07geithner.html?_​r=0 [Accessed 28 September 2016]. Glass–​Steagall refers to Sections 16, 20, 21, and 32 of the Banking Act of 1933. Section 16 was codified as 12 U.S.C. § 24 (Seventh). Section 20 was codified as 12 U.S.C. §377. Section 21 was codified as 12 U.S.C. §378(a)(1). Section 32 was codified as 12 U.S.C. Gordon, Jeffrey N. and Gandia, Christopher M. 2014. “Money Market Funds Run Risk: Will Floating Net Asset Value Fix the Problem?” Columbus and Business Review 2014, pp. 313–​17. Gramm–​Leach–Bliley Act, the Financial Services Modernization Act of 1999, (Pub. L. 106-​102, 113 Stat. 1338, enacted Nov. 12, 1999). http://​www.gpo.gov/​fdsys/​pkg/​PLAW-​106publ102/​ html/​PLAW-​106publ102.htm [Accessed 29 September 2016.] Halstrick, Philipp. 2011. Tighter Bank Rules Give Fillip to Shadow Banks, Reuters, (Dec. 20, 4:17 a.m.). http://​www.reuters.com/​article/​2011/​12/​20/​uk-​regulation-​shadow-​banking-​ idUSLNE7BJ00T20111220 [Accessed 10 June 2013]. Hannoun, Hervé. 2010. Gen. Manager, Bank for Int’l Settlements, The Basel III Capital Framework: a decisive breakthrough, BoJ-​BIS High Level Seminar on Financial Regulatory Reform: Implications for Asia and the Pacific Hong Kong SAR. (Nov. 22). http://​www.bis. org/​speeches/​sp101125a.pdf [Accessed 28 September 2016]. Herring, Richard J., et al. 2009. Wharton Fin. Inst. Ctr. and Oliver Wyman Inst. 12th Annual Fin. Risk Roundtable  2009:  The New Role of Risk Management:  Rebuilding the Model (June 24). http://​knowledge.wharton.upenn.edu/​article.cfm?articleid=2268 [Accessed 29 September 2016]. Hockett, Robert. 2013. “Implementing Macroprudential Finance-​Oversight Policy:  Legal Considerations.” 12–​13 (Jan. 20, draft prepared for the International Monetary Fund; on file with author). Independent Commission on Banking, Final Report Recommendations (2011). International Regulatory Framework for Banks (Basel III). Bank for International Settlements. http://​www.bis.org/​bcbs/​basel3.htm [Accessed 3 August 2014]. Johnson, Kristin N. 2013. “Macroprudential Regulation: A Sustainable Approach to Regulating Financial Markets.” University of Illinois Law Review 2013, pp. 881–​ 916. Kearns, Jeff. 2010. Deutsche Bank Loses Option Trader Saiers to Hedge Fund Alphabet Management, Bloomberg. (July 15, 10:33 a.m.), http://​www.bloomberg.com/​news/​2010-​07-​ 14/​deutsche-​bank-​loses-​option-​trader-​saiers-​to-​hedge-​fund-​alphabet-​management.html [Accessed 28 September 2016]. Lane, Timothy. Deputy Governor of the Bank of Canada, “Shedding Light on Shadow Banking,” Speech to the CFA Society (June 26). http://​www.bis.org/​review/​r130628g.pdf [Accessed 28 September 2016]. Lynch, Sarah N. 2014. “SEC’s Long Path to Money Market Fund Reform Ends in Compromise.” Reuters. (July 23, 5:16  p.m.). http://​www.reuters.com/​article/​2014/​07/​23/​us-​sec-​ moneyfunds-​idUSKBN0FS08E20140723 [Accessed 28 September 2016]. Macey, Jonathan. 2011. “Reducing Systemic Risk: The Role of Money Market Mutual Funds as Substitutes for Federally Insured Bank Deposits.” Stanford Journal of Law, Business, and Finance 17, pp. 131–​8. McCoy, Patricia A. 2013. Professor, Lecture on Countercyclical Regulation and its Challenges at the Centre for Commercial Law Studies (June 26). McDonnell, Brett H. 2013. “Designing Countercyclical Capital Buffers.” North Carolina Banking Institute Journal 18, p. 123.

 

BANKING AND FINANCIAL REGULATION    445 Miller, Geoffrey and Cafaggi, Fabrizio. 2013. The Governance of Regulation of International Finance. Cheltenham: Edward Elgar. 75–​6. Nocera, Joe. 2009. “Risk Mismanagement.” The New York Times. Jan. 4. § 6 (Magazine), at 24. Pappenfus, James M. 2014. “Dodd-​Frank and Basel III’s Knowledge Problem.” Houston Journal of International Law 36, pp. 253–​262. Parliamentary Commission on Banking Standards, Proprietary Trading. 2012–​13, H.C. 1034, at 15–​19. Pillar 3 Disclosure Requirements for Remuneration. 2011. Basel Committee on Banking Supervision 1. (July). http://​www.bis.org/​publ/​bcbs197.pdf [Accessed 28 September 2016]. Pistor, Katharina. 2012. “On the Theoretical Foundations for Regulating Financial Markets.” (June draft). http://​works.bepress.com/​katharina_​pistor/​11) [Accessed 28 September 2016]. Prasso, Sheridan. 2014. “Shadow Banking.” Bloomberg. (Apr. 16). http://​www.bloomberg.com/​ quicktake/​shadow-​banking/​ [Accessed 28 September 2016]. Quagliariello, Mario. 2009. Stress-​Testing the Banking System: Methodologies and Application 1. Basel Committee on Banking Supervision 42 (originally released Jan. 1996, last updated Nov. 2005). http://​www.bis.org/​publ/​bcbs119.pdf. Rapaport, William J. et al. 1998. Artificial intelligence and cognitive science. Language and meaning in cognitive science: cognitive issues and semantic theory. Vol 4. Ed. Josefa Toribio and Andy Clark. New York: Routledge. Regulatory Capital Rules:  Regulatory Capital, Implementation of Basel III, Minimum Regulatory Capital Ratios, Capital Adequacy, Transition Provisions, and Prompt Corrective Action, 77 Fed. Reg. 52,791 (proposed Aug. 30, 2012) (to be codified in scattered parts of 12 C.F.R.). Ren, Haocong. Countercyclical Financial Regulation 3. Working Paper No. 5823, 2011. The World Bank. http://​elibrary.worldbank.org/​doi/​pdf/​10.1596/​1813-​9450-​5823 [Accessed 28 September 2016]. Report to G20 Leaders on Monitoring Implementation of Basel III Regulatory Reforms. 2013. Basel Committee on Banking Supervision 1. (Aug.). http://​www.bis.org/​publ/​bcbs260.pdf [Accessed 28 September 2016]. Schwarcz, Steven L. 2008. “Disclosure’s Failure in the Subprime Mortgage Crisis.” Utah Law Review 1109, pp. 1113–​15. Schwarcz, Steven L. 2008. “Systemic Risk.” Georgetown Law Journal 97, p. 193. Schwarcz, Steven L. 2009. “Conflicts and Financial Collapse:  The Problem of Secondary-​ Management Agency Costs.” Yale Journal on Regulation 26, p. 457. Schwarcz, Steven L. 2009. “Keynote Address: Understanding the Subprime Financial Crisis.” South Carolina Law Review 60, p. 549. Schwarcz, Steven L. 2009/​2010. “Regulating Complexity in Financial Markets.” Washington University Law Review 87, p. 211. Schwarcz, Steven L. 2011. “Securitization and Structured Finance.” Elsevier’s Encyclopedia of Financial Globalization. 6. Schwarcz, Steven L. 2012. “What is Securitization? And for What Purpose?” Southern California Law Review 85, p. 1283. Schwarcz, Steven L. 2012. “Marginalizing Risk.” Washington University Law Review 89, p. 487. Schwarcz, Steven L. 2012–​2013. “Regulating Shadow Banking.” Review of Banking & Financial Law 31, p. 619. Schwarcz, Steven L. 2013. “Ring-​Fencing.” Southern California Law Review 87, p. 69.

 

446   STEVEN L. SCHWARCZ Schwarcz, Steven L. 2014. “The Governance Structure of Shadow Banking:  Rethinking Assumptions about Limited Liability.” Notre Dame Law Review 90, 1. http://​ssrn.com/​ abstract=2364126 [Accessed 28 September 2016]. Schwarcz, Steven L. 2015. Derivatives and Collateral:  Balancing Remedies and Systemic Risk, University of Illinois Law Review 699 (Symposium Issue). http://​ssrn.com/​ abstract=2419460 [Accessed 28 September 2016]. Schwarcz, Steven L. 2015. “Intrinsic Imbalance: The Impact of Income Disparity on Financial Regulation.” Law and Contemporary Problems 78, p. 97. Schwarcz, Steven L. 2016. “Regulating Financial Change: A Functional Approach.” Minnesota Law Review 100, p. 1441. http://​ssrn.com/​abstract=2469467. Schwarcz, Steven L. 2016. “Misalignment: Corporate Risk-​Taking and Public Duty.” Notre Dame Law Review 92, p. 1 (Nov. 2016). http://​ssrn.com/​abstract=2644375. Schwarcz, Steven L. and Anabtawi, Iman. 2011. “Regulating Systemic Risk: Towards an Analytical Framework.” Notre Dame Law Review 86, p. 1349. Schwarcz, Steven L. and Anabtawi, Iman. 2013. “Regulating Ex Post: How Law Can Address the Inevitability of Financial Failure.” Texas Law Review 92, p. 75. Schwarcz, Steven L. and Chang, Lucy. 2012. “The Custom-​to-​Failure Cycle.” Duke Law Journal 26, p. 767. Slovic, Paul, et al. 2004. “Risk as Analysis and Risk as Feelings: Some Thoughts about Affect, Reason, Risk, and Rationality.” Risk Analysis 24, pp. 311–​15. Tarullo, Daniel. 2013. “Governor, Governors of the Federal Reserve System, Speech at the Americans for Financial Reform and Economic Policy Institute Conference.” (Nov. 22). http://​www.federalreserve.gov/​newsevents/​speech/​tarullo20131122a.htm [Accessed 28 September 2016]. Banking on Basel 29 and 45. (2008). Touryalai, Halah. “Top JPMorgan Prop Trader Leaves to Launch Hedge Fund.” Forbes. (Feb. 15, 12:48  p.m.). http://​www.forbes.com/​sites/​halahtouryalai/​2013/​02/​15/​top-​jpmorgan-​prop-​ trader-​leaves-​to-​launch-​hedge-​fund/​ [Accessed 28 September 2016]. Weber, Robert. 2014. “A Theory for Deliberation-​ Oriented Stress Testing Regulation.” Minnesota Law Review 98, pp. 2236–​39. Whitehead, Charles. 2011. “The Volcker Rule and Evolving Financial Markets.” Harvard Business Law Review 1, pp. 39–​40.

 

Chapter 18

EC ONOMI C S OF BANKRU P TC Y Michelle J. White

18.1. Introduction Bankruptcy is the legal process by which the debts of firms, individuals, corporations, and some local governments in financial distress are resolved. Debtors file for bankruptcy because they cannot pay debts as they come due and/​or because their total liabilities exceed their assets.1 However, countries vary in whether they have bankruptcy procedures at all and which types of debtors are allowed to use them. Bankruptcy law always includes several components. First, it provides a collective framework for simultaneously resolving all the debts of the bankrupt, regardless of whether they are due immediately or in the future and regardless of whether they are contingent or not. Part of the bankruptcy process involves creating a list of debts. Another part of the bankruptcy process involves finding and valuing the bankrupt’s assets and determining which assets must be used to repay debt. Here, bankruptcy law differs depending on whether bankrupts are corporations, individuals, or governments: corporations in bankruptcy may be required to use all of their assets to repay, but individuals and governments in bankruptcy are always allowed to keep some of their assets. Bankrupts may also be required to use some of their future earnings to repay and bankruptcy law provides rules for determining how much and for how long. These rules determine the size of the repayment pie in bankruptcy. Bankruptcy law also provides rules for dividing the pie among creditors—​called priority rules. Thus, bankruptcy law provides rules that determine both the size and division of the pie. Second, bankruptcy law provides rules for protecting the collective debt resolution procedure and maximizing the value of assets that go into it. When debtors are in 1 

Michelle J. White is with the Department of Economics, University of California, San Diego, Cheung Kong Graduate School of Business and NBER. E-​mail: [email protected].

 

448   MICHELLE J. WHITE financial distress, individual creditors have an incentive to grab assets in order to keep them outside of the collective bankruptcy procedure and avoid sharing them with other creditors. This race to be first to remove assets can disrupt the debtor’s operations and can be economically costly. To protect the collective debt resolution procedure, bankruptcy includes a stay on legal proceedings against the debtor that stops creditors from attempting to collect and from removing assets—​the stay starts as soon as the debtor files for bankruptcy. Third, bankruptcy law punishes bankrupts for failing to repay their debts in full. Punishment is intended to protect lenders by discouraging default generally and discouraging debtors from hiding assets that could be used to repay. In the past, punishments for bankruptcy have been very harsh, including the death penalty, maiming, exile, selling bankrupts into slavery, and putting them in debtors’ prisons. Modern punishments for bankruptcy are less severe, but still exist. In the United States, bankrupts’ names are made public and their bankruptcy filings remain on their credit records for 10 years, thus lowering their credit scores and making it more difficult for them to borrow, rent housing, and get jobs. In the UK, bankrupts cannot manage firms or hold certain public offices for several years after filing. In France, corporate managers can face criminal charges if they do not file for bankruptcy when their firms become insolvent. Another aspect of the punishment for bankruptcy is whether and when bankrupts receive a discharge of their unpaid debts. In the United States, most bankrupt individuals obtain a quick discharge. But in France and Germany, and other countries, the discharge occurs only after bankrupts have used part of their earnings for several years to repay and the bankruptcy judge decides that they have used reasonable effort. The longer the required period of repayment, the harsher the punishment for bankruptcy. In other countries, there is no debt discharge until the bankrupt person dies.2 In analyzing the economic effects of bankruptcy law, a variety of economic objectives need to be considered because the particular objectives that are important vary depending on whether the bankrupt is a corporation, an individual, or a government. The most important single objective in corporate bankruptcy is deciding efficiently whether corporations in bankruptcy should reorganize versus liquidate. Corporations that reorganize retain some or all of their assets, but adopt a reorganization plan that uses part of their future earnings to repay debt; corporations that liquidate sell all their assets—​either piecemeal or as a going concern—​and use all of the proceeds to repay pre-​bankruptcy debt. From an economic efficiency standpoint, corporations should liquidate if the most efficient use of their assets is different from the current use, so that shutdown frees the assets to move to more valuable uses. Conversely, corporations should reorganize if the best use of their assets is the current use, so that a reorganization allows the assets to remain in place. But deciding whether corporations should reorg­ anize or liquidate is difficult because it involves predicting whether the value of the firms’ 2  Sandage (2005) and Mann (2002) discuss attitudes toward debt and default in the United States during the nineteenth century. Efrat (2006) gives multicountry information on punishments for default and bankruptcy.

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    449 assets would be higher in a different use, which may be in a different industry. “Filtering failure” in bankruptcy occurs when economically efficient corporations are liquidated in bankruptcy or economically inefficient corporations are reorganized in bankruptcy. However, for individuals in bankruptcy, efficient filtering is not an economic objective. This is because individuals’ most valuable asset is usually their human capital, which cannot be liquidated without selling the individual into slavery. Since slavery has been abolished, bankrupt individuals are allowed to keep their human capital and the right to decide whether and how to use it. This means that all individual bankruptcies are reorganizations, although some of individuals’ non-​human capital may be liquidated to repay their debts in bankruptcy. Another important economic objective of bankruptcy that applies particularly to corporations is preventing corporate managers from wasting the corporation’s assets. When corporations are financially distressed, managers have an incentive to gamble with the assets because a successful gamble benefits managers and shareholders by saving the firm, while a failed gamble only harms creditors by increasing their losses. Allowing corporations to reorganize in bankruptcy has the advantage of reducing managers’ incentive to gamble because they usually remain in charge during at least the initial stages of the reorganization. But because managers always want to save their jobs, allowing them to remain in charge potentially means that too many financially distressed corporations reorganize. An important economic role of personal as opposed to corporate bankruptcy is that of providing individual debtors with partial consumption insurance by discharging part of their debt when their ability-​to-​pay turns out to be low, and allowing them to keep some of their assets in bankruptcy. The insurance objective of bankruptcy is intended to prevent larger negative effects that may result from sharp drops in debtors’ consumption, such as debtors’ children being forced to drop out of school in order to work or debtors’ health problems going untreated for lack of funds. The insurance objective of bankruptcy is also related to another objective of bankruptcy: that of encouraging individuals to become entrepreneurs. Starting a business is risky and risk-​averse individuals are more likely to do so if bankruptcy softens the consequences of failure by discharging the entrepreneur’s business and other debts. A final objective of bankruptcy that applies to all types of bankrupts is that of protecting credit markets. A pro-​debtor bankruptcy law makes existing debtors better off, but increases the probability that they will default and reduces the amount they repay conditional on default. This causes lenders to reduce the supply of credit, which harms future borrowers. A pro-​creditor bankruptcy law has the opposite effect. An efficient bankruptcy law needs to strike a balance between the interests of present versus future debtors that assures a reasonable supply of credit. In this review of bankruptcy law, I examine whether and when the law encourages debtors and creditors to behave in economically efficient ways, both before and after they are in financial distress. I also consider how bankruptcy law could be changed to improve economic efficiency. The discussion abstracts from individual countries’ bankruptcy laws in order to focus on common features of bankruptcy. However, because

 

450   MICHELLE J. WHITE much of the literature on the economic effects of bankruptcy law is US-​based, the discussion often focuses on US bankruptcy law in particular. I examine corporate bankruptcy first and then turn to personal and small business bankruptcy.

18.2.  Corporate Bankruptcy Bankruptcy law affects the economic efficiency of corporate behavior, both when corporations are in financial distress and when they are financially healthy.

18.2.1. Theoretical Research on Corporate Bankruptcy 18.2.1.1. Priority Rules in Bankruptcy and the Efficiency of Corporate Behavior Priority rules are rules for dividing repayment in bankruptcy among creditors and shareholders of a corporation. The basic priority rule in bankruptcy is the “absolute priority rule” (APR), which requires that unsecured creditors be repaid in full before shareholders receive anything. When there are multiple creditors, priority among them is determined by whether creditors have a secured interest in a particular asset owned by the corporation or by whether creditors have made agreements with the corporation that specify an ordering. To illustrate, suppose a corporation has creditors A and B and A’s loan was made before B’s. If A’s contract with the corporation specifies that its claim will take priority in bankruptcy over the claims of all later lenders, then A’s claim will be paid in full in bankruptcy before B receives anything. Alternatively, suppose A has a secured claim on the corporation’s computer. Then A can take the computer in bankruptcy, which means that A’s claim is paid up to the value of the computer before B receives anything. If there is no contractual agreement or security, then A and B have equal priority in bankruptcy, and the APR requires that they be paid the same proportion of their claims. “Deviations from the APR” refer to lower-​priority creditors or shareholders being paid some amount in bankruptcy when higher-​priority creditors are not paid in full. The legal justification for the APR is that it treats creditors in bankruptcy according to the contracts they made with the corporation outside of bankruptcy. Priority rules directly affect only the division of the pie, rather than its size. But, indirectly, they have widespread effects on the economic efficiency of corporate behavior. Consider first how priority rules affect the efficiency of managers’ bankruptcy decisions. Assume that the corporation is in financial distress and managers—​representing the interests of shareholders—​must choose between filing for bankruptcy versus continuing to operate the firm outside of bankruptcy. The only bankruptcy procedure is liquidation. Corporations in financial distress may be either economically efficient or economically inefficient. They are economically efficient (despite being in financial distress) if the

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    451 most valuable use of their assets is the current use and economically inefficient if their assets are more valuable in some other use. When corporations are economically inefficient, the best outcome is liquidation, since liquidation frees their assets to move to higher-​value uses. Conversely, when they are efficient, the best outcome is for them to continue operating outside of bankruptcy, since this keeps the assets in their current use. Filtering failure occurs when corporations that should liquidate continue to operate or vice versa. Assume that managers and creditors are fully informed about the value of the corporation’s assets in both their current and alternate uses. Suppose the corporation owes a debt of dollars to creditor A which is due in period 1 and a debt of DB to creditor B, which is due in period 2. Total debt D equals DA + DB. The corporation has no cash on hand. If it liquidates in period 1, the value of its assets is L. Since L < D, the corporation is insolvent. If the corporation continues to operate outside of bankruptcy, then it will earn P2 with certainty in period 2, but the liquidation value of its assets will fall to zero. Ignoring the time value of money, continuation in period 1 is economically efficient if P2 > L and liquidation is economically efficient otherwise. Managers decide between liquidating the corporation in bankruptcy in period 1 or continuing to operate it outside of bankruptcy until period 2. But in order to avoid bankruptcy in period 1, they must repay creditor A and the only way they can do so is to obtain a new loan for the amount owed, which is DA. Suppose the new loan, if it is made, will be from creditor C and will be due in period 2. If the corporation obtains the loan and continues to operate until period 2, it will then shut down and distribute its assets according to the APR. Depending on the terms of creditor B’s and C’s loan contracts, either of them could have priority under the APR or they could have equal priority. Assume first that creditor B takes priority, i.e., priority is in chronological order. Creditor C and managers are assumed to make the corporation’s bankruptcy decision jointly, so that creditor C makes the loan if it and shareholders jointly gain when the corporation continues to operate. This means that shareholders are willing to pay creditor C up to the value of their shares in return for making the loan. If the corporation liquidates in period 1, then all of its assets go to pay creditors and shareholders receive nothing. If the corporation continues to operate in period 1, then creditor C and shareholders together will receive max [P2 − DB ,0] − DC, in period 2. The condition for creditor C and shareholders to prefer continuation over liquidation is that this expression is positive, which implies that P2 > DB + DC = D . But since D > L, the two conditions together imply that P2 > L . Thus creditor C and shareholders choose continuation only when it is economically efficient. But they may choose liquidation when continuation is more efficient: the inefficient outcome occurs if L < P2 < D. Thus we have a one-​sided efficiency result: corporations continue to operate only when doing so is economically efficient, but they sometimes liquidate when continuing to operate is economically efficient. Thus filtering failure occurs in bankruptcy because some economically efficient corporations shut down. This result occurs because choosing continuation increases creditor B’s repayment in period 2, but managers and creditor C ignore this gain because they do not share it. Overall, when priority among creditors is in chronological order, too much liquidation occurs in bankruptcy.

 

452   MICHELLE J. WHITE Now suppose priority among creditors B and C is in reverse chronological order. Then creditor C is more likely to lend, because creditor C and shareholders receive more in period 2. As a result, financially distressed corporations are more likely to continue operating rather than liquidating in period 1. But the condition for continuation to be economically efficient remains the same. Thus, when priority is in reverse chronologi­ cal order, fewer economically efficient corporations liquidate in bankruptcy, which improves efficiency. But now the opposite type of filtering failure may occur, since some inefficient corporations may avoid bankruptcy and continue operating. These simple examples show that priority rules affect the economic efficiency of corporations’ bankruptcy decisions and the type of filtering failure that occurs. Too much liquidation occurs when priority among lenders is in chronological order, while too much continuation may occur when priority is in reverse chronological order. Another way to see this result is that priority in reverse chronological order allows late lenders to jump over earlier lenders in the priority ordering, which gives them an incentive to lend and increases the probability that corporations—​whether efficient or inefficient—​ continue to operate.3 Now suppose corporations’ future earnings are uncertain rather than certain. Suppose earnings if the corporation continues until period 2 are P2 + G or P2 – G ​ , each with .5 probability. Suppose creditor B has priority over creditor C and assume that earnings in the good outcome are sufficient to repay creditor B in full, while earnings in the bad outcome are not. Now if creditor C lends and the corporation continues to operate, creditor C and shareholders’ joint expected return in period 2 is .5(P2 + G − DB ) − DC . Creditor C lends and the corporation continues to operate if this expression is positive, but continuation is still economically efficient if P2 ≥ L. This means that as the corporation’s earnings become more uncertain (G rises), continuation is more likely to occur even if it is inefficient. This is because creditor C and shareholders get the additional earnings in the good outcome, but creditor B bears the additional losses in the bad outcome. Corporate managers and shareholders thus tend to prefer risky over safe investments even when risky investments have lower expected returns, because shareholders disproportionately gain when risky investments succeed. This effect applies both to corporations’ bankruptcy decisions and to their investment decisions generally.4 Now suppose there is a reorganization procedure in bankruptcy.5 Managers of corporations in financial distress are now assumed to choose among continuing to operate outside of bankruptcy, liquidating in bankruptcy, or reorganizing in bankruptcy. When corporations reorganize in bankruptcy, managers are assumed to remain in control at 3 

See Bulow and Shoven (1978) and White (1980) for coalition models of the bankruptcy decision and Stulz and Johnson (1985) and Bebchuk and Fried (1996) for discussions. These results can be seen as applications in bankruptcy of Myers’ (1977) “debt overhang” problem. 4  See Stiglitz (1972) and Jensen and Meckling (1976) for discussion in the non-​bankruptcy context. 5  In the United States, managers have the right to choose between reorganization versus liquidation in bankruptcy, but in other countries, this decision is usually made by a trustee or bankruptcy court official who replaces the manager. For comparisons of bankruptcy law across countries, see Franks, Nybourg, and Torous (1996); White (1996); Berkovitch and Israel (1998); Franks and Sussman (2005).

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    453 least temporarily and unsecured debt payments are suspended until a reorganization plan is adopted. This temporary debt holiday improves corporations’ cash flow and allows them to continue operating. Managers have the exclusive right to propose the reorganization plan and it promises to pay all creditors a fraction r of their claims in period 2. (Payments to creditors under the plan must make them at least as well off as they would be in liquidation.) Also assume that the corporation has only one creditor, creditor E, whose claim of DE is due in period 1. Because of the debt holiday, the corporation no longer needs a new loan in period 1 if it reorganizes in bankruptcy. Assume that if it reorganizes, its earnings in period 2 are still P2 ± G in period 2, each with 50% prob­ ability, and its assets will still be worthless at the end of period 2. Introducing reorganization allows us to examine the effects of deviations from the APR. Deviations from the APR often occur when US corporations reorganize in bankruptcy, because reorganization plans must be approved by separate votes of both shareholders and creditors. Shareholders, therefore, must receive some positive payment in order to induce them to vote for the plan.6 Suppose shareholders are promised a mini­ mum payment equal to a fraction α of creditors’ claims, or αDE. Deviations from the APR occur when α is positive rather than zero; higher values of α imply that the payoff rate r to creditors is lower. If the corporation reorganizes, shareholders’ expected return is .5(P2 + G – ​rDE) + .5(αDE), where the first term represents shareholders’ return in the good outcome and the second term is their return in the bad outcome (earnings are assumed to be high enough even in the bad outcome to make this payment). Thus, larger deviations from the APR raise shareholders’ return in both the good and bad outcomes and make it less risky. Because shareholders receive nothing if the firm liquidates in period 1, managers prefer reorganization over liquidation in bankruptcy as long as this expression is posi­ tive and they prefer reorganization over continuing to operate outside of bankruptcy since .5(P2 + G – ​rDE) + .5(αDE) exceeds .5(P2 + G – ​DE). But it is economically efficient for the corporation to continue operating only if P2 > L, and this condition is unaffected by introducing reorganization as an alternative to continuation outside of bankruptcy. Thus introducing reorganization in bankruptcy increases filtering failure, since more corporations continue operating in bankruptcy, some of which should liquidate.7 Introducing reorganization in bankruptcy also affects managers’ incentive to make efficient choices between safe versus risky investment projects. When corporations are in financial distress, suppose the probability of the bad outcome increases in our example from .5 to .9. Shareholders’ return thus depends much more strongly on their payoff in the bad outcome. But if deviations from the APR are zero (αDE = 0), shareholders receive nothing in the bad outcome. This means that managers have an incentive to 6 

Deviations from the APR can alternatively be seen as payments by creditors to prevent shareholders from delaying the reorganization process. See Bebchuk and Chang (1992) for a model and Bebchuk (1998) and White (1989) for discussion of the US reorganization process generally. 7  See Wruck and Weiss (1998) for discussion of Eastern Airlines, the best-​known example of an inefficient corporation that was saved in bankruptcy under Chapter 11 when it should have liquidated.

 

454   MICHELLE J. WHITE invest in very risky projects (those with high G), because shareholders receive a payoff only when the risky investment project is chosen, it succeeds, and its return in the good outcome (P2 + G – ​DE) is large enough to save the corporation. Managers, therefore, prefer risky projects even when these projects have low expected returns and are economically inefficient. But deviations from the APR give shareholders a positive return even in the bad outcome, so that managers’ incentive to select excessively risky investment projects falls. Thus, deviations from the APR improve efficiency when corporations are in financial distress by reducing managers’ incentive to gamble on extremely risky investment projects.8 This discussion shows that introducing reorganization as an alternative bankruptcy procedure increases filtering failure by causing more financially distressed corporations to continue operating when they should liquidate. But the option of reorganizing has the offsetting gain of reducing managers’ incentives to invest in excessively risky investment projects when their corporations are in financial distress. The discussion also implies that none of the commonly used priority rules in bankruptcy always gives corporate managers an incentive to make both efficient bankruptcy decisions and efficient investment choices.

18.2.2. Strategic Default and Managerial Effort Now turn to the effect of bankruptcy law on whether corporations default on their debt obligations when they are not in financial distress—​called strategic default. Suppose there are two types of corporations, solvent versus insolvent, and the most efficient outcome for both types is to continue operating. Managers of both types of corporations decide whether to default or repay in full. If they default, they offer to pay creditors a fraction of their claims and creditors must decide whether to accept or reject. If creditors accept, then the new debt agreement—​called a “non-​bankruptcy workout”—​goes into effect. If creditors reject, then suppose managers of insolvent corporations liquidate in bankruptcy; while managers of solvent corporations repay in full and do not file for bankruptcy. Because bankruptcy is assumed costly, the most efficient outcome is for all insolvent corporations to use non-​bankruptcy workouts to resolve their financial distress and all solvent corporations to repay their loans in full and avoid bankruptcy. This outcome is efficient because there are no strategic defaults and no costly bankruptcy filings. Managers of insolvent corporations are always assumed to default and propose workouts, while managers of solvent corporations choose between strategic default and repaying in full. Creditors would like to accept all workout plans offered by insolvent corporations and reject all workout plans offered by solvent corporations. If they could do so, then the efficient outcome would occur (i.e., no strategic defaults and no costly 8 

But deviations from the APR have the opposite effect on managers’ incentives when corporations are not in financial distress. See Bebchuk (2002) and Cornelli and Felli (1997) for discussion.

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    455 bankruptcies). But models of strategic default assume that there is asymmetric information about corporations’ financial status, meaning that managers know whether their corporations are solvent, but creditors do not. As a result, creditors must respond in the same way to all workout offers. Creditors have an incentive to accept non-​bankruptcy workout plans, since bankruptcy costs are high and they would receive little in bankruptcy. But creditors have an offsetting incentive to reject workout plans in order to discourage strategic default. In equilibrium, creditors therefore reject some or all workout plans and this means that at least some insolvent corporations end up in bankruptcy. Asymmetric information thus implies that there is always some strategic default or some costly bankruptcy, or a combination of both.9 A number of papers in the financial contracting literature consider ways to reduce this tradeoff. Bolton and Scharfstein (1996) develop a model in which corporations borrow from multiple creditors and they show that doing so reduces managers’ probability of strategically defaulting. This is because each individual creditor has the right to force the corporation to liquidate following default, so that strategic default only succeeds if no creditor chooses liquidation, and this outcome is less likely as the number of creditors increases. Berglof and von Thadden (1994) consider a similar model in which the corporation has both short-​term and long-​term debt. Creditors holding long-​term debt have a greater stake in the corporation than creditors holding short-​term debt, since only the former benefit from its future earnings. As a result, short-​term creditors are more likely to liquidate the corporation following default. Berglof and von Thadden show that entrepreneurs are less likely to default strategically if some of the corporation’s creditors hold only short-​term debt. There is also research on how bankruptcy law affects managerial effort levels. Povel (1999) develops a model that analyzes how bankruptcy law affects the tradeoff between entrepreneurs’ effort levels and whether the number of bankruptcy filings is efficient. In his model, corporations’ future earnings may be either high or low. The best outcome is for them to file for bankruptcy when earnings are low and avoid bankruptcy when earnings are high. Entrepreneurs make the bankruptcy decision and they decide whether to use high or low effort, where high effort increases the probability of high earnings. But creditors cannot observe entrepreneurs’ effort levels and they also do not observe a signal that arrives concerning whether earnings will be high or low. There are two possible bankruptcy laws: “soft” versus “tough,” corresponding to reorganization versus liquidation in bankruptcy. Entrepreneurs are assumed to keep their jobs under the soft bankruptcy law and lose them under the tough bankruptcy law. When bankruptcy law is soft, Povel shows that entrepreneurs file for bankruptcy whenever the signal suggests that earnings are likely to be low, since they are treated well in bankruptcy. But because they have a soft landing in bankruptcy, they use less effort. In contrast, when bankruptcy law is tough, entrepreneurs avoid bankruptcy regardless of 9  Models of the tradeoff between strategic default and bankruptcy include Webb (1987); Gertner and Scharfstein (1991); Schwartz (1993); White (1994); Bester (1994); Bolton and Scharfstein (1996); Hart and Moore (1998).

 

456   MICHELLE J. WHITE the signal, since filing for bankruptcy costs them their jobs. But then they have an incentive to use high effort in order to increase the probability that earnings will be high. Thus, there is a tradeoff between the extent of filtering failure and entrepreneurs’ effort level: a tough bankruptcy law results in too many bankruptcies but an efficient effort level by managers, while a soft bankruptcy law has the opposite effect. Depending on whether efficient effort by managers or efficient levels of filtering failure is more valu­ able, either a soft or a tough bankruptcy law could be more economically efficient. To summarize, theoretical models of bankruptcy law show that bankruptcy affects managers’ incentive to make efficient bankruptcy decisions, to default strategically, to make efficient investment decisions, and to use efficient effort levels. The models consider both the effects on economic efficiency of changing the priority rules in bankruptcy and changing bankruptcy law in other ways. The results show that, except in special cases, no one bankruptcy procedure results in economically efficient outcomes along all the dimensions considered.10

18.2.2.1. Reforms of Bankruptcy Law: Auctions, Options, and Bankruptcy by Contract When managers of US corporations file under Chapter 11—​the US bankruptcy reorganization procedure—​they remain in charge at least temporarily and have the exclusive right for the first few months to propose the reorganization plan. For the plan to be adopted, it must be approved by a majority vote of each class of creditors and by shareholders as a class. Chapter 11 is thought to encourage too many corporations to reorga­ nize rather than liquidate in bankruptcy, both because managers favor reorganization as a means of saving their jobs and because even economically inefficient corporations can adopt reorganization plans by using deviations from the APR to obtain shareholders’ consent. Reform proposals advocate substituting market-​based methods to value corporate assets in bankruptcy and propose to take away managers’ right to decide whether bankrupt corporations shut down or reorganize. Auctions. One proposal is to auction all corporations in bankruptcy. If corporations were operating when they file, they would be auctioned as going concerns and, if they have shut down, their assets would be auctioned piecemeal. The proceeds of the auction would be distributed to creditors and equity according to the APR, without deviations. The winner of the auction—​rather than old managers—​would decide whether the corporation would continue to operate or shut down. Auctions would essentially eliminate the distinction between reorganization and liquidation in bankruptcy. Auctions have a number of advantages. They would improve economic efficiency by allowing new buyers to decide whether distressed corporations will liquidate or 10  Related work includes Berkovitch, Israel, and Zender (1997), who explore how bankruptcy law affects managers’ incentives to invest in firm-​specific human capital, Berkovitch and Israel (1999), who explore whether creditors or entrepreneurs should have the right to initiate bankruptcy; Tarantino (2013), who explores the effect of soft versus tough bankruptcy laws on managers’ choice between short-​ term versus long-​term investments; and Triantis (1993), who explores how bankruptcy law affects the efficiency of buyers’ and sellers’ incentives to breach contracts.

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    457 reorganize. While managers and old shareholders always prefer reorganization, buyers have an incentive to make economically efficient choices because they have their own funds at stake. The reorganization process would be also be quicker and less costly, since there would be no need to negotiate and vote on reorganization plans.11 But a number of problems with bankruptcy auctions have been noted. One is that, if few bankrupt firms are auctioned, then buyers may assume that they are lemons and respond with low bids. This problem is likely to be less severe if more auctions occur. Another is that auctions may increase the level of concentration in an industry, since the most likely buyers of bankrupt corporations are other firms in the same industry. Finally and most importantly, the theoretical models discussed herein do not support the idea that strict application of the APR in bankruptcy reorganization increases efficiency. Instead, using the APR without deviations may result in too many liquidations occurring and may distort managers’ pre-​bankruptcy investment decisions. Options. Bebchuk (1988) proposed using options to value the assets of corporations in bankruptcy and eliminate deviations from the APR. To illustrate, suppose a bankrupt firm has 100 creditors who are each owed $1, and 100 shares of old equity. Also suppose the reorganized firm will have 100 shares of new equity. Under the options approach, each old shareholder is given an option to purchase the interests of a creditor for $1. Options must be exercised at a particular date. If old shareholders think that their shares are worth less than $1, then they will not exercise their options. Then each loan is converted into a new share in the reorganized corporation, so that each creditor ends up with one new share worth less than $1 and old shareholders receive nothing. But if old shareholders think that their shares are worth more than $1, then they exercise their options. Each creditor then ends up with $1, and each old shareholder ends up with one new share minus $1. Regardless of whether the options are exercised, the APR is followed because old shareholders receive nothing unless creditors are repaid in full. A market for the options would operate before the exercise date, so that creditors and shareholders would have a choice between exercising their options or selling them to investors. This procedure can be extended to multiple classes of creditors, where each class of creditors is given options to purchase the claims of the next highest class of creditors for the face value of their claims. In Bebchuk’s proposal, there is no explicit method for determining whether the old managers will be replaced and how the reorganized firm’s assets will be used. After the options are exercised, the new shareholders elect a board of directors that hires a manager—​the same procedure as is followed by non-​bankrupt firms. Aghion, Hart, and Moore (1992) extended Bebchuk’s options scheme to include a vote by the new shareholders on how the reorganized firm’s assets will be used. Under their proposal, the bankruptcy judge solicits bids that could involve either cash or non-​cash offers for the reorganized firm’s new shares or simply offers to manage the firm with the new 11  For arguments in favor and against auctioning corporations in Chapter 11, see Baird (1986, 1987, 1993); Roe (1983); Jackson (1986); Shleifer and Vishny (1992); Berkovitch, Israel, and Zender (1997, 1998); Baird and Rasmussen (2002); LoPucki (2003).

 

458   MICHELLE J. WHITE shareholders retaining their shares. The bids would be announced at the same time that the options are issued, so that the parties could use the information contained to decide whether to exercise their options. After the options are exercised, new shareholders would vote to determine which bid is selected. Bankruptcy contracts. Bankruptcy is mandatory in the sense that, when firms become insolvent, the bankruptcy law in the relevant country must be followed. Debtors and creditors are not allowed to contract for any alternative dispute-​resolution procedure or (in the United States) for any limits on managers’ right to file for bankruptcy and to choose between liquidation and reorganization in bankruptcy. They also cannot contract out of use of the APR in bankruptcy liquidation. In this sense, bankruptcy differs from other aspects of commercial law, where the law provides a set of default rules, but the parties are generally allowed to reject the default rules by agreeing on alternatives. A number of authors have argued that efficiency would be enhanced if creditors and debtors could choose their own bankruptcy procedure when they negotiate their debt contracts. This argument makes sense in light of the financial contracting models discussed above, which show that the most economically efficient bankruptcy procedure may vary depending on circumstances. For example in the Povel (1999) model, the most economically efficient bankruptcy law might be either soft or tough. The most radical approach to bankruptcy contracting was suggested by Adler (1993), who proposed completely abolishing bankruptcy. Instead, debt contracts would incorporate a procedure to deal with financial distress called “chameleon equity.” If a corporation became insolvent, equity would be eliminated and the corporation’s lowest-​priority debts would be converted into new shares. If the corporation was still insolvent, the next-​higher-​priority debt claims would be converted into equity and the lowest-​priority debt claims would be eliminated. The process would continue until the corporation is solvent again. These changes would preserve the APR. Creditors would no longer have the right to sue corporations for repayment following default. The proposal has a number of problems. The most important is strategic default, since managers would gain from invoking the procedure even if the corporation were solvent. The lack of a penalty for default would undermine credit markets and greatly reduce credit availability. In addition, inefficient corporations would never be forced to shut down, since they could always convert their debt to equity. Overall, the proposal suggests the importance of having a mandatory bankruptcy procedure. While it might improve efficiency to allow debtors and creditors to contract about specifics of bankruptcy, it would not improve efficiency to eliminate bankruptcy. Schwartz (1997) considers a model in which bankruptcy reorganization retains its current form, but debtors and creditors can contract in advance to change some aspects of the law. In particular, creditors could contract in advance to deviate from the APR in bankruptcy by paying shareholders a predetermined amount if managers chose liquidation rather than reorganization in bankruptcy. All other aspects of bankruptcy law would remain unchanged. Schwartz argues that this type of contract can reduce filtering failure by reducing managers’ incentive to favor reorganization over liquidation in bankruptcy. The more

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    459 inefficient is the corporation, the more likely are managers to shift from choosing liquidation to choosing reorganization in bankruptcy when there is a predetermined payment from creditors, so that fewer inefficient firms would reorganize. But the payments may increase the opposite type of filtering failure, i.e., liquidation of efficient corporations that should reorganize in bankruptcy. This is because a high predetermined payment could induce managers of efficient corporations to choose liquidation over reorganization in order to receive the payment. Thus, allowing parties to contract over some aspects of bankruptcy law may improve economic efficiency relative to the current mandatory bankruptcy regime, but this result depends on specific conditions and does not hold in general.12

18.2.3. Empirical Research on Corporate Bankruptcy A problem with empirical research on corporate bankruptcy is that researchers are often interested in the behavior of large publicly traded corporations, but few of them file for bankruptcy. Empirical research is therefore divided between studies of large corporations in bankruptcy that use small samples versus studies of representative samples of corporations in bankruptcy that use large samples, but where the average corporation is small.

18.2.3.1. Characteristics of Corporations in Bankruptcy and Bankruptcy Costs There have been several studies of the characteristics of firms in bankruptcy and the costs of bankruptcy under both Chapter 7—​the US bankruptcy liquidation procedure—​ and Chapter 11. One recent study is Bris, Welch, and Zhu (2006), who examined all of the corporations that filed for bankruptcy in two US bankruptcy courts during the late 1990s. They found that the average size of corporations filing under Chapter 11 was ten times as large as that of corporations filing under Chapter 7, and the former were more deeply underwater. The first result suggests that the high fixed costs of reorganizing under Chapter 11 make it prohibitively expensive for small corporations, while the second result is surprising because it goes against the presumption that managers choose reorganization when their corporations’ financial condition is less dire because having more resources improves the chance of a successful reorganization.13

12 

In most European countries, the choice between reorganizing or liquidating in bankruptcy is not made by managers, but by an appointed administrator or bankruptcy court official. But there may still be filtering failure, because the bankruptcy official may not always make efficient decisions or may be charged to save the corporation’s jobs. In the UK, too much liquidation is thought to occur because a single creditor has the right to liquidate the corporation’s assets following default. See Webb (1991). 13  Other studies that examine large corporations in bankruptcy include Weiss (1990); Franks and Torous (1989); LoPucki and Whitford (1990); Betker (1995). Other studies of small firms in bankruptcy include LoPucki (1983) and White (1983).

 

460   MICHELLE J. WHITE Other studies provide evidence that that bankruptcy reorganization is very disruptive, which implies that the costs of bankruptcy must be high. Gilson (1990) found that the turnover rates of top executives and directors were much higher for large corporations that reorganized in bankruptcy than for non-​bankrupt corporations. Carapeto (2000) found that when large corporations in bankruptcy offer multiple reorganization plans, the total payoff offered to creditors declines by 14% between the first and the last plan. This implies that the cost of remaining in bankruptcy for longer increases quickly.

18.2.3.2. Deviations from the APR Several authors have examined the frequency and size of deviations from the APR in corporate reorganizations. The size of deviations from the APR is measured by the amount paid to equity in violation of the APR divided by the total amount paid to creditors under the reorganization plan. For example, suppose a corporation in bankruptcy owes $1,000,000 to creditors, but its reorganization plan pays creditors $500,000 and gives old shareholders $50,000. Then deviations from the APR are $50,000/​500,000 or 10%. Studies of deviations from the APR have typically found that between 75% and 90% of large corporations’ Chapter 11 plans deviate from the APR and the average APR deviation is in the range of 3% to 7%.14 What determines the size of deviations from the APR and how do deviations from the APR relate to the financial condition of corporations in Chapter 11? The first relationship can be estimated by regressing the amount paid to equity as a fraction of unsecured creditors’ claims on the amount paid to unsecured creditors as a fraction of their claims (i.e., the payoff rate to unsecured creditors). If the APR were always perfectly followed, deviations would be zero as long as the payoff rate to unsecured creditors was less than 100%, but would jump when the payoff rate to creditors reached 100%. But when there are deviations from the APR, the shareholders’ payoff will increase gradually as the unsecured creditors’ payoff rate approaches 100%. Thus, in practice, the predicted relationship is a smooth curve with a positive and increasing slope. White (1989) and Betker (1995) examined this relationship and found that shareholders receive a minimum payoff of about 5% of unsecured creditors’ claims and that their payoff rate increases as the payoff rate to unsecured creditors rises. This result is consi­ stent with a bargaining model of Chapter 11 such as Bebchuk and Chang (1992), in which equity gets a minimum payoff in return for giving up its right to delay the reorganization and gets more as equity’s option on the corporation comes closer to being in the money. Bris et al. (2006) also find that deviations from the APR are larger when managers own more of the corporation’s equity, which means that managers gain more from avoiding liquidation.15 14 

See Weiss (1990); Eberhart et al. (1990); Betker (1995); Bris et al. (2006). There is also empirical literature that compares bankruptcy reorganizations to out-​of-​bankruptcy workouts: see Gilson et al. (1990); Tashjian et al. (1996); Morrison (2009). 15 

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    461

18.2.3.4. Is Chapter 11 Efficient? Several studies have examined the efficiency of Chapter 11 in the United States, sometimes by comparing it to other countries’ reorganization procedures. Hotchkiss (1995) and Bris et al. (2006) both examined the performance of samples of corporations that successfully completed reorganizations under Chapter 11 and found that one-​third and one-​half of them liquidated or filed for bankruptcy a second time within a few years. These results suggest that Chapter 11 saves too many firms, including some that should have shut down. Thorburn (2000) compares Sweden’s auction-​based bankruptcy system with Chapter 11 in the United States and argues that the Swedish procedure works better in terms of completing reorganizations quickly and minimizing deviations from the APR. But Ravid and Sundgren (1998) compared Chapter 11 with Finland’s reorganization procedure and came to the opposite conclusion. Chang and Schoar (2007) use an innovative identification method to examine whether a pro-​debtor versus pro-​creditor version of Chapter 11 would lead to more economically efficient results for corporations that reorganize. They argue that all bankruptcy judges have either a pro-​debtor or a pro-​creditor bias and they develop a measure of individual judges’ bias based on how each judge rules on court motions that favor debtors versus creditors. Because Chapter 11 bankruptcy filings are randomly assigned to judges and judges’ bias varies, they use the assignment of Chapter 11 filings to bankruptcy judges as a quasi-​experiment that randomly assigns corporations in bankruptcy to a pro-​debtor or a pro-​creditor version of Chapter  11. They find that corporations assigned to the pro-​debtor treatment are more likely to shut down, have slower growth after the completion of the bankruptcy procedure, and are more likely to file for bankruptcy a second time. They conclude that Chapter  11 works better when firms are assigned to pro-​creditor bankruptcy judges and, by extension, that Chapter 11 would work better overall if it were more pro-​creditor.

18.2.3.5. External Effects of Corporate Bankruptcy Do corporate bankruptcies have external effects on other, solvent firms? There are several ways in which bankruptcies may affect other firms, including both competitors in the same industry and firms in other industries. Corporations benefit when their competitors liquidate, since clients of the liquidated firm transfer their demand to the remaining firms in the industry; but may be harmed when their competitors reorganize if the reorganization cuts their production costs. Corporations may also benefit or be harmed by the liquidation of competitors’ assets in bankruptcy, since they can buy up the assets at fire-​sale prices, but the value of their own assets that are used as collateral to secure their debt falls when similar assets are sold at low prices. Corporations in general may also be harmed if a large number of bankruptcies during a recession cause banks to cut back on lending generally. Empirically, Lang and Stulz (1992) show that airline bankruptcies cause the share values of non-​bankrupt rival airlines to fall and Benmelech and Bergman (2010) show that airline bankruptcies cause the cost of collateralized borrowing to rise for non-​bankrupt

 

462   MICHELLE J. WHITE airlines that use similar planes as collateral. Jorion and Zhang (2007) show that corporations in a variety of industries are harmed when their competitors file under Chapter 11, but benefit when their competitors file under Chapter 7—​these findings presumably reflect the fact that firms gain when their rivals disappear, but are harmed when their rivals continue to operate and cut their costs by reorganizing in bankruptcy.16

18.3.  Personal Bankruptcy Like corporate bankruptcy law, personal bankruptcy law determines both the total amount that debtors must repay—​the size of the pie—​and how the pie is divided among creditors. A larger pie benefits future borrowers by increasing the supply of credit and lowering interest rates. But a larger pie is costly to existing debtors, since high repayment obligations may reduce debtors’ consumption to the point that they or their families suffer permanent harm. High repayment obligations may also cause debtors to work less and may prevent them from starting new businesses. The division of the pie also has efficiency implications. When debtors default, creditors have an incentive to race against each other to be first to collect, because bankruptcy filings terminate collection efforts. Winning the race to be first means that they collect more at other creditors’ expense. But aggressive collection efforts can harm debtors, since they may quit their jobs if creditors garnish wages or lose their jobs if creditors repossess their cars. Some of the economic objectives of personal bankruptcy are different from those of corporate bankruptcy. Because bankrupt individuals always reorganize rather than liquidate, the issue of filtering failure does not exist in personal bankruptcy. Another feature of personal bankruptcy law that differs from corporate bankruptcy law is that bankrupt individuals are protected by a set of exemptions that allow them to keep some or all of their financial assets and future earnings in bankruptcy. An important economic question in personal bankruptcy is how high these exemptions should be.17

18.3.1. Theoretical Research on Personal Bankruptcy 18.3.1.1. Consumption Insurance and Work Effort  Suppose there is only one personal bankruptcy procedure that obliges bankrupts to repay from both their financial wealth and their postbankruptcy earnings, but provides 16 

There is also empirical work on the effect of bankruptcy law on business credit markets—​see the discussion of credit markets under personal bankruptcy. 17  Corporations that reorganize in bankruptcy are also allowed to keep some of their assets, but the justification is that these corporations will repay creditors more from their future earnings if they reorganize than they would if they liquidate.

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    463 exemptions for both.18 These assumptions differ from US bankruptcy law, where most commonly used personal bankruptcy procedure—​Chapter 7 bankruptcy—​exempts all future earnings from the obligation to repay. The complete exemption for future earnings is commonly referred to as the “fresh start.”19 Not assuming that all future wages are exempt allows us to consider whether the fresh start is economically efficient. Assume that the wealth exemption in bankruptcy is X dollars, regardless of the form of the wealth, and the future earnings exemption is x% of postbankruptcy earnings.20 Bankrupts are therefore obliged to use all their wealth above X dollars and (1 – x)% of their future earnings to repay pre-​bankruptcy debt, where the obligation to repay from future earnings is assumed to last for a fixed number of years. If any debt remains unpaid at the end of the repayment period, it is discharged. Bankruptcy filings are also assumed to cost debtors S dollars in court fees and lawyers’ fees. The model that we now discuss illustrates how bankruptcy provides consumption insurance to debtors and how additional consumption insurance is provided when the wealth and earnings exemptions are higher. It also illustrates the tradeoffs involved in determining the levels of the two exemptions. In period 1, individuals borrow a fixed amount B at interest rate r from a single lender, to be repaid in period 2. The interest rate is determined to satisfy the lender’s zero profit constraint. In period 2, debtors are assumed to have fixed earnings, but an uncertain amount of wealth. At the beginning of period 2, debtors learn their actual wealth, after which they decide whether to file for bankruptcy. They then choose their period 2 labor supply, which may depend on whether they file for bankruptcy. Period 2 is assumed to last for the entire period when bankrupts are obliged to repay from future earnings in bankruptcy. Debtors are assumed to work less after filing for bankruptcy, because their earnings are subject to the “bankruptcy tax” of (1 –​x)%. (They also have an incentive to work more after filing, because bankruptcy reduces their wealth. But we assume that the substitution effect exceeds the wealth effect, so that they work less.) Individuals’ utility depends positively on consumption and negatively on labor supply in each period and they are assumed risk averse. They decide whether to file for bankruptcy based on whether doing so increases their utility. There is a threshold level ^ of period 2 wealth W , where debtors are indifferent between filing versus not filing; they 18 

This section draws on Rea (1984); Jackson (1986); White (2005); Fan and White (2003); Wang and White (2000); Adler, Polak, and Schwartz (2000). Posner (1995) discusses the relationship between the insurance provided by bankruptcy law and government-​provided social insurance programs such as unemployment compensation, and Fisher (2005) provides an empirical test. See Livshits, MacGee, and Tertilt (2007) and Athreya (2002) for macroeconomic models of personal bankruptcy law, which are not discussed here. 19  Other countries typically require that bankrupts repay from future income for 3 to 8 years after filing. Since 2005, some higher-​income bankrupts in the United States have also been required to repay from future earnings. See White (2007) for discussion of the US bankruptcy reform of 2005. 20  The assumption concerning the earnings exemption follows the format of the wage garnishment exemption in the United States, which applies outside of bankruptcy. It covers 75% of wages, but—​unlike the assumption here—​it also has a fixed dollar component. See Hynes (2002) for discussion of alternate ways of taxing debtors’ postbankruptcy earnings.

 

464   MICHELLE J. WHITE C

Region 1 X+S

Region 2

Region 3 W

W

Figure 18.1  The insurance effect of bankruptcy. Note: The diagram shows period 2 consumption on the vertical axis and period 2 wealth on the horizontal axis. Labor supply is assumed to be higher outside of bankruptcy than in bankruptcy. Debtors file for bankruptcy in regions 1 and 2 and avoid bankruptcy in region 3.

file if their wealth is below the threshold and do not file otherwise. Figure 18.1 shows debtors’ period 2 consumption as a function of their period 2 wealth. Consumption is divided into three regions: region 3 where debtors repay in full and avoid bankruptcy; region 2 where they file for bankruptcy and partially repay the debt from both wealth and future earnings; and region 1 where they file for bankruptcy and repay only from future earnings, since all of their wealth is exempt. The boundary between regions 2 ^ and 3 occurs at W . In region 2, consumption is constant because debtors keep X dollars of wealth, but must use any wealth above X to repay. There is a discontinuous drop in consumption from region 3 to region 2, because debtors work less when they file for bankruptcy. The wealth and earnings exemptions both provide debtors with consumption insurance. To see this, note that raising the wealth exemption X reduces debtors’ consumption in region 3 because creditors raise interest rates on loans, but increases debtors’ consumption in region 2 because they keep more of their wealth when it is low and they go bankrupt. Consumption is unaffected in region 1 because all of debtors’ wealth is already exempt. Similarly, raising the earnings exemption x reduces debtors’ consumption in region 3 for the same reason, but increases debtors’ consumption in both regions 2 and 1 because debtors keep more of their earnings in bankruptcy. The higher the wealth and/​ or earnings exemptions, the more consumption insurance that bankruptcy provides to debtors. If we extended the model by allowing the amount borrowed B to increase, the ^ results would remain the same except that the threshold level of wealth W where bankruptcy occurs would shift to the right. Thus the main tradeoff in raising bankruptcy exemptions is that, when exemption levels rise, existing debtors benefit because they have more consumption insurance,

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    465 which reduces their downside risk of borrowing. Debtors benefit from the additional consumption insurance as long as they are risk averse, with more risk-​averse debtors benefiting more. On the other side, higher exemption levels raise debtors’ default rates and reduce their repayment conditional on default. Lenders respond by reducing the supply of credit and raising interest rates, which makes all future borrowers worse off. The determination of the most economically efficient exemption levels depends on this tradeoff between the value of additional consumption insurance to existing debtors versus the reduction in credit availability to future borrowers. The model also suggests that the consumption insurance provided by a higher earnings exemption is more valuable than the consumption insurance provided by a higher wealth exemption. This is because a higher earnings exemption raises debtors’ consumption in region 1 where it is lowest and raises debtors’ postbankruptcy work effort, while a higher wealth exemption only raises debtors’ consumption in the middle region 2. These results suggest that optimal personal bankruptcy law should have a higher exemption for earnings and a lower exemption for wealth. The higher value of the earnings exemption relative to the wealth exemption suggests an economic justification for the “fresh start.”21 This sketch of an economic model of bankruptcy exemptions yields several testable hypotheses. First, in jurisdictions that have higher wealth exemptions in bankruptcy, debtors have more consumption insurance and therefore their demand for alternative forms of consumption insurance is lower. Second, lenders are worse off in jurisdictions with higher wealth exemptions. They are therefore predicted to charge higher interest rates and reduce the supply of credit. Third, if debtors are risk averse, then they are predicted to demand more loans when the downside risk of borrowing is lower. This means that demand for credit is predicted to be higher in jurisdictions with higher wealth exemptions. Similarly, if potential entrepreneurs are risk averse, then they are more willing to take the risk of going into business if higher bankruptcy exemptions reduce the cost of business failure. Jurisdictions with higher bankruptcy exemptions are therefore predicted to have more entrepreneurs. In the empirical section below, I discuss studies that test these hypotheses. 2. Default versus bankruptcy. In the previous section, debtors were assumed to choose between defaulting on their loans and filing for bankruptcy versus repaying in full. But in fact, debtors often default on their loans without going bankrupt or default first and go bankrupt later. Dawsey and Ausubel (2004) called default without bankruptcy “informal bankruptcy.” When debtors default, creditors attempt to collect by calling the debtor and demanding payment. If this does not work, their most important legal weapon is garnishment of debtors’ earnings. In the United States, Federal law exempts at least 75% of debtors’ wages from garnishment, with several states exempting 90% or more. Garnishment is risky for creditors, since they must obtain a judge’s order and it is 21  However, if the earnings exemption covered a fixed dollar amount of earnings rather than a percentage of earnings, then the result that the earnings exemption should be higher than the wealth exemption would be weaker. See Wang and White (2000) for a simulation.

 

466   MICHELLE J. WHITE only successful if the debtor is employed, the creditor can determine the employer, and garnishment does not cause debtors to lose or quit their jobs. Also, debtors may respond to garnishment by filing for bankruptcy, since garnishment of wages ends at the time of the bankruptcy filing. White (1998b) used an asymmetric information model to examine whether, in equilibrium, debtors might default without going bankrupt. The model assumes that there are two types of debtors, strategic versus nonstrategic. Both types decide whether to default and, following default, creditors decide whether to garnish debtors’ wages. Garnishment is assumed costly for creditors. The two types of debtors differ in how they respond to garnishment: strategic debtors repay in full, while nonstrategic debtors file for bankruptcy because they cannot repay. Creditors are assumed unable to identify individual debtors’ types, so they must respond in the same way to all defaults. I show that, in equilibrium, all nonstrategic debtors default, at least some strategic debtors also default, and creditors play mixed strategies of sometimes instituting garnishment in response to default. This means that, in equilibrium, a group of debtors ends up in informal rather than formal bankruptcy because creditors do not initiate garnishment following default. These debtors obtain the benefit of debt forgiveness without having their wages garnished. The model suggests that having a personal bankruptcy system encourages default by strategic debtors, because creditors do not always respond to default with garnishment. The model also suggests that wage garnishment rules may be as or more important than exemption levels as determinants of debtors’ bankruptcy decisions.

18.3.1.2. Waiving the Right to File for Personal Bankruptcy In the corporate bankruptcy context, researchers have argued that debtors should be allowed to contract with creditors about bankruptcy procedures to be followed if default occurs (see the discussion above). In the personal bankruptcy context, the issue is whether debtors should be allowed to waive their right to file for bankruptcy.22 Would individual debtors ever choose to issue waivers when obtaining loans? The main advantage to debtors of issuing waivers is that more credit would be available at lower interest rates. The main drawback is that if debtors who issued waivers defaulted, they could not use bankruptcy to prevent or end wage garnishment. Issuing a waiver would therefore offset the consumption insurance provided by bankruptcy because debtors who issued waivers would have higher consumption in region 3 of Figure 18.1, but lower consumption in region 2 and possibly region 1 (if there is no fresh start in bankruptcy). Debtors who issued waivers would probably work more in order to offset some of the extra risk. This suggests that risk-​averse debtors would not issue waivers, but risk-​neutral or risk-​loving debtors might. However, a number of externality arguments support the current policy of prohibiting waivers. One is that waivers may make individual debtors’ families worse off, since spouses and children bear most of the cost of reduced consumption if the debtor’s wealth 22 

In the United States, waivers are unenforceable and the rules of bankruptcy cannot be changed by contract. See Rea (1984); Jackson (1986); Adler, Polak, and Schwartz (2000); Hynes (2004) for discussion.

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    467 turns out to be low, but debtors may not take this into account in deciding whether to issue waivers. Also, debtors may be excessively optimistic about their future wealth prospects or may be hyperbolic discounters, leading them to issue waivers even when it is against their self-​interest. Third, prohibiting waivers benefits the government itself, since the government’s expenses for social safety net programs are lower when debtors can file for bankruptcy and avoid repaying their debts. Finally, allowing waivers might have adverse macroeconomic effects. This is because if many debtors simultaneously had a bad draw on wealth, all would reduce their consumption simultaneously and the economy might go into a recession.

18.3.1.3. The Option Value of Filing for Bankruptcy Debtors’ right to file for bankruptcy can be expressed as a put option. If debtors’ future wealth turns out to be high, they repay their debts in full; but if their future wealth turns out to be low, they can exercise their option to “sell” the debt to creditors by filing for bankruptcy. The price of exercising the put option is the cost of filing plus the amount that debtors are obliged to repay in bankruptcy from their nonexempt wealth and earnings. Also, because debtors in the United States can only file for bankruptcy once every 6 years, they gain from timing their bankruptcy decisions. White (1998a) calculated the value of the option to file for bankruptcy for a representative sample of US households during the early 1990s. The results showed that at that time, many more households had a positive option value of filing for bankruptcy than had actually filed for bankruptcy.

18.3.2. Empirical Research on Personal and Small Business Bankruptcy Most of the empirical research on personal bankruptcy uses US data and makes use of the fact that bankruptcy law is uniform all over the United States, except that states are allowed to choose their own exemption levels for wealth.23 Because exemption levels vary widely, they allow researchers to investigate how differences across states or changes over time in wealth exemptions affect a variety of behaviors by debtors and creditors. In this section, I review empirical research on various aspects of personal and small business bankruptcy.

18.3.2.1. Bankruptcy as Consumption Insurance The model discussed above showed that higher exemption levels for wealth provide debtors with additional consumption insurance. This is because when negative shocks occur, debtors living in states with higher wealth exemptions can have their debts 23  Hynes, Malani, and Posner (2003) estimate a model that explains states’ wealth exemption levels. Posner (1997) discusses the adoption of the 1978 US Bankruptcy Code, which gave the states the right to adopt their own wealth exemption levels.

 

468   MICHELLE J. WHITE discharged in bankruptcy while keeping more of their assets. One implication of the model is that households’ demand for alternate types of consumption insurance will be lower if they live in states with higher wealth exemption levels. One alternative type of consumption insurance is being married, because if both individuals in a couple work or have wealth, they insure each other against negative financial shocks that would reduce their joint consumption. But the insurance provided by marriage is less valuable if households live in states with higher exemption levels, because bankruptcy provides more of the same type of insurance. Traczynski (2011) tests the divorce hypothesis and finds that increases in state exemption levels from 1989 to 2005 resulted in 200,000 additional divorces during this period. Similarly, debtors have less incentive to buy health insurance if they live in states with higher wealth exemption levels. This is because having health insurance provides individuals with financial protection against negative medical shocks, but the insurance is less valuable if they live in states where bankruptcy provides more of the same type of insurance. Mahoney (2012) shows empirically that individuals are less likely to buy health insurance if they live in states with higher wealth exemption levels.24

18.3.2.2. Why Do Debtors File for Bankruptcy? In the model discussed above, debtors were assumed to file for bankruptcy if doing so makes them better off. This means that they may file when they experience negative financial shocks, but it also means that they gain from behaving strategically in making the bankruptcy decision. Extending the model to allow for variable levels of debt and variable wealth exemptions, debtors have an incentive to compare their financial gain from filing against their costs of filing, where the financial gain equals the value of debt discharged in bankruptcy and the costs of filing equal the value of nonexempt wealth that they must give up in bankruptcy plus the costs of filing plus the cost of reduced access to credit after bankruptcy. Debtors are better off filing for bankruptcy if their financial gain exceeds these costs. This means that the most important determinants of households’ bankruptcy decisions are the amount of dischargeable debt they hold and value of their wealth in excess of the wealth exemption in their state. Their earnings do not affect the bankruptcy decision as long as earnings are fully exempt from the obligation to repay in bankruptcy. An alternative model of the bankruptcy decision, proposed by Sullivan, Warren, and Westbrook (1989), is that debtors do not make their bankruptcy decisions strategically. Instead, they file for bankruptcy only when some adverse event occurs that makes it impossible for them to repay their debts. Under this view, the main determinants of bankruptcy filings are households’ income and whether adverse events such as illness, job loss, or divorce have occurred recently. A third view of bankruptcy is that those who file tend to be hyperbolic discounters who can’t follow a budget, rather than people who have experienced negative financial

24 

See, also, Grant and Koeniger (2009).

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    469 shocks. In this model, income is unlikely to be an important determinant of bankruptcy filings, because even high-​income households may be unable to control their spending. The strategic/​economic view of bankruptcy versus the adverse events view can be tested against each other. This is because, under the strategic view, debtors’ probability of filing depends on their dischargeable debt and their nonexempt wealth, but does not depend on their income or whether adverse events have occurred. In contrast, under the adverse events model, the main determinants of bankruptcy are income and whether adverse events have occurred. Fay, Hurst, and White (2002) tested the two models against each other, using household panel data. They found that debtors are significantly more likely to file for bankruptcy when their financial gain from filing is higher. But they also found that ability-​to-​pay affects bankruptcy decisions—​households with higher incomes were significantly less likely to file. They also tested the importance of adverse events and found that neither job loss nor illness of the household head or spouse in the previous year was significantly related to bankruptcy. But a divorce in the previous year was found to increase the probability of bankruptcy and the result was marginally statistically significant. Thus the study supports both the hypotheses that financial benefit and ability-​to-​ pay affect the bankruptcy decision, but does not support the adverse events hypothesis.25 The issue of the extent to which serious illnesses and uninsured medical expenses cause bankruptcy has been especially controversial. Using data from surveys of bankruptcy filers, Himmelstein et al. (2005) claimed that 55% of bankruptcy filings were caused by illness, injury, or uninsured medical bills. Their claim was disputed by Dranove and Millenson (2006), who argued that they overstated the importance of medical bills by counting bankruptcy filings as triggered by medical bills even when the medical bills were very small. Recent studies have reexamined this question, using experimental approaches. Ramsey et al. (2013) examined bankruptcy-​filing rates of non-​elderly individuals who did and did not receive a diagnosis of cancer—​an adverse health shock. They found that the cancer patients had much higher bankruptcy-​filing rates, suggesting that uninsured medical costs and lost earnings owing to cancer play an important role in bankruptcy. But Morrison et al. (2013) examined whether individuals who were involved in car crashes—​another adverse shock—​were more likely to file for bankruptcy. They found no relationship between being involved in a crash and filing for bankruptcy once they took account of the fact that the two outcomes are positively correlated, so that individuals who were involved in car crashes were also more likely to file for bankruptcy before the crash occurred. Similarly, a study by Baicker and Finkelstein (2011) uses a random expansion of Medicaid to low-​income adults in Oregon and finds that those who gained access to Medicaid did not have lower bankruptcy-​filing rates, suggesting that adverse medical events were not an important determinant of bankruptcy.26 25 

Fisher and Lyons (2006) argue that endogeneity causes the effect of divorce on bankruptcy filings to be overstated. However, Keys (2010) finds that job loss does significantly increase debtors’ probability of filing for bankruptcy in the following year. 26  See also Gross and Notowidigdo (2011), who found the opposite result using evidence from Medicaid expansions.

 

470   MICHELLE J. WHITE Other possible causes of bankruptcy filings include the increased availability of gambling in the United States. As of 1980, casino gambling was only allowed in Nevada and Atlantic City, New Jersey, but by 2000, it had spread over most of the United States. A  study by Barron et  al. (2002) found that bankruptcy-​filing rates were significantly higher in counties that contained a casino or were adjacent to a county with a casino than elsewhere, although the size of the increase was small. Another recent study by Hankins, Hoekstra, and Skiba (2011) examines the effect of winning the lottery on the probability of bankruptcy. They find that winning a large versus a small prize in a lottery postpones rather than reduces debtors’ probability of bankruptcy. They interpret their results as supporting the theory that bankruptcy filers are likely to be hyperbolic discounters who cannot follow a budget, rather than individuals who have experienced an adverse event. Payday loans are another possible cause of bankruptcy filings. Payday loans are a type of predatory loans—​borrowers receive a short-​term loan and give the lender a check for the principle and interest that is dated after their next paycheck. These short-​term loans carry interest rates up to 400% on an annual basis. Although payday loans are usually small, borrowers often renew the loan repeatedly and/​or obtain payday loans from multiple lenders, adding to their debt burden. Using a regression discontinuity approach, Skiba and Tabacman (2011) found that when first-​time applicants receive payday loans, their bankruptcy-​filing rate over the following 2 years doubled.27 Finally, several papers have tested the importance of wage garnishment exemptions as a determinant of bankruptcy filings. As discussed above, at least 75% of wages are exempt from garnishment, but some states exempt a higher percentage and a few exempt wages completely. Once debtors file for bankruptcy, the bankruptcy prohibition on efforts by creditors to collect ends wage garnishment. This means that in states with higher wage garnishment exemptions, debtors’ incentive to file for bankruptcy is weaker since most or all of their wages are already protected outside of bankruptcy. In contrast, wealth exemptions protect debtors’ wealth both in and out of bankruptcy, although the amount of the wealth exemption changes in some states when debtors file. Lefgren and McIntyre (2009) examined the importance of wage garnishment exemptions on bankruptcy decisions. They found that, in states with higher wage garnishment exemptions, more debtors use informal rather than formal bankruptcy (i.e., they default but do not file for bankruptcy). Miller (2013) examined the importance of both wealth exemptions and garnishment exemptions on bankruptcy decisions. She found that garnishment exemptions are determinants of bankruptcy that are more important for poor households, while wealth exemptions are determinants that are more important for rich households. These study results provide support for the strategic model of the bankruptcy decision and for the importance of informal bankruptcy.28 27 

See, also, Fay et al. (2003); Gross and Souleles (2002); and Cohen-​Cole and Duygan-​Bump (2010), for studies of the role of bankruptcy stigma in debtors’ bankruptcy decisions. 28  Other work examining the personal bankruptcy decision and bankruptcy filing rates include Shepard (1984); Boyes and Faith (1986); Peterson and Aoki (1984); White (1987); Domowitz and Eovaldi (1993); Buckley (1994); Domowitz and Sartain (1999); Dawsey and Ausubel (2004).

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    471

18.3.2.3. The Effect of Bankruptcy on Debtors’ Labor Supply and Mortality In the theoretical model discussed previously, debtors are predicted to work less after filing for bankruptcy if they are required to repay from future earnings. However, the situation in the United States differs from the assumptions of the model, because most bankrupts are not required to repay from postbankruptcy earnings, but debtors not in bankruptcy are often subject to wage garnishment. This means that filing for bankruptcy reduces rather than increases their obligation to repay from earnings and, as a result, they are predicted to work more rather than less after filing. Han and Li (2007) examined empirically how filing for bankruptcy affects debtors’ labor supply. They found that debtors did not increase their labor supply after filing for bankruptcy. Their results undermine the argument that the fresh start in bankruptcy is valuable because debtors work more after filing. A recent paper by Dobbie and Song (2013) revisited this issue, using only bankruptcy filings under Chapter  13—​the US procedure for debtors to repay from future wages rather than from nonexempt wealth. Under Chapter 13, debtors in bankruptcy propose a plan to repay partially their debt from future wages, and the bankruptcy judge decides whether to accept the plan. Comparing debtors whose Chapter 13 repayment plans have been accepted versus rejected by bankruptcy judges, Dobbie and Song find that having a plan accepted is associated with an increase in debtors’ earnings of $6,300 per year and a reduction in debtors’ 5-​year mortality rate of 1.1 percentage point. These large and significant results suggest that successfully going through the bankruptcy process both increases debtors’ work effort and improves their health. But because Dobbie and Song focus on debtors whose Chapter  13 repayment plans are accepted versus rejected by bankruptcy judges, it is unclear whether the same large effects would apply when comparing debtors who file versus don’t file for bankruptcy.29

18.3.2.4. Bankruptcy and Portfolio Composition Bankruptcy also affects the composition of debtors’ portfolios. When debtors live in a state with a higher wealth exemption, they have an incentive to borrow more and to hold more assets, rather than using their assets to repay their debts. This is because if households hold the assets in a form that is exempt in bankruptcy, the debt will be discharged when they file for bankruptcy, and they can keep the assets. The assets are usually held in the form of home equity or retirement accounts, since these assets are frequently exempt in bankruptcy. Lehnert and Maki (2002) call this behavior “borrowing to save.” They find empirical support for the hypothesis that households living in states with higher wealth exemptions are more likely to borrow to save.

29 

Dobbie and Song’s identification is because debtors in Chapter 13 are randomly assigned to bankruptcy judges, whose acceptance rates for repayment plans vary.

 

472   MICHELLE J. WHITE

18.3.2.5. Bankruptcy and Entrepreneurial Behavior When individuals start or own unincorporated businesses, their consumption has high variance. This is because both their businesses may succeed or fail and they incur high business debts for which they are personally liable. The personal bankruptcy system provides partial insurance for this risk since, if businesses fail, entrepreneurs can file for personal bankruptcy and have both their business and personal debts discharged. The partial consumption insurance provided by bankruptcy thus makes it more attractive for risk-​averse individuals to become entrepreneurs. Also because wealth exemptions vary across US states, high-​exemption states provide more consumption insurance than low-​exemption states do, and, therefore, becoming an entrepreneur is more attractive in high-​exemption states. In many of these states, entrepreneurs who are homeowners can keep their homes in bankruptcy when their businesses fail. Fan and White (2003) tested whether households living in states with higher wealth exemptions are more likely to start or own businesses. They focused on homestead exemptions, which are wealth exemptions that apply to home equity; in most states, the exemption for home equity is the largest wealth exemption. They found that homeowners were 35% more likely to own businesses if they live in states with high or unlimited homestead exemptions compared with homeowners in states with low homestead exemptions. They also found a similarly large and significant effect for renters, suggesting that most renters who own businesses expect to become homeowners in the future.30 Armour and Cumming (2008) also examined whether entrepreneurship rates are higher when bankruptcy law is more favorable to debtors, using cross-​country data for 15 countries in Europe and North America. They similarly found that entrepreneurship is higher in countries with more debtor-​friendly bankruptcy laws.

18.3.2.6. Bankruptcy and Credit Markets Now turn to the effect of bankruptcy law on credit markets. In general, we expect creditors to adjust the supply of loans in response to variations in the strength of their legal rights when default occurs. Because higher wealth exemptions allow debtors to keep more of their assets in bankruptcy and, therefore, weaken creditors’ legal rights, they are predicted to cause lenders to tighten the supply of credit. But higher wealth exemptions also affect demand for credit, since risk-​averse debtors demand more credit when higher exemptions reduce the downside risk of borrowing. Thus, a rise in exemption levels is predicted to cause both the supply of credit to fall and the demand for credit to rise. This means that interest rates are predicted to rise, but the number and size of loans could either rise or fall. Gropp, Scholz, and White (1997) examined the effect of wealth exemptions on consumer credit markets generally. They found that households were 5.5 percentage points more likely to be turned down for credit if they lived in states with high- rather than 30 

Also, see Georgellis and Wall (2006), who compare bankruptcy exemption levels with other policy variables as determinants of entrepreneurship rates across US states.

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    473 low-​wealth exemptions. Also, interest rates were higher in states with high-​wealth exemptions, but the size of the increase depended strongly on debtors’ wealth. Low-​ wealth households paid higher interest rates if they lived in states with high rather than low-​wealth exemptions, but high-​wealth households paid the same interest rates regardless of the exemption level. Similarly, in states with high- rather than low exemptions, low-​wealth households borrowed less and high-​wealth households borrowed more. The latter finding suggests that, in states with high- versus low-​wealth exemptions, lenders redistribute credit from low-​wealth to high-​wealth households. While policy-​makers often think that high-​wealth exemptions help the poor, in fact they appear to harm the poor and benefit the rich. Other studies have examined the effect of wealth exemptions in bankruptcy on specialized credit markets, of which one is the market for small business loans. Wealth exemptions are predicted to affect small business loan markets as well as personal loan markets, since small business loans are personal liabilities of the business owner whenever the business is noncorporate (and often are personal liabilities of the owner when the business is corporate, since the owner may have personally guaranteed the loan). Berkowitz and White (2004) found that small businesses were more likely to be turned down for loans if they were located in states with high-​wealth exemptions and, if they received loans, interest rates were higher. These results, combined with the effect of bankruptcy on entrepreneurial behavior, suggest that higher wealth exemptions are a two-​edge sword: they encourage more individuals to become entrepreneurs, but cause their businesses to be more credit constrained.31 Other research has used cross-​country data to examine the effects of variations in the strength of debtors’ or creditors’ rights under bankruptcy law on small business credit markets. This type of study is more difficult than comparing bankruptcy law across US states, because many features of bankruptcy law—​rather than just a single feature—​ differ across countries, and the overall impact of the differences on the pro-​creditor or pro-​debtor bias of bankruptcy may not be clear. One recent study is Davydenko and Franks (2008), which compared the effects of bankruptcy law on small business credit markets in France, Germany, and the UK. They characterize bankruptcy law as being most pro-​creditor in the UK, most pro-​debtor in France, and intermediate in Germany. Among their results is that, in France, lenders demand higher collateral per dollar of debt, because bankruptcy officials there often sell firms in bankruptcy for less than the highest bid in order to obtain a new owner who will save the firm and preserve its jobs. They also find—​surprisingly—​that interest rates on small business loans are not strongly influenced by cross-​country differences in bankruptcy law. In the United States, bankruptcy filings remain on individuals’ credit records for up to 10 years. Han and Li (2011) examine how filing for bankruptcy affects debtors’ access to credit in the years after the filing. They find that debtors borrow less and pay higher interest rates following bankruptcy and that the effect persists for the entire 10-​year 31 

The effect of bankruptcy law on home mortgage markets has also been studied; see Berkowitz and Hynes (1999); Lin and White (2001); Chomsisengphet and Elul (2006).

 

474   MICHELLE J. WHITE period. This suggests that the US practice of allowing bankruptcy filings to remain on debtors’ credit records for a full decade is a nontrivial punishment for bankruptcy. The negative effect is magnified by the fact that credit scores are often checked when applicants apply for jobs or apartments, as well as when they apply for loans.

18.3.2.7. Bankruptcy Law and Mortgage Default Prior to 2005, homeowners in financial distress could use bankruptcy to save their homes. This is because filing for bankruptcy allowed them to have their unsecured debts discharged, which increased their ability-​to-​pay to make their mortgage payments. But in 2005, a reform of US bankruptcy law made filing for bankruptcy more expensive for debtors and forced high-​earning debtors to use some of their postbankruptcy income to repay unsecured debt.32 As a result, bankruptcy became less attractive to homeowners as a means of saving their homes; bankruptcy-​filing rates fell; and this change is hypothesized to have caused default rates on mortgages to rise. Li, White, and Zhu (2010) and Morgan, Iverson, and Botsch (2008) both tested this prediction and found that default rates on mortgages in fact jumped after the 2005 bankruptcy reform. They argue that the jump in default rates on mortgages was at least partly responsible for the bursting of the housing bubble, which caused housing prices to fall and led to the 2008 mortgage crisis. They conclude that bankruptcy reform was in part responsible for the “Great Recession.” Overall, the empirical research on bankruptcy suggests that it has important and wide-​ranging effects on individual behavior, corporate behavior, and the economy as a whole.

References Adler, B. E. 1993. “Financial and Political Theories of American Corporate Bankruptcy.” Stanford Law Review 45, pp. 311–​346. Adler, B. E., Polak, B., and Schwartz, A. 2000. “Regulating Consumer Bankruptcy: A Theoretical Inquiry.” Journal of Legal Studies 29, pp. 585–​613. Aghion, P., Hart, O., and Moore, J. 1992. “The Economics of Bankruptcy Reform,” Journal of Law, Economics and Organization 8, pp. 523–​546. Armour, J., and Cumming, D. 2008. “Bankruptcy and Entrepreneurship.” American Law and Economics Review 10, pp. 303–​350. Athreya, K. B. 2002. “Welfare Implications of the Bankruptcy Reform Act of 1999.” Journal of Monetary Economics 49, pp. 1567–​1595. Ausubel, L. M., and Dawsey, A. E. 2004. “Informal Bankruptcy.” Working Paper, University of Maryland Department of Economics. Baicker, K. and Finkelstein, A. 2011. “The Effects of Medicaid Coverage—​Learning from the Oregon Experiment.” The New England Journal of Medicine 365, pp. 683–​685. 32  See White and Zhu (2010) for discussion of the treatment of homeowners in bankruptcy. Dobbie and Song (2013) also find that debtors whose Chapter 13 repayment plans were accepted by judges had lower rates of foreclosure.

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    475 Baird, D. G. 1986. “The Uneasy Case for Corporate Reorganizations.” Journal of Legal Studies 15, pp. 127–​147. Baird, D. G. 1987. “A World without Bankruptcy.” Law and Contemporary Problems 50, pp. 173–​193. Baird, D. G. 1993. “Revisiting Auctions in Chapter  11.” Journal of Law & Economics 36, pp. 633–​653. Baird, D. and Rasmussen, R. 2002. “The End of Bankruptcy.” Stanford Law Review 55, p. 751. Barron, J. M., Staten, M. E., and Wilshusen, S. M. 2002. “The Impact of Casino Gambling on Personal Bankruptcy Filing Rates.” Contemporary Economic Policy 20, pp. 440–​445. Bebchuk, L. A. 1988. “A New Method for Corporate Reorganization.” Harvard Law Review 101, pp. 775–​804. Bebchuk, L. A. 2002. “The Ex Ante Costs of Violating Absolute Priority in Bankruptcy.” Journal of Finance 57, pp. 445–​460. Bebchuk, L. A. and Chang, H. 1992. “Bargaining and the Division of Value in Corporate Reorganization.” Journal of Law, Economics, and Organization 8, pp. 523–​546. Bebchuk, L. A. and Fried, J. M. 1996. “The Uneasy Case for the Priority of Secured Claims in Bankruptcy.” Yale Law Journal 105, pp. 857–​934. Benmelech, E. and Bergman, N. K. 2011. “Bankruptcy and the Collateral Channel.” Journal of Finance LXVI(2), pp. 337–​374. Berglof, E. and von Thadden, E.-​L. 1994. “Short-​Term Versus Long-​Term Interests: Capital Structure with Multiple Investors.” Quarterly Journal of Economics 109, pp. 1055–​1084. Berkovitch, E. and Israel, R. 1999. “Optimal Bankruptcy Law across Different Economic Systems.” Review of Financial Studies 12, pp. 347–​378. Berkovitch, E., Israel, R., and Zender, J. F. 1997. “Optimal Bankruptcy Law and Firm-​Specific Investments.” European Economics Review 41, pp. 487–​497. Berkovitch, E., Israel, R., and Zender, J. F. 1998. “The Design of Bankruptcy Law: A Case for Management Bias in Bankruptcy Reorganizations.” Journal of Financial and Quantitative Analysis 33, pp. 441–​467. Berkowitz, J. and Hynes, R. 1999. “Bankruptcy Exemptions and the Market for Mortgage Loans.” Journal of Law and Economics 42, pp. 908–​930. Berkowitz, J. and White, M. J. 2004. “Bankruptcy and Small Firms’ Access to Credit.” Rand Journal of Economics 35, pp. 69–​84. Bester, H. 1994. “The Role of Collateral in a Model of Debt Renegotiation.” Journal of Money, Credit, and Banking 26, pp. 72–​85. Betker, B. L. 1995. “Management’s Incentives, Equity’s Bargaining Power, and Deviations from Absolute Priority in Chapter 11 Bankruptcies.” Journal of Business 62, pp. 161–​183. Bolton, P. and Scharfstein, D. 1996. “Optimal Debt Structure and the Number of Creditors.” The Journal of Political Economy 104, pp. 1–​25. Boyes, W. J. and Faith, R. L. 1986. “Some Effects of the Bankruptcy Reform Act of 1978.” Journal of Law and Economics 19, pp. 139–​149. Bris, A., Welch, I., and Zhu, N. 2006. “The Costs of Bankruptcy: Chapter 7 Liquidation vs. Chapter 11 Reorganization.” Journal of Finance 61(3), pp. 1253–​1305. Buckley, F. H. 1994. “The American Fresh Start.” Southern California Interdisciplinary Law Journal 4, pp. 67–​97. Bulow, J., and Shoven, J. 1978. “The Bankruptcy Decision.” Bell Journal of Economics 9, pp. 437–​456.

 

476   MICHELLE J. WHITE Carapeto, M. 2000. “Is Bargaining in Chapter  11 Costly?” EFA 0215; EFMA 2000 Athens Meetings, http://​ssrn.com/​abstract=241569. [Accessed 6 September 2016]. Chang, T. and Schoar, A. 2007. “Judge Specific Differences in Chapter 11 and Firm Outcomes.” Working Paper, MIT. www.mit.edu/​~aschoar/​ChangSchoar_​Judges52007.pdf [Accessed 6 September 2016]. Chomsisengphet, S. and Elul, R. 2006. “Bankruptcy Exemptions, Credit History, and the Mortgage Market.” Journal of Urban Economics 5, pp. 171–​188. Cohen-​Cole, Ethan, and Duygan-​Bump, Burcu. 2010. “Household Bankruptcy Decision: The Role of Social Stigma vs. Information Sharing.” Risk and Policy Analysis Unit, Working Paper, QAU08-​6, Federal Reserve Bank of Boston. Cornelli, F. and Felli, L. 1997. “Ex-​ante Efficiency of Bankruptcy Procedures.” European Economic Review 41, pp. 475–​485. Davydenko, S. A. and Franks, J. 2008. “Do Bankruptcy Codes Matter? A Study of Defaults in France, Germany, and the U.K.” Journal of Finance LXIII, pp. 565–​608. Dobbie, W. and Song, J. 2013. “Debt Relief and Debtor Outcomes: Measuring the Effects of Consumer Bankruptcy Protection.” Working Paper, NBER. Domowitz, I. and Eovaldi, T. 1993. “The Impact of the Bankruptcy Reform Act of 1978 on Consumer Bankruptcy.” Journal of Law and Economics 26, pp. 803–​835. Domowitz, I. and Sartain, R. 1999. “Determinants of the Consumer Bankruptcy Decision.” Journal of Finance 54, pp. 403–​420. Dranove, D. and Millenstein, M. L. 2006. “Medical Bankruptcy:  Myth versus Fact.” Health Affairs 25, pp. w74–​w83. Eberhart, A. C., Moore, W. T., and Roenfeldt, R. L. 1990. “Security Pricing and Deviations from the Absolute Priority Rule in Bankruptcy Proceedings.” Journal of Finance 44, pp. 747–​769. Efrat, R. 2006. “The Evolution of Bankruptcy Stigma.” Theoretical Inquiries in Law 7(2), pp. 365–​393. Fan, W. and White, M. J. 2002. “Personal Bankruptcy and the Level of Entrepreneurial Activity.” Journal of Law & Economics 46, pp. 543–​568. Fay, S., Hurst, E., and White, M. J., 2002, “The Household Bankruptcy Decision.” American Economic Review 92, pp. 706–​7 18. Fisher, J. D. 2005. “The Effect of Unemployment Benefits, Welfare Benefits and Other Income on Personal Bankruptcy.” Contemporary Economic Policy 23(4), pp. 483–​492. Fisher, J. D. and Lyons, A. 2006. “Till Debt do us Part:  A  Model of Divorce and Personal Bankruptcy.” Review of Economics of the Household 4(1), pp. 35–​52. Franks, J. R. and Sussman, O. 2005. “Financial Innovations and Corporate Bankruptcy.” Journal of Financial Intermediation 14(3), pp. 283–​317. Franks, J. R. and Sussman, O. 2005. “Financial Distress and Bank Restructuring of Small to Medium Size U.K. Companies.” Review of Finance 9, pp. 65–​96. Franks, J. R. and Torous, W. N. 1989. “An Empirical Investigation of U.S. Firms in Reorganization.” Journal of Finance 44, pp. 747–​769. Franks, J. R., Nybourg, K., and Torous, W. N. 1996. “A Comparison of U.S., U.K., and German Insolvency Codes.” Financial Management 25, pp. 19–​30. Georgellis, T. A. and Wall, H. J. 2006. “Creating a Policy Environment for Entrepreneurs,” Working Paper 2005–​064B, Federal Reserve Bank of St. Louis. Gertner, R. and Scharfstein, D. 1991. “A Theory of Workouts and the Effects of Reorganization Law.” Journal of Finance 44, pp. 1189–​1222.

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    477 Gilson, S. C. 1990. “Bankruptcy, Boards, Banks and Blockholders.” Journal of Financial Economics 27, pp. 355–​387. Gilson, S. C., John, K., and Lang, L. 1990. “Troubled Debt Restructurings: An Empirical Study of Private Reorganization of Firms in Default.” Journal of Financial Economics 27, pp. 315–​355. Grant, C. and Koeniger, W. 2009. “Redistributive Taxation and Personal Bankruptcy in U.S. States.” Journal of Law & Economics 52(3), pp. 445–​467. Gropp, R. J., Scholz, K., and White, M. J. 1997. “Personal Bankruptcy and Credit Supply and Demand.” Quarterly Journal of Economics 112, pp. 217–​252. Gross, D. B. and Souleles, N. S. 2002. “An Empirical Analysis of Personal Bankruptcy and Delinquency.” Review of Financial Studies 15, pp. 319–​347. Gross, T. and Notowidigdo, M. J. 2011. “Health Insurance and the Consumer Bankruptcy Decision:  Evidence from Expansions of Medicaid.” Journal of Public Economics 95, pp. 767–​778. Han, S. and Li, G. 2011. “Household Borrowing After Personal Bankruptcy.” Journal of Money, Credit and Banking 43(2–​3), pp. 491–​517. Han, S. and Li, W. 2007. “Fresh Start or Head Start? The Effect of Filing for Personal Bankruptcy on Labor Supply.” Journal of Financial Services Research 31(2), pp. 132–​152. Hankins, S., Hoekstra, M., and Skiba, P. 2011. “The Ticket to Easy Street? The Financial Consequences of Winning the Lottery.” Review of Economics and Statistics 93(3), pp. 961–​969. Hart, O. D. and Moore, J. 1998. “Default and Renegotiation:  A  Dynamic Model of Debt.” Quarterly Journal of Economics 113, pp. 1–​41. Himmelstein, D. U., Warren, E., Thorne, D., and Woolhandler, S. 2005. “Illness and Injury as Contributors to Bankruptcy.” Health Affairs 24, pp. w5–​w63. Hotchkiss, E. 1995. “Postbankruptcy Performance and Management Turnover.” Journal of Finance 50, pp. 3–​21. Hynes, R. M. 2002. “Optimal Bankruptcy in a Non-​Optimal World.” Boston College Law Review XLIV(1), pp. 1–​78. Hynes, R. M., Malani, A., and Posner, E. A. 2004. “The Political Economy of Property Exemption Laws.” Journal of Law & Economics 47(1), pp. 19–​44. Hynes, R. M. 2004. “Why (Consumer) Bankruptcy?” Alabama Law Review 56(1), pp. 121–​179. Jackson, T.H. 1986. The Logic and Limits of Bankruptcy Law. Cambridge, MA: Harvard University Press. Jensen, M. and Meckling, W. 1976. “Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure.” Journal of Financial Economics 3, pp. 305–​360. Jorion, P. and Zhang, G. 2007. “Good and Bad Credit Contagion: Evidence from Credit Default Swaps.” Journal of Financial Economics 84, pp. 860–​883. Keys, B. 2010. “The Credit Market Consequences of Job Displacement.” Finance and Economics Discussion Series number 2010–​24, Board of Governors of the Federal Reserve System. Lang, L. and Stulz, R. 1992. “Contagion and Competitive Intra-​Industry Effects of Bankruptcy Announcements.” Journal of Financial Economics 32(1), pp. 45–​60. Lefgren, L. and McIntyre, F. 2009. “Explaining the Puzzle of Cross-​State Differences in Bankruptcy Rates.” Journal of Law & Economics 52(2), pp. 367–​393. Lehnert, A. and Maki, D. M. .2002. “Consumption, Debt and Portfolio Choice: Testing the Effects of Bankruptcy Law.” Working Paper, Board of Governors. Li, W., White, M. J., and Zhu, N. 2011, “Did Bankruptcy Reform Cause Mortgage Defaults to Rise?” American Economic Journal: Economic Policy 3(4), pp. 123–​147.

 

478   MICHELLE J. WHITE Lin, E. Y. and White, M. J. 2001. “Bankruptcy and the Market for Mortgage and Home Improvement Loans.” Journal of Urban Economics 50, pp. 138–​162. Livshits, I., MacGee, J., and Tertilt, M. “Consumer Bankruptcy:  A  Fresh Start.” American Economic Review 97(1), pp. 402–​418. LoPucki, L. 1983. “The Debtor in Full Control:  Systems Failure under Chapter  11 of the Bankruptcy Code?” American Bankruptcy Law Journal 57, pp. 247–​273. LoPucki, L. 2003. “The Nature of the Bankrupt Firm: A Reply to Baird and Rasmussen’s ‘The End of Bankruptcy.’” Stanford Law Review 56(3). LoPucki, L. and Whitford, W. 1990. “Bargaining over Equity’s Share in the Bankruptcy Reorganization of Large, Publicly Held Companies.” University of Pennsylvania Law Review 139, pp. 125–​196. Mahoney, N. 2012. “Bankruptcy as Implicit Health Insurance.” American Economic Review. ssrn.com/​abstract=2329327 [Accessed 6 September 2016]. Mann, B. H. 2002. Republic of Debtors:  Bankruptcy in the Age of American Independence. Cambridge, MA: Harvard University Press. Miller, M. P. 2013. “Who Files for Bankruptcy? State Laws and the Characteristics of Bankrupt Households.” Working Paper, Rutgers Business School. millerm.business.rutgers.edu/​who_​ files.pdf [Accessed 6 September 2016]. Morgan, D. P., Iverson, B., and Botsch, M. 2008. “Seismic Effects of the Bankruptcy Reform.” Staff Report number 358, Federal Reserve Bank of New York. Morrison, E. R. 2009. “Bargaining Around Bankruptcy: Small Business Workouts and State Law.” Journal of Legal Studies 38(255). Morrison, E. R., Gupta, A., Olson, L. M, Cook, L. J., and Keenan, H. 2013. “Health and Financial Fragility: Evidence from Car Crashes and Consumer Bankruptcy.” Working Paper. Myers, S. 1977. “Determinants of Corporate Borrowing.” Journal of Financial Economics 5, pp. 147–​175. Peterson, R. L. and Aoki, K. 1984. “Bankruptcy Filings Before and After Implementation of the Bankruptcy Reform Law.” Journal of Economics and Business 36, pp. 95–​105. Posner, E. A. 1995. “Contract Law in the Welfare State: A Defense of the Unconscionability Doctrine, Usury Laws, and Related Limitations on the Freedom to Contract.” Journal of Legal Studies 24, pp. 283–​319. Posner, E. A. 1997. “The Political Economy of the Bankruptcy Reform Act of 1978.” Michigan Law Review 96, pp. 47–​126. Povel, P. 1999. “Optimal ‘Soft’ or ‘Tough’ Bankruptcy Procedures.” Journal of Law, Economics, and Organization 15, pp. 659–​684. Ramsey, S., Blough, D., Kirchhoff, A., Kreizenbeck, K., Fedorenko, C., Snell, K., Newcomb, P., Hollingworth, W., and Overstreet, K. 2013. “Washington State Cancer Patients Found to Be at Greater Risk for Bankruptcy than People without a Cancer Diagnosis.” Health Affairs 32:6. http://​content.healthaffairs.org/​content/​early/​2013/​05/​14/​hlthaff.2012.1263. abstract Rasmussen, R. K. 1992. “Debtor’s Choice: A Menu Approach to Corporate Bankruptcy.” Texas Law Review 71, pp. 51–​121. Ravid, S. and Sundgren, S. 1998. “The Comparative Efficiency of Small-​Firm Bankruptcies: A Study of the US and Finnish Bankruptcy Codes.” Financial Management 27:4. Rea, S. A. 1984. “Arm-​breaking, Consumer Credit and Personal Bankruptcy.” Economic Inquiry. 22, pp. 188–​208.

 

ECONOMICS OF CORPORATE AND PERSONAL BANKRUPTCY LAW    479 Roe, M. J. 1983. “Bankruptcy and Debt: A New Model for Corporate Reorganization.” Columbia Law Review 83, pp. 527–​602. Sandage, Scott. 2005. Born Losers: A History of Failure in America. Cambridge, MA: Harvard University Press. Schwartz, A. 1993. “Bankruptcy Workouts and Debt Contracts.” Journal of Law and Economics 36, pp. 595–​632. Schwartz, A. 1997. “Contracting about Bankruptcy.” Journal of Law, Economics, and Organization 13, pp. 127–​146. Shepard, L. 1984. “Personal Failures and the Bankruptcy Reform Act of 1978.” Journal of Law and Economics 27, pp. 419–​437. Shleifer, A. and Vishny, R. W. 1992. “Liquidation Values and Debt Capacity:  A  Market Equilibrium Approach.” Journal of Finance 47, pp. 1343–​1366. Skiba, P. and J. Tabacman. 2011. Do Payday Loans Cause Bankruptcy? Vanderbilt Law and Economics Research Paper No 11-​13. Stiglitz, J. E. 1972. “Some Aspects of the Pure Theory of Corporate Finance: Bankruptcies and Take-​Overs.” Bell Journal of Economics 3, pp. 458–​482. Stulz, R. and Johnson, H. 1985. “An Analysis of Secured Debt.” Journal of Financial Economics. 14, pp. 501–​421. Sullivan, T., Warren, E., and Westbrook, J. 1989. As We Forgive Our Debtors. New York: Oxford University Press. Tarantino, E.T., 2009, “Bankruptcy Law and Corporate Investment Decisions.” CentER Discussion Paper, Tilburg University, The Netherlands, Volume 2009-​86. Tashjian, E., Lease, R., and McConnell, J. 1996. “Prepacks:  An Empirical Analysis of Prepackaged Bankruptcies.” Journal of Financial Economics 40, pp. 135–​162. Thorburn, K. 2000. “Bankruptcy Auctions: Costs, Debt Recovery, and Firm Survival.” Journal of Financial Economics 58, pp. 337–​368. Traczynski, Jeffrey. 2011. “Divorce Rates and Bankruptcy Exemption Levels in the U.S.” Journal of Law & Economics 54, pp. 751–​779. Triantis, G. G. 1993. “The Effects of Insolvency and Bankruptcy on Contract Performance and Adjustment.” University of Toronto Law Journal 43, pp. 679–​7 10. Wang, H. -​J. and White, M. J. 2000. “An Optimal Personal Bankruptcy System and Proposed Reforms.” Journal of Legal Studies 39, pp. 255–​286. Webb, D. C. 1991. “An Economic Evaluation of Insolvency Procedures in the United Kingdom: Does the 1986 Insolvency Act Satisfy the Creditors’ Bargain?” Oxford Economic Papers 43, pp. 139–​157. Weiss, L. A. 1990. “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims.” Journal of Financial Economics 27, pp. 285–​314. Weiss, L. A. and Wruck, K. H. 1998. “Information Problems, Conflicts of Interest, and Asset Stripping: Chapter 11’s Failure in the Case of Eastern Airlines.” Journal of Financial Economics 48, pp. 55–​97. White, M. J. 1980. “Public Policy Toward Bankruptcy: Me-​First and Other Priority Rules.” Bell Journal of Economics 11, pp. 550–​564. White, M. J. 1983. “Bankruptcy Costs and the New Bankruptcy Code.” Journal of Finance 38, pp. 477–​488. White, M. J. 1987. “Personal Bankruptcy under the 1978 Bankruptcy Code:  An Economic Analysis.” Indiana Law Journal 63, pp. 1–​57.

 

480   MICHELLE J. WHITE White, M. J. 1989. “The Corporate Bankruptcy Decision.” Journal of Economic Perspectives 3, pp. 129–​151. White, M. J. 1994. “Corporate Bankruptcy as a Filtering Device: Chapter 11 Reorganizations and Out-​of-​Court Debt Restructurings.” Journal of Law, Economics, and Organization 10, pp. 268–​295. White, M. J. 1998a. “Why Don’t More Households File for Bankruptcy?” Journal of Law, Economics, and Organization. 14, pp. 205–​231. White, M. J. 1998b. “Why It Pays to File for Bankruptcy: A Critical Look at Incentives under U.S. Bankruptcy Laws and A Proposal for Change.” University of Chicago Law Review 65, pp. 685–​732. White, M. J. 2005. “Personal Bankruptcy:  Insurance, Work Effort, Opportunism and the Efficiency of the ‘Fresh Start.’” Working Paper, UCSD. www.ucsd.edu/​~miwhite/​ bankruptcy-​theory-​white.pdf [Accessed 6 September 2016]. White, M. J. 2007. “Bankruptcy Reform and Credit Cards,” Journal of Economic Perspectives 21, pp. 175–​199.

 

Chapter 19

L AW AND EC ONOMI C S OF INSURA NC E Daniel Schwarcz and Peter Siegelman

Insurance concepts routinely play an important role in law and economics scholarship.1 This is perhaps clearest in the law and economics literature on torts, where insurance principles provide the dominant framework on issues ranging from the desirability of emotional distress damages (Shavell 1987; Avraham 2005) to the appropriate scope of products liability law (Calabresi 1970; Epstein 1985). But insurance ideas also play a prominent role in a broad spectrum of law and economics scholarship on other topics, spanning contract law (Posner and Rosenfield 1977; Shavell 2004), property law (Blume, Rubinfeld, and Shapiro 1984), and financial regulation (Scott 1987; Myerson 2014), to name just a few. Despite the wide-​ranging importance of insurance concepts to law and economics generally, law and economics scholarship specifically addressing insurance law is surprisingly limited. This is particularly true when insurance law is defined to exclude insurance regulation or when law and economics is defined to exclude traditional economics scholarship published outside of legal journals. In the remaining set of legal scholarship focused on court-​made insurance law, the scholarly tradition has been principally doctrinal rather than rooted in law and economics, at least outside of a few select areas such as liability insurers’ duty to settle claims against their policyholders. This chapter therefore takes a broad approach to defining the law and economics of insurance. It provides an overview of both economically oriented legal scholarship and traditional economics scholarship addressing judicial doctrines of insurance, insurance regulation, and insurance legislation. Aside from defining a deep, but manageable, scope for the chapter, this broad vantage point offers several interrelated benefits.

1  Daniel Schwarcz is Julius E. Davis Professor at the University of Minnesota Law School. Peter Siegelman is Phillip I. Blumberg Professor of Law at the University of Connecticut Law School. We thank Lokys Gust for excellent research assistance.

 

482    DANIEL SCHWARCZ AND PETER SIEGELMAN First, it reveals the centrality of information asymmetries to insurance law and regu­ lation. Like insurance economics (Rothschild and Stiglitz 1976; Akerlof 1970; Arrow 1963), insurance law and legal scholarship have been substantially influenced by the prospect that insurers may know less about consumers’ riskiness than consumers themselves know. For instance, adverse selection—​which focuses on consumers’ private knowledge of their own “fixed-​in-​advance” riskiness—​has been explicitly invoked by roughly 200 federal and state court opinions since 1913 and has had widespread influence on both judicial and regulatory understandings of insurance markets (Siegelman 2004). Concern for adverse selection also lies at the heart of both the Affordable Care Act’s “individual mandate,” as well as state insurance antidiscrimination laws (Avraham, Schwarcz, and Logue 2014). Similarly, over 700 federal and state court opinions since 1868 have explicitly discussed moral hazard, or the prospect that insurance reduces consumers’ reason to avoid risks in ways that are unobservable to insurers. Insurance law is also deeply influenced by information asymmetries that, in contrast to adverse selection and moral hazard, favor insurers over policyholders. Such information asymmetries may be common with respect to various features of the insurance relationship, including insurance policy terms and conditions, insurers’ financial strength, and the appropriate matching of policies and consumers. In some cases, insurers may be able to exploit these deficits in policyholder information or sophistication by providing more limited coverage than policyholders believe they are purchasing, or by adopting excessively aggressive claims-​handling strategies. A core goal of insurance law is to respond to these types of consumer protection concerns. The chapter’s broad vantage point also provides a second benefit:  it suggests ways in which the law might be improved by embracing understandings of the economics of information asymmetries that are more sophisticated. For instance, in many cases, insurance law and regulation assume that adverse selection and moral hazard are important problems in all insurance markets, even though both phenomena come in varying degrees, so that their magnitude is an empirical question (Cohen and Siegelman 2010).2 An equally significant lacuna in much insurance law is the absence of an equilibrium approach that anticipates insurance market reactions to legal interventions. Similarly, courts, regulators, and legal scholars are only beginning to assimilate the specific insights of behavioral economics to understand anomalies in insurance demand and to craft a legal response to such divergence from rational behavior. All of this indicates that the law and economics of insurance is still ripe for fuller development. By weaving together the insights of traditional economics scholarship and economically sophisticated legal scholar­ ship on a broad range of insurance law topics, this chapter attempts to jumpstart this development.

2 

To be fair, the empirical economics of insurance has lagged far behind the theory, perhaps because insurance data are largely proprietary, making it difficult for researchers to test theoretical predictions.

 

LAW AND ECONOMICS OF INSURANCE    483

19.1.  Insurance Regulation The business of insurance is subject to extensive ex ante regulation in virtually all developed countries. From an economic perspective, the desirability of such regulation depends, first, on the existence of market failures and, second, on the possibility that regulatory policies can effectively and efficiently counteract them. As to the former, while insurance markets are well known for potential market failures, the magnitudes and potential social welfare consequences of such failures are highly variable. Similarly, the potential for ex ante regulation to efficiently and effectively correct substantial market failures is itself context-​dependent. This section explores these broad themes in four areas of ex ante insurance regulation: (i) solvency regulation, (ii) consumer protection regulation, (iii) antidiscrimination laws, and (iv) government nudges to improve consumer decision-​making.

19.1.1. Solvency Regulation There are multiple market failures that might justify insurance solvency regulation. Perhaps the most compelling is a principal–agent problem involving policyholders and insurers. Insurance is distinctive because it operates on an inverted production cycle: policyholders pay premiums in exchange for future, contingent, promises of payment. For this reason, insurers can, and almost always do, rely principally on policyholders to finance their operations. Unlike traditional firms, insurers generally maintain only limited debt and, in the case of mutual companies, do not even have shareholders (Jaffee and Russell 1997). Policyholders face substantial difficulties, relative to creditors or shareholders, in monitoring insurance managers and safeguarding their interests (Plantin and Rochet 2007; Weber 2011). Policyholders are dispersed: no single policyholder is likely to provide more than a very small fraction of the premiums collected by a particular insurer. Policyholders also tend to have limited interest or expertise in the details of their carriers’ ongoing operations and strategies because they think of themselves as having purchased a product from the company rather than having “invested” in it. Finally, most policyholders (unlike shareholders) have no “voice” in how their insurer operates and often have few exit opportunities as well. Thin or nonexistent secondary markets for their interests and contractual limitations on their ability to terminate policies without forfeiting a substantial sum or a prepurchased benefit make it very difficult for policyholders to switch if they are dissatisfied with their current insurer.3 3  As an example of the latter, consider a level premium term life insurance policy. In essence, policyholders overpay in initial years so that they can underpay for the same coverage in later years, when their risk of dying increases. Although a policyholder could stop paying premiums in response to financial troubles at the company, he or she would thereby forfeit the prepurchased benefit.

 

484    DANIEL SCHWARCZ AND PETER SIEGELMAN These features of insurance finance mean that all insurance—​and particularly insurance that is long term, such as life, annuities, long-​term care, disability, and long-​tail liability—​is subject to potentially substantial principal–agent problems. In particular, insurance managers may have incentives to pursue excessively risky strategies from the standpoint of policyholders. Managers may enjoy various benefits from increasing the short-​term profitability of the companies they operate, particularly if the company is a stock company. By contrast, policyholders are generally exposed only to the downside of such risk-​taking.4 The divergence of interests between managers and policyholders may become particularly acute for carriers that are facing financial difficulties: in these instances, managers have incentives to adopt very risky strategies to stave off the threat of losing their jobs, whereas policyholders have strong interests in avoiding risk because they will principally bear the costs of insolvency (Bohn and Hall 1998). In addition to this corporate governance justification, solvency regulation can also be justified (in many, though not all, markets) based on more straightforward consumer protection analysis.5 To the extent that policyholders undervalue insurers’ financial strength at the time of purchase, insurers may have insufficient incentives to avoid risky, but profitable, investment strategies. Some policyholders may indeed have limited information about insurers’ financial strength at the time of purchase, though this problem is mitigated by the availability of financial strength ratings from private rating agencies. Perhaps more convincingly, many policyholders may unduly discount the prospect that their chosen insurer may experience financial trouble. Alternatively, insurance consumers may fail to appreciate the adverse consequences that they could experience if their insurer’s financial strength were compromised. A different—​and increasingly important—​justification for insurance solvency regu­ lation may be that it is necessary to limit systemic risks, which are a form of negative externality. Before 2008, conventional wisdom in regulatory and policy circles was that, unlike banking, the insurance industry posed no meaningful risk to broader financial stability in the economy. But the prominent role of American International Group and financial guaranty insurers in the crisis, as well as the temporary but substantial capital deterioration of many life insurers in 2008–​2009, poses a challenge to this view (Harrington 2009). Systemic risk in insurance is clearest in the case of insurance companies that engage in many of the same types of financial transactions as banks, such as writing credit default swaps and providing financial guaranty insurance (Cummins and Weiss 2014). But the risk may be broader, given insurers’ extensive involvement in various financial markets and their constantly evolving product designs and investment strategies (Schwarcz and Schwarcz 2014).

4 

This is unless their policies include potential dividends, as with some life policies. Yet another potential justification for solvency regulation is that it is necessary precisely because market discipline is blunted by the existence of guaranty funds that protect policyholder funds even when their insurer becomes insolvent. Of course, this explanation begs the question why guaranty funds are necessary, which, in turn, reverts to the justifications discussed in the text. 5 

 

LAW AND ECONOMICS OF INSURANCE    485 In response to these risks, insurers are subject to an extensive array of solvency regulations. These rules govern how much insurers must set aside in reserves to pay future claims, the character of their risk-​management practices, and the permissibility of major transactions that may implicate the company’s financial health. They provide regulators with the authority to take over financially troubled insurers and, in some countries, protect policyholders from insolvency through guaranty funds (Klein 2009). Perhaps most importantly, they dictate the amount of capital (roughly, assets minus liabilities) that insurers must hold on their balance sheets. Larger amounts of regulatory capital increase the size of losses that must be borne by the company’s owners before policyholders are impacted. For that reason, they also encourage insurers to operate more conservatively, an effect that, in many respects, resembles a deductible on an insurance policy. Substantial scholarly attention has assessed the efficiency and effectiveness of the US’s Risk-​Based Capital (RBC) rules, which seek to calibrate insurers’ capital requirements to their overall risk level (Brown and Klein [2015] survey the literature.) To do so, these rules rely on a complex set of formulas that attempt to measure a carrier’s exposure to various types of risks, such as a decrease in asset values or an increase in insured losses.6 Cummins, Harrington, and Klein (1995) find that the RBC formula for property-​ casualty companies does a poor job of predicting insurance company failures. They propose several modifications, including changing the weight of various factors within the formula and including the organizational form of the insurer (mutual or stock), as well as firm size. While echoing some of these criticisms, Harrington (2005) suggests that the best solution may be simpler and less stringent capital rules for insurers. Still others, such as Holzmuller (2009) and Cummins and Phillips (2009), have argued that capital requirements should move beyond formula-​based approaches to calculating capital and embrace more advanced risk-​management techniques, such as stochastic modeling. Some commentators, such as Myerson (2014), note that risk-​based capital can increase systemic risk by concentrating assets in categories that might not turn out to be safe (for instance, sovereign debt of EU member governments).7 Recently, insurers’ capital requirements have come under renewed scrutiny because of requirements in the Dodd–​Frank Wall Street Reform and Consumer Protection Act8 that the Federal Reserve impose consolidated capital requirements on insurance companies that are designated as systemically important or that own federally insured depository institutions. There are different ways to implement a consolidated capital requirement, but its key feature is that it applies across the various legal entities within a firm.9 The appropriateness of such capital requirements is a matter of substantial 6 

Eling and Holzmuller (2008) provide a good overview of alternative approaches to risk-​based capital requirements used in other parts of the world. 7  Myerson’s analysis applies equally to banks and to insurance companies. 8  Pub. L. No. 111-​203, 124 Stat. 1376 (2010). 9  The Federal Reserve recently released an Advance Notice of Proposed Rule-​Making that outlined two approaches to developing a consolidated capital standard. The first, which it labeled a building-​ block approach, would simply aggregate capital requirements and resources across different legal entities. The second would instead focus on a consolidated balance sheet for the entire enterprise, an

 

486    DANIEL SCHWARCZ AND PETER SIEGELMAN debate in regulatory and policy circles, though scholarly analysis of the issue is currently limited.10 An important set of recent papers has focused attention on the risks associated with insurers’ liabilities, which primarily consist of reserves set aside to pay future claims. Koijen and Yogo (2013) find that many US regulated life insurers have reinsured a substantial percentage of their business with affiliated, “unauthorized” reinsurance companies, which are subject to much looser regulatory rules than those governing the ceding insurer. Schwarcz (2015) describes how these types of shadow insurance transactions create four distinct types of risks: (i) the risk that captive reinsurers will default on their obligations to the underlying insurers; (ii) the prospect that an insurer will no longer be allowed to receive favorable accounting treatment for shadow insurance transactions; (iii) the risk that a single financial shock will similarly affect multiple individual companies within a broader financial conglomerate, and (iv) risks arising from increased linkages between the insurance and banking sectors. State regulatory rules governing insurers’ reserve levels can not only generate regulatory arbitrage, but can also distort insurers’ market behavior. Koijen and Yogo (2014a) find that these rules caused many insurers to sell life insurance and annuities to the public at huge economic losses in the midst of the financial crisis in order to generate accounting profits. In a policy-​focused summary of their work, Koijen and Yogo suggest that these findings indicate that a market-​based approach to valuing insurers’ liabilities may reduce the costs of financial regulation while providing a more transparent accounting of insurers’ long-​term obligations (Koijen and Yogo 2014b).

19.1.2. Consumer Protection Regulation Much state insurance regulation consists of consumer protection rules:  licensing requirements for insurers and agents; content and rate rules for insurance products; prohibitions against unfair or misleading underwriting, claims-​paying, and advertising; regulator-​operated complaint hotlines; and disclosure rules. These consumer protections are usually grounded in two potential failures in insurance markets. The first involves policyholders’ limited information regarding the character and quality of the insurance they purchase. Depending on the type of coverage and policyholders at issue, insurers may have better information than policyholders do regarding the generosity of the insurance contract, its appropriateness for the purchasing policyholder, and the insurer’s claims-​paying practices. The potential prevalence of these approach that would be insensitive to where any particular assets or liabilities were located within the entire consolidated enterprise. The Notice suggested that the building block approach would be more appropriate for non-​systemically significant entities, whereas the consolidated approach would be more appropriate for insurance-​focused entities that had been designated as systemically significant. See 81 Fed. Reg. 38631–​38637 (2016). 10 

For discussion of the importance of consolidated capital rules in insurance generally, see Schwarcz (2015).

 

LAW AND ECONOMICS OF INSURANCE    487 asymmetries reflects the fact that insurance is a classic “credence good,” in that its true value is often difficult for policyholders to assess even after purchase (Darby and Karni 1973). This is for several reasons. First, the insurance product itself is a complicated legal document whose implications are not always clear, even to experts. (Abraham 1986). Second, by design, most policyholders rarely or never use the coverage they purchase (particularly for low-​probability, high-​cost events), so that they have a limited store of experience with how that policy operates in practice. Third, reputation may provide weak or inconsistent information to insurance policyholders because of the context-​ specific nature of coverage disputes or mismatches between insurance products and consumer needs (Schwarcz 2007). A second potential market failure in insurance that may justify consumer protection regulations involves systematic and pervasive behavioral biases among policyholders. The character and magnitude of these biases varies greatly among types of coverage and policyholders. As described more extensively below, individuals are subject to various well-​established heuristics and biases when it comes to making insurance decisions. These biases may justify regulatory intervention because market forces can otherwise compel firms to exploit biases in ways that decrease social welfare (Bar-​Gill 2012). For instance, insurers may offer limited coverage for non-​salient risks while providing coverage for salient risks that are sufficiently low magnitude that insurance makes little sense. (As we suggest below, however, the equilibrium effects of behavioral biases in markets with informational asymmetries are far from straightforward.) Because these two rationales for regulatory intervention depend so substantially on the nature of the insurance purchaser, the stringency or applicability of consumer protection rules often corresponds to the purchaser’s presumed characteristics and the type of coverage at issue. For instance, policy forms are generally more substantially regulated in life, annuities, homeowners, and automobile insurance markets than they are in commercial property/​casualty markets (Butler 2002). Similarly, rate regulation is much more prevalent in personal coverage lines than commercial lines (Tennyson 2007). One interesting, and arguably troubling, inversion of this pattern involves the legal duties of insurance intermediaries:  intermediaries serving commercial clientele often are deemed to owe greater loyalty and obligations to their clients than are those who operate in personal lines markets, where consumers are presumably in greater need of expert assistance (Schwarcz 2008; Schwarcz and Siegelman 2015). The effectiveness of consumer protection regulation in insurance varies across fields and jurisdictions. The most widely studied consumer protection tool is rating restrictions that are designed to prevent insurers from charging excessive prices. Not surprisingly, economic studies have shown that this form of rate review can have substantial unintended negative consequences, such as intensifying rate volatility and discouraging carriers from decreasing their rates (Tennyson 2007). There is even evidence that this form of regulation does not actually result in the reduction of rates over the long run (Harrington 2002). Some studies, however, indicate that rate review can be effective when it is appropriately implemented, pointing to California’s apparently successful regulatory regime as an example (Jaffee and Russell 2002; Rosenfield 1998).

 

488    DANIEL SCHWARCZ AND PETER SIEGELMAN Literature on the effectiveness of other insurance consumer protection strategies is generally quite thin. One recent study found that the content of homeowners insurance policies varies substantially across insurance companies in ways that were deeply opaque to consumers (Schwarcz 2011). Moreover, most of the deviations from the standard-​industry form tended to reduce coverage for consumers. These results suggest that insurance regulation, as well as the insurance industry itself have generally done a poor job of making coverage differences across carriers transparent to consumers or market intermediaries, a trend that Schwarcz [2014] argues elsewhere extends to other consumer protection issues, such as differentials in claims-​handling quality, the availability and limits of guaranty fund protection, and the availability and affordability of coverage for traditionally underserved populations. These results are broadly in keeping with the regulatory capture literature suggesting that regulations initially designed to help consumers may end up being used by sellers to restrict competition and increase profits (Carpenter and Moss 2013). The underlying logic is that consumers are a diffuse group with little incentive to acquire the knowledge needed to monitor regulators, while producers are much more highly invested in manipulating policy in their favor. A small literature also examines the need for regulations designed to protect policyholders from biased or incompetent advice from insurance intermediaries (for a recent survey, see Schwarcz and Siegelman [2015]). Several papers offer competing predictions about this risk, with much depending on the sophistication of policyholders as well as various institutional and behavioral details (Cummins and Doherty 2006; Gravelle 1994; Schwarcz 2007, 2008). Meanwhile, empirical evidence about the quality of insurance intermediary advice is limited, but provides some reason to believe that biased and incorrect advice is not uncommon, especially in consumer-​oriented markets (Eckardt 2007; Anagol, Cole, and Sarkar 2012; Browne, Knoller, and Richter 2012; Brown and Minor 2012). Virtually none of this literature, however, examines the potential effectiveness of ex ante regulation in addressing the risk of biased or misleading agent advice. One exception, Lex, Richter, and Tennyson (2014), provides reason to be skeptical that insurance agent licensing standards are an effective means for ensuring quality. They find that new licensing rules for insurance agents in Germany substantially reduced the total number of agents, but did not produce any meaningful difference in rates of policy cancellation between the customers of agents who dropped out of the market and those who did not, which they use as a proxy for the quality of agents’ advice.

19.1.3. Insurance Antidiscrimination Laws A broad range of insurance laws and regulations attempt to restrict insurers’ ability to discriminate or differentiate among policyholders in underwriting or rating. Such laws limit insurers’ consideration of policyholder characteristics such as race, gender, health status, genetic information, and credit information, to name a few. From an economic

 

LAW AND ECONOMICS OF INSURANCE    489 perspective, these restrictions on “discrimination” create the prospect of “regulatory adverse selection,” as they may increase the cost of insurance for observably low-​risk policyholders, who may consequently opt for more limited coverage or for no coverage at all (Hoy 2006; Hoy and Ruse 2005). The risk of such regulatory adverse selection actually transpiring depends on numerous factors, including the size and risk levels of the population with the “high-​risk” characteristic whose use is prohibited, the elasticity of demand among the population of “low-​risk” policyholders, and the ability of high-​risk policyholders to purchase large sums of insurance (Avraham, Schwarcz, and Logue 2014). Despite their costs, insurance antidiscrimination laws can be given an economic justification, in addition to the more abstract fairness based concerns that are often cited in the legal literature. Perhaps most importantly, risk-​classification restrictions are a potentially important response to market failures that prevent insurers from offering coverage against “classification risk,” or the prospect that an individual will become high-​risk in the future, and thus unable to obtain insurance at reasonable rates (Abraham and Chiappori 2015). Commentators disagree about the ability of markets to supply such classification risk coverage (Cochrane 1995; Crocker and Snow 2000; Abraham and Chiappori 2015). Although this type of coverage is broadly available in life insurance, it is generally unavailable in other contexts, such as health and property insurance. In the extreme, where a policyholder’s high-​risk status exists before birth—​as is the case for various genetic disorders—​market solutions seem virtually impossible. Risk-​classification restrictions can also potentially be justified on other efficiency grounds: insurers’ classification practices may deter private acquisition of valuable information (as in the case of genetic information) or may result in costly efforts to classify policyholders into different risk pools that result only in the realloca­ tion of policyholders among carriers rather than real changes in the overall insured population (as potentially may be the case in health insurance) (Avraham, Schwarcz, and Logue 2014). Given these competing costs and benefits to risk-​classification restrictions, their efficiency will often depend on various context-​specific factors. But such laws can be paired with complementary strategies that attempt to limit their primary cost: the risk of adverse selection. Perhaps most notably, regulations can pair insurer-​side antidiscrimination restrictions with a mandate that customers purchase insurance (and a penalty for failing to do so). This strategy, of course, is employed by the Affordable Care Act to offset the risk of adverse selection that might result from its prohibitions on discrimination based on health characteristics and gender, and its limitations on age-​based discrimination. Similarly, laws may pair antidiscrimination rules with minimum-​coverage requirements for insurance policies. This combination limits the ability of insurers to indirectly classify risks by inducing self-​selection on the part of policyholders. This can be achieved by offering less generous coverage options that are specifically designed to attract low-​risk policyholders (a practice known as “cream-​skimming”). This strategy, as well, is a centerpiece of the Affordable Care Act.

 

490    DANIEL SCHWARCZ AND PETER SIEGELMAN

19.1.4. Nudging Toward Better Insurance Equilibria As noted above,11 there has been a long scholarly tradition describing the failures of insurance consumers to act rationally (i.e., in accordance with the canonical Expected Utility model of choice under uncertainty).12 By now, the evidence for behavioral anomalies in insurance can be fairly characterized as overwhelming. Framing effects, loss-​ aversion, availability bias, affective clouding, and a large and growing catalog of other behavioral frailties have been demonstrated in both experimental and real-​world insurance purchases. Kunreuther, Pauly, and McMorrow (2013) survey the experimental results. For instance, consumers routinely buy insurance they should rationally avoid, such as bicycle theft coverage (Browne, Knoller, and Richter 2012), homeowner policies with low deductibles (Sydnor 2010), and extended warranties on relatively inexpensive consumer durables (Baker and Siegelman 2014). Simultaneously, consumers avoid or underconsume insurance they should rationally want, such as flood or life insurance (Kunreuther, Pauly, and McMorrow 2013; Cutler and Zeckhauser 2004; Logue 2001). Consumers’ insurance purchases are significantly clouded by “affective” or emotional considerations that have no place in the economic theory of insurance demand (Hsee and Kunreuther 2000). These findings have begun to generate concrete policy applications, although scholars have predictably been ahead of regulators in this respect. For example, Baker and Siegelman (2010) suggest that many young people are overly optimistic about their chances of getting sick, which reduces their demand for health insurance. They propose to encourage this group to buy health insurance by bundling it with a “prize” that they could collect if they didn’t “need” to use the insurance (i.e., if they remained healthy). Kunreuther and Pauly (2013) note that consumers tend to have myopic perceptions of risk: they are willing to take out flood insurance just after a major flood occurs, but they let it lapse if they do not experience a flood for a few years. To overcome this problem, they suggest requiring that sellers move from single-​year coverage to policies with a much longer time-​horizon, making lapses less likely. The UK Office of Fair Trade (discussed in Baker and Siegelman [2014, 53]) relied on behavioral economics to design regulations controlling the over-​selling of extended warranties—​small-​scale insurance policies—​on consumer durables. While behavioral insights are beginning to find their way into insurance regulation, they have thus far made less explicit inroads into judge-​made law: there are only three federal or state cases that use both “behavioral economics” and “insurance,” and none of these are actually insurance cases. But given the strong empirical support for irrational 11 

See Section 19.1.2. For an introduction to the classic model of insurance demand, see Eeckhoudt, Gollier, and Schlesinger (2005). Eisner and Strotz (1961) is an early applied theory paper exploring the irrational purchase of flight insurance. Kunreuther (1978) and his co-​authors (Johnson et al. 1993) pioneered the experimental and theoretical analysis of behavioral anomalies in insurance demand; see Kunreuther, Pauly, and McMorrow (2013) for a book-​length treatment of these issues. Cutler and Zeckhauser (2004) is another important reference. 12 

 

LAW AND ECONOMICS OF INSURANCE    491 behavior in insurance demand, it may only be a matter of time before judges and regulators begin to take more explicit account of consumers’ behavioral frailties. Ultimately, however, insurance law will need to do more than merely try to correct for consumers’ deviations from rational behavior. It will need to consider expressly how insurance markets equilibrate in the presence of behavioral anomalies. Otherwise, well-​intended efforts to correct irrational behavior may turn out to be welfare reducing. Consider one relatively straightforward example. Handel (2013) examines “inertia” in individuals’ choice of employer-​provided health insurance plans and finds strong evidence that people tend to stick with a given plan, even when other offerings are clearly better for them. Such irrational inertia obviously leads to individual welfare losses, and one might be tempted to conclude that policy should strive to reduce choice stickiness, for example, by educating consumers about the menu of choices they face. But the upside of inertia is that it reduces adverse selection, precisely because it retards consumers’ tendency to utilize any informational advantage in choosing the insurance plan that is best for them. A welfare analysis thus needs to combine both inertia and adverse selection. That, in turn, requires a model of how insurers would react to the increased selection pressures that result from reducing consumer inertia. For example, Handel (2013) concludes that an intervention that “reduces inertia by three-​quarters … improves consumer choices conditional on prices, but … also exacerbates adverse selection, leading to a 7.7% reduction in welfare” (emphasis added). In this case, at least, the upshot is that regulatory intervention to improve consumer choice may actually decrease consumer welfare.

19.2.  Insurance Law in the Courts Courts play a fundamental role in most insurance markets. Many types of insurance policies—​including property, casualty, health, disability, and long-​term care—​often raise difficult issues about what they actually cover because they turn on the application of broad policy language to facts about a specific loss. Liability insurance presents special coverage and coverage-​related issues for courts because of its fundamental role in funding the litigation system in the United States and providing compensation for injured plaintiffs.13 Additionally, courts often play an important ex post regulatory role on insurance issues ranging from misleading or abusive sales tactics to unreasonable claims han­ dling to unfair discrimination. In all of these cases, economic principles can, and often do, help to influence the role of courts in insurance markets. This Section describes the role of courts in insurance law and regulation through four parts: (1) insurance policy

13  It is for precisely this reason that the American Law Institute has been developing a Restatement of Liability Insurance, a project that is ongoing as of 2016. For an excellent an overview of some of the key issues in the project from a law-​and-​economics perspective, see Geistfeld (2015).

 

492    DANIEL SCHWARCZ AND PETER SIEGELMAN interpretation and regulation, (2) bad faith, (3) the duty to defend, and (4) the duty to settle.

19.2.1. Insurance Policy Interpretation and Ex Post Policy Regulation Courts routinely resolve disputes regarding the proper application of policy language to a particular loss. Economic principles can play an important role in these cases because they often help illuminate the intended purpose of contested policy language. For instance, courts frequently invoke a concern for moral hazard to justify pro-​insurer readings of exclusionary clauses. Thus, in W. Bend Mut. Ins. Co. v Arbor Homes LLC,14 a contractor whose obvious fault caused an injury to its customer was denied coverage because it settled with the customer before obtaining consent from its insurer. The court noted that the contractor behaved honorably, but that policy language excluding cover­age for “Voluntary Payments” made to a plaintiff without the insurer’s consent was necessary, among other things, to prevent moral hazard. (That is, if the policyholder had insurance coverage that included payments made at its own discretion, it would have a strong incentive to make such payments.) Similarly, in Amerisure Ins. Co. v Nat’l Sur. Corp.,15 the court read a “Cross Liability” exclusion to deny coverage for a suit between two parties covered by the same insurance. “Without the Exclusion,” the court suggested, “parties insured under the same policy would have no disincentive to sue one another … [which] sets up what is known to economists as a moral hazard, because the party taking the risk will not bear the costs of its behavior.” Although moral hazard explanations of coverage exclusions often play a central role in coverage disputes, courts may be too quick to invoke moral hazard justifications. Just because a policy exclusion might help to address a moral hazard concern does not mean that it in fact does so. The prospect of moral hazard itself depends, among other things, on the extent to which money compensates for a covered loss and individuals are in control of loss-​producing behavior (Baker 1997). And even when moral hazard is a concern, policy exclusions will only limit this risk (rather than shifting it to policyholders) to the extent that policyholders are informed about the coverage exclusion (Schwarcz 2011). Concern for adverse selection has had a similar influence on judicial decisions. Courts have invoked adverse selection in a variety of areas, from employer-​provided health insurance to antitrust law to the coverage of mental illness in health insurance policies (Siegelman 2004). For example, during the mid-​1980s, Blue Cross of Rhode Island began to worry that it would lose younger, healthier customers to Health Maintenance Organizations (HMOs), which offered health plans that were more comprehensive than its own offerings. In response, it implemented a series of changes in its contracts, giving employers an incentive not to offer their workers an HMO that would compete 14  15 

703 F.3d 1092 and 1096 (7th Cir. 2013). 695 F.3d 632, 635 (7th Cir. 2012).

 

LAW AND ECONOMICS OF INSURANCE    493 with Blue Cross’ plan. This so-​called “adverse selection program” raised serious antitrust concerns, but the court nevertheless upheld it because of a fear that adverse selection might otherwise destroy the health care market altogether.16 As with moral hazard, however, law often embraces the overly simplistic notion that all insurance markets are equally susceptible to adverse selection. In fact, empirical research has increasingly demonstrated that adverse selection is a highly context-​specific phenomenon whose actual impact on insurance markets is quite variable (Cohen and Siegelman 2010). Focusing courts on the intended purpose of policy language—​whether or not that purpose is couched in insurance economics terms—​does encourage them to adopt an ex ante perspective in their interpretations of that language. This approach is particularly important in coverage disputes, which generally pit sympathetic policyholders against an insurance company resisting coverage. To concretize this point, Ronen Avraham suggests that judges facing insurance coverage disputes should explicitly evaluate total social welfare on two hypothetical islands, each one of which adopts a different interpretation of contested policy language (Avraham 2012). This approach can help judges implement an ex ante perspective by forcing them to think through the impact that their determinations may have on insurance market rates, coverage options, and insurance uptake. Law and economics also helps illuminate several distinctive principles of insurance contract interpretation. The most important generally applicable interpretive principle in insurance is contra proferentem, which requires that ambiguities in insurance policies should be interpreted against the drafter (Abraham 1996). This rule can be justified as a classic penalty default rule: it fills gaps in contracts with a default that is less favorable to the more informed party (Ayres and Gertner 1989). This, in turn, should have the effect of inducing the more informed party (i.e., the insurer) to fill the gap with its desired term and thereby convey information to the less informed party (Boardman 2013). The ambiguity rule can also be defended on the more general basis that, by favoring policyholders in cases of doubt, it helps to offset some of the potential inefficiencies that may result from policyholders’ lack of understanding of policy terms (Keeton and Widiss 1989). Both rationales for the rule, of course, mirror the general justification for the ex ante regulation of insurance policy forms described above. Several commentators have criticized the efficiency of the contra proferentem doctrine. Boardman, for instance, has argued that the doctrine ultimately exacerbates consumer ignorance of coverage terms. The very act of finding a clause ambiguous, she argues, tends to lock in unclear policy language by providing it with a fixed meaning that insurers can price. Consequently, insurers often retain policy language that courts have previously deemed ambiguous, precisely because that determination sets insurers’ coverage responsibilities going forward, even though the language remains ambiguous to uninformed consumers (Boardman 2006). Rappaport (1995) argues that the doctrine fosters uncertainty in insurance markets and results in costly insurer redrafting of ambiguous language, thus making insurance policy language even more opaque to 16 

Ocean State Physicians Health Plan, Inc. v Blue Cross & Blue Shield of R.I., 692 F. Supp. 52 (1988).

 

494    DANIEL SCHWARCZ AND PETER SIEGELMAN ordinary policyholders. He also argues that the rule is ill suited to address information asymmetries between insurers and policyholders because it targets ambiguities, rather than presumptively inefficient terms. These criticisms of contra proferentem raise larger questions of whether courts, rather than legislatures and regulators, are best situated to improve transparency in insurance markets. In theory, regulators and legislatures have numerous advantages over courts in advancing this objective: they have more expertise in both insurance and consumer literacy, they can observe company responses to rules over time and adjust accordingly, they receive feedback from policyholders routinely, and they can test different strategies to determine their effectiveness. Despite these advantages, US insurance regulators devote relatively limited attention to improving policyholder comprehension of coverage terms, with most states having sparse, and generally ineffective, disclosure and transparency rules about the scope of coverage (Schwarcz 2014). Of course, some have argued that such disclosure-​based approaches to improving consumer information in regulated markets are bound to fail (Ben-​Shahar and Schneider 2014). But others express more faith in such strategies to make meaningful inroads when they are appropriately designed (Bar-​Gill 2012; Craswell 2013). The reasonable expectations doctrine is another generally applicable principle of insurance that has been the subject of economically oriented critique. Although the doctrine has several versions, in its classical form—​which has been explicitly adopted by only a small number of courts—​it provides that policyholders are entitled to coverage consistent with their objectively reasonable expectations, notwithstanding policy language suggesting otherwise (Keeton 1970). Unlike the ambiguity rule, the reasonable expectations rule thus creates the possibility that courts could refuse to enforce clear policy language. The primary economic justification for the reasonable expectations doctrine is that insurers may draft inefficiently restrictive policy terms. Rational consumers would respond to such coverage restrictions by reducing their willingness to pay for the insurance, which is of course worth less the more restrictive it is. But given the various informational and cognitive limitations of policyholders described above, insurers might be able to restrict coverage without having to decrease price enough to compensate policyholders for more limited coverage.17 In this sense, the rationale for the doctrine is simply a specific application of the broader literature on the efficiency (or lack thereof) of standard form contracts (Schwartz and Wilde 1979; Korobkin 2003; Bar-​Gill 2012). Consistent with this rationale, the doctrine generally is not applicable in cases involving sophisticated policyholders (Stempel 1993). Even if insurance contract language is inefficiently restrictive in some markets, however, scholars have expressed mixed views regarding the capacity of a robust reasonable expectations doctrine to counteract this market failure efficiently. Abraham, for 17  Whether this is possible in a competitive equilibrium is not clear as a theoretical matter. Game-​ theoretic models (e.g., Gabaix and Laibson 2006) suggest that if some consumers lack foresight, competition will not eliminate these problems.

 

LAW AND ECONOMICS OF INSURANCE    495 instance, argues that the reasonable expectations doctrine opens the door for “judge-​ made” insurance, which will tend to undermine the efficiency of insurance markets by supplanting the cost–benefit calculations of insurers with the inexpert ex post decisions of judges (Abraham 1986). Others have emphasized that the doctrine is too unpredict­ able and unmoored to presumptive efficiency failures to serve as an effective tool against inefficiently restrictive coverage (Schwarcz 2007). As an alternative, Schwarcz (2007) suggested a products liability framework that would hold insurers liable for failing to “warn” consumers of specific coverage issues and employ explicit cost/​benefit analysis to determine whether particular policy terms are “defective.” By contrast, in the context of health insurance, Korobkin (1999) has argued that legislatures are institutionally better situated than courts to solve market failures that may produce inefficiently restrictive policies, but that expert administrative bodies may be an even better option for determining optimal benefit mandates. The pseudo-​regulatory nature of the reasonable expectations doctrine raises the broader question of whether courts, rather than regulators and legislatures, should be regulating the content of insurance policies. Several prominent commentators, including Abraham (1999) and Baker and Logue (2015), have suggested that regulators are better situated than courts to regulate policy language. Indeed, many of the classic advantages of regulators over courts—​particularly their expertise and capacity to moni­ tor over time—​are important in the context of regulating policy terms. Additionally, such regulation inevitably involves making tradeoffs that are inherently political. This may favor regulators, who are more democratically accountable than courts, since insurance commissioners are either directly elected or appointed by the state’s governor. At the same time, one important institutional advantage that courts have over regulators is that they actually observe the ways in which insurance policy language is applied in specific cases (Schwarcz 2007). Policy language that may seem relatively unobjection­ able when evaluated in isolation can conceivably present substantial concerns when applied in specific cases. Consider the “absolute pollution exclusion,” which broadly limits insurers’ exposure to liability involving the release of pollution, even if the release is “sudden and accidental.” In isolation, this exclusion seems eminently reasonable, at least in part because pollution liability is subject to substantial adverse selection concerns—​ firms with private knowledge of their significant potential pollution liability would be able to insure against such liability at rates that do not reflect their higher-​than-​average risk. However, insurers have occasionally invoked the broad language of these clauses to deny coverage in situations that do not involve paradigmatic pollution or the risk of adverse selection. In one case an insured’s employees accidentally spilled ammonia from a blueprint machine in the course of moving equipment.18 In another case, a construction worker applied a sealant to a warehouse floor that immediately contaminated the food stored in the building.19 Courts, rather than regulators, are better situated to observe such over-​reach and to limit the scope of exclusionary language accordingly. 18 

19 

Deni Assocs. of Fla. v State Farm Fire & Cas. Ins. Co., 711 So. 2d 1135, 1136 (Fla. 1998). Cincinnati Ins. Co. v Becker Warehouse, Inc., 635 N.W.2d 112, 114-​15 (Neb. 2001).

 

496    DANIEL SCHWARCZ AND PETER SIEGELMAN Additionally, courts may be less subject to regulatory capture than state regulators precisely because they are less political actors. Law and economics also provides helpful guidance on the general question of which insurance law doctrines or policy terms should be immutable, and which parties should be able to contract-​around. In the first comprehensive treatment of this question, Baker and Logue (2015) suggest a straightforward efficiency-​based answer: courts should draw this line such that the mutability of a particular insurance law principle and the justification for that principle are consistent. Applying this perspective, courts would refuse to enforce insurance policy terms that attempted to disclaim the reasonable expectations doctrine. Because that doctrine is itself premised on information asymmetries between insurers and policyholders, it would make little sense to credit insurers’ attempts to disclaim this rule. By contrast, Baker and Logue suggest that virtually all rules in insurance law should be default rules in the case of sophisticated policyholders, at least when the underlying rationale for the rule is based on information asymmetries or similar consumer-​oriented rationales.

19.2.2. Bad Faith In many settings, insurers have an incentive to be too aggressive in denying legitimate claims or delaying claims payment. As with solvency risk, this prospect stems from the inverted production cycle of insurance, whereby the policyholder first pays premiums and the insurer then performs by paying a claim if, and only if, a covered loss occurs. This sequence of performance may allow insurers to profit by denying legitimate claims: every dollar that an insurer avoids paying in claims adds to its bottom line. Similarly, insurers may profit in the short-​run by delaying payment, allowing them to continue to benefit from the time value of money. Moreover, delaying payment gives insurance companies leverage to settle disputed claims on favorable terms, as policyholders who have recently incurred a loss typically have high discount rates (Sykes 1996). Although insurers can clearly benefit in the short term by adopting excessively aggressive claims-​handling strategies, the long-​run profitability of such an approach would be uncertain if it caused policyholder demand for the insurer’s coverage to decrease. However, consumer demand in some markets may not be substantially responsive to overly aggressive claims handling owing to information asymmetries and behavioral anomalies. If prospective purchasers of insurance cannot distinguish between companies that adopt excessively aggressive claims handling and those that do not, or if consumers discount the probability that they will make a claim in the future, then market forces will exert a muted impact on insurers’ claims handling practices. Policyholders may be particularly poor judges of the reasonableness of different carriers’ claims han­ dling because it is very difficult to differentiate between legitimate and illegitimate claims denials, which turn on the facts of individual cases. The actual prevalence of insurer bad faith is a hotly contested issue, precisely because of the inherently fact-​bound nature of each alleged instance. However, there

 

LAW AND ECONOMICS OF INSURANCE    497 is compelling evidence that some insurers have deliberately adopted a company-​wide strategy of illegitimately minimizing claims paid (Langbein 2007; Feinman 2010), and most insurers face at least some incentives to reduce payouts. On the other hand, others have argued that many instances in which insurers have been found to engage in bad faith involve reasonable claims-​paying judgments by insurers (Sykes 1996). Estimating the prevalence of insurer bad faith is made even more difficult by the fact that insurers may need to adopt aggressive claims handling to deal with the risk of fraudulent claims. Estimating the rate of fraudulent claims is obviously difficult, but there is abundant anecdotal evidence of significant fraud. Dornstein (1998) discusses the “Friends of the Friendless,” a large and sophisticated fraudulent auto accident enterprise in Southern California, involving several doctors and lawyers. Knowledgeable observers believe that while “few people cut false claims from whole cloth, … nearly everyone exaggerates his loss.” (Ross 1970; quoted in Derrig 2002). More rigorous estimates of the amount of fraud founder on the difficulties of defining and identifying it, but virtually all estimates suggest that it is a substantial problem for insurers (Derrig 2002). This in turn means that there is an inherent tension between two valid goals: paying legitimate claims and denying payment of illegitimate ones. In order to counteract the risk of excessively aggressive claims handling, many states allow successful policyholder-​litigants to receive attorneys’ fees, emotional distress damages, statutory penalties and even punitive damages in cases where insurers are deemed to have unreasonably denied or delayed claims payment. These forms of damages, which are ordinarily unavailable in contract breach cases, are usually tied to some negligence, recklessness, or intentional misconduct in the insurer’s denial or delay of a claim. These laws clearly have a substantial impact on insurer claims-​handling practices. Browne, Pryor, and Puelz (2004) find that settlements are significantly larger in states that permit tort-​based bad faith liability against insurers. Asmat and Tennyson (2014) reach a similar conclusion using panel (combined time-​series and cross-​section) data that allow for stronger causal inferences about the effect of bad faith liability on settlement amounts. They also find that bad faith liability reduces the chances that a claim is substantially underpaid (by about 7%). The extant literature provides little concrete guidance on whether bad faith laws ultimately enhance social welfare. Sykes (1996), for instance, argues that these laws create more problems than they solve because courts tend to be unduly aggressive in identifying bad faith and the underlying risk of insurer bad faith is relatively limited because of market discipline. Tennyson and Warfel (2010) argue that bad faith law increases the incidence of fraudulent insurance claiming and discourages rigorous claims-​ handling investigations. Asmat and Tennyson (2015) are more cautious in their welfare assessment. Once again, the literature and law are remarkably sparse with respect to assessing the competence of courts, relative to regulators and legislatures, in disciplining insurers’ claims-​handling practices. Virtually every state has adopted some version of the Model Unfair Claims Settlement Practices Act (UCSPA), which authorizes state regulators to take action in cases of flagrant or repeated unfair claims practices. But little evidence

 

498    DANIEL SCHWARCZ AND PETER SIEGELMAN exists regarding the impact of these laws. Whether insurers’ claims practices are best controlled by regulatory oversight ex ante or by litigation by aggrieved policyholders ex post, or some combination of the two, thus remains a largely unsettled question.

19.2.3. Duty to Defend The basic scope of a liability insurer’s duty to defend is set by the so-​called “eight-​ corners rule,” which provides that when an insured is sued by a third party, the insurer’s duty to defend depends only on the terms of the underlying insurance policy and the pleadings of the third-​party claimant (two documents, eight total ‘corners’), without regard to the truth of the plaintiff/​victim’s allegations. This duty has been the subject of very little scholarship in law and economics (an excellent recent survey by Silver [2015] appears to be the sole exception), but has received considerable attention from lawyers and legal scholars (Stempel 1999, with updates; Ostrager and Newman 2012). Despite the lack of law and economics scholarship on the topic, liability insurers’ duty to defend has a significant impact on the conduct of ordinary litigation. For instance, plaintiffs’ lawyers understand that virtually all of any recovery will come from the defendant’s insurance company (Baker 2001; Zeiler et al. 2007), and often attempt to frame their pleadings so as to trigger the insurer’s duty to defend—​that is, to “plead into coverage.”20 Similarly, the duty can create innumerable difficulties and potential conflicts among insurers, policyholders, and insurance defense council (Silver and Syverud 1995). From an economic perspective, there is an obvious efficiency rationale for bundling the insurer’s duty to defend claims against the insured with its duty to indemnify, as occurs under typical liability insurance policies. By providing insurance against litigation expenses, the insurer is generally also able to control key litigation decisions as well as the identity of defense council. Pairing indemnity insurance with defense cost insurance thus helps ensure that the party who bears the cost of a potential judgment also makes the decision about how much to invest in defending against such a judgment. This should generally result in an efficient amount being devoted to defending liability claims. By contrast, consider a defendant who is fully covered against underlying liability, but has to spend out of pocket to defend a lawsuit. Such a defendant would choose to spend nothing on the lawsuit because any savings from a successful defense would redound only to the insurer’s benefit. Nonetheless, some insurance policies do not pair indemnity coverage with insurance defense coverage and/​or the right to control the defense. Table 19.1 (reproduced from Silver [2015]) gives examples of various combinations of the duty to indemnify, the duty to defend, and the right to control the conduct of the defense in different types 20 See Employers Mut. Cas. Co. v PIC Contractors, Inc., 24 F. Supp. 2d 212, 216 (D.R.I. 1998) (suggesting, “a plaintiff cannot ‘plead into’ coverage by labeling the claim as something that is inconsistent with the factual allegations in the complaint.”).

 

LAW AND ECONOMICS OF INSURANCE    499 Table 19.1 Types of Insurance Policies with Identified Features Duty to Indemnify

Duty to Defend

Right to Defend

Types of Policies*

Yes

Yes

Yes

Personal Auto; Commercial General Liability (CGL); Medical Professional Liability

Yes

Yes

No

Director & Officer (D&O) Ins.; Lawyers Professional Liability Coverage

Yes

No

Yes

Financial Institutions Risk Protector

Yes

No

No

Pure Indemnity; D&O Ins.; Excess Coverage

No?

Yes

Yes

None?

No

Yes

No

Medical Liability Mutual Ins. Co.; Employment Practices Liability

*Note: Some policies of this type have this set of features, but the same type of policy may come with different features and thus may appear in more than one row.

of insurance policies.21 While the typical policy allocates all three rights/​duties to the insurer, as in row 1, Silver [2015] explains why the bundle might differ across different insurance products, and explains the variety of ancillary contractual devices used to generate approximately efficient outcomes when the three duties are disaggregated. For instance, Directors and Officers Liability insurance often package indemnity coverage with a duty to defend, but without the right of the insurer to control the litigation. Consequently, the insured is potentially entitled to spend very large amounts of the insurer’s money defending against liability. The moral hazard problem this creates might make sense, however, if the object is to deter litigation in the first instance. Potential plaintiffs are less likely to sue if they know the defendant can spend almost unlimited amounts of its insurer’s money fighting the lawsuit.22 The duty to defend is also important from an economic perspective for at least two other reasons. First, it is a significant part of the overall risk-​transfer from policyholder to insurer, simply because the costs of defending against a legal claim are often very substantial in their own right. Second, the duty has the effect of concentrating specialized expertise (in both the substance and the procedure of litigation) in the hands of liability insurers. This presumably leads to better decisions about litigation strategy, and may

21  There are technically eight possible combinations of these three binary features (23). But a policy lacking all three would be a logical impossibility, as would a policy that had only a right to control the defense with no duty to defend or indemnify. 22  We thank Steve Thel for this insight.

 

500    DANIEL SCHWARCZ AND PETER SIEGELMAN encourage more competitive pricing by defense-​side lawyers who are retained by the insurers.

19.2.4. Duty to Settle As the previous section explained, efficiency generally dictates that the party who must ultimately pay for any liability should also control the defense against that liability. This assignment of responsibility works well when the insured’s potential liability is less than the limits of her liability insurance policy. But when potential damages may be larger than the limits of the defendant’s insurance coverage, the insurer and the insured will have a conflict about how to manage the litigation. This conflict is most acute with respect to the decision whether to accept a settlement offer. Giving full control over settlement decisions to insurers—​as most policies purport to do—​creates important conflicts of interest when there is a potential above-​limits judgment. This is because insurers evaluating settlement offers will give insufficient consideration to the risk that going to trial will expose policyholders to personal liability from an above-​limits judgment.23 A simple numeric example illustrates this conflict of interest. Suppose a victim has sued an insured defendant for an injury the latter has caused. Suppose also that: • The insured’s liability policy only covers payouts up to 100; any award above this amount must be paid by the defendant out of her own pocket. • The defendant is known to be liable to the victim, but the extent of harm is unknown, and is either 60 or 140. This amount is to be determined at trial, but ex ante, either result is equally likely. • There are no costs of trial. In this example, the expected trial outcome is an award of (½×60 + ½×140 =) 100. Absent liability insurance, risk aversion should lead both plaintiff and defendant to be willing to settle for this amount. (The parties would be even more willing to settle if there were trial costs to be saved). However, the liability insurer in this example would be unwilling to accept this settlement offer, because it would expect to pay only 80 (½×60 + ½×{policy limit = 100}) by going to trial.24 Courts have responded to this problem by creating a “duty to settle:” a liability insurer must accept a reasonable settlement demand in a lawsuit against its policyholder. If it fails to do so, it forfeits its policy limit and is liable for the full amount of any subsequent

23  The exact obverse of this problem occurs when a policy contains a deductible and expected liability that is less than this amount. Now, the insurer will be eager to settle for the amount of expected liability, since settlement costs will be borne entirely by the insured defendant. And it is the defendant who will prefer to go to trial because its maximum loss is capped by the deductible. 24  This is an example of the marginal claimant principle that recurs often in law and economics. For a lucid explanation of the general problem, and solutions, see Cooter (1985).

 

LAW AND ECONOMICS OF INSURANCE    501 damages award.25 In determining whether a particular settlement offer is, in fact, reasonable, courts and commentators have often invoked the “disregard the limits” test, which asks whether the settlement offer would have been accepted if the insurer had no policy limits. A substantial scholarly literature critiques the efficiency of the duty to settle rule. Perhaps the most commonly debated issue is whether the doctrine could be improved by moving to a strict liability standard, under which insurers who rejected within-​ limits offers would always be required to pay any subsequent above-​limit judgment (Schwartz 1975; Syverud 1990; Logue 1993; Hyman, Black, and Silver 2011). A  strict liability approach would force insurers to evaluate the full costs and benefits of settlement offers by removing the possibility that some of the costs of failing to settle could be shifted to the policyholder. It should therefore produce more efficient settlement decisions than the ex post judgments of courts regarding whether a particular settlement offer was reasonable at the time it was made. Additionally, a strict liability approach may reduce administrative costs associated with litigating the reasonableness of settlement demands and be more consistent with policyholders’ risk aversion. On the other hand, such an approach limits the usefulness to liability insurers of coverage limits and potentially may induce strategic settlement offers by plaintiffs looking to increase the pool of insurer-​provided funds to pay an eventual judgment. Although the optimal form of the duty to settle has been much debated in the lit­ erature, few have questioned the efficiency of some sort of limitation on liability insurers’ discretion to settle. An exception is Sykes (1994), who emphasizes that the duty to settle did not emerge as a voluntary term in insurance policies—​suggesting that it may not, in fact, be efficient—​and points out that the duty to settle might weaken the overall bargaining position of the combined defendants (insurer and policyholder) when the defendant would otherwise be partially judgment proof.26 Of course, Sykes’ argument can reasonably be flipped: if a court-​designed duty to settle is in fact inefficient, then it is unclear why the parties do not contract-​around this rule, as there is no strong reason to believe that it is a mandatory, rather than a default, term. Additionally, as Logue (1993) emphasizes, Sykes’ judgment-​proof argument can be reasonably addressed by an alternative rule, proposed by Schwartz (1975), in which damages for violation of the duty to settle are capped at the policy limit plus the policyholder’s collectible assets. The impact of the duty to settle on litigation has also been examined in the literature. Hyman, Black, and Silver (2011) find that the existence of a duty to settle substantially affects settlement dynamics, resulting in the faster resolution of cases and an increased number of cases that settle at, or near, the defendant’s policy limits. Squire (2012, 2015) points out that the canonical conflict of interest animating the duty to settle is only one among several potential conflicts created by policy limits. He 25 

Crisci v Security Ins. Co., 66 Cal.2d 425 (1967). Of course, society as a whole has a stake in the amount of the settlement, since the liability of defendants is the principal means by which deterrence is realized (Meurer 1992). Taking account of this externality greatly complicates any welfare analysis. 26 

 

502    DANIEL SCHWARCZ AND PETER SIEGELMAN emphasizes that limits can result in excessive settlement amounts when defendant-​policyholders are able to compel settlement over an insurer’s objection. This can happen, he notes, when a plaintiff makes an above-​limit settlement demand, and courts compel insurers to contribute the policy limits toward that settlement because the policyholder is willing to pay out of pocket the difference between the settlement amount and the policy limit. Using the example above, suppose that the plaintiff makes a demand to settle the case for 110. Unless trial costs exceed 10, this is an excessive settlement demand, because it exceeds the expected trial outcome. Nonetheless, suppose that the policyholder would be willing to accept this settlement and pay the 10 above the policy limit, because the policyholder’s expected cost of going to trial is 20.27 Imposing a duty on the insurer to “contribute” its limits to this settlement thus results in overpayment of plaintiffs. Squire suggests that a solution to this problem—​and to the misaligned incentives of policyholders and insurers more generally—​is to allow each party to resolve separately its slice of potential liability with the plaintiff. Under this proposal, the policyholder in the above example would be free to settle its potential individual liability to the plaintiff, but this would not impact the insurer’s ability to proceed to trial to determine what percentage of its policy limits it owes to the plaintiff. The virtue of this approach is that it would eliminate the capacity of any party—​insurer, policyholder, or excess insurer28—​to shift potential exposure to liability on to another party. On the other hand, this proposal might plausibly be objected to because it would increase risk to policyholders, who might often be asked to contribute some amount to settlement, and complicate the insurer’s obligation to fund defense expenses associated with advising policyholders on settlement offers.

19.3. Conclusion The law and economics of insurance is both a fragmented and an underdeveloped field. Yet core economic concepts—​particularly information asymmetries—​are fundamental to a coherent normative understanding of insurance law and regulation. For this reason, there is substantial scope for future scholarly inquiry in the law and economics of insurance. By drawing together a variety of insurance-​related topics that are often addressed within silos of the academy, we hope that this chapter helps facilitate and encourage that development. The results could be a substantial improvement not only in the scholarly domain, but also in the legal and regulatory spheres, where policy is too often either divorced entirely from economics or based on reductionist understandings of economic concepts. 27 

Half of the time, the plaintiff collects 60 from the insurer and the policyholder pays nothing. Half the time, the plaintiff collects 140, of which 100 (the policy limit) comes from the insurer and the remaining 40 from the defendant herself: ½×0 + ½×40 = 20. 28  Excess insurance is coverage that only kicks in after the exhaustion of a primary layer of coverage, which may be in the form of a self-​insured retention or a primary insurance policy.

 

LAW AND ECONOMICS OF INSURANCE    503

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504    DANIEL SCHWARCZ AND PETER SIEGELMAN Bar-​Gill, Oren. 2012. Seduction by Contract:  Law, Economics and Psychology in Consumer Markets. Oxford: Oxford University Press. Ben-​Shahar, Omri and Schneider, Carl E. 2014. More Than You Wanted to Know: The Failure of Mandated Disclosure. Princeton, NJ: Princeton University Press. Black, Bernard, Silver, Charles, Hyman, David A., and Sage, William M. 2005. “Stability, Not Crisis:  Medical Malpractice Claim Outcomes in Texas, 1988–​2002.” Journal of Empirical Legal Studies 2(2), pp. 207–​259. Boardman, Michelle E. 2006. “Contra Proferentem:  The Allure of Ambiguous Boilerplate.” Michigan Law Review 104, pp. 1105–​1128. Boardman, Michelle E. 2013. “Penalty Default Rules in Insurance Law.” Florida State University Law Review 40, pp. 305–​348. Bohn, James G. and Hall, Brian J. 1998. “The Costs of Insurance Company Failures.” In: David F. Bradford, ed., The Economics of Property-​Casualty Insurance. Chicago: The University of Chicago Press. 139–​166. Brown, Elizabeth F. and Klein, Robert W. 2015. “Insurance Solvency Regulation: A New World Order?” In: Daniel Schwarcz and Peter Siegelman, eds., Research Handbook on the Law & Economics of Insurance. Northampton, MA: Edward Elgar. Brown, Jennifer, and Dylan B. Minor. 2012. Misconduct in Credence Goods Markets. Working Paper 18608, NBER. Browne, Mark J., Christian Knoller, and Andreas Richter. 2012. Behavioral Bias, Market Intermediaries and the Demand for Bicycle and Flood Insurance. Working Paper, Munich Risk and Insurance Center. Browne, Mark J., Pryor, Ellen S., and Puelz, Bob. 2004. “The Effect of Bad‐Faith Laws on First‐Party Insurance Claims Decisions.” The Journal of Legal Studies 33(2), pp. 355–​390. Butler, Richard. J. 2002. “Form Regulation in Commercial Insurance.” In: J. David Cummins, ed., Deregulating Property–​Liability Insurance: Restoring Competition and Increasing Market Efficiency. Washington, DC: Brookings Institute Press. 321–360. Calabresi, Guido. 1970. The Costs of Accidents: A Legal and Economic Analysis. New Haven, CT: Yale University Press. Carpenter, Daniel and Moss, David A., eds. 2013. Preventing Regulatory Capture: Special Interest Influence and How to Limit It. New York: Cambridge University Press. Cochrane, John H. 1995. “Time Consistent Health Insurance.” Journal of Political Economy 103, pp. 445–​473. Cohen, Alma and Siegelman, Peter. 2010. “Testing for Adverse Selection in Insurance Markets.” Journal of Risk and Insurance 77, pp. 39–​84. Cooter, Robert D. 1985. “Unity in Tort, Contract and Property:  The Model of Precaution.” California Law Review 73, pp. 1–​45. Craswell, Richard. 2013. “Static versus Dynamic Disclosures, and How Not to Judge Their Success or Failure.” Washington Law Review 88, pp. 333–​384. Crocker, Keith J. and Snow, Arthur. 2000. “The Theory of Risk Classification.” In: Georges Dionne, ed., Handbook of Insurance. Boston: Kluwer Academic Publishers. 245–​276. Cummins, J. David and Doherty, Neil A. 2006. “The Economics of Insurance Intermediaries.” Journal of Risk and Insurance 73(3), pp. 359–​396. Cummins, J. David and Phillips, Richard D. 2009. “Capital Adequacy and Insurance Risk-​ Based Capital Systems.” Journal of Insurance Regulation 28(1), pp. 26–​72.

 

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506    DANIEL SCHWARCZ AND PETER SIEGELMAN Holzmüller, Ines. 2009. “The United States RBC Standards, Solvency II and the Swiss Solvency Test: A Comparative Assessment.” The Geneva Papers on Risk and Insurance 34, pp. 56–​77. Hsee, Christopher K. and Kunreuther, Howard C. 2000. “The Affection Effect in Insurance Decisions.” Journal of Risk and Uncertainty 20, pp. 141–​159. Hyman, David A., Black, Bernard S., and Silver, Charles. 2011. “The Impact of the Duty to Settle on Settlement: Evidence From Texas.” Journal of Empirical Legal Studies 8, pp. 48–​84. Jaffee, Dwight M. and Russell, Thomas. 1997. “Catastrophe Insurance, Capital Markets, and Uninsurable Risks.” Journal of Risk and Insurance 64, pp. 205–​230. Jaffee, Dwight M. and Russell, Thomas. 2002. “The Regulation of Automobile Insurance in California.” In: J. David Cummins, ed., Deregulating Property-​Liability Insurance: Restoring Competition and Increasing Market Efficiency. Washington, DC: Brookings Institution Press. 195–​236. Johnson, Eric J., Hershey, John, Meszaros, Jacqueline, and Kunreuther, Howard. 1993. Framing, Probability Distortions, and Insurance Decisions. Netherlands: Springer. Keeton, Robert E. 1970. “Insurance Law Rights at Variance with Policy Provisions.” Harvard Law Review 83, p. 961. Keeton, Robert E. and Widiss, Alan I. 1989. Insurance Law: A Guide to Fundamental Principles, Legal Doctrines and Commercial Practices. St. Paul, MN: West Publishing Company. Klein, Robert W. 2009. “The Insurance Industry and Its Regulation: An Overview.” In: Martin F. Grace and Robert W. Klein, eds., The Future of Insurance Regulation in the United States. Washington, DC: Brookings Institution Press. 13–​53. Koijen, Ralph S.  J. and Yogo, Motohiro. 2013. Shadow Insurance. Working Paper No. 19568, NBER. Koijen, Ralph S. J., and Yogo, Motohiro. 2014. The Cost of Financial Frictions for Life Insurers. Chicago Booth Research Paper No. 12–​30. Koijen, Ralph S. J. and Yogo, Motohiro. 2014. “Is the Insurance Sector at Risk?” Business Strategy Review 25, pp. 30–​33. Korobkin, Russell. 1999. “The Efficiency of Managed Care Patient Protection Laws: Incomplete Contracts, Bounded Rationality, and Market Failure.” Cornell Law Review 85, pp. 1–​88. Korobkin, Russell. 2003. “Bounded Rationality, Standard Form Contracts, and Unconscionability.” University of Chicago Law Review 70, pp. 1203–​1295. Kunreuther, Howard and Slovic, Paul. 1978. “Economics, Psychology and Protective Behavior.” American Economic Review: Papers and Proceedings 68(May), pp. 64–​68. Kunreuther, Howard C., Pauly, Mark V., and McMorrow, Stacey. 2013. Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry. New York: Cambridge University Press. Langbein, John. 2007. “Trust Law as Regulatory Law:  The Unum/​ Provident Scandal and Judicial Review of Benefit Denials under ERISA.” Northwestern Law Review 101, pp. 1315–​1342. Lex, Christoph, Andreas Richter, and Sharon Tennyson. 2014. EU Intermediary Regulation and its Impact on Agent Quality. http://​publicchoicesociety.org/​content/​papers/​ sharontennyson-​1013-​2014-​1014.pdf [Accessed 27 September 2016]. Logue, Kyle D. 1993. “Solving the Judgment-​ Proof Problem.” Texas Law Review 72, pp. 1375–​1394. Logue, Kyle D. 2001. “The Current Life Insurance Crisis:  How the Law Should Respond.” Cumberland Law Review 32, pp. 1–​67.

 

LAW AND ECONOMICS OF INSURANCE    507 Meurer, Michael J. 1992. “The Gains from Faith in an Unfaithful Agent: Settlement Conflicts between Defendants and Liability Insurers.” Journal of Law, Economics, and Organization 8, pp. 502–​522. Myerson, Roger B. 2014. “Rethinking the Principles of Bank Regulation: A Review of Admati and Hellwig’s The Bankers’ New Clothes.” Journal of Economic Literature 52, pp. 197–​210. Ostrager, Barry R. and Newman, Thomas R. 2012. Handbook on Insurance Coverage Disputes. New York: Aspen. Plantin, Guillaume and Rochet, Jean-​Charles. 2007. When Insurers Go Bust:  An Economic Analysis of the Role and Design of Prudential Regulation. Princeton, NJ:  Princeton University Press. Posner, Richard A. and Rosenfield, Andrew M. 1977. “Impossibility and Related Doctrines in Contract Law: An Economic Analysis.” The Journal of Legal Studies 6(1), pp. 83–​118. Rappaport, Michael B. 1995. “The Ambiguity Rule and Insurance Law:  Why Insurance Contracts Should Not Be Construed Against the Drafter.” Georgia Law Review 30, pp. 171–​257. Rosenfield, Harvey. 1998. “Auto Insurance:  Crisis and Reform.” University of Memphis Law Review 29, pp. 69–​127. Rothschild, Michael and Stiglitz, Joseph. 1976. “Competitive Insurance Markets:  An Essay on the Economics of Imperfect Information.” Quarterly Journal of Economics 90, pp. 629–​649. Ross, H. Lawrence. 1970. Settled Out of Court. Chicago: Aldine. Schwarcz, Daniel. 2007. “A Products Liability Theory for the Judicial Regulations of Insurance Policies.” William and Mary Law Review 48, pp. 1389–​1463. Schwarcz, Daniel. 2008. “Redesigning Consumer Dispute Resolution:  A  Case Study of the British and American Approaches to Insurance Claims Conflict.” Tulane Law Review 83, pp. 735–​812. Schwarcz, Daniel. 2011. “Reevaluating Standardized Insurance Policies.” University of Chicago Law Review 77, pp. 1263–​1348. Schwarcz, Daniel. 2014. “Transparently Opaque: Understanding the Lack of Transparency in Insurance Consumer Protection.” UCLA Law Review 61, pp. 394–​462. Schwarcz, Daniel. 2015. “A Critical Take on Group Regulation of Insurers in the United States.” UC Irvine Law Review 5, pp. 537–​558. Schwarcz, Daniel and Schwarcz, Steven. 2014. “Regulating Systemic Risk in Insurance.” University of Chicago Law Review 81, pp. 1569–​1640. Schwarcz, Daniel and Siegelman, Peter. 2015. “Insurance Agents in the 21st Century: the Problem of Biased Advice.” In: Daniel Shwarcz and Peter Siegelman, eds., Research Handbook on the Law & Economics of Insurance. Northampton, MA: Edward Elgar. 36–70. Schwartz, Alan and Wilde, Louis L. 1979. “Intervening in Markets on the Basis of Imperfect Information: A Legal and Economic Analysis.” University of Pennsylvania Law Review 127, pp. 630–​635. Schwartz, Victor E. 1975. “Statutory Strict Liability for an Insurer’s Failure to Settle: A Balanced Plan for an Unresolved Problem.” Duke Law Journal 1975, 901–​919. Scott, Kenneth E. 1987. “Deposit Insurance—​The Appropriate Roles for State and Federal Governments.” Brooklyn Law Review 53, pp. 27–​43. Shavell, Steven. 1987. Economic Analysis of Accident Law. Cambridge, MA:  Harvard University Press.

 

508    DANIEL SCHWARCZ AND PETER SIEGELMAN Shavell, Steven. 2004. Foundations of Economic Analysis of Law. Cambridge, MA:  Harvard University Press. Siegelman, Peter. 2004. “Adverse Selection in Insurance Markets: An Exaggerated Threat.” Yale Law Journal 113, pp. 1223–​1280. Silver, Charles. 2015. “Basic Economics of the Defense of Covered Claims.” In: Daniel Schwarcz and Peter Siegelman, eds., Research Handbook on the Law & Economics of Insurance. Northampton, MA: Edward Elgar. 438–460. Silver, Charles and Syverud, Kent. 1995. “The Professional Responsibilities of Insurance Defense Lawyers.” Duke Law Journal 45, pp. 255–​363. Squire, Richard. 2012. “How Collective Settlements Camouflage the Costs of Shareholder Lawsuits.” Duke Law Journal 62, pp. 1–​77. Squire, Richard. 2015. “Settlement Conflict as Artificial Collective-​Action Problem.” In: Daniel Schwarcz and Peter Siegelman, eds., Research Handbook on the Law & Economics of Insurance. Northampton, MA: Edward Elgar. Stempel, Jeffrey W. 1993. “Reassessing the Sophisticated Policyholder Defense in Insurance Coverage Litigation.” Drake Law Review 42, pp. 807–​857. Stempel, Jeffrey W. 1999. Law of Insurance Contract Disputes. New York: Aspen. Sydnor, Justin. 2010. “(Over)insuring Modest Risks.” American Economic Journal:  Applied Economics 2, pp. 177–​199. Sykes, Alan O. 1994. “Judicial Limitations on the Discretion of Liability Insurers to Settle or Litigate: An Economic Critique.” Texas Law Review 72, pp. 1345–​1372. Sykes, Alan O. 1996. “Bad Faith Breach of Contract by First Party Insurers.” Journal of Legal Studies 25, pp. 405–​444. Syverud, Kent D. 1990. “The Duty to Settle.” Virginia Law Review 76, pp. 1113–​1209. Tennyson, Sharon. 2007. “Efficiency Consequences of Rate Regulation in Insurance Markets.” Networks Financial Institute, at Indiana University, Policy Brief, 2007-​ PB-​ 03. http://​ indstate.edu/​business/​nfi/​leadership/​briefs/​2007-​PB-​03_​Tennyson.pdf [Accessed 27 September 2016]. Tennyson, Sharon and Warfel, William J. 2010. “The Law and Economics of First Party Insurance Bad Faith Liability.” Connecticut Insurance Law Journal 15, pp. 203–​242. Weber, Rob. 2011. “Combating the Teleological Drift of Life Insurance Solvency Regulation: The Case for a Meta-​Risk Management Approach to Principles-​Based Reserving.” Berkeley Business Law Journal 8, pp. 35–​115. Zeiler, Kathryn, Silver, Charles, Black, Bernard, Hyman, David A., and Sage, William M. 2007. “Physicians’ Insurance Limits and Malpractice Payments: Evidence from Texas Closed Claims 1990–2003.” Journal of Legal Studies 36, pp. S9–​S45.

 

Chapter 20

E NVIRONM EN TA L L AW AND EC ON OMI C S Michael A. Livermore and Richard L. Revesz

20.1. Introduction The law and economics perspective provides a useful lens for many environmental policy questions. Normative deliberation concerning the construction of environmental policy can be informed by an economics perspective. Economic analysis can also be brought to bear on empirical questions concerning the effects of environmental policies (Faure 2012) and the political economy factors that affect the selection of environmental policies (Keohane, Revesz, Stavins 1996; Burtraw 2012). Indeed, the overlap between environmental policy and economics is sufficiently extensive that environmental economics constitutes a distinct discipline within the field of economics (Field and Field 2012). Revesz and Stavins (2007) presented an overview of environmental law and economics, focusing on three themes that have been of particular importance in the field: cost– benefit analysis, instrument choice, and the allocation of policymaking responsibility in a federal system. That work canvassed the robust literature that had developed on those themes and examined the political and policy contexts that affected the application of law and economics to environmental policymaking. There have been important developments since the publication of Revesz and Stavins (2007). Climate change has become an even more dominant issue in environmental law, both in the United States and internationally. The scale of the threatened harms from climate disruption, the global and diffused nature of greenhouse gas emissions, the degree of scientific uncertainty, the long time horizons involved, and the extent of economic transformation needed to substantially curtail emissions all make climate change a uniquely vexing environmental problem (Intergovernmental Panel on Climate Change [IPCC] 2013).

 

510    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ The issue of climate change has precipitated important changes in the field of environmental law and economics. Many normative and positive challenges are posed by climate change and attempts to reduce greenhouse gas emissions, and scholars have responded to those challenges with important conceptual and empirical advances. The political context of environmental law and economics has also been affected by conflict over climate policies. After providing a brief general overview of the economics of environmental law, this chapter will focus on these recent developments, with an emphasis on the experience of the United States. Consistent with Revesz and Stavins (2007), this chapter focuses on pollution control and does not examine natural resource management. When setting environmental policy, decision makers must address two general types of questions. The first concerns the ends of environmental policy, and examines the socially desirable level of environmental quality. The second type of question concerns the means of policymaking and focuses on the types of regulatory instruments that will be used and the allocation of responsibility between governmental actors. Section 20.2 addresses the first type of question concerning the goals of environmental policy. Sections 20.3 and 20.4 address the means of environmental policy, focusing on instrument choice and jurisdictional allocation, respectively.

20.2.  Cost–Benefit Analysis There is widespread agreement that environmental quality is a good worth providing. Not only do people enjoy the benefits of environmental quality directly—​for example, through improved health and better recreational opportunities—​but natural systems provide the foundation for many diverse forms of economic activity (such as agriculture) and, indeed, create the basic conditions for human life to exist at all. But although it is impossible to dismiss the value of a clean environment, there is much less agreement on the level of environmental quality that society ought to pursue. The question of how clean is clean enough? is an essential preliminary to environmental policymaking, and one on which economics provides useful guidance.

20.2.1. Normative Issues and Analysis Welfare economics provide a general framework for answering questions concerning the ends of environmental policy. The general recommendation is that environmental policy should be selected to maximize well-​being, measured by the value that individuals place on improved environmental quality minus the value of sacrifices that must be made to achieve those improvements. Because most environmental policy involves tradeoffs between positive and negative consequences, the value of those consequences

 

ENVIRONMENTAL LAW AND ECONOMICS    511 must be weighed against each other. The dominant technique for weighing policy consequences and estimating the net effects of policy options is cost–benefit analysis.

20.2.1.1. General Framework Pollution presents a classic market failure that can be addressed through appropriate government intervention. Pollution can be described as an externality (Pigou 1920) in which the “activity of one agent … affects the well-​being of another agent and occurs outside the market mechanism” (National Research Council 2010). The solution proposed by Pigou is a tax or fee to internalize the external costs imposed by pollution. Such a move is not necessary in world of well-​defined property rights and low transaction costs because private bargaining will account for all relevant effects (Coase 1960; Krutilla and Krause 2011). Nevertheless, the existence of transaction costs and incomplete property rights imply that private bargaining alone will not always result in a social-​welfare-​maximizing outcome. Once it is determined that government intervention can, in principle, improve well-​ being, the question of the socially desirable level of pollution control must be addressed. Within the field of welfare economics, the traditional answer is the test developed by Kaldor (1939) and Hicks (1939) of potential Pareto improvements. A Pareto improvement is one that makes at least one person better off and no one worse off (Pareto 1896). A potentially Pareto improvement is one in which the beneficiaries of the policy could fully compensate those who are burdened by the policy. Kaldor–Hicks efficiency is the basis for formal cost–benefit analysis (Zerbe and Bellas 2006). A measure is Kaldor–​Hicks efficient if it maximizes the difference between the value of its benefits (as measured by the beneficiaries) and its costs (as measured by bearers of those costs). Because total benefits typically increase at a decreasing rate while cost increases at an increasing rate, net benefits are maximized by policies that equate marginal benefits with marginal costs. There is a robust debate over the normative attractiveness of cost–​benefit analysis as a means of identifying socially desirable environmental policy. Issues that are relevant to this debate include the normative status of preference satisfaction (Adler and Posner 2006), the importance of distribution of costs and benefits for well-​being (Adler 2012; Cai et al. 2010; Farrow 2011), and broader critiques concerning incommensurability (Anderson 1995; Ackerman and Heinzerling 2004) or commodification (Radin 2001). While many of the criticisms leveled against cost–benefit analysis apply generally to normative economics, the use of cost–​benefit analysis to evaluate environmental policies has been particularly controversial (Kysar 2010). Additional conceptual frameworks for evaluating environmental policy include environmental rights (Kelman 1981a), environmental justice (Rhodes 2003), non-​anthropocentric approaches (Ariansen 1998), green growth (Livermore 2013), and sustainable development (Dasgupta and Heal 1974; Stiglitz 1974; Solow 1974; Organisation for Economic Cooperation and Development [OECD] 2004). Many of these concepts can be understood as emphasizing distributional, rather than efficiency, considerations (Stavins et al. 2003). For example, one definition of sustainable development that is reasonably well accepted in the economics

 

512    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ community is monotonically increasing consumption (Solow 1986; Hartwick 1977; Daly 1990), which concerns the intergenerational allocation of resources, rather than the static maximization of welfare. Environmental policymaking poses several methodological difficulties for cost–​ benefit analysis. Several of these are described in detail in Revesz and Stavins (2007). The most important environment-​specific challenge is to provide valid monetary estimates of the value of hard-​to-​price goods, including non-​market goods (like clean air) (Alberini and Scarpa 2005; Banzhaf 2010; Phaneuf et al. 2009) and mortality risk reduction (Cropper et al. 2011). Continent valuation (e.g., stated preference studies) remains the most widespread tool to estimate non-​market values (Viscusi et al. 2008). While this approach has been endorsed by leading economists, it remains controversial (Hausman 2012). In recent years, the concept of ecosystem services—​the goods and services provided by natural systems—​has been used to help structure research on the benefits of environmental protection (Goulder and Kennedy 2011; Brown et al. 2007). An important challenge for the ecosystems ser­ vices approach is to identify estimation methods that disaggregate intermediary goods, such as water quality from final services such as recreation or human health (Keeler et al. 2012).

20.2.1.2. Discounting and Future Generations Carbon dioxide, the most important greenhouse gas pollutant, has a long atmospheric lifetime, about 100 years (IPCC 2013). In addition, global warming processes are not instantaneous, but involve the interaction of large, complex physical systems that may involve irreversible feedback loops (IPCC 2013). The consequences of greenhouse gas emissions today, then, will be felt for many years into the future. As in many other environmental contexts, limits on greenhouse gas emissions impose immediate costs to produce benefits that will accrue only in the long term. Traditionally, future benefits have been discounted at a constant rate. The choice of a discounting procedure and rate is particularly important in the case of climate change because of the very long time horizons involved (Revesz and Shahabian 2011). The stan­ dard approach to analyzing this problem is contained in the following formula (Arrow et al. 1996):

d = ρ + θg

where d is the discount rate, ρ is the rate of pure time preference, θ is the absolute value of the elasticity of marginal utility of consumption and g is the growth rate of per capita consumption. There are two interpretations for the first term, ρ. Under a prescriptive approach, ρ would be derived from ethical principles (Arrow et al. 1996). There is no strong consensus concerning whether a pure time preference is normatively justified. Many prominent economists agree with the proposition, first articulated by Ramsey (1928), that ρ should be zero (Broome 1992; Dasgupta 2008; Cline 2006; Harrod 1966; Heal 2009;

 

ENVIRONMENTAL LAW AND ECONOMICS    513 Koopmans 1967; Philibert 1999; Solow 1974). Others disagree (Arrow 1999; Beckerman and Hepburn 2007). Revesz (1999) and Revesz and Shahabian (2011) argue that there is an ethical distinction between intergenerational and intragenerational discounting that is relevant for determining the appropriate pure rate of time preference. The latter reflects individuals’ preferences to spread consumption across their lifetime. The former reflects a social decision concerning the allocation of resources between individuals. While there are reasons to endorse policies that reflect individuals’ desire to consume sooner rather than later, there is no straightforward justification for a bare social preference for current over future generations. The descriptive approach avoids the preceding normative questions and simply substitutes observed market interest rates for the discount rate in cost–benefit analysis. The benefit of this approach is that it does not attempt to address difficult questions of intergenerational equity. The problem is that it fails to provide a normative reason for why market interest rates are an appropriate source for the social discount rate (Revesz and Shahabian 2011). Sophisticated defenders of intergenerational discounting recognize the possibility for “net welfare losses and distributional inequity” but argue that the issue of moral obligations to future generations should be treated as a separate inquiry from efficiency (Sunstein and Rowell 2007). Once society decides how to trade off utility between generations, discounting can be used to account for opportunity costs in determining the degree to which pollution control should be included in the basket of future-​oriented investments (Schelling 1995; Samida and Weisbach 2007; Weisbach and Sunstein 2009). Accounting for the marginal utility of consumption through growth discounting also generates difficulties. As a preliminary matter, long-​term growth is difficult to predict (Moyer et al. 2013). The countries most likely to benefit in the future from current climate change mitigation—​developing countries in the tropics—​are far poorer than the industrial powers that are most likely to pay in the present for such mitigation (Ruhl 2012). And even in the relatively distant future, these developing countries may be poorer than developed countries are today. Scholars have also argued that greenhouse gas reductions in developed countries can be viewed as foreign aid and noted that intragenerational wealth transfers are a more efficient mechanism to reduce global inequality than climate mitigation (Schelling 1995; Posner and Sunstein 2007). There appears to be an emerging consensus that discount rates should decline with the length of the time horizon, with higher discount rates applied to the near-​term future and lower discount rates applied to the long-​term future (Gollier and Weitzman 2010). A declining discount rate approach has been adopted by France and the United Kingdom (Cropper 2012). The first argument in favor of such an approach is that it is more consistent with observed behavior. Stated preference studies typically indicate that individuals apply a very low discount rate to benefits to future generations (Cropper et al. 1992; Johannesson and Johansson 1997). Even in individual market behavior, hyperbolic discounting is commonly observed (Laibson 1997), although it raises rationality concerns (Skog 2005).

 

514    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ The second and more powerful argument in favor of declining discount rates stems from uncertainty about the appropriate discount rates (Arrow et al. 2013; Gollier and Weitzman 2010). When these rates are uncertain, the utility maximizing approach requires that decisions be made based on expected discounted costs and benefits, not discounted expected costs and benefits (Weitzman 1998, 2001). The consequence is that the correct discount rate is lower than the mean of the probability distribution of pos­ sible rates. Over sufficiently long time horizons, the lowest rate in the distribution dominates (Weitzman 2001). Newell and Pizer (2003) show that rational treatment of interest rate uncertainty, based on historic variance in US Treasury bill rates, leads to quickly declining discount rates.

20.2.1.3. Employment Effects A growing area of research interest, spurred in part by changes in the political context of cost–​benefit analysis discussed below, concerns the effects of environmental regulation on employment. A threshold question is whether, and how, effects on labor markets ought to be accounted for in cost–benefit analyses of environmental regulation. The standard approach for government agencies in the past had been to assume a well-​functioning, full-​employment labor market (Environmental Protection Agency [EPA] 2000). Under these conditions, workers hired to comply with an environmental regulation are reallocated from positions with similar wages, and workers that are laid off because an environmental regulation find new positions at similar compensation levels. When the assumption of full employment is relaxed, the estimation of the labor effects of environmental regulation is extremely difficult (Coglianese et al. 2014). Morgenstern et al. (2002) note three distinct potential effects of regulation on employment. A demand effect occurs if regulation increases production costs, thereby increasing prices and lowering the quantity of production, resulting in lower demand for labor. A cost-​effect occurs if plants must add more capital and labor per unit of output, potentially increasing demand for labor. A factor-​shift effect occurs if a regulation induces a shift in spending from capital to labor or vice versa. The authors note that the net effects of these three effects are ambiguous, and in a study of four highly polluting and regulated industries, find mild positive employment effects from regulation. Sectoral studies have found negative employment effects from environmental regulation, but may measure employment shifts rather than net losses (Greenstone 2002; Kahn 1997). Walker (2011) examines wage effects from the Clean Air Act, finding that wages within regulated industries declined because of environmental controls. Office of Management and Budget (OMB) (2011) provides a useful overview of research on employment effects from environmental regulation. Masur and Posner (2012) argue that, when realistic economic conditions are taken into account, there can be substantial costs associated with layoffs. Not only do laid-​ off workers incur transition costs, including job search costs and time away from work, but there are psychological and physical hardships associated with joblessness that are

 

ENVIRONMENTAL LAW AND ECONOMICS    515 not fully captured by lost wages or search costs. Adler (2014) discusses how a welfare-​ oriented approach would account for these types of harms. Labor effects from environmental regulation are not always negative. If firms that must hire new workers to comply with an environmental regulation draw from a pool of unemployed labor, then the social costs are below the wages that are paid out to those workers, because the opportunity costs of these workers are very low (Bartik 2013). There may also be physical and psychological benefits associated with hiring unemployed workers that imply a negative social cost (CBO 2012).

20.2.1.4. Behavioral Economics and the Energy Paradox Since the mid-​1990s, scholars have begun applying the insights of behavioral economics to the law (Krieger 1995; Korobkin and Ulen 2000; McAdams 1997; Sunstein 1996). The behavioral revolution has touched environmental economics as well (Shogren and Taylor 2008). Arguably, the most important consequence of behavioral research for cost–​benefit analysis of environmental policy concerns the issue of energy efficiency standards. Measures to promote energy efficiency have taken on increasing importance as a low-​cost means of reducing greenhouse gas emissions. Energy-​efficiency standards have two potential categories of benefits. By reducing energy consumption, they can reduce externalities such as air pollution from burning fossil fuels or thermal pollution associated with nuclear power generation. A second category of benefits is consumer savings. Consumer savings, however, are complicated by the fact that rational consumers should be willing to invest in all net present value-​positive energy-​efficiency improvements (Jaffe et al. 2004). Therefore, under the standard model of rational economic behavior, it should be impossible for government regulation to generate consumer benefits through energy-​efficiency mandates in most circumstances. Notwithstanding this prediction, there is much literature demonstrating widespread underinvestment in energy efficiency (Gillingham et al. 2009). This phenomenon is referred to as the “energy paradox” in the environmental economics literature (Jaffe and Stavins 1994). Several behavioral hypotheses have been forwarded to explain the energy paradox: consumers may myopically apply above market discount rates to future energy savings (Alcott and Wozny 2012); account for energy efficiency only after having settled on other product characteristics (Geistfeld et al. 1977); demonstrate loss aversion (Greene 2008); incorrectly associate energy efficiency with poor performance (Rogers and Shrum 2012); or use other decision heuristics that fail to account for efficiency (Helfand and Wolverton 2011). There is no consensus on the dominant source of the energy paradox. Despite the lack of a strong theoretical understanding of the energy paradox, its persistence in the marketplace indicates that consumer savings are a valid benefit associated with energy-​efficiency standards. While market-​based tools, such as an energy tax, are likely to be lower-​cost tools for achieving emissions reductions (Karplus and Paltsev 2012), energy-​efficiency standards may be justified even in situations where they have no environmental benefits, for example when implemented together with a comprehensive

 

516    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ cap on emissions. In those cases, efficiency standards could be justified purely based on consumer savings (Bubb and Pildes 2014).

20.2.2.  Positive Issues and Analysis Cost–benefit analysis has become the dominant paradigm for environmental policy analysis in the United States, and its use is now becoming more common around the globe. But that does not mean that the technique is uncontroversial, and debates about its use continue.

20.2.2.1.  A Changing Political Context for Cost–Benefit Analysis In US environmental law, two general alternatives to cost–​benefit analysis for setting environmental standards are absolute standards (Sinden 2005) and feasibility standards (Driesen 2005). Absolute standards seek to set environmental quality at levels that present zero (or negligible) risk of harm. The National Ambient Air Quality Standards (NAAQS) under the Clean Air Act, which must be set at a level “requisite to protect the public health” with an “adequate margin of safety”1 are the most important examples of an absolute health-​based standard in US environmental law. Feasibility standards are set to maximize stringency, subject to the constraints of “physically impossible environmental improvements” or standards “so costly that they cause widespread plant shutdowns” (Dreisen 2011). Both absolute standards and feasibility standards are subject to serious objections. Absolute standards raise conceptual and practical problems if there is no known threshold that presents zero risk (McGarity 1979; Coglianese and Marchant 2004; Sunstein 1999). Furthermore, and paradoxically, the majority of recent NAAQS (adopted under an absolute health-​based approach) are less stringent than would be economically efficient, which undermines the normative justification for such an approach (Livermore and Revesz 2014). Feasibility standards have been criticized as “creating significant problems of over-​and underregulation” because they are completely insensitive to some costs while weighing other costs as infinitely high (Masur and Posner 2010). Perhaps in part because of the limitations of these alternatives, cost–benefit analysis has come to be the dominant framework for US environmental policy (Sunstein 2002). While cost–​benefit analysis is required in only a few environmental statutes—​notably the Toxic Substances Control Act;2 the Federal Insecticide, Fungicide, and Rodenticide Act;3 and the Safe Drinking Water Act4 —​for more than 30 years, US presidents have required that significant proposed regulations be subject to cost–benefit analysis (Revesz and Livermore 2008). This presidential requirement applies to all agency 1 

42 U.S.C. § 7409(b)(1) (2012). 15 U.S.C. §§ 2601–​2629 (2012). 3  7 U.S.C. §§ 136–​136y (2012). 4  42 U.S.C. § 300f et seq. (2012). 2 

 

ENVIRONMENTAL LAW AND ECONOMICS    517 decisions unless precluded by statute.5 The most important case limiting the use of cost–​benefit analysis within the environmental arena is American Trucking Associations, Inc v Whitman6, in which the Supreme Court held that the statutory silence in Section 109 of the Clean Air Act should be interpreted to bar the consideration of costs (and therefore the use of cost–​benefit analysis) for setting the NAAQS. The effect of American Trucking on other statutory provisions was called into question in the 2009 decision Entergy Corp. v Riverkeeper, Inc.7 In that case, the Supreme Court declined to extend American Trucking to cover a provision of the Clean Water Act that was silent on the use of cost–​benefit analysis. After Riverkeeper, it appears that, except in perhaps a handful of instances, Executive Order 13,563 will apply and require agencies to justify their significant environmental regulations by reference to cost–benefit analysis. Cost–​benefit analysis and the closely related practice of regulatory impact analysis are now common practices outside the United States as well. The European Union has undertaken several important steps to promote assessment of costs and benefits of regulatory policy (Wiener 2006). Cost–​benefit analyses carried out by governments, independent academics, or non-​governmental organizations is now commonly used in many developing and emerging countries to evaluate environmental policy as well (Livermore and Revesz 2013). The global growth of cost–​benefit analysis, and its universal support by presidents of both major US political parties over the past three decades, masks a complex political struggle over the degree to which concerns over economic efficiency ought to inform how environmental policy is set. Because there are important policy consequences associated with cost–​benefit analysis, its use is not only debated by scholars, but by orga­ nized interest groups as well (Revesz and Livermore 2008). In the United States, when the Reagan executive order placed cost–benefit analysis at the center of the regulatory state, protection-​oriented groups (such as environmentalists) strongly opposed the move, while interest groups that favored more lax regulation (such as industry trade associations) promoted expanded use of the technique. This interest group dynamic remained remarkably consistent over time, surviving multiple changes in party control of the White House (Revesz and Livermore 2008). Recently, however, the political alignment around cost–​benefit analysis has become less stable. In light of congressional failure to enact climate legislation in 2009, the Obama administration has pursued an aggressive agenda of clean air protections, which either directly limit greenhouse gas emissions or have substantial climate co-​benefits. At the same time, the administration has continued the long-​standing presidential support for cost–​benefit analysis and relied heavily on economic arguments to support environmental standards that are more stringent. 5  Executive Order 13563, Improving Regulation and Regulatory Review, 76 Fed. Reg. 3821 (Jan. 18, 2011). 6  531 U.S. 457 (2001). 7  556 U.S. 208 (2009).

 

518    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ Three environmental rules adopted by the EPA under the Obama administration were supported by particularly persuasive cost–benefit analyses: the updated Corporate Average Fuel Economy (CAFE) Standards released in 2012; the 2013 Mercury and Air Toxics Standards (MATS); and EPA’s Cross-​State Air Pollution Rule. The CAFE Standards will raise average fuel economy to 54.5 mpg by 2025, with estimated net benefits of approximately $700 billion by 2025 (National Highway Traffic Safety Administration 2012). The MATS extended air-​quality standards for mercury and other toxic pollutants to power plants, with estimated net benefits of at least $27 billion in 2016 (EPA 2011a). The Cross-​State Air Pollution Rule (CSAPR) is the EPA’s latest attempt to address air-​quality problems presented by interstate externalities. The agency’s impact assessment estimated that the rule will produce at least $120 billion annually in net benefits by 2014 (EPA 2011b). Statutorily mandated retrospective analysis prepared by the EPA of air-​quality rules adopted pursuant to the Clean Air Act Amendments of 1990 estimated that by 2020, the rules would have at least $1 trillion in net benefits and, under more favorable assumptions, up to $35 trillion (EPA 2011c). Perhaps unsurprisingly, willingness to endorse cost–​benefit analysis has shifted in light of these developments. Protection-​oriented groups have shown greater openness to cost–benefit analysis (Livermore and Revesz 2011). At the same time, regulatory skeptics have distanced themselves from the technique (Volokh 2011) as did the 2012 Republican presidential nominee Mitt Romney, who argued that cost–benefit analysis “tend[s]‌to be vulnerable to manipulation and also disconnected from the central issue confronting our country today, namely, generating economic growth and creating jobs” (Romney 2011). An important component of this political realignment is an expanded emphasis on the employment effects of regulation by the regulated community and some politicians. The phrase “job-​killing regulation,” which appeared only four times in major US newspapers in 2007, appeared nearly 700 times in the same outlets 4 years later (Livermore and Schwartz 2014). During the 112th congressional session, employment effects were used to justify several bills to reduce EPA’s regulatory authority.8 The House Republican Plan for America’s Job Creators included several provisions affecting the rulemaking process (House Republican Conference 2011) and the Regulatory Freeze for Jobs Act, 8  For example, the following bills were proposed during 2011 by the 112th Congress: H.R. 1 (a continuing appropriations resolution for FY2011, which passed the House in February, containing more than twenty riders restricting or prohibiting the use of funds to implement various regulatory activities under EPA’s jurisdiction); H.R. 199, Protect America’s Energy and Manufacturing Jobs Act of 2011 (proposing a 2-​year suspension of climate rules); H.R. 457, H.R. 517, H.R. 2018, and S. 272 (to modify EPA’s authority under the Clean Water Act); H.R. 750 and S. 228, Defending America’s Affordable Energy and Jobs Act (pre-empting any regulation to mitigate climate change); H.R. 872, Reducing Regulatory Burdens Act of 2011 (amending the Clean Water Act and FIFRA to alter EPA regulation of pesticide discharge into water); H.R. 910, Energy Tax Prevention Act (to prevent greenhouse gas regulations under the Clean Air Act); H.R. 960 and S. 468, Mining Jobs Protection Act (amending EPA’s consultation procedure under the Clean Water Act); H.R. 1391, Recycling Coal Combustion Residuals Accessibility Act of 2011, and H.R. 1405 (prohibiting coal ash from being regulated under Subtitle C of RCRA); H.R. 2021, Jobs and Energy Permitting Act of 2011 (amending the Clean Air Act to change permitting of off shore sources); H.R. 2250 and S. 1392, EPA Regulatory Relief Act of 2011 (to delay the Boiler MACT

 

ENVIRONMENTAL LAW AND ECONOMICS    519 which would block all new significant regulations until unemployment dropped below 6%, passed the House in July 2012.9 Estimates of the employment effects of regulation have become common in political discourse over environmental policy (Livermore and Schwartz 2014). These estimates, which are typically based on input–output or computable general equilibrium models, are highly sensitive to analytic assumptions and modeling choices, resulting in widely disparate results. In one telling example, a report by the America Coalition for Clean Coal Electricity estimated that two EPA rules would trigger 1.4 million job losses, while a Political Economy Research Institute study predicted the same two rules would spur a 1.4 million job gain (Livermore and Schwartz 2014). Agencies have also begun to include employment effects alongside cost–​benefit analyses. The EPA in particular has included a statement on employment effects in several high profile rulemakings (e.g., EPA 2012a; EPA 2012b). Employment effect estimates generated by agencies are often quite modest, providing a useful counterweight to extravagant jobs claims made by advocacy organizations.

20.2.2.2. Social Cost of Carbon The application of cost–​benefit analysis to regulations with greenhouse gas emissions has become a particular focal point for political conflict over the methodology. In 2009, the Obama administration convened an interagency task force that was charged with developing a “social cost of carbon” to be used across the government to assign a monetary value to greenhouse gas emission reductions in cost–benefit analyses of rulemakings (Interagency Working Group on Social Cost of Carbon [IWG] 2010). The original central estimate provided by the 2010 report for Year 2015 was $24 (2007 dollars), using a 3% discount rate (IWG 2010), and an updated estimate was released in 2013 of $38 (IWG 2013). Since being developed, the social cost of carbon has been used in a number of important rulemakings, including EPA’s fuel-​efficiency standards and several Department of Energy appliance efficiency rules (e.g., EPA 2010a; Department of Energy 2013). The taskforce based its estimate on three Integrated Assessment Models (IAMs) that link the physical and economic effects of climate change: the Dynamic Integrated Model of Climate and the Economy (DICE) (Nordhaus and Sztorc 2013); the Climate Framework for Uncertainty, Negotiation, and Distribution (FUND) model (Anthoff and Tol 2013); and the Policy Analysis of the Greenhouse Effect (PAGE) model (Hope 2013). These models translate predictions concerning greenhouse gas emission,

rules); H.R. 2584 (an appropriations bill with various riders); H.R. 2681, Cement Sector Regulatory Relief Act (to delay the Cement MACT rules); H.R. 3400 and S. 1720, Jobs Through Growth Act (incorporating several of the above restrictions on EPA authority); and S.J. Res. 27 (a resolution to disapprove EPA’s cross-​state air pollution rule). 9 

H.R. 4078, Regulatory Freeze for Jobs Act (July 25, 2012). http://​www.gop.gov/​bill/​112/​2/​hr4078 [Accessed 29 September 2016].

 

520    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ temperature change, and physical impacts associated with climate change (such as sea-​ level rise or effects on agricultural productivity) into monetary terms. Because many of the systems that are represented by these IAMs are not well understood, there is considerable uncertainty concerning the accuracy of their estimates (Pindyck 2013). Some scholars have argued that these uncertainties make climate change a special case where cost–benefit analysis cannot be usefully applied (Masur and Posner 2011; Rose-​Ackerman 2011). These arguments have been repeated by industrial trade associations and politicians that oppose greenhouse gas regulations in support of efforts to prohibit the use of the social cost of carbon. Environmental advocacy groups, on the other hand, have argued that the social cost of carbon can be a useful tool for setting climate policy, although they argue that current estimates are too low, because, for example, they fail to adequately account for catastrophic outcomes (Environmental Defense Fund et al. 2013; Weitzman 2009; Weitzman 2011;). The social cost of carbon, then, represents another example where the traditional interest group alignment concerning cost–​benefit analysis has been inverted by new political dynamics.

20.3. Instrument Choice Identifying the socially desirable level of environmental quality is useful only if there are means to achieve that end. This section explores different types of government interventions (i.e., policy instruments) that can be used to reduce pollution. It first discusses normative questions and then examines instrument choices that have been made in US environmental policymaking. Section 20.4 will explore questions concerning the level of government that is best suited to implement these instruments.

20.3.1. Normative Issues and Analysis There are a wide range of policies that can be adopted to achieve environmental goals, including labeling and disclosure requirements, technology standards, liability regimes, effluent fees, and tradable emission allowances. These policies may differ along a number of important dimensions, including the flexibility they provide for regulated actors, their ease of enforcement, the information necessary to implement the policy, and the incentives they provide for technological development on the part of private actors (Goulder and Parry 2008). Selecting among instruments involves a sometimes-​complex inquiry that is conceptual, as well as practical, and context specific.

20.3.1.1. General Framework For a given environmental goal, the cost-​effective policy will be the one that achieves that goal at the lowest total cost (Office of Management and Budget 2003). While there is substantial controversy about appropriate environmental goals, the aspiration of

 

ENVIRONMENTAL LAW AND ECONOMICS    521 cost-​effectiveness is widely shared. In general, cost-​effective policies will equalize marginal abatement costs across all pollution sources or which reductions are possible. When marginal abatement costs are not equal, lower-​cost abatement opportunities have not been fully implemented, implying that cost-​effectiveness has not been achieved. An important qualification to the general principle that marginal costs be equalized is the need to ensure compliance with environmental requirements. Enforcement may be easier at some sources than others: point sources of pollution are easier to monitor than non-​point sources; inspection of a small number of large sources is less costly than inspection of a large number of small sources; certain companies or private individuals may be judgment proof, undermining the incentive effect of potential penalties (Farmer 2007). For these reasons, and others, the aspiration of equalizing marginal abatement costs may sometimes be subject to practical enforcement constraints. Cost-​effective policies will achieve environmental goals at the lowest aggregate costs, including monitoring, inspection, and enforcement, meaning that some theoretical lower-​cost abatement opportunities may not be realized. Dynamic effects may also provide reasons to depart from cost-​effectiveness in the short term. Environmental regulations often generate incentives for the development and deployment of new technologies (Downing and White 1986; Ellerman et al. 2003; Malueg 1989; Milliman and Prince 1989). Frequently, cost-​effective instruments will provide the correct incentive for efficient technological development: firms will make marginal decisions to invest in new technologies or use existing technologies in ways that minimize the present value of their compliance costs (Zerbe 1970; Downing and White 1986; Milliman and Prince 1989). Positive externalities associated with knowledge spillovers, however, may result in underinvestment in technological development (Katsoulacos and Xepapadeas 1996). In such cases, regulations designed to require firms to overinvest in new technologies (relative to their private costs and benefits) may be welfare maximizing (Jaffe et al. 2001). In the long run, this approach would be cost-​ effective, but in the short term, lower-​cost abatement opportunities may be forgone. An additional element of instrument choice concerns the selection of regulatory tools in the face of uncertainty. A social decision maker can be uncertain about either environmental damages or abatement costs, or both. Weitzman (1974) shows that when a regulator must either set a price (e.g., through effluent fee) or a quantity (e.g., through a pollution cap) cost uncertainty can significantly affect this choice, with the relative elasticity in damage and cost functions determining whether a price instrument is more efficient that a quantity instrument. Recent research shows that nonlinear taxes, graded quantities, or hybrid tax-​ quantity instruments have advantages over either flat prices or fixed quantities (Roberts and Spence 1976; Weitzman 1978; Kaplow and Shavell 2002; Pizer 2002; Fell et al. 2012).

20.3.1.2.  Market Mechanisms versus Command and Control Regulation A particularly important choice that is often presented in the environmental context is between command-​and-​control style regulation and market-​based approaches. The typical example of a command-​and-​control environmental regulation is a design standard

 

522    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ that requires a specific pollution reduction technology to be adopted by all regulated firms. An example of a market-​based mechanism is a comprehensive, economy-​wide “cap-​and-​trade” system of tradable emission allowances. There are many alternatives along a command-​to-​market continuum (Freeman and Kolstad 2006). Performance-​ based standards, which set effluent limits but do not specify a particular technology, are more market-​like than they are a prescriptive design standard (EPA 2010b). Flexibility can be added to a command-​and-​control standard by allowing firms to comply with emissions requirement through offsets, in which new emissions must be accompanied by equivalent reductions. A particular version of an offset mechanism is the use of “bubbling” to treating a facility or firm as a single source. The use of bubbling under the Clean Air Act new source performance standards provision was the substantive question at the heart of Chevron v NRDC,10 the case that sets out the contemporary stan­ dard of judicial deference to agency statutory interpretations. Compliance flexibility can also be enhanced through banking and/​or borrowing, in which past or future emissions reductions can “count” toward emissions limits. Environmental liability rules (Viscusi and Zeckhauser 2011) and labeling and disclosure can be used to achieve environmental goals (Thaler and Sunstein 2008) in place of, or as a supplement to, ex ante controls. More market-​ like instruments are often favored on cost-​ effectiveness grounds because they provide firms with flexibility in achieving emissions reductions and tend to equalize marginal abatement costs across firms (Montgomery 1972; Baumol and Oates 1988; Tietenberg 1995). On the other hand, command-​and-​control mechanisms may be easier to enforce (Grossman and Cole 1999) and they avoid problems that arise when emissions are not spatially or temporally fungible (Sado et al. 2010).

20.3.1.3. Environmental Transitions and Grandfathering As in all areas of policy change, environmental law creates issues of retroactivity when private or public actions are undertaken under a prior regime that can, at least potentially, be governed by the new regime (Fisch 1997). The issue of retroactivity can be especially important in the environmental context because environmental standards can affect decisions that are extremely widespread (e.g., car purchase decisions in the context of fuel economy standards for automobiles) or touch on extremely high-​value infrastructure investments (e.g., power plants affected by air-​quality standards). Many environmental regimes adopt a bifurcated approach in response to the retroactivity problem, treating new emissions sources differently than existing sources. Three general justifications can be given for a bifurcated approach. First, existing sources have a life cycle of depreciation and technological obsolescence for reasons unrelated to the environmental regime. Requiring expensive investments to upgrade existing emissions sources that will soon be retired may be unjustified. Second, the marginal cost of pollution control achieved by retrofitting existing sources may be much higher than the same pollution reductions at new sources. Finally, public choice theory may predict that existing sources may act as an effective lobbying coalition against 10 

467 U.S. 837 (1984).

 

ENVIRONMENTAL LAW AND ECONOMICS    523 economically justified environmental protections; grandfathering may be the second-​ best solution to overcome opposition to new controls (Revesz and Westfahl Kong 2011). An important dynamic effect of the bifurcated approach is referred to as the “old plant effect” (Ackerman and Hassler 1980). When additional costs are imposed on new plants in the form of stringent environmental standards, the life of the existing plants is extended and their replacement by new plants is delayed. The favorable treatment extended to existing sources under the bifurcated approach increases their value, and crowds out new sources based on technologies that are more efficient and would out-​ compete existing sources in the absence of the environmental policy. The net result on emissions from the imposition of an environmental standard when it is accompanied by an exemption for existing sources is ambiguous (Nash and Revesz 2007). The old plant effect is compounded by a public choice dynamic in which beneficiaries of a grandfathering policy lobby to extend their favorable treatment for as long as possible (Revesz and Westfahl Kong 2011). Auction-​based cap-​and-​trade or effluent fee systems represent an efficient approach to allocating abatement costs and investments between new and existing sources (Montero 2008). In cases where pure market-​based mechanisms are infeasible, bifurcated treatment may be justified, despite the old plant effect. The standard approach to determining the optimal bifurcated treatment is through a two-​step, sequential inquiry (Shavell 2008). The first question is the optimal stringency for new sources; the second question concerns the optimal transition rule for existing sources in light of the standards for new sources. The sequential approach, however, does not account for the old plant effect and, therefore, leads to better-​than-​optimal treatment of existing sources; jointly optimizing the grandfathering rule and the new source standard leads to superior results (Revesz and Westfahl Kong 2011).

20.3.2. Positive Issue and Analysis Nearly a half-​century after the United States embarked on major expansion in federal environmental law, this natural experiment has generated some useful results that can inform future policy design. In particular, experience with the sulfur dioxide trading program established by the Clean Air Act Amendments of 1990 showed that market-​based mechanisms have great promise for achieving impressive emissions cuts and low cost. Whether political leaders will profit from this experience is another question.

20.3.2.1. Experience with Market-​Based Mechanisms As noted by Schmalensee and Stavins (2010), “market-​based policies … were innovations developed by conservatives in the [Ronald] Reagan, George H. W. Bush, and George W. Bush administrations.” Given this pedigree, it is perhaps unsurprising that many environmental groups opposed marketable permit schemes (Hahn and Hester 1989). The only major environmental organization that showed a strong interest in

 

524    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ developing market-​based solutions to environmental problems, the Environmental Defense Fund, was strongly criticized (Krupp 2008). Developments in the late 1980s and early 1990s shifted this dynamic, holding out the promise that a new political consensus in support of market mechanisms was attainable. The passage of the Clean Air Act Amendments of 1990, which established a national market for trading in sulfur dioxide emissions, is generally regarded as the first large-​ scale collaboration across the political spectrum to support a marketable permit scheme (Joskow and Schmalensee 1998). The legislation was adopted with wide bipartisan support; only five Democratic and five Republican senators voted against the bill. The sulfur dioxide emissions-​trading program is widely viewed as a major success (Chan et al. 2012). Impressive emissions reductions occurred at low costs (Ellerman et al. 1997). Use of the trading mechanisms allowed firms to deploy relatively low-​cost alternatives such as fuel shifting and other production process changes (Doucet and Strauss 1994). The trading program also may have led to technological change that would not have been induced through a design standard (Burtraw 1996; Ellerman and Montero 1998; Bohi and Burtraw 1997; Keohane 2001). The program also resulted in higher-​than-​ expected benefits as the severe health consequences associated with particulate matter (of which sulfur dioxide is a precursor) have become more clear (EPA 2011c). The success of the US sulfur dioxide program spurred major interest in tradable allowance systems (Ayres 2000). Environmental issues for which tradable allowance systems have been implemented include fisheries management and water quality (Shortle and Horan 2006). Most important, a tradable allowance system is widely recognized as the preferred approach to climate change among political leaders (Stavins 2008). The European Emissions Trading System (ETS), created to fulfill obligations under the Kyoto Protocol, is the most important existing greenhouse gas emissions–​allowances trading system (IPCC 2007). Despite some continuing difficulties in maintaining price stability, in part owing to an excessively generous overall cap on emissions, the European ETS has led to important emissions reductions and provided valuable lessons in market design (Brown et al. 2012). Within the United States, the political consensus around market-​based approaches to greenhouse gas reductions was nearly universal, with presidential nominees of both major parties strongly supporting a cap-​and-​trade system and environmentalists largely dropping their opposition to market mechanisms (Bernton 2008). The promise of consensus, however, was short-​lived. Comprehensive legislation was an early priority for the Obama administration. A bill to create a comprehensive cap-​ and-​trade regime was adopted by the Democratic-​dominated House of Representative without a single Republican vote.11 When the bill passed the House, debate shifted to the Senate, where it took on a highly partisan tenor. Regulated industry led a major lobbying and public relations push to oppose the legislation. Advocates and 11 

Office of the Clerk of the U.S. House of Representatives. (June 26, 2009). “Final Vote Results for Roll Call 477.” http://​clerk.house.gov/​evs/​2009/​roll477.xml [Accessed 29 September 2016].

 

ENVIRONMENTAL LAW AND ECONOMICS    525 politicians that opposed the bill cast it as a tax on energy that would hurt consumers (Boehner 2009). The opposition campaign was ultimately successful, and the bill died in the Senate without being called to a vote (Stromberg 2010). Opposition to cap-​and-​ trade became a centerpiece of the successful Republican effort to retake the House in 2010 (Good 2011). By the time of the 2012 presidential election, the issue had become a political litmus test for conservatism in the Republican primary (Weigel 2011). There is now a broadly shared view that legislation to create a market-​based system to control greenhouse gas emissions is not politically achievable in the current political environment (Broder 2010). In the absence of legislation, the EPA moved forward with regulations under the Clean Air Act (Executive Office of the President 2013). While the statutory structure of the Act, especially Section 115, may be broad enough to accommodate a flexible, market-​based approach (Chettiar and Schwartz 2009; Chang 2010), there is substantial legal uncertainty given the vagueness of the statutory language.

20.3.2.2. Labeling and Disclosure While political consensus concerning market-​based approaches to pollution control was short-​lived, there has been renewed interest in labeling and disclosure as a lower cost and, therefore, more politically palatable means of improving environmental quality. In particular, Cass Sunstein’s tenure as the Administrator of the Office of Information and Regulatory Affairs (OIRA) at the White House Office of Management and Budget from 2009 to 2012 was marked by efforts to improve the design of labeling and disclosure regimes to maximize their effectiveness (Office of Information and Regulatory Affairs [OIRA] 2010). A new fuel economy label adopted in 2011 required all new automobiles to “provide a clear statement about anticipated fuel savings (or costs) over a five-​year period” (Sunstein 2012). The label simplifies and clarifies fuel economy information pertinent to consumer decision making, no longer “leav[ing] it to consumers to do the arithmetic needed to figure out the net economic effects of fuel economy standards on their budgets and lives” (Sunstein 2012; EPA 2011d). The design of the new label was foreshadowed in Sunstein and Thaler (2008), which argued for display of multiyear estimates of fuel costs. Similarly, in 2009 the EPA promulgated a mandatory greenhouse gas reporting rule,12 which mimics disclosure programs like the Toxic Release Inventory (TRI) required by the Emergency Planning and Community Right to Know Act. The TRI, which requires reporting of both storage and release of potentially hazardous chemicals, without requiring any additional action, has led to significant reductions in toxic releases into the environment (Khanna et al. 1997). The Greenhouse Gas Reporting Program (GGRP) will create a database covering 85%–​90% of total US greenhouse gas emissions by requiring reporting from sources that “emit 25,000 metric tons or more of carbon dioxide equivalent per year in the United States,” excluding the agricultural sector (EPA

12 

40 C.F.R. pt. 98.

 

526    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ 2013). The GGRP will increase the quantity of greenhouse gas (GHG) emission information, as well is its visibility and salience, among both GHG sources and the public (OIRA 2010; Cohen and Viscusi 2012).

20.3.2.3. Social Norms There have also been recent efforts to use government institutions to influence social norms in an environmentally friendly direction, an approach that has received attention as a “libertarian paternalist” mechanism to promote social goals (Sunstein and Thaler 2008). One such example is an executive order13 that seeks to increase the visibility and salience of energy costs within the federal government through methods such as public scorecards and leadership awards (Sunstein 2011). As part of this effort, the federal government has partnered with the private sector to set joint goals for energy efficiency, leveraging its own efficiency improvements to spur improvements more broadly (e.g., Department of Energy 2013). These efforts expand on voluntary partnerships programs that have existed in the environmental area for some time (Borck and Coglianese 2009; Coglianese and Nash 2009).

20.3.2.4. Reducing the Effect of Grandfathering under the Clean Air Act Although a bifurcated approach to new and existing sources is a common feature of US environmental law, in recent years the EPA has undertaken a number of significant mea­ sures designed to limit the scope of grandfathering. For example, the agency has engaged in a multiyear effort to establish a marketable permit scheme to control interstate pollution that reduces favorable treatment for inefficient pre-​Clean Air Act sources. As discussed above, the most recent iteration of this effort, the Cross-​State Air Pollution Rule adopted in 2011, was struck down by the D.C. Circuit in 2012. Also in 2011, EPA adopted the MATS, which limits the emissions of a number of toxic air pollutants from both new and existing power plants.14 And, in 2013, President Obama indicated that in 2014, EPA will propose a rule limiting the greenhouse gas emissions of existing power plants under Section 111(d) of the Clean Air Act.15 The combined effect of these approaches could significantly accelerate the shutdown of existing plants that had been grandfathered for more than 40 years.

20.4.  Jurisdictional Allocation The existence of externalities, transaction costs, and imperfect property rights imply that an unregulated marketplace is unlikely to provide efficient levels of 13  Executive Order 13,514, Federal Leadership in Environmental, Energy and Economic Performance, 74 Fed. Reg. 194 (Oct. 5, 2009). 14  78 Fed. Reg. 79 (Apr. 24, 2013). 15  The White House, “Presidential Memorandum—​Power Sector Carbon Pollution Standards.” http://​ www.whitehouse.gov/​the-​press-​office/​2013/​06/​25/​presidential-​memorandum-​power-​sector-​carbon-​ pollution-​standards [Accessed June 25, 2013].

 

ENVIRONMENTAL LAW AND ECONOMICS    527 environmental quality—​government intervention is necessary. Once that preliminary observation has been made, there is a second question concerning how governmental authority over environmental policy ought to be allocated among different levels of government, from the local (municipalities) to the global (international institutions). This question has important implications for the effectiveness and legitimacy of environmental policy.

20.4.1. Normative Issues and Analysis The allocation of policymaking responsibility across jurisdictions is an important question in many legal domains, and one that has caught the attention of law and economics scholars (Faure and Johnston 2009). Economics, in particular, can address the role of incentives in determining whether a policymaking context is amenable or not to local control. Environmental policymaking presents a number of specific issues that are rel­ evant to questions of jurisdictional allocation.

20.4.1.1. General Framework Several important inputs into environmental protection can vary by geographic region, a fact that increases the desirability of locally tailored standards. These geographically variable inputs include the marginal costs of pollution control, preferences concerning the value of environmental quality (compared with other goods), and the level of exposure to environmental risk (which is affected by population density, among other factors) (Mendelsohn 1986; Nordhaus 1994). To the extent that information about geographic variability is more likely to be held by local government officials, there is a justification for a rebuttable presumption in favor of local control over environmental policy (Revesz and Stavins 2007). At the same time, environmental protection is also an area where, at least in some instances, the local-​ control presumption is rebutted by the existence of interjurisdictional externalities (Revesz 1996). Alternative justifications have been given for why national-​level control over environmental protection is desirable, but they have important weaknesses. Most prominently, scholars have argued that environmental protection presents a “race-​to-​the-​bottom” problem in which interjurisdictional competition leads to inefficiently low levels of regulation (Esty 1996). Basic models have demonstrated, however, that rational, self-​ regarding jurisdictions in a perfectly competitive market will arrive at efficient levels of pollution control (Revesz 1992). If the assumption of rationality or perfect competition is relaxed, jurisdictions may over-​or underregulate (Revesz 1997). Federal floors (which are common in environmental law), then, are no better justified than federal ceilings (which are relatively uncommon, although not unknown). In addition, to the extent that environmental protection is federalized, jurisdictions may simply compete in other areas more directly under local control and simply over-​or underprovide some other public good or service (Revesz 1997).

 

528    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ

20.5.2. Positive Issues and Analysis While economics provides a theoretically attractive framework for analyzing how jurisdiction over environmental policymaking ought to be allocated, observed behavior sharply diverges from its recommendations.

20.4.2.1. Jurisdictional Mismatch The allocation of authority between the national government and the states in US environmental law is not tailored to a jurisdiction-​externality justification for federal authority. There are many federal statutes that address environmental problems that do not have any interjurisdictional externalities. These include federal programs to remediate hazardous waste sites,16 and set limits on the allowable level of contaminants in drinking water.17 Furthermore, the Clean Air Act and Clean Water Act, which do address pollution sources with the potential to generate important interstate externalities, are generally focused on local, rather than interstate, pollution. The core of the Clean Air Act consists of federally prescribed air-​quality standards designed and implemented at the local level.18 Indeed, facilities can meet these air-​quality standards by exporting more pollution across state lines (Revesz 1996). Plant-​level emissions standards are not oriented toward facilities with important interstate consequences, instead covering all sources by pollution category and vintage.19 The sections of the Clean Air Act that are specifically targeted toward interstate pollution have been devilishly difficult for the EPA to implement, with multiple attempts being struck down by the D.C. Circuit Court of Appeals.20 The Clean Water Act fares little better, with most of its emphasis placed on pollution sources that have only intrastate effects (Stewart 1982).

20.4.2.2. Lack of a Global Agreement on Climate Change If governance power should be allocated to the minimally extensive jurisdiction that internalizes any relevant externality, in the context of climate change, that jurisdiction is the entire globe. Because greenhouse gas emissions in any country lead to climate change risks in all countries, a global approach to greenhouse gas limits is well justified. There has been a substantial effort through the United Nations Framework Convention on Climate Change (UNFCCC) to negotiate a set of meaningful mandatory limits on emissions that would apply to all countries. While the UNFCCC 16 

Comprehensive Environmental Response, Compensation, and Liability Act, 42 U.S.C. § 103 et seq. (2012). 17  Safe Water Drinking Act, 42 U.S.C. § 300f et seq. (2012). 18  See Clean Air Act §§ 108–​109, 42 U.S.C. §§ 7408–​7409 (2012). 19  § 111, 42 U.S.C. § 7411 (2012). 20 See North Carolina v EPA, 531 F.3d 896 (D.C. Cir) (striking down the Clean Air Interstate Rule); EME Homer City Generation, L.P. v EPA, 696 F.3d 7 (D.C. Cir. 2012) (striking down the Cross State Air Pollution Rule), rev’d., EPA v EME Homer City Generation L.P., 134 S. Ct. 1584 (2014).

 

ENVIRONMENTAL LAW AND ECONOMICS    529 process has had some successes, it has faced extremely serious stumbling blocks. In particular, the failure to negotiate a successor agreement to the Kyoto Protocol at the 15th Conference of the Parties meeting in Copenhagen, Denmark, was seen as a major setback for the Intergovernmental Panel on Climate Change (IPCCC) process (Vidal et al. 2009). Absent progress at the international level, for a time, initiative for climate policy devolved to the regional or domestic level. The European ETS remains the most robust international emissions-​trading program and serves as the primary vehicle for emissions reductions within European countries (European Commission 2013). Domestic efforts to curb greenhouse gas controls have been forwarded successfully in some countries but met with stiff resistance in other countries, such as Australia (Plumer 2013).

20.4.2.3. State Innovation Within the United States, the lack of national emissions limits, and especially the lack of climate legislation, resulted in a further devolution to the state level (Carlarne 2008). US states have adopted three basic approaches. Early efforts tended to involve command-​and-​control regulation. In 1997, Oregon enacted the first legislation in the United States addressed at limiting greenhouse gas emissions, setting a standard for carbon dioxide emissions from the state’s natural gas electric plants (Environmental Defense Fund 2012). In 2001, Massachusetts enacted carbon dioxide regulations for all power plants, as part of a comprehensive bill aiming to cut pollution from the electricity sector (Daley 2001). In 2002, California enacted legislation that required the state regulatory agency to “adopt regulations that achieve the maximum feasible and cost-​effective reduction of greenhouse gas emissions from motor vehicles.”21 The California effort was especially significant because the state plays a special role under the Clean Air Act (Carlson 2009). Section 209 of the Act allows California to request a waiver from the EPA to set more stringent mobile source standards than the federal standards.22 Other states can then follow suit, and depart from the federal standard, if they choose. When California issued regulations in 2004 establishing greenhouse gas limits for motor vehicles, it set in motion a politi­ cal chain of events that ultimately led to a “car deal” negotiated among major automobile manufacturers, the federal government, and other stakeholders in support of a national greenhouse gas standard for new automobiles under the Clean Air Act (Freeman 2011). Subsidies to encourage greater reliance on renewable sources of electricity are a second approach adopted by many states. The most common approach, referred to as “renewable portfolio standards,” is a mandate that a target share of the state’s energy 21  California Assembly Bill 1493 (July 22, 2002). http://​www.leginfo.ca.gov/​pub/​01-​02/​bill/​asm/​ab_​ 1451-​1500/​ab_​1493_​bill_​20020722_​chaptered.pdf [Accessed 29 September 2016]. 22  Clean Air Act § 209, 42 U.S.C. § 7543 (2012).

 

530    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ supply be generated by renewable sources (Davies 2012). For example, California’s stan­ dard requires suppliers to obtain 20% of their energy from renewable sources, with this proportion rising to 33% by 2020 (Farber 2008). Clean energy subsidies face important challenges, including the need to define “renewable” in a manner that accurately captures environmental benefits (Duane 2010) and likely results in relatively high-​cost emission reductions (OECD 2013). Finally, states have experimented with a cap-​and-​trade approach to greenhouse gas emissions limits. The Regional Greenhouse Gas Initiative (RGGI) is one such effort. RGGI is a collaboration of northeastern states that have signed a joint memorandum of understanding (MOU) setting out each state’s share of a regional carbon dioxide cap, adopted legislation or regulation approving that MOU, and, beginning in 2008, implemented an auctioning and trading process (Duane 2010). While one state from the initial group of ten (New Jersey) has withdrawn, the RGGI regime has remained relatively stable and has raised over $1 billion for participating states in the first four years of oper­ ation (Rabe 2009). In 2006, California passed the California Global Warming Solutions Act, commonly known as AB 32.23 That legislation launched a multistep process to reduce greenhouse gas emissions in the state to 1990 levels by 2020. The centerpiece of the regulatory approach implementing AB 32 is a statewide cap-​and-​trade program. California, however, has not adopted a purely market-​based approach, having augmented its cap-​and-​ trade approach with a range of additional policies, including plant specific performance standards, energy-​efficiency requirements, and a renewable portfolio standard. Many of these additional measures are likely to lead to increased costs without obvious climate benefit (Carlson 2013). These state efforts set the stage for a renewed round of federal efforts, primarily the Clean Power Plan that was finalized by the EPA in 2015. This rule, promulgated under the agency’s existing authority under the Clean Air Act, establishes state-​by-​state emissions limitations in part based on prior state experience with emissions reductions. Under the Plan, states have considerable discretion in choosing between different approaches to meeting their emissions budget, a process of experimentation that may ultimately produce information that helps alleviate political gridlock at the national level (Livermore 2017, forthcoming). The EPA’s move to regulate greenhouse gas emissions at the national level in turn helped support efforts by the Obama administration to negotiate a successful emissions reduction agreement during the 21th Conference of the Parties meeting in Paris, France. The Paris Agreement is widely perceived as providing a substantially more meaningful roadmap to genuine greenhouse gas emissions than the products of earlier climate negotiations. 23 

Global Warming Solutions Act, California Assembly Bill 32 (Sept. 27, 2006). http://​www. leginfo.ca.gov/​pub/​05-​06/​bill/​asm/​ab_​0001-​0050/​ab_​32_​bill_​20060927_​chaptered.pdf [Accessed 29 September 2016].

 

ENVIRONMENTAL LAW AND ECONOMICS    531

20.5. Conclusion Since the publication of Revesz and Stavins (2007), there have been some significant normative advances in the area of environmental law and economics. For example, the emergence of climate change as the area of central concern for environmental regulation has brought a great deal of attention to the question of how to discount benefits that accrue into the far future and primarily affect individuals not yet born. Also, the rise of behavioral law and economics has created a shift away from exclusive reliance on neoclassical models. But the most significant changes have been on the positive side. In particular, the traditional alignment of interest groups has come close to experiencing an about-​face. Conservative, antiregulatory groups traditionally favored cost–​benefit analysis, market-​based instruments, and decentralization. Progressive, proregulatory groups traditionally opposed these approaches. In recent years, however, the tables have often been turned. These shifts suggest that commitment to principles is secondary to commitment to substantive regulatory outcomes, with groups of both sides of the spectrum availing themselves of whatever argument will better promote their preferences concerning the stringency of regulation.

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538    MICHAEL A. LIVERMORE AND RICHARD L. REVESZ Khanna, M, Quimio, W., and Bojilova, D. 1997. “Toxics Release Information: A Policy Tool for Environmental Protection.” Journal of Environmental Economics and Management 36, pp. 243–​266. Koopmans, T. C. 1963. “On the Concept of Optimal Economic Growth.” Pontificae Academiae Scientarium Scripta Varia 28, pp. 225–​300. Korobkin, R. and Ulen, T. 2000. “Law and Behavioral Science:  Removing the Rationality Assumption from Law and Economics.” California Law Review 88, pp. 1051–​1144. Krause, R. and Krutilla, K. 2011. “Transaction Costs and Environmental Policy: An Assessment Framework and Literature Review.” International Review of Environmental and Resource Economics 4(3/​4), pp. 261–​354. Krieger, L. 1995. “The Content of Our Categories: A Cognitive Bias Approach to Discrimination and Equal Employment Opportunity.” Stanford Law Review 47, pp. 1161–​1248. Krupp, F. 2008. “The Making of a Market-​Minded Environmentalist.” Strategy+Business 51. http://​www.strategy-​business.com/​media/​file/​sb51_​08201.pdf [Accessed 27 September 2016]. Kysar, D. 2010. Regulating from Nowhere. New Haven, CT: Yale University Press. Laibson, D. 1997. “Golden Eggs and Hyperbolic Discounting.” Quarterly Journal of Economics 112(2), pp. 443–​478. Livermore, M. 2013. “The Meaning of Green Growth.” Michigan Journal of Environmental & Administrative Law 3(1), pp. 33–​86. Livermore, M. [2017] Forthcoming. “The Perils of Experimentation.” Yale Law Journal 126(3). Livermore, M. and Revesz, R. 2011. “Retaking Rationality Two Years Later.” Houston Law Review 48, pp. 1–​41. Livermore, M. and Revesz, R., eds. 2013. “The Globalization of Cost-​Benefit Analysis in Environmental Policy.” New York: Oxford University Press. Livermore, M. and Revesz, R. 2014. “Rethinking Health-​Based Environmental Standards.” New York University Law Review 89(4), pp. 1184–​1267. Livermore, M. and Schwartz, J. 2014. “Analysis to Inform Public Discourse on Jobs and Regulations.” In: C. Coglianese, A. Finkel, and C. Carrigan, eds., Does Regulation Kill Jobs? Philadelphia: Pennsylvania Press. 239–​255 Maleug, D. 1989. “Emission Credit Trading and the Incentive to Adopt New Pollution Abatement Technology.” Journal of Environmental Economics and Management 16, pp. 52–​57. Masur, J. and Posner, E. 2010. “Against Feasibility Analysis.” University of Chicago Law Review 77, pp. 657–​7 14. Masur, J. and Posner, E. 2012. “Regulation, Unemployment, and Cost-Benefit Analysis.” Virginia Law Review 98, pp. 579–634. Masur, J. and Posner, E. 2011. “Climate Regulation and the Limits of Cost-​Benefit Analysis.” California Law Review 99, pp. 1557–​1598. McAdams, R. 1997. “The Origin, Development, and Regulation of Norms.” Michigan Law Review 96, pp. 338–​433. McGarity, T. 1979. “Substantive and Procedural Discretion in Administrative Resolution of Science Policy Questions:  Regulating Carcinogens in EPA and OSHA.” Georgetown Law Journal 67, pp. 729–​810. Mendelsohn, R. 1986. “Regulating Heterogeneous Emissions.” Journal of Environmental Economics and Management 13, pp. 301–​312. Milliman, S. R. and Prince, R. 1989. “Firm Incentives to Promote Technological Change in Pollution Control.” Journal of Environmental Economics and Management 17, pp. 247–​265.

 

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Author Index

Abel, Richard  102, 111 Abraham, Kenneth S.  75 n. 34, 319, 487, 489, 493, 494–​5 Abramowicz, Michael B.  246 n. 14 Abrams, David  209 n. 27 Acheson, James  189 Acitelli, Linda K.  289 Ackerman, B. 523 Ackerman, F. 511 Adelman, Martin J.  201 n. 2 Adler, B. E.  458, 463 n. 18, 466 n. 22 Adler, Matthew  104, 511, 515 Aghion, P.  457–​8 Akcigit, Ufuk  209 n. 27 Akerlof, George A.  241, 482 Alacer, Juan  209 n. 27 Alberini, A. 512 Alcott, H. 515 Alderman, Harold  281 Allen, D. W.  151, 283 Allen, William T.  343, 354 Allison, John R.  201 n. 3, 209 Alston, L. J.  158 Alva, Curtis  358, 363 Anabtawi, Iman  424 n. 7 Anagol, Santosh  488 Andel, Charles  120, 124 Anderson, E. 511 Anderson, Roy Ryden  21 n. 1, 24 n. 9 Andrade, Gregor  374 Andrews, Lori B.  63 n. 18 Anthoff, D. 519 Aoki, K.  470 n. 28 Ariansen, P. 511 Aristotle  179–​80 Arlen, Jennifer  42 n. 2, 44, 45, 47, 48, 49, 51, 52, 53, 54, 55, 56, 60, 62 n. 17, 64 n. 20, 64 n. 23, 65 n. 24, 66, 67, 68, 69, 70 n. 29, 71, 72, 73, 74, 75, 76, 77, 78, 82, 83, 84, 85, 86

Armour, J. 472 Arora, A.  193 n. 18, 208 Arrighi, Barbara A.  289 Arrow, Kenneth J.  61 n. 15, 71, 235 n. 50, 240–​1, 260 n. 14, 270 n. 46, 482, 512, 513, 514 Arruñada, B. 167 Artis, Julie E.  285, 286, 288 Asmat, Danial P.  497 Athreya, K. B.  463 n. 18 Attansio, Orazio  281 Ausubel, L. M.  465, 470 n. 28 Avraham, Ronen  98, 100, 103, 107, 127, 129, 131, 134, 136, 138, 139, 140, 312, 481, 482, 489, 493 Ayotte, K. 160 Ayres, Ian  14, 15, 139, 159, 164, 165, 312, 318, 493 Ayres, R. 524 Babcock, Linda  51 n. 8 Badr, Hoda  289 Baicker, Katherine  130, 136, 469 Bainbridge, Stephen M.  345, 350, 351 Baird, Douglas G.  10, 13, 14, 15 Baker, Tom  69, 71, 129, 490, 492, 495, 496, 498 Bakos, Yannis  15, 71, 75 Baldwin, C. Y.  149 Baldwin, Carliss  267 n. 41 Baldwin, L. 134 Bank, Stephen A.  339 Banzhaf, H. S.  512 Bar-​Gill, Oren  208 n. 24, 487, 494 Barnes, W. David  249 n. 18 Barnett, Jonathan M.  207, 208 Barnett, Joshua  193 Baron, Jonathan  316 Bartik, T. 515 Bartley, Sharon J.  286 Barton, John H.  3 Barzel, Yoram  153, 154–​5, 158, 159, 160, 167, 187

 

544   author index Barzuza, Michal  366, 367, 376 Batalova, Jeanne A.  289 Bator, Francis M.  244 n. 8 Baum, Charles  300 Baumol, William J.  363, 522 Baxter, Janeen  289 Baxter, Lawrence G.  441 n. 93 Bebchuk, Lucian  312, 345, 346, 358, 369, 374, 380, 381, 391 n. 26, 392 n. 28, 452 n. 3, 453 n. 6, 454 n. 8, 457, 460 Becher, Elise C.  120 Becht, Marco  359 Bechtold, Stefan  201 n. 6 Becker, Gary  281 Beckerman, W. 513 Beebe, Barton  201 n. 5 Beider, Perry  133 Bell, A.  196 n. 28, 196 n. 29 Bellas, A. 511 Ben-​Shahar, Omri  16, 49, 494 Benkler, Yochai  244 n. 7, 246, 249, 261 n. 22, 261 n. 23, 261 n. 24, 262 n. 28, 263 n. 29, 265 n. 33, 267 n. 39, 267 n. 40, 273 n. 48 Benmelech, E.  461–​2 Bennett, Fran  283 Berglas, Eitan  257 n. 3 Berglof, E. 455 Bergman, N. K.  461–​2 Bergstrom, Theodore C.  281 Berkovitch, E.  452 n. 5, 456 n. 10 Berlà, Edward P.  104 Berle, A. A.  170, 346 Bernanke, Ben S.  424 n. 7 Bernstein, L. 162 Bernton, H. 524 Bertacchini, E. 171 Bester, H.  455 n. 9 Betker, B. L.  459 n. 13, 460 Bhagat, Sanjai  372 n. 12, 373, 375, 377, 378 Bianchi, Suzanne M.  284, 285, 286, 287, 289, 290, 291 Bigoni, Maria  316 Biondi, Yuri  343 Birmingham, Robert L.  22 n. 5 Bishop, William  319 Bittman, Michael  283, 285 Black, Bernard S.  501

Black, Jeff  435 n. 64 Blair, Margaret M.  339, 340, 342, 345, 346, 347, 348, 351, 352 Blau, Francine  280 Blinfanti, Tamamra C.  354 Blume, Lawrence  481 Blundell, Richard  282 Boardman, Michelle E.  493 Bodie, Matthew T.  343, 346 Boehner, J. 525 Bohi, D. 524 Bohn, James G.  484 Bolton, P.  17, 455 n. 9 Borck, J. 526 Born, Patricia  129 Bortolotti, Stefania  316 Botsch, M. 474 Botterell, Andrew  24 n. 10 Bouchard, Geneviève  283, 284, 286, 287, 288 Bovbjerg, Randall R.  97, 321 Boyes, W. J.  470 n. 28 Boyle, James  242 n. 4, 260 n. 16, 261 Bracha, Oren  270 n. 46 Braun, Michael  291 Brennan, Troyan A.  63 n. 19, 75 n. 34 Breyer, Stephen  243, 244 n. 6 Brines, Julia  288–​9 Brinig, Margaret  283 Bris, A.  459, 460, 461 Broder, J. 525 Bronsteen, John  101 Brooks, Richard R. W.  28 n. 15 Broome, J. 512 Brougham, Brian J.  391 n. 27 De Brouwer, Gordon  428 n. 22 Brown, Elizabeth F.  485 Brown, Jennifer  488 Brown, John Prather  43, 44, 45, 51, 52 n. 8 Brown, L. 524 Brown, Patrick O.  268 Browne, Kingsley  293 Browne, Mark J.  488, 497 Bubb, R. 516 Buccafusco, Christopher  201 n. 6, 211, 212 Buchanan, James  171, 190–​1, 257 n. 3 Bulow, J.  452 n. 3 Burggraf, Shirley  299

 

author index   545 Burk, D. L.  192 n. 13, 208 Burton, John F.  111 Burtraw, D.  509, 524 Butler, Henry N.  359 Butler, Richard J.  487 Buzbee, W. W.  195 n. 27 Cabana, Michael  139 Cafaggi, Fabrizio  431 n. 34 Cai, B. 511 Calabresi, Guido  20, 41, 42, 159, 163, 164, 309, 312, 313, 481 Calfee, John E.  55, 56, 161 Calfo, Steve  131 Callo, Christopher  362 Canziani, Arnaldo  343 Carapeto, M. 460 Carlane, C. 529 Carlson, A. 530 Carney, William J.  362 n. 5, 365, 367 Carpenter, Daniel  488 Carrigan, C. 514 Carter, Stephen L.  225 n. 14, 229 n. 23 Cary, William L.  360, 361, 366, 372, 380 Cha, Youngjoo  288 Chamallas, M.  96 n. 1, 98 Chamblee, Elizabeth L.  109 Chan, G. 524 Chandra, Amitabh  123 Chang, H.  453 n. 6, 460 Chang, T. 461 Chang, Yun-​Chien  103 Chassin, Mark  120 Cheffins, Brian R.  372 n. 9 Chepke, Lindsey M.  128 n. 9, 129 Chettiar, I. 525 Cheung, S. N.S.  171 Chiappori, Pierre-​André  282, 489 Choi, Albert  9, 49, 69, 71, 75, 76 Christensen, Glenn L.  203 n. 13 Chu, C. Y. Cyrus  78, 84 Chung, Tai-​Yeong  327 n. 22 Ciepley, David  338, 339, 342, 348, 349 Clark, John Bates  202 n. 9 Clark, K. B.  149 Clark, Robert C.  339, 341 Clarkson, Kenneth W.  327

Clemens, Jeffrey  127 Clermont, Kevin M.  297 Cline, W. R.  512 Coase, R. H.  6, 7, 42, 49, 86, 150, 151, 163, 195, 242 n. 3, 250, 263, 399, 511 Coates IV, John C.  348 Cochrane, John H.  489 Cockburn, Ian  210 Coffee, John C., Jr.  241, 247 Coglianse, C.  514, 516, 526 Cohen, Alma  358, 380, 381, 392 n. 28, 482, 493 Cohen, David  316 Cohen, Ellen L.  290 Cohen, Julie E.  261 Cohen, M. 526 Cohen, Philip N.  289 Cohen, W. M.  193 n. 18 Cohen, Wesley  203 n. 11 Cohen-​Cole, Ethan  470 n. 27 Cole, D. 522 Cole, Shawn  488 Coleman, Jules L.  313 n. 5 Coltrane, Scott  284, 289, 290 Condon, Christopher  435 n. 65 Cooper, George  438 n. 77 Cooter, Robert D.  45, 47, 48, 52, 53, 55, 56, 165, 166, 308, 316, 317, 329, 500 n. 24 Cornelli, F.  454 n. 8 Cornes, Richard  249, 257 n. 3 Cotet, Anca M.  131, 136 Cournot, Antoine-​Augustin  191 Crafton, Steven M.  283 Craswell, Richard  55, 56, 161, 316, 494 Cremers, K. J. M.  386 Crocker, Keith J.  489 Croley, Steven P.  97, 321 n. 13 Cropper, M.  512, 513 Cumming, D. 472 Cummings, Douglas J.  359 Cummins, J.  484, 485, 488 Cunnien, Alan J.  99 Cunningham, Lawrence A.  439 n. 89 Cunningham, Mick  285, 286 Cunnington, Ralph  24 n. 10 Currie, Janet  67 n. 26, 121, 127, 129, 135, 136 Cutler, D. M.  133, 490

 

546   author index Dagan, H.  186 n. 10, 190 Daines, Robert  358, 360, 362, 375, 376 n. 14, 381–​2, 392 Daley, B. 529 Daly, H. 512 Dam, Kenneth W.  245 n. 10 Damman, Jens  359 Dan-​Cohen, Meir  162 Daniels, Ronald J.  359 Danzon, Patricia M.  67, 69, 70, 72, 113, 128, 321 Darby, M. R.  487 Dari-​Mattiacci, Giuseppe  49, 57, 319 Dasgupta, P.  511, 512 Daughety, Andrew F.  57, 60, 61, 62 n. 17 Davies, L. 530 Davis, Gerald F.  350 Davis, Shannon N.  285, 287, 288 Davydenko, S. A.  473 Dawsey, A. E.  465, 470 n. 28 De Henau, Jerome  287 de Mot, J.  171 de Tocqueville, Alexis  359 DelCampo, Robert L.  290 Demsetz, H.  158, 183, 258, 372 Demyanyk, Yuliya  424 n. 6 DePianto, David  48 Depoorter, B.  171, 190, 191, 193 n. 20 DeRosia, Eric D.  203 n. 13 Derrig, Richard A.  497 Deutsche, Francine M.  284 Dewatripont, Mathias  17 Dhankhar, Khan M.  134 n. 13 Diamond, Peter A.  44, 45, 49, 50, 56 Diamond, Shari Seidman  97, 98, 103 Dillbary, Shahar  312 n. 4 Diller, Matthew  111 Dinwoodie, Graeme B.  210 Dobbie, W.  471, 474 n. 32 Dobbs, Dan B.  317, 320 Dodd, Peter  373 n. 11 Dogan, Stacey L.  232 n. 33, 236 n. 54 Doherty, Neil  488 Domínguez-​Folguera, Marta  289 Domowitz, I.  470 n. 28 Dornstein, Ken  497 Dosi, Giovanni  202 n. 10 Doss, Cheryl  281, 282

Doucet, J. 524 Downing, P. 521 Dranove, D. 469 Dranove, David  126, 127 Dreisen, D. 516 Duane, T. 530 Dubay, Kaestner R.  134 Duffy, John  210 Dunn, Abe  201 n. 3 Duygan-​Bump, Burcu  470 n. 27 Easterbrook, Frank H.  170, 220 n. 1, 340, 344, 346, 360 n. 1, 371, 384 Eberhart, A. C.  460 n. 14 Eckardt, Martina  488 Economides, Nicholas S.  220 n. 2 Edlin, Aaron S.  23 n. 6 Eeckhoudt, Louis  490 n. 12 Efrat, R.  448 n. 2 Eggertsson, T.  151, 186 n. 10 Eguchi, Aya  205 n. 21 Eisen, Michael  268 Eisenberg, Melvin A.  346 Eisenberg, Rebecca  192 Eisner, Robert  490 n. 12 Eldar, Ofer  366, 377, 382–​3 Eling, M.  485 n. 6 Ellerman, A. D.  521, 524 Ellet, Charles  191 Ellickson, R. C.  156, 157, 159, 162, 188, 195, 205 n. 18 Elliott, Douglas J.  429 n. 24, 438 n. 78 English, Robert C.  264 n. 31 Enriques, Luca  359 Environmental Defense Fund  520 Environmental Protection Agency (EPA) 525 Epstein, Richard A.  42, 58, 67 n. 26, 68, 69, 70, 71 n. 30, 72, 73, 76, 85, 161, 165, 167, 172, 322, 481 Essert, C. 157 Esty, D. 527 Evertsson, Marie  285 Eyster, Sandra L.  290 Faith, R. L.  470 n. 28 Fan, Pi-​Ling  286, 288

 

author index   547 Fan, W.  463 n. 18, 471 Farber, Daniel A.  241, 530 Farmer, A. 521 Farnsworth, Allan E.  317, 320, 322 Farrow, S. 511 Fasig, Lauren G.  212 Fauchert, Emmannuelle  204 Faure, M. 509 Fay, S.  469, 470 n. 27 Feinberg, Kenneth  110 Feinman, jay  497 Feldberg, Greg  429 n. 24, 438 n. 78 Feldman, Y.  160, 162 Fell, H. 521 Felli, L.  454 n. 8 Fennell, L. A.  164, 171, 181, 210 Ferber, Marianne  280 Ferguson, Joshua  51 n. 8 Ferrell, Allen  369 Ferriell, Jeff  21 Field, B. C.  153 Finkel, A. 514 Finkelstein, A. 469 Fischel, Daniel R.  170, 340, 344, 346, 360 n. 1, 371 Fisher, J. D.  463 n. 18, 469 n. 25 Fitzpatrick, Thomas J., IV  247 n. 15, 248 Folbre, Nancy  299 Frakes, Michael  67 n. 26, 124, 129, 135–​6, 138 Frank, Robert  299 Franklyn, David J.  235 n. 51 Franks, J. R.  452 n. 5, 459 n. 13, 473 Frantz, C. J.  190 Franzoni, Luigi Alberto  49 Freeman, J.  522, 529 Freeman, R. Edward  351, 352 Fried, J. M.  452 n. 3 Friedman, Daniel  23 n. 7 Friedman, David  154, 162, 324 n. 17 Friedman, E. 160 Friedman, Ori  212 Frischmann, Brett M.  246, 248, 261–​2, 270 Frisco, Michelle L.  291 Fudenberg, Drew  73 Fuller, L. L.  3, 6 Fung, Archon  241 n. 2, 247 Fuwa, Makiko  285, 287

Gabaix, Xavier  494 n. 17 Galasso, Alberto  209 Galbraith, John K.  252 Gandhi, Tehal K.  112 Gandia, Christopher M.  436 n. 67 Garfinkel, Simson L.  261 n. 18 Gawande, Atul  133 Geistfeld, L. 515 Geistfeld, Mark  48, 61, 69, 71, 101, 491 n. 13 Geithner, Timothy  434 n. 62 Georgellis, T. A.  472 n. 30 Gergen, M. P.  165 Gershuny, Jonathan  286, 288 Gertner, Robert H.  14, 318, 455 n. 9, 493 Gervais, Roger O.  99 Gilles, Stephen G.  50 Gillingham, K. 515 Gilson, Ronald J.  247, 350 Gilson, S. C.  460 Girvan, M. 153 Gittelman, Michelle  209 n. 27 Glaberson, William  106 Gleick, James  239 Glied, Sherry  61 n. 15, 76, 77 n. 36 Goetz, Charles J.  12, 316 n. 6, 325, 326 Gold, A. 154 Goldberg, John C. P.  105 Golden, J. M.  165 Goldin, Claudia  292–​3, 299 Goldstein, Paul  248 n. 17 Gollier, Christian  490, 513, 514 Good, C. 525 Gordon, H. S.  171 Gordon, Jeffrey N.  383, 436 n. 67 Gordon, Wendy  246 Gottlieb, Joshua D.  127 Goulder, L.  512, 520 Grady, Mark F.  49, 52, 57 Graham, R. 140 Graham, Stuart J. H.  203 n. 11 Grant, C.  468 n. 24 Gravelle, Hugh  488 Greene, D. 515 Greenstein, Theodore N.  285, 287, 288, 289 Greenstone, M. 514 Greenwood, Daniel J.H.  351 Grey, T. C.  151

 

548   author index Grimmelmann, J. 171 Gropp, R. J.  472–​3 Gross, D. B.  469 n. 26, 470 n. 27 Grossman, P. 522 Grossman, Sanford  68, 69, 70, 73, 155 n. 6 Gruber, Jonathan  127, 135, 295, 297–​8 Gupta, Sanjiv  285, 290 Haddock, David  52 n. 9 Hagen, Stuart  133 Hahn, R. 523 Hakim, Catherine  294–​5 Hall, Brian J.  484 Hall, Bronwyn H.  209 Halstrick, Philipp  424 n. 3 Han, S.  471, 473–​4 Handel, Benjamin R.  491 Hankins, S. 470 Hansmann, Henry  85, 152 n. 3, 167, 169, 170, 339, 345, 347, 348, 349, 350, 351, 420 Hanson, Jon D.  97, 321 n. 13 Hardin, Garrett  180, 182, 257 n. 2 Hardin, Russell  370 Harrington, Scott E.  484, 485, 487 Harris, E. 158 Harrod, R. F.  512 Hart, Oliver  8, 155 n. 6, 157, 455 n. 9, 457–​8 Hartwick, J. 512 Hasen, Richard L.  164, 241 n. 2 Hassler, W. 523 Hausman, J. 512 Havighurst, Clark C.  69, 70, 138 Hayden, Grant M.  343, 346 Hazlett, Thomas  193 Heal, G. 511 Heal, Geoffrey  512 Heald, Paul  201 n. 6, 208 n. 24 Heinzerling, L. 511 Helfand, G. 515 Heller, M. A.  171, 181 n. 5, 186 n. 9, 186 n. 10, 190, 193 n. 19, 193 n. 21, 195 n. 25 Hemphill, C. Scott  205, 245 Hendriks, Eva S.  57 Hepburn, C. 513 Heron, Randall A.  373 n. 10, 374 n. 12 Herrera, Ruth S.  290 Herring, Richard J.  428 n. 17

Hess, Charlotte  260 n. 12 Hester, G. 523 Heverly, R. A.  171 Heylighen, F. 166 Hicks, J. R.  511 Himmelstein, D. U.  469 Himmelweit, Susan  280, 281, 282, 283, 287 Hippel, Eric von  204, 267 n. 41 Hockett, Robert  438 n. 76 Hoekstra, M. 470 Hogan, Christopher  131 Hohfeld, W. N.  151 Holmes, Oliver Wendell  3, 4 Holtz-​Eakin, Douglas  128 Holzmüller, Ines  485 Hood, Bruce  212 Hope, C. 519 Hornuf, Lars  359 Hotchkiss, E. 461 Hoy, Michael  489 Hsee, Christopher K.  490 Hsieh, Chee Ruey  98 Hume, David  148–​9, 155 Hunter, Erica  287 Hurst, E. 469 Hylton, Keith N.  49, 51 n. 8, 57, 69, 70, 72, 164 Hyman, David A.  128, 138, 501 Hymowitz, Kay S.  286, 291–​2 Hynes, R. M.  463 n. 20, 466 n. 22, 467 n. 23 Ibrahim, Darian M.  391 n. 27 Institute of Medicine (IOM)  124, 140 Intergovernmental Panel on Climate Change (IPCC) 509 Israel, R.  452 n. 5, 456 n. 10 Iverson, B. 474 Jackson, T. H.  463 n. 18, 466 n. 22 Jacoby, Jacob  236 n. 57 Jaffe, A.  209, 515 Jaffee, Dwight M.  483, 487 Jahera, John S.  379 Jefferson, Thomas  242, 243, 248–​9 Jena, Anupam B.  126, 135–​6 Jensen, Michael C.  170, 338, 346, 354, 452 n. 4 Jensen, Paul H.  210 Johannesson, M. 513

 

author index   549 Johansson, P.–​O.  513 John, Daphne  283, 284, 289, 290 Johnson, Eric J.  490 n. 12 Johnson, H.  452 n. 3 Johnson, Kristin N.  438 n. 79 Jolls, Christine  295, 297, 298 Jorion, P. 462 Joskow, P. 524 Judge, Kathryn  247 Kahan, Marcel  49, 57, 361, 362, 363, 364, 381, 392 n. 28 Kahn, M. 514 Kaldor, N. 511 Kamar, Ehud  361, 362, 363, 364 Kamo, Yoshinori  290 Kangas, Olli  294 Kangiesser, Patricia  212 Kapczynski, Amy  244, 269 Kaplow, Louis  42, 159, 165, 521 Kapor, Mitchell  261 n. 18 Karapanou, Vaia  105 Karni, E. 487 Karplus, V. 515 Karpoff, Jonathan M.  371, 378, 379 Katsoulacos, Y. 521 Katz, Avery  71, 75 Katz, L. 157 Keay, Andrew R.  343, 354 Keeler, B. 512 Keeton, Robert E.  493, 494 Kelly, D. B.  159 Kelty, Christopher  264 n. 31 Kennedy, D. 512 Keohane, N.  509, 524 Kessler, Daniel  67 n. 26, 133, 134 n. 14 Keys, B.  469 n. 25 Khanna, M. 525 Kieff, F. Scott  245 n. 10 King, Joseph H.  97, 102, 328 King, Stephen P.  108 Kirat, Thierry  343 Kitch, Edmund  201 n. 2, 210, 245, 246 Klass, Gregory  101 Klausner, Michael  390–​1 Klein, Robert W.  485 Klerman, Daniel  236 n. 55

Knetsch, Jack L.  316 Knoller, Christian  488 Knudson, Knud  284, 285, 286, 289 Kobayashi, Bruce H.  359, 392–​3 Koeniger, W.  468 n. 24 Koijen, Ralph S. J.  486 Kolber, Adam J.  98, 99, 165 Kolstad, C. 522 Koomans, T. C.  513 Kornhauser, Lewis A.  78, 79, 81, 82, 83 Korobkin, Russell  67 n. 26, 494, 495, 515 Kortum, Samuel  210 Kovarsky, Lee  245 Kraakman, Reinier  78, 84, 85, 152 n. 3, 167, 169, 170, 247, 339, 345, 348, 350, 351, 420 Kraus, Jody  313 n. 5 Krause, R. 511 Krieger, L. 515 Krier, J. E.  171 Krim, Tanya  205 n. 19 Kronman, Anthony  315 Krupp, F. 524 Krutilla, K. 511 Kull, Andrew  24 n. 9 Kung, Justin  139 Kunreuther, Howard C.  490 Kysar, D. 511 La Porta, Rafael  372 n. 9 Lachance-​Grzela, Mylène  283, 284, 286, 287, 288 Laibson, David  494 n. 17, 513 Landes, William N.  41, 42, 43, 44, 45, 52 n. 8, 220 n. 2, 224 n. 12, 249, 250, 318 Lane, Timothy  424 n. 5 Lang, L. 461 Langbein, John  497 Larson, Lex K. and Larson, Arthur  110 Lau, M. W.  169 Laycock, D. 165 Lechene, Valerie  281 Lee, B. A.  153, 164 Lee, Thomas R.  203 n. 13 Leff, A. A.  161 Lefgren, L. 470 Leftwich, Richard  373 n. 11 Lehnert, Andrea  429 n. 24, 438 n. 78, 471

 

550   author index Lemley, M. A.  192 n. 13, 193, 203 n. 13, 209, 232 n. 31, 232 n. 33, 235 n. 50, 236 n. 54, 246, 248, 249 Lennon, Mary-​Clare  291 Lerner, Josh  260 n. 16, 265 n. 32 Lessig, Lawrence  261 Leval, Pierre N.  222 n. 7 Levin, Richard C.  202, 203 n. 12, 208, 209 Levmore, S.  171, 328 Lewellen, Wilbur G.  373 n. 10, 374 n. 12 Lex, Christoph  488 Li, G.  473–​4 Li, Vivian  212 Li, W.  471, 474 Libecap, G. D.  155, 158, 168, 194 n. 24 Lichtman, Douglas  245 Liebowitz, S. J.  391 Liikanen, Erkki  433 n. 52 Linck, James S.  367 Lincoln, Anne E.  286 Listokin, Yair  372 litman, Jessica  261 Livermore, M.  511, 516, 517, 518, 519 Livshits, I.  463 n. 18 Localio, A. R.  134 Logue, Kyle  482, 489, 490, 495, 496, 501 Long, Clarisa  222 n.8, 233 n. 42 LoPucki, L.  459 n. 13 Lord, Richard A.  36 n. 26 Losee, Robert  240 Loshin, Jacob  204 Lotstein, James I.  362 Loutskina, Elena  424 n. 6 Lueck, D.  155, 168 Lundberg, Shelly  281, 282, 283 Lunney, Glynn S., Jr.  210, 221 n. 5 Luppi, Barbara  312–​13 Lynch, Sarah N  436 n. 70 Lyons, A.  469 n. 25 Lytton, Timothy  71 McAdams, R. H.  164, 515 Macaulay, Lord  241 McCaffery, Edward J.  102 McCarthy, J. Thomas  233 n. 40, 234 n. 49 McClellan, Mark  67 n. 26, 133, 134 n. 14 McCloskey, D. 151

McCoy, Patricia A.  439 n. 84 McCubbins, Mathew D.  363 McDonnell, Brett H.  208, 438 n. 81 McElheney, James W.  102 Macey, Jonathan R.  373 n. 10, 424 n. 6 McGarity, T. 516 MacGee, J.  463 n. 19 McGlynn, Elizabeth A.  63 n. 18, 64 n. 23 Machlup, Fritz  220 n. 1 MacIntosh, Jeffrey G.  359 McIntyre, F. 470 McKay, Colin  112 McKenna, Mark P.  201 n. 7, 203 n. 13 MacLeod, Bentley W.  47, 49, 51, 52, 53, 54, 55, 56, 62 n. 17, 64 n. 20, 64 n. 23, 65 n. 24, 66, 67, 68, 69 n. 28, 70 n. 29, 71, 72, 73, 74, 75 n. 34, 78, 82, 83, 85, 86, 121, 127, 129, 135, 136 McMorrow, Stacey  490 McPeak, John  282 Magat, Wesley A.  241 n. 2, 247 Magliocca, Gerard N.  249 Magnolfi, Lorenzo  366, 382–​3 Mahoney, J. D.  196 Mahoney, N. 468 Mahony, Rhona  282 Maki, D. M.  471 Malani, R. M.  467 n. 23 Malatesta, Paul H.  371, 378, 379 Maletic, V. 99 Malueg, D. 521 Mann, B. H.  448 n. 2 Mann, Ronald J.  201 n. 3 Manne, Henry G.  340, 342, 346, 368 Mannino, Clelia A.  284 Mansfield, Edwin  202 n. 10 Marchant, G. 516 Margolis, Stephen E.  391 Marini, Margaret M.  286, 288 Markovits, Daniel  27 n. 13, 28 n. 15, 29 n. 16, 30 n. 18, 31 n. 19, 314 Marotta-​Wurgler, Florencia  15 Martin, Roger  350 Masada, Steven  107 Mashima, Rieko  208 n. 24 Maskin, E.  153 n. 4 Masur, J.  514, 516, 520

 

author index   551 Matsuda, Yoshiaki  259 n. 10 Mattingly, Marybeth J.  291 Maume, David J., Jr.  289 Means, G. C.  170, 346 Meckling, W. H.  170, 338, 346, 452 n. 4 Medina, Barak  316 Melamed, Douglas A.  20, 42, 159, 163, 164, 309, 312, 313 Mello, Michelle M.  63, 75 n. 34, 78, 125, 128, 141 Mendelsohn, R. 527 Menell, Peter S.  202 n. 9, 242 n. 4 Merges, Robert P.  204, 206 n. 23, 207, 208, 209 n. 25, 210 Merrill, T. W.  151, 152, 154, 155, 157, 164, 167, 169, 172, 210 Meurer, Michael J.  501 n. 26 Michelman, F. J.  181 n. 5 Mikulka, Gerold  290 Milkie, Melissa A.  291 Mill, John Stuart  240, 242, 243 Millenson, M. L.  469 Miller, Geoffrey P.  373 n. 10, 431 n. 34 Miller, M. P.  470 Miller, Roger L.  327 Miller, Ted R.  105 Milliman, S. R.  521 Millon, David  343, 344 Minor, Dylan B.  488 Mittenberg, Wiley  99 Moglen, Eben  243–​4 Molyneux, Philip  365 Montero, J.  523, 524 Montgomery, D. 522 Moodie, Gordon  360, 362, 365, 373 n. 10, 380, 387 Moore, J.  8, 155 n. 6, 455 n. 9, 457–​8 Morell, Mayo F.  266 n. 37 Morgan, D. P.  474 Morgenstern, R. 514 Morrin, Maureen  236 n. 57 Morris, M. 164 Morrison, E. R.  460 n. 15, 469 Moss, David A.  488 Mowery, David C.  270 n. 47 Moyer, E. J.  513 Mueller, B. 158 Muris, Timothy J.  327

Myers, S.  452 n. 3 Myerson, Roger B.  481, 485 Nabseth, Lars  365 Nachbar, Thomas B.  250 Nash, J. R.  523, 526 National Partnership for Women and Families 297 Neary, Karen R.  212 Nelson, Richard R.  202 n. 10, 203 n. 11, 260 n. 14 Nermo, Magnus  285 Netter, Jeffry  374 n. 12 Newell, R. 514 Newhouse, Joseph P.  76 Newman, M. E. J.  153, 155 Newman, Thomas R.  498 Nocera, Joe  427 n. Nordhaus, W.  519, 527 Nordhaus, William D.  208, 209 Notowidigdo, M. J.  469 n. 26 Nybourg, K.  452 n. 5 Oates, W. 522 Offer, Shira  291 O’Grady, T. 168 Oliar, Dotan  204 Olsaretti, Serena  299 Olson, Charles  202 n. 8 Olson, Kristina R.  212 Olson, Mancur  257 n. 3, 258 Orbuch, Terri L.  290 Organisation for Economic Cooperation and Development (OECD)  284, 511 O’Rourke, Maureen A.  236 n. 56 Ortiz, D. R.  165 Ostrager, Barry R.  498 Ostrom, E.  158, 183, 257 n. 4, 258–​60 Ostrom, Vincent  258–​9 Owen-​Smith, Jason  270 n. 47 Owings, Maria  127, 135 Pace, Nicholas M.  128 Paik, Myungho  129, 130, 131 Palangkaraya, Afons  210 Palmer, Tom G.  245 Paltsev, S. 515

 

552   author index Pappenfus, James M.  432 n. 46 Parchomovsky, G.  196 n. 28, 196 n. 29, 208 n. 24 Pargendler, Mariana  349 Parisi, F.  151, 162, 171, 191, 193 n. 20, 312–​13, 316 Parker, Wendy  297 Parkman, Allen M.  285, 287 Pauly, Mark V.  490 Pavalko, Eliza K.  285, 286, 288 Penner, J. E.  156, 167 Perdue, William R.  3, 6 Perzanowski, Aaron  204 Peters, Philip G., Jr.  67 n. 26, 124 Peterson, R. L.  470 n. 28 Phaneuf, D. 512 Philibert, C. 513 Picker, Randal C.  14 Pierce, John  239 Pigou, A. C.  202 n. 9, 511 Pildes, R. 516 Pindyck, R. S.  520 Pinto, Kaye M.  284 Pistor, Katharina  441 n. 92 Pizer, W.  514, 521 Plant, Arnold  202 n. 9, 209 Plantin, Guillaume  483 Plott, Charles R.  101 Plumer, B. 529 Polak, B.  463 n. 18, 466 n. 22 Polanyi, Karl  269 Polinsky, A. Mitchell  42, 52 n. 9, 60, 61, 62, 68, 78, 79, 81, 82, 83, 202 n. 9 Pollack, Robert A.  282, 283 Popadak, Jillian  209 n. 27 Porat, Ariel  316, 317, 323, 324 n. 17, 325, 328, 329, 330, 331 Posner, Eric A.  9, 331, 463 n. 18, 467 n. 23, 511, 513, 514, 516, 520 Posner, Richard A.  3, 4, 5, 14, 17, 22, 41, 42, 43, 44, 45, 52 n. 8, 58, 67, 151, 155, 220 n. 2, 224 n. 12, 232 n. 32, 249, 250, 313, 316, 318, 325, 326, 481 Potuchek, Jean L.  289 Poulsen, Annette  374 n. 12 Povel, P.  455, 458 Powell, Walter W.  270 n. 47 Prasso, Sheridan  424 n. 4

Priest, George  69, 70 Prince, R. 521 Pryor, Ellen S.  497 Puelz, Bob  497 Pugh, William N.  379 Qian, Yingy  78, 84 Quagliariello, Mario  434 n. 61 Rabin, Robert L.  98 Radin, M. J.  511 Rahdert, Mark  110 Rajagopalan, M. S.  266 n. 34 Ramsey, F. P.  512 Ramsey, S. 469 Rapaport, William J.  428 n. 17 Rappaport, Michael B.  493–​4 Raustiala, Kal  201 n. 4, 204, 243, 246 Ravid, S. 461 Ray, George F.  365 Rea, Samuel A.  321, 463 n. 18, 466 n. 22 Reagle, Joseph  266 Recupero, Patricia R.  140 Reingaman, Jennifer  57, 60, 61, 62 n. 17 Ren, Haocong  438 n. 80 Revesz, R.  509, 510, 512, 513, 516, 517, 518, 523, 527, 528, 531 Rhoads, Steven E. and Rhoads, Christopher H.  293–​4 Rhodes, E. L.  511 Ribstein, Larry E.  359, 366, 376–​7, 392–​3 Richter, Andreas  488 Ringe, Wolf-​Georg  359 Ritov, Ilana  316 Robe, Jean-​Philippe  337, 345 Roberts, M. 521 Robinette, Christopher J.  105 Robinson, Bryan K.  286 Robinson, Glen O.  69, 70, 72 Rochet, Jean-​Charles  483 Rock, Edward B.  338, 342, 350 Roe, Mark  383, 384–​6 Rogers, Selwyn O.  112 Rogers, T. 515 Rogerson, William P.  7 Romano, Roberta  358, 360, 361, 362, 363, 364, 365, 366, 367, 368, 369, 370, 371, 373, 374,

 

author index   553 375, 377, 378, 380, 381, 384, 386, 387–​8, 389, 390, 391 n. 27 Romney, Mitt  518 Rose, Carol M.  153, 164, 189, 195, 246, 256, 260, 261, 270 Rose-​Ackerman, S.  520 Rosenberg, Nathan  202 n. 10 Rosenblatt, Elizabeth  204 Rosenfeld, Andrew M.  481 Rosenfeld, Sarah  291 Rosenfield, Harvey  487 Rosenthal, Elisabeth L.  133 Rosoff, A. J.  138 Ross, H. Lawrence  497 Rostgaard, Tine  294 Rothschild, Michael  482 Rowell, A. 513 Rubin, Paul  69, 70 Rubinfeld, Daniel L.  481 Ruhm, Christopher  300, 301–​2 Ruse, Michael  489 Russell, Thomas  483, 487 Sado, Y. 522 Sag, Matthew  201 n. 5 Sage, William M.  68, 75 n. 34, 141, 247 Sagers, Chris  247 n. 15, 248 Samida, D. 513 Sampat, Richard R.  270 n. 47 Samuelson, Pamela  211, 261 Samuelson, Paul  240, 242 n. 3, 244 n. 9, 281 Sandage, Scott  448 n. 2 Sandler, Todd  249, 257 n. 3 Sano, Masaaki  259 n. 10 Sarkar, Shayak  488 Sartain, R.  470 n. 28 Satria, Arif  259 n. 10 Sayer, Liana C.  291 Saylor, Joseph Michael  106, 107 Scafidi, Susan  206 n. 22 Scarpa, R. 512 Schäfer, Hans-​Bernd  319 Schankerman, Mark  209 Schanzenbach, Max  127, 131, 134, 136 Scharfstein, D.  455 n. 9 Schechter, Frank I.  231 n. 29, 234 n. 48 Schelling, T. C.  513

Scheppele, Kim L.  13 Schlager, Edella  259 n. 8 Schlesinger, Harris  490 n. 12 Schmalensee, R. 524 Schneider, Barbara  291 Schneider, Carl E.  16, 494 Schoar, A. 461 Scholz, K.  472–​3 Schultz, Mark F.  204 n. 14 Schulz, N.  171, 191 Schündeln, Matthias  359 Schwab, Stewart J.  297 Schwarcz, Daniel  482, 484, 486, 487, 488, 489, 491, 494, 495 Schwarcz, Steven L.  424 n. 2, 424 n. 7, 426 n. 8, 426 n. 9, 427 n. 12, 428 n. 15, 432 n. 47, 434 n. 56, 437 n.73, 437 n. 74, 484 Schwartz, Alan  16, 23, 27 n. 13, 28 n. 15, 29 n. 16, 31 n. 19, 70, 315, 324, 325, 466 n. 22, 494 Schwartz, Andrew A.  339, 342, 353 Schwartz, J.  518, 519, 525 Schwartz, Thomas  363 Schwartz, Victor  97, 104, 501 Schweick, Carles M.  264 n. 31 Scotchmer, Suzanne  202 n. 9, 210, 260 n. 15 Scott, Kenneth E.  481 Scott, Robert E.  11, 12, 316 n. 6, 325, 326 Segerson, Kathleen  81 Shaddle, John H.  130, 134 Shahabian, M.  512, 513 Shamroukh, Nidal  365 Shapiro, Carl  192, 207 Shapiro, Perry  481 Sharkey, Catherine M.  52 n. 9 Shavell, Steven  5, 6, 22 n. 5, 41, 42, 43, 45, 49, 50, 51, 52, 55, 56, 58, 59, 61, 62, 68, 71, 77, 78, 79, 81, 82, 83, 84, 138, 165, 202 n. 9, 246, 313, 314, 321, 322 n. 14, 326 n. 19, 481, 521, 523 Shaw, Alex  212 Sheff, Jeremy  203 n. 13 Shekelle, Paul G.  140 Shelton, Beth Anne  283, 284, 289, 290 Shepard, L.  470 n. 28 Shepsle, Kenneth A.  384 Shiffrin, Seana Valentine  5, 23, 25, 313

 

554   author index Shih, J-​S.  514 Shogren, J. 515 Shoven, J.  452 n. 3 Shrum, T. 515 Shurtz, Ity  121, 136 Sichelman, T. 153 Siegelman, Peter  27 n. 14, 482, 487, 488, 490, 492, 493 Silver, Charles  138, 498, 499, 501 Silverman, Cary  97, 104 Simcoe, Timothy S.  207 Simon, Herbert A.  149, 354 Sinclair, Sandra  111 Sinden, A. 516 Sirletti, Sonia  435 n. 64 Skiba, P. 470 Skinner, Jonathan  123, 132 Skog, O.J.  513 Sloan, F. A.  98, 128 n. 9, 129, 130, 134 Slovic, Paul  428 n. 16 Smith, David  366, 376 Smith, H. E.  151, 152, 153, 154, 155, 156, 157, 158, 159, 160, 162, 164, 165, 166, 167, 169, 171, 210, 345 Smith, J. L.  194 n. 24 Smith, Mark  120, 126 Snow, Arthur  489 Solow, R.  511, 512, 513 Song, J.  471, 474 n. 32 Souleles, N. S.  470 n. 27 South, Scott J.  289 Sowka, M. Patricia  111 Spence, M. 521 Spence, Michael  42, 60, 61, 68, 69, 70, 73, 241 Spier, Kathryn E.  6, 49, 59, 69, 71, 75, 76, 327 n. 22 Spitze, Glenna D.  289 Sprigman, Christopher  201 n. 4, 204, 211, 212, 243, 246 Spulber, Daniel  170 Squire, Richard  339, 348, 501–​2 Stallman, Richard M.  261 n. 18 Stavins, R.  509, 510, 511, 512, 515, 524, 527, 531 Steenson, Mike  106, 107 Stein, Alex  328, 329 Stempel, Jeffrey W.  494, 498 Sterk, S. E.  161

Stern, Scott  210 Stiglitz, Joseph E.  241, 452 n. 4, 482, 511 Stikoff, R. H.  169 Still, Mary C.  297 Stout, Lynn A.  339, 340, 341, 342, 344, 345, 346, 347, 348, 349, 350, 351, 352, 353, 354 Strauss, T. 524 Stromberg, S. 525 Strotz, Robert H.  490 n. 12 Studdert, David M.  63, 78, 111, 112, 125, 126, 128, 131, 138 Stulz, R.  452 n. 3, 461 Subramanian, Guhan  375–​6, 380, 381 Sugarman, Stephen D.  98, 108 Sugden, Robert  149, 155 Suk, Jeannie  205, 245, 296, 297 Sullivan, Mathew C.  108 Sullivan, Oriel  286, 288 Sullivan, T. 468 Sundgren, S. 461 Suner, Peter  267 n. 42 Sunstein, Cass R.  69, 70, 101, 247, 251, 513, 515, 516, 522, 525, 526 Sussman, O.  452 n. 5 Sweden Road Traffic Injuries Commission  113–​14 Syed, Talha  244, 269, 270 n. 46 Sykes, Alan O.  67 n. 26, 68, 69, 71 n. 30, 78, 79, 81, 82, 83, 85, 86, 496, 497, 501 Syverud, Kent  498, 501 Szewczyk, Samuel H.  371 Sztorc, P. 519 Tabacman, J. 470 Tabbach, Avraham  324 n. 17 Talley, Eric L.  51 n.8 Tarantino, E. T.  456 n. 10 Tarullo, Daniel  429 n. 26, 432 n. 46 Tashjian, E.  460 n. 15 Taylor, L. 515 Teece, David  203 n. 11, 208 Tennyson, Sharon  487, 488, 497 Tertilt, M.  463 n. 18 Thadden, E.-​L. von  455 Thaler, Richard H.  69, 70, 101, 522, 525, 526 Thébaud, Sarah  288 Thel, Steven  27 n. 14

 

author index   555 Thompson, Barton H. Jr.  194 n. 24 Thorburn, K. 461 Thucydides 180 n. 2 Thumin, Frederick J.  223 n. 11 Tiebout, Charles M.  359 Tierney, J. 189 Tietenberg, Tom  81, 522 Tirole, Jean  73, 153 n. 4 Tol, R. S.  519 Torous, W. N.  452 n. 5, 459 n. 13 Totaro, Martin  102 Traczynski, Jeffrey  468 Trajtenberg, Manuel  209 Triantis, George C.  9, 19 Tröger, Tobias H.  359 Trossen, David R.  15 Tsetsekos, George P.  371 Tucker, Catherine  201 n. 6 Uizuka, Toshiaki  135 Ulen, Tom  45, 47, 56, 315, 515 Ullmann-​Margalit, Edna  251 Vairo, Ggeorgene M.  109 Valuck, Tom  247 n. 16 Van Den Bos, J.  120, 124 Van Houweling, M. S.  168 van Schewick, Barbara  264 n. 30 Vanneste, S.  190, 193 Varian, Hal  207 Varnus, Harold  268 Vermeulen, Frederic  281 Vertinsky, Liza  210 Vidal, J. 529 Vidmar, Neil  98 Viscusi, W. Kip  101, 241 n. 2, 247, 512, 522, 526 Visscher, Louis  105 Volokh, A. 518 Wærness, Kari  284, 285, 286, 289 Wager, Tor D.  98 Waidmann, Timothy  134 Waldfogel, Jane  295, 300–​1 Wales, Jimmy  266 Walker, W. R.  514 Wall, H. J.  472 n. 30 Walsh, John P.  193 n. 18, 203 n. 11

Wang, H.-​J.  463 n. 18, 465 n. 21 Wang, Jianghong  375 Wang, Wendy  291 Warfel, William J.  497 Warming, J. 171 Warren, E. 468 Wax, Amy  282, 284, 295, 298–​9, 300 Webb, D. C.  455 n. 9, 459 n. 12 Weber, Robert  434 n. 60, 483 Webster, Elizabeth  210 Wehner, Paul  127 Weigel, D. 525 Weiler, Paul C.  58, 63 n. 18, 75 n. 34, 122 Weinstein, Jack B.  108, 109 Weinstein, Mark  341 Weisbach, D.  160, 513 Weiss, L. A.  453 n. 7, 459 n. 13, 460 n. 14 Weiss, Mary  484 Weitzman, M.  513, 514, 520, 521 Welch, I. 459 Wells, Harwell  359 Westbrook, J. 468 Westfahl Kong, A.  523 Whaley, Douglas J.  96 Wheeler, John Archibald  240 Whincop, Michael J.  392 Whinston, Michael D.  6, 327 n. 22 White, L. 521 White, Lawrence J.  247 n. 15 White, M. J.  452 n. 3, 452 n. 5, 453 n. 6, 455 n. 9, 459 n. 13, 460, 463 n. 18, 463 n. 19, 465 n. 21, 466, 469, 470 n. 28, 472–​3, 474 Whitehead, Charles  433 n. 55 Whitford, W.  459 n. 13 Wickelgren, Abraham  49, 59, 69, 71, 73, 74 Widiss, Alan I.  493 Wiener, J. 517 Wilde, Louis L.  16, 494 Wilkinson-​Ryan, Tess  316, 326 n. 21 Williams, Joan  292, 297 Williams, Kristi  291 Williamson, Oliver E.  160, 388 Williston, Samuel  3 Winkler, Anne  280 Winter, Ralph K.  360, 361, 366, 371, 372, 373 Wittry, Michael D.  378 Wolverton, A. 515

 

556   author index Worthington, S. 167 Wozny, N. 515 Wriggins, J.  96 n.1, 98 Wruck, K. H.  453 n. 7 Wyman, K. M.  158, 171 Xepapadeas, A. 521 Yogo, Motohiro  486 Yoo, Christopher  244, 249–​50 Yoon, Y. J.  171, 190–​1 Yorio, Edward  27 n. 14 Ypersele, Tangay van  246

Zamir, Eyal  316 Zaring, David  439 n. 89 Zeckhauser, Richard A.  490, 522 Zeiler, Kathryn  101, 498 Zender, J. F.  456 n. 10 Zerbe, R.  511, 521 Zhang, G. 462 Zhu, N.  459, 474 Ziedonis, Ardvis  270 n. 47 Ziedonis, R. H.  193, 209 Zimmerman, R.  152 n. 2 Zipursky, Benjamin C.  105, 313 n. 5

 

Subject Index

A. Gay Jenson Farms v Cargill (1981)  410–​11 9/​11 Victims’ Compensation Fund  106–​7, 114 academic publication, open–​access to  267–​8, 270–​1 accession 155, 210 accidents between strangers bilateral care  44, 45–​7 bilateral risk  44, 45 classic model: full information  44–​8 liability when information about optimal behavior is costly  43, 48–​57 litigation costs and settlement  58–​9 risk-​averse victims  57–​8 wrongful death and serious permanent injury 48 activity levels  60–​1, 405, 406 excessive 56, 61 optimal  41, 43, 44, 45, 49, 50, 51, 61, 62, 81 organizational 78, 79, 81 actual authority of an agent  403, 404 in partnership  416 ad coelum rule  161 adverse interest  413 adverse possession  154 adverse selection  322–​3 contract  72, 74–​7 and insurance markets  482, 489, 491, 492–​3 and optimal liability rule  61 n. 16 advertising 224, 252 false 221, 222 affiliated depository institutions (ADIs) 424 n. 6 affiliated mortgage companies (AMCs)  424 n. 6, 424 n. 7 affirmative asset partitioning  169, 170

Affordable Care Act of 2010, US  120, 482, 489 agency  399–​401, 403–​14, 420–​1 apparent or ostensible  403, 408, 409 and employment relationship  400–​1 inherent agency power  415 and problem of collusion, agent-​third party collusion  403, 413 principal-​third party collusion  403, 413–​14 see also principal-​agent collusion transactional 400, 406 undisclosed principal problem  403–​4, 408–​13, 418 agency costs  170, 338, 342, 399 agency failure  426–​7, 437, 442 Agent Orange  108–​9 aggregation theory of corporations  344–​5 Ajaxo Inc v E*Trade Grp, Inc. (2005)  24 n. 11 Alaska Packers’ Association v Domenico (1902)  8–​9 alienability  149, 157, 158, 167, 210 Allen v Wal-​Mart Stores, Inc. (2001)  97 America Coalition for Clean Coal Electricity 519 American International Group  484 American Tort Reform Association  129 American Trucking Associations, Inc. v Whitman (2001)  517 Amerisure Ins. Co. v Nat’l Sur. Corp. (2012)  492 Anheuser-​Busch Inc. v Andy’s Sportswear Inc. (1996) 233 n. 41 anticommons  178–​97 “commedy of the anticommons”  196 economics of  190–​2 complements versus substitutes  191–​2 full exclusion resources  189 group exclusion resources  189–​90, 196 puzzles  192–​4 see also tragedy of the anticommons

 

558   subject index antidiscrimination laws, insurance  488–​9 apparent agency  408, 409 apparent authority in agency law  403, 404, 407, 409, 413 in partnership law  415–​16 arbitrage 150, 165 regulatory 426, 430 arbitration, litigation costs  59 asbestos trusts  109 n. 9 asset partitioning  169–​70 asset-​backed commercial paper (ABCP) conduits 424 asymmetric information see information asymmetry Asynchronous Transmission Protocol (ATM) 264 AT&T  273–​4 attention economy  251 attribution (creative works)  211–​13 Australia corporate law  392 damage caps  107–​8 Babies Beat, Inc. (1990)  227 n. 17 bad faith  496–​8 bailments 167 bank holding companies (BHCs)  424 n. 6 banking regulation 423 shadow  424, 432, 436, 437, 442 see also financial regulation bankruptcy  434, 447–​80 collective debt resolution procedure  447–​8 and credit market protection  449 discharge of unpaid debts  448 government 447 and mortgage default  474 priority rules  447 punishments for  448 small business  472, 473 see also corporate bankruptcy; personal bankruptcy bargaining models of household functioning  281–​3 cooperative models  282 non-​cooperative (separate spheres) models 282, 283

threat-​point analysis  282–​3 Basel I  430, 434 Basel II market discipline  430, 431 minimum capital requirements  430 supervisory review  430, 432 Basel III  431–​2 capital conservation buffer  432 countercyclical capital buffer  432 Basel Committee on Banking Supervision (BCBS)  429–​30 Beck v Mason (1991)  34 n. 23 Beery v Plastridge Agency, Inc. (1962)  33 behavioral decision theory  162 behavioral economics and environmental policy  515–​16 and insurance  482, 490–​1 Belgium, pain and suffering damage schedules 113 bilateral care  44, 45–​7, 56 bodily injury, lost income and damages for  323–​5 Botta v Brunner (1958)  99–​100 brands 252 Britain see United Kingdom (UK) British Petroleum (BP) Deepwater Horizon Oil Spill  109 BSD (Berkley Software Distribution) license 265 Budapest Open Access Initiative  268 building encroachments  160–​1, 163 bundle of rights view of property  150, 151, 152, 170 Burwell v Hobby Lobby Stores Inc. (2014) 344, 351 Business Roundtable v SEC (1990)  386 n. 24 California corporate law  380–​1 environmental policy  529, 530 Global Warming Solutions Act (AB 32) (2006) 530 capital markets, distribution of information in 247 capital requirements  429–​32, 436, 440–​1 countercyclical  438–​9 insurance companies  485–​6

 

subject index   559 capital-​adequacy ratios  429, 430, 431 care 51 bilateral  44, 45–​7, 56 due  46–​7, 48, 49, 51, 52, 55–​6, 57, 58, 67 n. 26, 69, 79 employees’ level of  78, 79, 80, 81, 82, 83 excessive 47, 56, 57 marginal cost of  46, 80 optimal  43, 49, 50, 51, 52, 54, 55–​7, 59–​60, 62, 81 social marginal benefit of  46, 57, 80 caregivers, mandated benefits and antidiscrimination laws  295–​302 causation, reciprocal  163 caveat emptor 13 Cement Sector Regulatory Relief Act, US 519 n. 8 centralized management, corporate entities  341–​2 chameleon equity  458 Chevron v NRDC (1984)  522 childcare, gender roles and  293–​4 children, contribution to household labor  290 Cincinnati Ins. Co. v Becker Warehouse, Inc. (2001) 495 n. 19 Civil Rights Act (1964) Title VII, US  295, 296, 297 Clean Air Act, US  514, 516, 517, 522, 523, 525, 526, 529, 530 amendments (1990)  518, 524 Clean Power Plan  530 Clean Water Act, US  517, 518 n. 8, 528 climate change  509–​10, 512, 519–​20, 528–​9, 530, 531 Climate Framework for Uncertainty, Negotiation, and Distribution (FUND) model 519 Clinical Practice Guidelines (CPGs)  121, 123, 137–​40, 142 club goods  257, 277 Coase Corollary  152 Coase Theorem  2, 150, 151, 152, 310 Coca-​Cola Co. v Gemini Rising, Inc. (1972) 233 n. 41 collateral source rule  128, 129 n. 10, 135 collective action problems  259, 427, 428 collective goods  63, 72–​3

comedy of the anticommons  196 comedy of the commons  195 Commercial Paper Funding Facility (CPFF)  436 n. 71, 442 commission-​created pain-​and-​suffering damage schedules  100, 113–​14 common law  308 of contract  4, 5, 10, 12, 13, 16, 17, 20 of property  150, 155, 260 and trademark protection  222, 237 common property regimes (CPRs)  259–​60, 275, 277 common-​pool resources  259–​60 commons  171, 186, 187 “comedy of the commons”  195 limited (group) access  180 n. 3, 186, 188, 189 optimal use of  187–​8 ordinary use  185, 187 Ostrom  257, 258–​60, 275 overuse of  179–​81, 187, 188 privatization of  180, 181, 183, 184, 185, 188, 259 see also anticommons; open-​access commons; semicommons; tragedy of the commons commons-​based peer production  257, 265–​7 Communication and Resolution Programs (CRPs)  121, 140–​1 compensatory damages  42 n. 2, 323–​5 complements  191–​2 complete contracts  69–​70 Comprehensive Environmental Response, Compensation, and Liability Act (2012), US 528 n. 16 congestible public goods  260, 261, 269, 271 Connecticut, corporate law  362 consequential damages  322–​3 conservation easements  196 consumer protection  247 and insurance regulation  482, 484, 486–​8 Consumer Protection Act (2010), US  485 consumption insurance, personal bankruptcy as  449, 462–​6, 467–​8 continent valuation  512 contingent capital debt  441 contra proferentem doctrine  493–​4

 

560   subject index contract law  3–​19, 308, 309, 481 apparent agency in  408 “benefit of the bargain damages”  20 consequential losses  322–​3 contract terms as a product attribute  15–​17 and contract theory  17–​18 contracting costs  25, 28, 29 damages for breach of contract  313–​14, 315 expectation damages see expectation interest, damages liquidated damages  32–​7, 316, 325–​7 punitive damages  24, 25 reliance damages  3, 6, 314 restitution damages  3 default terms  14–​15 disclosure, duty of  13, 14 disgorgement  24, 25 n., 27, 28, 29 dual performance contracts  21, 26, 27, 28, 29–​30, 31–​7 efficient breach see efficient breach expectation interest see expectation interest fiduciary contracts  30, 31 forseeability of losses  317, 318 freedom of contract  3–​4, 11, 22 gain-​seeking breaches  313, 316 good faith, duty of  30 n. 18 liquidated damages clauses  32–​7 loss-​avoiding breaches  313–​14, 316 mitigation doctrine  23, 23–​4 n. 8 nonpecuniary loss  320–​1 “off-​the-​rack terms”  12–​13, 14 overreliance problem  6, 8, 316, 317 price terms  32 promises  3, 4–​5, 20, 23, 24, 26, 29 pure economic loss  318–​19 reliance interest  20 remedy limitations  34–​5 renegotiation  7–​9, 25, 28, 29, 30 restitution interest  20 specific performance  7–​8, 23, 24, 25, 27, 28, 29, 32, 33, 36, 38, 313, 314, 315 supracompensatory remedies  23–​4, 30, 31 warranty of merchantability  12–​13, 16 contract theory  17–​18 contracting over liability  70–​7 contracting through standard form contracts and adverse selection  74–​7

imperfect information  71 inefficient informed: incomplete contracts 72 post-​contractual care and collective goods problem  72–​3 pre-​contractual care: renegotiation and time inconsistency  73–​4 standard form contracts  71, 72 contracts 148 adverse selection  72, 74–​7 bankruptcy  458–​9 collective goods problem  72–​3 complete  69–​70 fungible goods  315 incomplete  72, 153 n. 4, 314 renegotiation of  7–​9, 25, 28, 29, 73–​4, 75 standard form  71, 72, 75 time inconsistency  72, 73–​4 unique goods  315 contractual liability with informed consumers and complete contracts  69–​70 versus tort liability  68–​9 contributory and comparative negligence  43, 45, 46–​7, 50, 56–​7, 77 cooperative solutions to anticommons  190 to commons overuse  183, 185, 188 copying 245 in fashion industry  205–​6 copyright  168, 201 n. 5, 204, 210, 213–​1 4, 220, 241, 243, 245, 246, 250, 261, 270, 277 anticommons 193 n. 20 fair use doctrine  249 fashion 205 Corporate Average Fuel Economy (CAFE) Standards 518 corporate bankruptcy  447, 450–​62 auctions  456–​7 bankruptcy contracts  458–​9 continuing to operate outside of bankruptcy  451–​2, 453 empirical research characteristics of corporations in bankruptcy and bankruptcy costs  459–​60 deviations from the APR  460

 

subject index   561 efficiency of Chapter11 (reorganization procedure) 461 external effects  461–​2 filtering failure  449, 451, 452, 454, 456, 459 liquidation in bankruptcy (Chapter  7) 448–​9, 450, 451, 452, 455, 458–​9, 461, 462 and managerial effort levels  455–​6 non-​bankruptcy workouts  454–​5 options  457–​8 priority rules deviations from  460 and efficiency of corporate behavior  450–​4 reorganization in bankruptcy  448–​9, 452–​ 4, 457, 458–​9, 461 and soft versus tough bankruptcy law  455–​6 strategic default  454–​5 corporate governance  437 corporate law, market for  358–​98 federalism and  359–​60 national government as competitor in  383–​6, 393 shareholder voting rights  386 state competition  360–​7, 393–​4 defensive competition  279, 361–​3, 365, 390 evidence of  365–​6 and role of bar in statutory innovation  363–​5 state competition, beneficiaries of  372–​83 comparative performance studies  374–​7 event studies of changes in Delaware law  377–​8 firms’ domicile decisions studies  379–​83 reincorporation event studies  373–​4 takeover statutes event studies  378–​9, 380 state takeover regulation  367–​72, 378–​9, 380, 384 see also Delaware corporate liability economic justification for  81–​3 agents liability governed by negligence 82 employee asset insufficiency  83

firms’ noncontractible conduct directly affects expected accident costs  82 limitations of existing independent contractor rule  85–​6 limited liability  85 optimal  83–​4 corporate policing  78, 84 corporate purpose  349–​55 customer welfare theory of  349–​50 franchise theory of  348, 349 long-​term production theory of  353–​4 managerialist theory of  350 shareholder value theory of  350–​1, 353 stakeholder welfare theory of  350, 351–​2 team production theory of  352 corporate veil, piercing the  341 corporations agency cost problems  338, 342 aggregate theory of  344–​5 asset lock–​in  339–​40 delegated and professional management  339, 341–​2 entity shielding  339 entity theory of  343–​4 as franchise governments  348, 349 legal personality  338–​9, 339–​40, 351 limited liability for natural persons  339, 340–​1 nexus of contracts theory of  346–​7, 401 nonprofit 340, 353 ownership and control, separation of 340, 346 perpetual life  339, 342–​3 political theory of  348 property (“principal/​agent”) theory of  345–​6, 353 publicly traded  340, 353, 358 team production theory of  347–​8, 352, 354 transferable shares  339, 342 versus the firm  337–​8 corrective justice  3 court-​based damage pain-​and-​suffering schedules  100, 112–​13 covenants 159 Creative Commons Attribution ShareAlike license  265–​6 creativity effect  211, 212

 

562   subject index credit or credit-​growth ceilings  438 credit markets, and personal bankruptcy  472–​4 credit rating agencies  430 credit risk  430 credit-​default swaps  427, 484 Crisci v Security Ins. Co. (1967)  501 n. 25 Cross-​State Air Pollution Rule (CSAPR) 518, 526 CTS Corp. v Dynamics Corp. of America (1987) 368 cultural production, open-​access commons for  265–​7 culture 256, 261 custom 162 customer welfare theory of corporate purpose  349–​50 Daily v Gusto Records, Inc. (2000)  25 n. Dalkon Shield Trust  109–​10 damage caps consequential losses  322–​3 fixed 100, 107 flexible  100, 107–​8 medical malpractice  100, 120, 128, 129, 130, 131, 134, 135–​6, 141 “most extreme case” rule  108 pain-​and-​suffering damages  100, 107–​8 damage schedules (pain-​and-​suffering) commission-​created  100, 113–​14 court-​based  100, 112–​13 legislated  100, 110–​12 damages accidental negligence  52–​3, 54, 66, 67, 68 accidents 48 breach of contract see contract law, damages for breach of contract compensatory  42 n. 2, 323–​5 consequential  322–​3 deliberate negligence  67 economic 98, 131 excessive 47 liquidated  32–​7, 316, 325–​7 punitive  24, 25, 52 n. 9, 59 n. 13, 497 reliance 3, 6, 314 restitution  3, 28 n. 15 and strict liability  45, 56

undercompensatory 315, 317 versus injunctions  163–​6 wrongful death and serious permanent injury  48, 52 n. 8 see also medical malpractice, damage limitations; pain-​and-​suffering damages Dastgheib v Genentech, Inc. (2006)  25 n. Davis v Isenstein (1913)  33 Day v Ouachita Paris School Bd. (2002)  97 death, wrongful  48, 52 n. 8 Debus v Grand Union Stores (1993)  102 DEC (Digital equipment Corp.)  264 Deepwater Horizon Oil Spill  109 Defending America’s Affordable Energy and Jobs Act  518 n. 8 defensive asset partitioning  169–​70 defensive medicine  121, 122, 125–​7, 130, 132, 137, 138, 330 Delaware corporate law  358–​9, 361, 362, 363, 365–​6, 367, 373 n. 10, 381–​2 and firm performance  374–​6 limited-​liability statute  378, 387, 388 and national government  383–​6 price effect of statutory changes  377–​8 takeover regulation  369–​70, 378, 379, 381, 383, 384 pre-​eminence as reincorporation state  387–​93, 394 and corporate franchise taxes  388–​9, 390 corporation code revision supermajority provision  389–​90 credible commitments  388–​90 first mover advantage  390 network effects  390–​3, 394 and nonredeployable assets  389 delegated management, corporate entities  339, 341–​2 Demsetz Thesis  158 Deni Assocs. of Fla. v State Farm Fire & Cas. Ins. Co. (1998)  495 n. 18 derivative suit procedure  348 deterrence, and tort liability  42 n. 2, 43, 58, 59, 63, 70, 71, 78, 79, 83, 86 directors’ and officers’ liability (D & O) insurance  363–​4

 

subject index   563 disclosed principal  412 disclosure, duty of  13 disgorgement remedy  24, 25 n., 27, 28, 29 division of household labor  283–​92 contributions of children  290 earnings and  285 economic-​dependency model  284, 288–​9 fairness in  290–​1 gender gap  285, 286 gender-​construction model  289 gender-​ideology model  287–​8 and marital status  289–​90 and race  290 relative-​resources model  284–​5 time-​availability model  285–​7 time-​use research  283–​4 divorce  282, 283, 291 and bankruptcy  468, 469 Dodd-​Frank Act (2010), US  370, 385, 432 n. 46, 434, 485 Dreamwerks Prod. Group, Inc. v SKG Studio (1998) 235 n. 52 drug patents  178, 192–​3 Duckwall v Rees (1949)  33 due care  46–​7, 48, 49, 51, 52, 55–​6, 57, 58, 67 n. 26, 69, 79 duty to defend  498–​500 duty to indemnify  414, 498, 499 duty to settle  500–​2 Dynamic Integrated Model of Climate and the Economy (DICE)  519 earnings, and division of household labor 285 EarthInfo, Inc. v Hydrosphere Res Consultants, Inc. (1995)  25 n. easements  153, 158, 159, 164 conservation 196 economic damages  98, 131 economic organization, and intellectual property  203–​4, 207–​9 economic-​dependency model of household labor  284, 288–​9 economic-​exchange model see economic-​dependency model ecosystem services  512

Edgar v MITE, Corp. (1982)  368 education levels, male, and household labor 288 efficient breach of contract  5, 10, 20–​40, 313–​16 critiques of  23–​5 gain-​seeking breach  313, 316 loss-​avoiding breach  313–​14, 316 moral issues  23–​4, 25, 26, 29–​31 EME Homer City Generation, L. P. v EPA (2012) 528 n. 20 Emergency Planning and Community Right to Know Act, US  525 emissions see greenhouse gas emissions emotional distress damages  96, 481, 497 employees care, level of  78, 79, 80, 81, 82, 83 strict liability  79, 80–​1, 82 employers negligent supervision  405 strict liability  406 vicarious liability see vicarious liability Employers Mut. Cas. Co. v PIC Contractors, Inc. (1998)  498 n. 20 employment and agency  400–​1 and environmental regulation  514–​15, 518–​19 employment protections employment discrimination litigation  296–​7 mandatory benefits  295–​6, 297–​302 and women’s caregiving responsibilities  295–​302 endowment effect theory  101, 211 energy paradox  515–​16 Energy Tax Prevention Act, US  518 n. 8 Entergy Corp. v Riverkeeper, Inc. (2009)  517 enterprise liability  406 entitlements  151, 163–​4, 165–​6 property rules and liability rules  309–​13 and transactions costs  309–​10, 311–​12, 312–​13 entity property  149, 159, 168, 169–​7 1 entity shielding  339 entity theory of the corporation  343–​4 environmental justice  511

 

564   subject index environmental policy  509–​43 cost-​benefit-​analysis  510–​20 anf changing political context  516–​19 behavioral economics and the energy paradox  515–​16 discounting and future generations  512–​512–​14 employment effects  514–​15, 518–​19 social cost of carbon  519–​20 instrument choice  520–​6 cost-​effectiveness  520–​1 enforcement constraints  521 grandfathering  522–​3, 526 labeling and disclosure  522, 525–​6 market mechanisms  523–​5, 526, 529, 530 versus command and control  521–​2 social norms mechanism  526 and uncertainty  521 jurisdictional allocation  526–​30 jurisdictional mismatch  528 and lack of global agreement on climate change  528–​9 state innovation  529–​30 see also greenhouse gas emissions; renewable energy Environmental Protection Agency (EPA)  518, 525, 526, 530 environmental rights  511 EPA v EME Homer City Generation, L. P. (2014) 528 n. 20 equity  159–​62, 167 Ethernet 257, 258 European Emissions Trading System (ETS) 524, 529 exclusion strategies, property rights  158–​9, 170–​1 exclusivity  259, 261, 269, 270, 275 expectation interest  20, 22–​3, 24, 38 damages  3–​6, 7, 8, 12, 23, 26, 27, 28, 29, 30, 31, 32, 36–​7, 38, 314 and change in circumstance  9 fungible commodities  10 limits of  9–​11 supercompensatory 10, 11 undercompensatory 10 liability rule protection  20, 25, 26–​7 n. 13 property rule protection  25, 26 n. 13, 28 expertise see information/​expertise

false advertising  221, 222 family and household economics  280–​307 caregivers, legal protections for  295–​302 gender leisure gap  290, 291 gender pay gap  290, 291–​2 household decision-​making models, bargaining models  281–​3 nonunitary models  281 unitary model  280–​1 working hours, full-​time versus part-​time  291–​2 see also division of household labor; work-​ life/​family balance Family and Medical Leave Act (FMLA) (1993), US  295–​6, 298, 300–​1 family responsibility discrimination (FRD) 297 family-​friendly workplace policies  293, 294, 299, 300 fashion industry, and intellectual property  204, 205–​6, 245 Federal Communications Commission (FCC) 273 Federal Insecticide, Fungicide, And Rodenticide Act (2012), US  516 Federal Reserve Act, US  433 federalism, and corporate law  359–​60 fiduciary contracts  30, 31 fiduciary duties  169, 170, 339, 348, 352, 368, 413, 419 fiduciary law  168, 169 financial crisis (2008)  424, 433, 435, 484 financial regulation  423–​46, 481 capital requirements  429–​32, 438–​9, 440–​1 and financial complexity  426, 427 macroprudential regulation  435–​41 breaking transmission of systemic shocks  439–​40, 442 limiting triggers of systemic shocks  435–​9, 442 stabilizing systemically important firms and markets  4401 microprudential regulation, correcting market failures  425–​9, 442 monitoring through stress testing  434–​5 ring-​fencing  432–​4, 440 solvency requirements  440–​1

 

subject index   565 Financial Services (Banking Reform) Act (2102), UK 433 Financial Services Modernization Act (1999), US 433 n. 50 Finland, bankruptcy  461 firm boundaries, and intellectual property  203–​4, 207–​9 firms, versus the corporation  337–​8 Fisher Separation Theorem  170 fishing rights  189 see also whaling fixed amount of pain-​and-​suffering damages  100, 106–​7 forseeability  317–​18 France bankruptcy 448, 473 environmental policy  513 franchise taxes  358, 362 n. 4, 365 Delaware  388–​9, 390 franchise theory of corporate purpose 348, 349 fraud  13, 16, 161 insurance 497 vicarious liability for  403, 407–​8 Free and Open Source Software (FOSS)  256, 257, 258, 264–​5, 267, 271 free-​riding  245, 246, 312 freedom of contract  3–​4, 11, 22 fungible good contracts  315 gambling, and personal bankruptcy  470 game theory  149, 191, 259, 281, 282, 295, 298, 494 n. 17 garnishment of wages  465–​6, 470, 471 Gassner v Lockett (1958)  24 n. 11 Geduling v Aiello (1974)  296 Gen. Elec. Broad. Co. (1978)  223 n. 10 gender gap in household labor  285 in pay  290, 291–​2 gender leisure gap  290, 291 gender roles, and childcare  293–​4 gender-​construction model of household labor 289 gender-​ideology model of household labor  287–​8 General Electric Co. v Gilbert (1976)  296 Georgia, corporate law  372

Germany bankruptcy 473 damage schedules  113 Giant Food Inc. v Satterfield (1992)  102 Gilman Yacht Sales, Inc v FMB Invs, Inc. (2000) 35 n. 25 Glass-​Steagall Act, US  433 Global Warming Solutions Act (AB 32) (2006), California  530 Golden Eagle Archery v Jackson (2003)  97 Golden Rule  100–​2 good faith  30 n. 18, 162, 414 good will  400 GPL (General Public License)  265 Graham v John Deere Co. (1965)  220 n. 1 Gramm-​Leach-​Bliley Act (1999), US 433 n. 50 green growth  511 Green Open Access repositories  268 greenhouse gas emissions  509, 512, 519–​20, 526 banking and/​or borrowing  522 global approach to  528–​9 offset mechanisms  522 state regulation of  529 tradable allowance systems  522, 524–​5, 526, 529, 530 Greenhouse Gas Reporting Program (GGRP)  525–​6 guaranty funds  484 n. 5, 485, 488 Hadley v. Baxendale (1854)  14 Harvard Malpractice Insurers Medical Error Prevention Study (MIMEPS)  111–​12 Hawk-​Dove game  154 health insurance/​insurers  63, 67–​8, 75–​6, 122, 131, 468, 489, 490, 491 hedge funds  424, 437 hedonic damages  97 hedonic loss  101 Henderson v Atl. Pelagic Seafood (2011)  103 Hokie Spirit Memorial Fund  110 household economics see family and household economics Hunt v. K-​Mart Corp (1999)  104 IBM 264 ICQ 273

 

566   subject index ideal worker paradigm  292, 293, 297 imperfect information, and contracting over liability 71 imputed knowledge  404, 413 in rem  149, 153, 166, 167 inalienability  163, 168, 210 income, loss of, and bodily injury  323–​5 incomplete contracts  72, 153 n. 4, 314 increase, law of  155 indemnity, duty of  414, 498, 499 Independent Commission on Banking (Vickers Report), UK  433 independent contractor rule  85–​6 induced demand medicine see offensive medicine information  239–​55, 260, 261, 400 congestion or overgrazing  249–​50, 251 distribution problems  246–​50 low marginal cost of production  248, 250 nonexcludability assumption  242–​5, 251, 260 nonrivalrous nature of  248–​9, 250, 251, 260, 269, 270 public good model of  239–​42, 244, 246, 250 reward schemes for production of  246 scientist’s concept of  240 underproduction  239, 242–​6, 250 underusage 250, 260 usage and value relationship  251–​2 information asymmetry  61 n. 16, 239, 241, 247–​8, 250, 251, 399 in financial markets  425–​6, 427 and insurance law  482 information commons see open-​access commons information costs  86 injurer  50–​2 and tort liability  42–​3, 48–​57, 59 n. 12, 60 victim 51 n. 8 information failure  425–​6, 437, 442 see also information asymmetry information/​expertise injurer investment in  51–​2, 53–​4, 55, 56 marginal benefit of  54, 57, 65 marginal cost of  54, 57, 65 in medical care context  63, 64, 65, 66, 67 infrastructure goods  256, 257, 261–​2, 270

inherent agency power  415 injunctions, versus damages  163–​6 injury, serious permanent  48, 52 n. 8 innovation  256, 258, 261, 269 decentralization of 261 Institutional Analysis and Development (IAD) framework 259 insurance  77, 481–​508 adverse selection  482, 489, 491, 492–​3 and behavioral economics  482, 490–​1 first-​party  58 fraud 497 guaranty funds  484 n. 5, 485, 488 health  63, 67–​8, 75–​6, 122, 131, 468, 489, 490, 491 indemnity 498 moral hazard  482, 499 principal-​agent problems  483, 484 shadow 486 systemic risk in  494 see also consumption insurance; liability insurance insurance law in the courts  491–​502 bad faith  496–​8 contra proferentem doctrine  493–​4 duty to defend  498–​500 duty to settle  500–​2 insurance policy interpretation and ex post policy regulation  492–​6 reasonable expectations doctrine  494–​5, 496 insurance regulation  483–​91 antidiscrimination laws  488–​9 consumer protection regulation  482, 484, 486–​8 nudging toward better insurance equilibria  490–​1 solvency regulation  483–​6 intellectual property  150, 168, 171, 200–​19, 239, 241, 244, 245–​6, 260, 261 contextualization  202–​9, 213 firm boundaries, and economic organization  203–​4, 207–​9 negative spaces  203, 204–​6 platform technologies  203, 206–​7 methodological diversity  209–​14 empirical studies  209–​10

 

subject index   567 experimental studies  211–​13 models and analytics  210–​1 see also brands; copyright; patents; trademark protection intentional infliction of emotion distress 96 n. 1 Intergovernmental Panel on Climate Change (IPCC) 529 internal ratings-​based (IRB) risk-​assessment  431 International Association for the Study of the Commons 183 International Financial Stability Board  440 International Intellectual Property Protection Alliance (IIPPA)  204 International Monetary Fund  440 International News Service v Associated Press (1918) 250 International Organization for Standardization (IOS)  264 International Telecommunications Union (ITU) 264 Internet  257, 260, 261 Internet protocols  256, 271, 277 TCP/​IP  257, 258, 264, 272–​3 Inwood Lab. v Ives Lab. (1982)  227 n. 16 Italy, pain and suffering damage schedules  113 Jarvis v Swan Tours (1972)  320 n. 10 Jobs and Energy Permitting Act (2012), US 518 n. 8 Jobs Through Growth Act, US  519 n. 8 joint and several liability rule  128–​9 n. 10, 135 judgment-​proof agents  405, 406, 501 Judicial Studies Board, UK  112 Kirk v Wash. State Univ. (1987)  97 knowledge 261 Kyoto Protocol  524, 529 labor force participation female  284, 286, 301 gender divergence in  292 and ideal worker paradigm  292, 293 land anticommons in 193 surveying 168

Lanham Act (1946), US  222, 223, 228 n. 22, 230 n. 25, 232 legal personality, corporate entities  338–​9, 339–​40, 351 legislated pain-​and-​suffering damage schedules  100, 110–​12 leisure gap, gender  290, 291 leverage ceilings  438 Lewis v Holmes (1903)  320 n. 12 liability caps on consequential damages  322–​3 forseeability of losses  317–​18 limited  85, 169, 339, 340–​1, 364, 365, 378, 387, 388, 437 nonpecuniary loss  320–​1 pollution 495 pure economic loss  318–​20 regulatory 50 waiving of 74 see also strict liability; tort liability liability insurance  51 n. 8, 77, 491, 498–​9, 500–​1 directors’ and officers’  363–​4 medical malpractice  122, 126 liability rule protection  20, 25, 26–​7 n. 13, 309–​13, 314 versus property rule protection  159, 163, 164, 165–​6 licenses, open access  168, 207, 265–​6 Liggett v Lee (1933)  343 Liikanen Report  433 limited liability  85, 169, 339, 340–​1, 364, 365, 378, 387, 388, 437 limited partnership  418 limited-​liability companies (LLCs)  392–​3 limited-​liability partnerships (LLPs)  392–​3, 418–​19 liquidated damages  32–​7, 316, 325–​7 liquidation, and corporate bankruptcy  448–​9, 450, 451, 452, 455, 458–​9, 461, 462 liquidity 441 liquidity default  435, 437 litigation costs arbitration 59 strict liability versus negligence  58–​9 long-​term production theory of corporate purpose 353

 

568   subject index Longshore and Harbor Worker’s Compensation Act  110 loss of consortium damages  96–​7 of enjoyment of life (hedonic damages)  97 forseeability of  317–​18 nonpecuniary  320–​1 pure economic loss  318–​20 Loss of Pleasure of Life (LPL) scale  100, 104 McFadden v Fuentes (1990)  35 McGarry v Horlacher (2002)  97 Major Depressive Disorder (MDD)  99 malingering 99 managerialist theory of corporate purpose 350 marital status, and division of household labor  289–​90 market failures agency failure  426–​7, 437, 442 information failure  425–​6, 437, 442 rationality failure  426, 437, 442 risk marginalization  428–​9 market risk  430 Market Share Liability (MSL) doctrine  329 market transactions, as solution to commons tragedy 180, 183 markets, and distribution of information  247–​8 Massachusetts corporate law  380 environmental policy  529 maternity-​related leave  295–​6, 298, 300–​2 Matos v Clarendon Nat. Ins. Co. (2002)  97 maturity transformation  435–​7 medical costs as a basis for pain and suffering  100, 103–​4 medical malpractice  43, 62–​7, 120–​47 accidental error  63, 65 Clinical Practice Guidelines (CPGs)  121, 123, 137–​40, 142 Communication and Resolution Programs (CRPs)  121, 140–​1 contracting over liability  70–​7 custom standard  123, 124, 138 damage limitations  121, 127–​36, 137, 141–​2 and cardiac and obstetric care  133–​6

collateral source reforms  128, 129 n. 10, 135 and healthcare utilization  130–​6 joint and several liability reform  128–​9 n. 10, 135 noneconomic damage caps  120, 128, 129, 130, 131, 134, 135–​6, 141 and quality of care  136 and reduction in awards and claiming  128–​9 defensive medicine  121, 122, 125–​7, 130, 132, 137, 138, 330 detection of errors  122, 124–​5, 138, 141 error in judgement rule  124 imperfectly informed producers  62–​7 informed consent  127 for insured patients  67–​8, 132, 136 liability insurance  122, 126 negligence liability  43, 64–​7 offensive or induced demand medicine  121, 122, 127, 134, 135, 136, 138 offsetting risks principle  327, 329–​31 physician investment in information/​ expertise  63, 64, 65, 66, 67 probabilistic recoveries  327–​9 reasonableness standard  123, 138 respectable minority rule  123–​4 risk-​averse victims  77 standard of care  121, 122, 123–​4, 141 treatment selection  64, 65, 66–​8, 122, 127, 329–​30 uninsured patients  64–​7 men and household labor  284, 285, 286, 287–​8, 289, 291 and education levels  288 and marital status  289–​90 and race  290 and ideal worker paradigm  292 mental anguish damages  96, 97 Mercury and Air Toxics Standards (MATS) 518, 526 Mining Jobs Protection Act, US  518 n. 8 Mishna, the 101 n. 3 mitigation, breach of contract  23, 23–​4 n. 8 Mkt Place P’ship v Hollywood Hangar, LLC (2007) 35

 

subject index   569 Model Business Corporation Act, US  362, 367, 381, 392 Model Unfair Claims Settlement Practices Act (UCSPA), US 497 money-​market mutual funds  424, 435–​6 monopoly  194–​5 moral hazard  61 n. 16, 436, 442, 482, 499 moral issues, efficient breach of contract  23–4, 25, 26, 29–​31 mortality, and personal bankruptcy  471 mortgage default, and bankruptcy  474 mortgage-​backed securities  427 Moss & Raley v Wren (1909)  33 N Am Steel Corp v Siderius (1977)  36 n. 26 N Ill gas Co v Energy Coop, Inc. (1984)  34 Nabisco, Inc. v PF Brands, Inc. (1999)  231 n. 28 National Ambient Air Quality Standards (NAAQS), US  516, 517 National Association of Insurance Commissioners 111, 112 National Practitioner Data Base  128, 129 negative spaces, intellectual property  203, 204–​6 negligence  48, 49, 50, 54, 56–​7, 58, 62, 81, 82, 317, 318 accidental  51–​3, 54, 56, 66, 67, 68 with contributory or comparative negligence  43, 45, 46–​7, 56–​7, 77 deliberate 47, 52, 67 litigation costs and settlement  58–​9 medical malpractice  43, 64–​7 pure 45, 46 negligent infliction of emotional distress 86 n. 1 negligent supervision  405 Nemmers v United States (1988)  97 Netherlands, damage schedules  113 network theory  153–​4 Nevada, corporate law  366–​7, 376–​7, 393, 394 New Institutional Economics  158 New State Ice Co. v Liebmann (1932)  359 nexus of contracts theory  346–​7, 399, 401 Non-​binding Age-​Adjusted Multipliers (NBAAM)  103, 104, 111 noneconomic damage caps

medical malpractice  120, 128, 129, 130, 131, 134, 135–​6, 141 pain-​and-​suffering fixed caps  100, 107 flexible caps  100, 107–​8 nonexcludability 269, 275 information  242–​5, 250, 251, 260 nonpecuniary loss  320–​1 countervailing deterrence argument  321 marginal utility of money argument  321 nonprofit corporations  340, 353 nonrivalry 269 information  248–​9, 250, 251, 260, 269, 270 North Carolina v EPA (2008)  528 n. 20 nuisance  150, 152, 154, 159, 163, 164–​5, 166, 319 Ocean State Physicians Health Plan, Inc. v Blue Cross & Blue Shield of R.I. (1988) 493 n. 16 offensive medicine  121, 122, 127, 134, 135, 136, 138 Office of Fair Trading, UK  490 offsetting risks principle  327, 329–​313 Ohio corporate law  380 Ontario Noneconomic Loss Study (ONELS)  111–​12 open-​access commons  180 n. 3, 186, 188, 189, 256–​79 Free and Open Source Software (FOSS)  256, 257, 258, 264–​5, 267, 271 Internet protocols  257, 258, 264, 271, 272–​3, 277 open-​access publication  257, 267–​8, 270–​1 and positive externalities  269, 270–​1, 277 reliance on queuing  256 symmetric use privileges  256, 269, 277 types of  275, 276 and uncertainty, freedom to operate, and exploration  269, 271–​5 unlicensed wireless spectrum  256, 257, 258, 262–​4, 271, 272, 273–​4, 277 Wikipedia and other commons-​based peer production  257, 265–​7 open-​access licenses  168, 207, 265–​6 open-​source platforms  207, 256, 257, 258, 264–​ 5, 267, 271 operational risk  430

 

570   subject index opportunism  160, 161, 165, 167 Oregon, environmental policy  529 organizational activity levels  78, 79, 81 organizations, tort liability  77–​81 entity-​level versus individual liability: the neutrality result  78–​81 see also corporate liability O’Shield v Lakeside Bank (2002)  33 Ostrom commons  257, 258–​60 overreliance problem  6, 8, 316, 317 overuse 185 of common resources  179–​81, 187, 188 see also tragedy of the commons ownership  157–​8, 210 children’s intuitions about  212–​13 co-​  168 common see anticommons; commons and control, separation of  170, 340, 346 P2PValue project  266–​7 Pagliero v Wallace China Co. (1952)  228 n. 19, 228 n. 21 pain-​and-​suffering damages  96–​9 “fair and reasonable compensation”  100 horizontal equity  97, 98, 100 intentional torts  96, 98 malingering, problem of  99 negligent torts  96 and scientific assessment of pain and suffering  98–​9 vertical equity  100 and victim exaggeration of losses  97, 98 pain-​and-​suffering damages, estimation of  99–​115 Golden Rule  100–​2 Loss of Pleasure of Life (LPL) scale  100, 104 medical costs as a basis for pain and suffering  100, 103–​4 per diem  100, 102–​3 Quality-​Adjusted Life Years (QALY)  100 routinization  100, 105–​14 commission-​created damage schedules  100, 113–​14 court-​based damage schedules  100, 112–​13 fixed amount for the entire injury  100, 108–​10

fixed amount of pain-​and-​suffering damages  100, 106–​7 legislated damage schedules  100, 110–​12 noneconomic damage fixed caps 100, 107 noneconomic damage flexible caps  100, 107–​8 parental leave see maternity-​related leave Paris Agreement on climate change (2016) 530 partial disability  110 partnership  341, 342, 399, 401–​3, 420–​1 as an entity  402, 414, 419 limited 418 limited liability  392–​3, 418–​19 problems of shared ownership and control, misappropriation of property and partner collusion with third parties  419–​19 partner authority to contract with third parties  415–​16 partner torts and vicarious partnership liability 417 vicarious partner liability for contracts and torts  417–​19 passing off  221, 223 patents  194–​5, 203, 204, 208, 209–​10, 220, 241, 245, 246, 250, 270, 277 drug  178, 192–​3 technology 193 Patient Protection and Affordable Care Act of 2010, US  120, 482, 489 pay gender gap in  290, 291–​2 see also wages payday loans  470 pedis possessio 156 Peeveyhouse v Garland Coal & Mining Co. (1962) 14 Pennsylvania, corporate law  371, 378, 380 per diem  100, 102–​3 Perfect Bayesian Separating Equilibrium (PBSE) 70, 73, 74 personal bankruptcy  447, 449, 462–​74 and adverse events  468, 469 consumption insurance  449, 462–​6, 467–​8 and credit markets  472–​4

 

subject index   571 and debtors’ labor supply  471 default versus bankruptcy (informal bankruptcy)  465–​6, 470 and entrepreneurial activity  472 future earnings exemption  463, 464–​5, 468 and gambling  470 and mortality  471 option value of filing for  467 and payday loans  470 and portfolio composition  471 reasons for filing for  468–​70 strategic/​economic view of  468, 469, 470 and wage garnishment  465–​6, 470, 471 waiving the right to file for  466–​7 wealth exemptions  463, 464–​5, 467–​8, 471, 472–​3 Pierce v N.Y. Cent.R.R.Co. (1969)  97 Pigovian taxes  6, 511 Plasticolor Molded Prods. v Ford Motor Co. (1989) 288 n. 19 platform technologies, and intellectual property  203, 206–​7 PLoS (Public Library of Science) journals 268 Policy Analysis of the Greenhouse Effect (PAGE) model  519 Political Economy Research Institute  519 political theory of corporations  348 pollution liability 495 see also environmental policy; greenhouse gas emissions possession  148–​9, 155, 156–​7 adverse 154 title rules on  157, 158 Post-​Traumatic Stress Disorder (PTSD)  99 precautions  49–​50 optimal  41, 42, 49, 50–​2, 53–​4, 55, 82 Pregnancy Discrimination Act (PDA), US 296 price terms, contract law  32 principal-​agent collusion  403–​13 collusion to mislead the third party about an agent’s solvency  409–​12 collusion to mislead the third party about the principal’s intention to contract  404–​5

collusion to mislead the third party about the principal’s solvency  412 collusion to mislead the third party about the transaction  407–​8 collusion to mislead the third party into thinking an agency relationship does not exist  408–​9 collusion to mislead the third party into thinking that an agency relationship exists 408 collusion to shield the principal from harmful information  413 collusion to shield principal from tort liability  405–​6 principal-​agent problems  426–​7 insurance 483, 484 principal-​agent relationship  338, 345–​6, 399–​400 private ordering  41, 42 private property  171, 172, 180, 182, 183, 184, 186, 187, 277 privatization 187 of commons  180, 181, 183, 184, 185, 188, 259 probabilistic recoveries  327–​9 products liability  43, 59–​77, 481, 495 contracting over liability  70–​7 contractual liability with informed consumers and complete contracts  69–​70 contractual liability versus tort liability  68–​9 risk-​averse victims  77 when all parties are perfectly informed  60–​1 when consumers cannot observe quality  61–​2 promises, contractual  3, 4–​5, 20, 23, 24, 26, 29 property  148–​77 bundle of rights view  150, 151, 152, 170 common see anticommons; commons entitlements  151, 163–​4, 165–​6 entity property  149, 159, 168, 169–​7 1 full property benchmark  150–​2 incompleteness 153 intellectual see intellectual property ontology for  154–​8 ownership  157–​8, 168, 210

 

572   subject index property (cont.) possession  148–​9, 154, 155, 156–​7 private  171, 172, 180, 182, 183, 184, 186, 187 public 171, 172 salience and convention  154–​6 separation  149, 150, 166, 167, 168, 169, 170, 171, 172 spillovers or externalities  149–​50, 158–​9, 171 standardization 167, 168 state  186–​7 strategic behavior problems  149, 150, 159, 165, 166, 167, 168, 169, 170, 171 as a system  150, 151, 152–​4 property rights  150, 210–​11, 245–​6, 258 extended  168–​72 interconnection problem  168 mixed regimes  171–​2 property rights, delineation of  158–​66 damages versus injunctions  163–​6 exclusion versus governance  158–​9, 170–​1 law versus equity  159–​62 property rule protection  25, 26 n. 13, 28, 309–​13, 314 versus liability rule protection  159, 163, 164, 165–​6 property theory of the corporation  345–​6, 353 proprietorships 341, 342 Protect America’s Energy and Manufacturing Jobs Act (2011)  518 n. 8 Pruitt v Allied Chemical Corp. (1981)  319 n. 9 psychic damages  97 public choice theory  259, 522–​3 public corporations  340, 353, 358 public good(s)  220, 234–​5, 244 n. 9, 257, 261 congestible  260, 261, 269, 271 information as  239–​42, 244, 246, 250 public property  171, 172 publication, open–​access  257, 267–​8, 270–​1 publication (creative works)  211, 212 Publ’ns Int’l, Ltd. v Landoll, Inc. (1998) 228 n. 19 punitive damages  24, 25, 52 n. 9, 59 n. 13, 497 pure economic loss  318–​20 Qualitax Co. v Jacobson Products Co. (1995)  223 n. 10, 227 n. 15, 228 n. 20

Quality-​Adjusted Life Years (QALY)  100, 104–​5 Quora 266 race, and division of household labor  290 rationality failure  426, 437, 442 Ray Farmers Union Elevator Co v Weyrauch (1975) 34 reasonable expectations doctrine  494–​5, 496 reciprocal causation  163 Recycling Coal Combustion Residuals Accessibility Act (2011), US  518 n. 8 Reducing Regulatory Burdens Act (2011), US 518 n. 8 Regional Greenhouse Gas Initiative (RGGI) 530 regulation 41, 42 anticommons 190 commons  180, 183, 185 Regulation Q, US  424 regulatory arbitrage  426, 430 Regulatory Freeze for Jobs Act (2012), US 519 n. 9 regulatory liability  50 relative-​resources model of household labor  284–​5 reliance damages  3, 6, 314 reliance interest  20 remedies  308–​33 disgorgement  24, 25 n., 27, 28, 29 measure of recovery  323–​7 partial recoveries  327–​31 promisee’s incentives  316–​17 property rules and liability rules  309–​13 scope of liability  317–​23 specific performance  7–​8, 23, 24, 25, 27, 28, 29, 32, 33, 36, 38, 313, 314, 315 see also damages renegotiation of contracts  7–​9, 25, 28, 29, 73–​4, 75 renewable energy subsidies  529–​30 respondeat superior  83, 84, 85 Restatement (Second) of Agency  410 Restatement (Second) of Torts  123 Restatement (Third) of Unfair Competition  221 n. 4, 229

 

subject index   573 restitution damages  3, 28 n. 15 restitution interest  20 reverse passing off  221 Rhoades v Walsh (2009)  103 ring-​fencing  432–​4, 440 risk credit 430 market 430 operational 430 risk marginalization  428, 437 risk neutrality  57 risk-​averse victims  57–​8, 77 Risk-​Based Capital (RBC) rules  485 Safe Drinking Water Act (2012), US  516 Sarbanes-​Oxley Act (2002)  367 satisficing 354 savings and loan (S&L) industry  439 Schreiber v Burlington Northern, Inc. (1985) 367 scientific publication, open-​access to  267–​8, 270–​1 securities 426, 427 Securities and Exchange Commission (SEC)  370, 371, 384, 385 n. 23, 386 securitization  424, 430, 434 Seffert v Los Angeles Transit Lines (1961) 98, 110 semicommons 171 separation of ownership and control  170, 340, 346 shadow banking  424, 432, 436, 437, 442 shadow insurance  486 shareholder value theory of corporate purpose  350–​1, 353 Skype 273 small business bankruptcy  472, 473 Smith v Van Gorkam (1985)  363, 364 Snepp v United States (1980)  24 n. 11 social cost of carbon  519–​20 social goods  261 social welfare  41, 44, 45, 51, 53, 58, 65, 66, 77, 80, 308, 314 solidarity goods  251–​2 solvency regulation, in insurance markets  483–​6

solvency requirements  440–​1 Sony Corp. of America v Universal City Studio, Inc. (1984)  249 special damages  103 specific performance remedy  7–​8, 23, 24, 25, 27, 28, 29, 32, 33, 36, 38, 313, 314, 315 specificatio 155 Specified Medical Conditions Matrix  109 Spur Industries, Inc. v Del E. Webb Development Co. (1972)  164–​5, 311 n.3 Stack Overflow  266 stakeholder welfare theory of corporate purpose  350, 351–​1 standard form contracts  71, 72, 75 strict liability  47, 52, 53, 55, 57–​8, 61 n. 16, 501 with contributory negligence  43, 45, 47, 50, 57, 77 and damages  45, 56 employees  79, 80–​1, 82 employers 406 litigation costs and settlement  58, 59 pure 46 see also products liability structured investment vehicles (SICs)  424 subsidies, renewable energy  529–​30 Sullivan v O’Connor (1973)  320 n. 11 sustainable development  511–​12 Sweden bankruptcy 461 pain-​and-​suffering damage schedules  113–​14 systemically important financial institutions (SIFIs) 440, 441 takeover regulation  367–​72, 378–​9, 380, 381, 383, 384 Talmud, the 101 n. 3 TCP/​IP  257, 258, 264, 272–​3 team production theory of the corporation  347–​8, 352, 354 technology patents  193 telecomms anticommons  193 Tennessee, corporate law  372 thing definition  155, 170 thinghood 149 things, possessory  156–​7

 

574   subject index “three times specials” approach  103 time inconsistency of contracts  72, 73–​4 time-​availability model of household labor  285–​7 title, rules of  157, 158 tort  308–​9, 481 apparent agency in  408 standard of care  323–​5 tort liability  41–​95 and compensation  42 n. 2, 323–​5 and deterrence  42 n. 2, 43, 58, 59, 63, 70, 71, 78, 79, 83, 86 foreseeability of losses  317–​18 and information costs  42–​3, 48–​57, 59 n. 12, 60 in market settings  43–​4, 59–​77 nonpecuniary loss  320–​1 pure economic loss  319–​20 and transactions costs  42, 49, 60 versus contractual liability  68–​9 see also accidents between strangers; corporate liability; medical malpractice; organizations, tort liability; products liability; vicarious liability total disability  110 Toxic Release Inventory (TRI)  525 Toxic Substance Control Act (2012), US  516 trade dress  222, 226–​8, 230 trademark protection  201 n. 6, 201 n. 7, 203 n. 13, 205, 220–​38, 249 benefits of trademarks  223–​4 boundaries of  224–​9 continuum of protection for word marks  225–​6 likelihood of confusion standard  221, 222, 228–​9, 234, 236 trade dress and functionality  226–​8 classic trademark law  222–​31, 232 common law foundation of  222, 237 costs of  229–​31 avoidance costs  229–​30 barrier to entry  229 failure to register  230–​1 dilution law  221, 222, 231–​6, 237, 249 blurring and tarnishment  232–​3, 235–​6, 249, 252

boundaries on  233–​4 costs and benefits of  234–​6 and producer goodwill  222, 232–​4, 235–​6 experience goods  224 inspection goods  224 reliance goods  224 tragedy of the anticommons  178, 179, 181–​2, 184, 188–​90, 194, 195, 196–​7 cooperative solutions to  189, 190 game theory approaches to  191 regulatory solutions to  190 tragedy of the commons  150, 155, 171, 178, 180, 182–​3, 190, 245, 258, 263, 277 solutions to cooperation 183, 185 market transactions  180, 183 privatization  180, 181, 183, 184, 185 regulation  180, 183, 185 state coercion  184 transaction costs  42, 49, 60, 150, 151, 152, 153, 163, 164, 170, 267, 399, 400, 511 asymmetric  312–​13 and efficient breach argument  315 and entitlements  309–​10, 311–​12, 312–​13 transactional agency  400, 406 transparency regulation  241 trespass  153, 154, 156, 158, 161, 166, 167 Trustees of Dartmouth College v Woodward (1819) 343 trusts  149, 167, 169, 170 Two Pesos, Inc. v Taco Caban, Inc. (1992) 223 n. 10 Ty Inc. v Perryman (2002)  233 n. 38, 233 n. 43 unconscionability, theory of  161 underuse 185, 187 of common resources see anticommons undisclosed principal  403–​4, 412–​13, 418 liability of agent of  408–​9 liability of  409–​12 unfair competition  220–​1, 222, 237 see also trademark protection Uniform Commercial Code (UCC)  20, 21 n. 2, 24, 27 n. 14 liquidated damages clauses  34, 35–​6, 325 remedy limitations  34, 35 Uniform Partnership Act, US  415, 416

 

subject index   575 unique good contracts  315 unitary model of household functioning  280–​1 “rotten kid” theorem  281 United Kingdom (UK) bankruptcy 448, 473 environmental policy  513 financial regulation  433 limited shareholder liability  341 personal injury damage schedules  112–​13 United Nations Framework Convention on Climate Change (UNFCCC)  528–​9 Univ of Colo Found v Am Cyanamid Co (2003) 25 n. Valu Engineering, Inc. v Rexnord Corp. (2002) 227 n. 18 VaR (value–​at–​risk) model  427 Varnell v Louisiana Tech University (1998)  97 veil piercing, doctrine of  341, 419 Velocity Express Mid–​Atl., Inc. v Hugen (2003) 102 vicarious liability  401, 405–​6 by estoppel  403, 408 for fraud  403, 407–​8 partnership law  417–​19 for physical torts  403, 407 Vickers Report, UK  433 Vioxx 109 n. 10 Volcker Rule  433 W. Bend Mut. Ins. Co. v Arbor Homes LLC (2013) 492 wage garnishment  465–​6, 470, 471 wages

women’s  297–​8, 300–​2 see also pay warranty of authority  412 warranty of merchantability  12–​13, 16 Watteau v Fenwick (1893)  411–​12 welfare economics  510–​11 whaling  156–​7, 162, 189 Wikipedia  257, 265–​7 Williams Act (2010), US  367, 368, 371 willingness to accept (WTA)  101 willingness to pay (WTP)  101–​2 wireless communications  260, 261 unlicensed spectrum  256, 257, 258, 262–​4, 271, 272, 273–​4, 277 women caregiving responsibilities  293 and employment protections see employment protections and household labor  284–​5, 286–​7, 289 and ideal worker paradigm  292, 297 labor force participation  284, 286, 301 wages  297–​8, 300–​2 and work-​life balance  293, 294–​5 see also gender work-​life/​family balance  290, 292–​5 and gender leisure gap  291 preference theory  293, 294–​5 Worker’s Compensation system  100, 105, 110–​11 working hours, full–​time versus part–​time  291–​2 wrongful death  48, 52 n. 8 X–​It Prods, LLC v Walter Kidde Portable Equip, Inc. (2001)  24 n. 11