Legal protection of property rights

The preceding section focused on the assignment of property rights; this is one role of the law. Another is to provide rules that both govern voluntary transfers and provide legal remedies for violations (involuntary transfers) of those rights.

The key distinction between the two rules is that the rightholder’s consent is required for a transfer under a property rule, but consent is not required under a liability rule. The tradeoff is that, on the one hand, consent guaran­tees that any exchanges that occur will be mutually beneficial and therefore efficient, but, on the other, the transaction costs involved in obtaining consent will sometimes be large enough to prevent the completion of otherwise efficient exchanges. This tradeoff suggests that property rules are the pre­ferred remedy when transaction costs are low because they facilitate mutually beneficial bargaining between private parties. In contrast, liability rules may be preferred when transaction costs are high because they allow the court to coerce exchanges when bargaining is not possible. The choice of liability rules in high transaction cost settings is not unqualified, however, because the court is generally not able to observe subjective values, which may result in some inefficient transfers, if, for example, the court sets the wrong damage amount. Thus, the cost of potentially inefficient exchanges under liability rules needs to be weighed against the cost of forgone transactions under property rules.

Controlling externalities trespass, nuisance and regulation

Externalities are a form of involuntary invasion or acquisition of one’s prop­erty rights. The above theory suggests that the law should provide remedies for these invasions so as to resolve them in the most efficient manner. The principal common law remedies for externalities are embodied in the laws of trespass and nuisance. Under trespass, a property owner can seek to enjoin unwanted invasions of his or her property, whereas, under nuisance, a prop­erty owner is entitled to relief (damages or an injunction) only if the harm is substantial and the nuisance-creating activity is judged to be unreasonable (inefficient).

Consistent with the above theory, Merrill (1985) has argued that transac­tion costs broadly explain this distinction. Specifically, he argued that when transaction costs between the parties to the dispute are low, trespass generally governs, whereas when the transaction costs are high, nuisance generally governs. Trespass is efficient when transaction costs are low because, like a property rule, it forces the parties to bargain over the allocation of property rights. In contrast, nuisance is preferred when transaction costs are high because the parties may not be able to resolve the dispute on their own. Thus the court dictates the conditions under which relief is granted by conducting a reasonableness test to determine whether or not the nuisance-creating activity is cost-justified. In doing so, the court in principle imposes a value-enhancing outcome. The case of Boomer v. Atlantic Cement Co. (1970), which con­cerned a cement company that imposed costs on several neighbouring landowners, illustrates the economic argument for choosing a court-imposed damage remedy in externality settings involving high transaction costs be­tween injurers and victims.

Externalities are often resolved, not by trespass and nuisance (private rem­edies), but by direct government regulation (a public remedy). In the same way that the choice between trespass and nuisance can be explained in terms of transaction costs, the decision to use a public rather than a private remedy can also be explained (Ellickson, 1973). In some externality settings, the costs will be dispersed across a large number of victims, as in the case of many types of environmental harms. (Such harms are generally referred to as public nuis­ances.) The problem in these cases is that no one victim may suffer enough harm to justify the cost of pursuing a private remedy, even though the aggre­gate harm exceeds the benefit of the activity (that is, a nuisance suit would have succeeded in obtaining a remedy). In that case, the government acts as an agent of the victims by regulating the offending activity (Landes and Posner, 1987, ch. 2). The justification for government regulation is thus high transaction costs among victims, which precludes a private remedy.

Table 15.1 summarizes the transaction cost argument for choosing among trespass, nuisance and public control. Specifically, it shows that a private

Table 15.1 Optimal remedies for externalities

remedy is preferred when transaction costs among victims are low, and a public remedy is preferred when these costs are high. It also shows that, in the case of a private remedy, trespass is preferred when transaction costs between the injurer and victim(s) are low, and nuisance is preferred when these costs are high.

Government acquisition of rights and compensation

The preceding argument provides an economic justification for the govern­ment’s acting as an agent of private individuals in regulating or acquiring private property from an owner who values the property less than the group collectively. This justification does not, however, explain why the govern­ment has the right to coerce such an exchange rather than having to bargain with the owner. In other words, once the government solves the collective action problem among those seeking a property right by acting as their agent in dealing with the owner of the right, why is the government not required to bargain with the owner for a mutually beneficial exchange?

The answer is that transaction costs between the government and the owner of the property may be high, thereby preventing successful bargaining. This is the economic justification for the government’s power of eminent domain, as shown by the bottom right entry in Table 15.1 (Epstein, 1985; Posner, 2003, p. 55). The typical source of the transaction costs when the government acquires property is the hold-out problem. Consider a situation in which the government is assembling a large number of properties for the purpose of building a public good like a highway. Once the assembly of properties has begun, it becomes very costly to seek an alternative route. Knowledge of this fact confers monopoly power on individual owners whose land is in the path of the project. They therefore have an incentive to hold out for prices in excess of the opportunity cost of their land. This problem (a form of rent seeking) creates the potential for very high transaction costs if the government has to bargain with each owner individually (that is, if each owner has property rule protection). Replacing the owners’ right to consent with a right to compensation (that is, substituting liability rule protection for property rule protection) reduces the transaction costs and allows beneficial public projects to go forward.

This discussion implies that when the government does not face a hold-out problem, it should be required to bargain with individual owners. (This is indicated by the entry labelled ‘market acquisition’ in Table 15.1.) The public use requirement may be one way that the court limits the government’s use of its taking power in such cases (Epstein, 1985). In addition, Fischel notes that eminent domain is ‘self-limiting’ in that, when the hold-out problem is ab­sent, the transaction costs of using the market are generally lower than the cost of using eminent domain (Merrill, 1986a; Fischel, 1995, p. 74).

A transaction cost argument also provides a basis for coercive government regulation (as opposed to acquisitions) of property. Specifically, the transac­tion costs involved in government acquisition of individual property rights that are more valuable to the public than to the owner (for example, the right to engage in land uses that degrade the environment or that threaten an endangered species) will ordinarily preclude acquisition by mutually benefi­cial exchange. Thus landowners do not have the right to block government acquisition of those sticks in their bundle of rights that would impose wide­spread costs on others.

In contrast to physical acquisitions, however, courts have generally not given property owners the right to compensation for these ‘partial acquisi­tions’, except when the reduction in the value of the land is total or substantial. (See Pennsylvania Coal Co. v. Mahon (1922) and Lucas v. South Carolina Coastal Council (1992).) Uncompensated regulations have been justified by courts as legitimate police power actions aimed at protecting public safety and welfare (Mugler v. Kansas, 1887). The problem is that failure to pay compensation creates the threat of over-regulation by the government (Fischel and Shapiro, 1988). At the same time, economists have shown that full compensation for lost value creates a moral hazard problem whereby prop­erty owners ignore the external costs that certain uses of their property may impose, thus causing them to overinvest in those uses (Blume et al., 1984). Economic approaches to the compensation question propose compensation rules that balance these and other factors. (See, for example, Michelman, 1967; Sax, 1964, 1971; Fischel, 1995; Miceli and Segerson, 1996.)