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ilities previously

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'. Since its publi-
ud economists in
?roblem of Social
now a relic, to be
mght. As regards
lomic analysis of
, as I said at the
in economics. In
achievement. If
be helpful in the
llize that it is not
s should "confine
lsk of scholars to
legal doctrines
sorne legitimate
,ase's article The
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Chapter 3
The Economics of Property
A. Introduction
We have already indirectly looked at sorne of the literature on the
economics of property law in our selections on the Coase Theorem. In this
section we shall examine excerpts from articles that deal directly with
property law. Our initial section deals with the most fundamental issues
of property law: which things should be privately owned and which pub-
licly owned or controlled? We then turn to a selection from one of the
most influentiallaw and economics pieces ever written, Guido Calabresi
and A. Douglas Melamed's Property Rules, Liability Rules, and Inalien-
ability: One View ofthe Cathedral and one ofthe articles that the article
inspired. N ext we look at sorne of the literature on the economics of
intellectual property, and finally, we shall examine sorne selections from
the law and economics literature on the governmental taking and regu-
lation of private property.
B. The Economic Foundations
of Property Law
We begin with a classic: The Tragedy of the Commons by Garrett
Hardin. Although this piece was not written by an economist or a lawyer
and was not directly concerned with property or any other legal issue, the
article has become a classic. Professor Hardin's principal concern was the
dire results ofuncontrolled human population growth, "uncontrolled" in
the sense that each individual family was making its own decisions I
about how many children to have without any regard for the costs that
more children might impose on others. The article introduced to a wide
audience the notion of externalities in the memorable phrase ofthe arti-
cle's title.
175
:L'76 LAW AND ECONOMICS ANTHOLOGY
([tarrett Hardin, * The Tragedy of the Commons, 162
:3\CIENCE 1243 (1968)**
[Hardin's address was principally about population control. His principal
point is that (assuming that human population is growing much too fast and
lleeds to be controlled) it would be a terrible mistake to leave decisions about
whether or not to have children and how many to have to individual parents. But
the reason that Hardin makes for not relying upon individual decision-making
npplies to many other social problems, too, as he points out.]
... We can make little progress in working toward optimum population size
llntil we explicitly exorcize the spirit of Adam Smith in the field of practical
clemography. In economic affairs, The Wealth of Nations (1776) popularized the
"invisible hand," the idea that an individual who "intends only his own gain," is,
HE: it were, "led by an invisible hand to promote ... the public interest."
Adam Smith did not assert that this was invariably true, and perhaps nei-
ther did any of his followers. But he contributed to a dominant tendency of
thought that has ever since interfered with positive action based on rational
namely, the tendency to assume that decisions reached individually will,
in fact, be the best decisions for an entire society. Ifthis assumption is correct it
j ustifies the continuance of our present policy of laissez-faire in reproduction. If
it is correct we can as sume that men will control their individual fecundity so as
to produce the optimum population. Ifthe assumption is not correct, we need to
reexamine our individual freedoms to see which ones are defensible. * * *
The tragedy of the commons develops in this way. Picture apasture open to
13.11. It is to be expected that each herdsman will try to keep as many cattle as pos-
sible on the commons. Such an arrangement may work reasonably satisfactorily
br centuries because tribal wars, poaching, and disease keep the numbers ofboth
man and beast well below the carrying capacity of the land. Finally, however,
comes the day of reckoning, that is, the day when the long-desired goal of social
stability becomes a reality. At this point, the inherent logicof the commons
remorselessly generates tragedy.
As a rational being, each herdsman seeks to maximize his gain. Explicitly
or implicitly, more or less consciously, he asks, "What is the utility to me of
adding one more animal to my herd?" This utility has one negative and one pos-
itive component.
(1) The positive component is a function of the increment of one animal.
Since the herdsman receives all the proceeds from the sale ofthe addi-
tional animal, the positive utility is nearly +1.
(2) The negative component is a function ofthe additional overgrazing cre-
ated by one more animal. Since, however, the effects of overgrazing are
shared by all the herdsmen, the negative utility for any particular deci-
sion-making herdsman is only a fraction of-1.
* Garrett Hardin is Professor Emeritus of Human Ecology at the University of California at
Santa Barbara.
** Reprinted with permission from 152 SCIENCE 1243. Copyright 1968, American Associa-
ti on for the Advancement of Science.
Adding toge1
concludes that thE
mal to his herd. Al
by each and every
Each man is lockel
limit-in a world 1
rush, each pursuin,
ofthe commons. Fl
Even at this
ranges demonstrat
pressuring federal i
grazing produces el
continue to suffer f
nations still respon
Professing to
species after specie
The National
tragedy of the com
Plainly, we must so
value to anyone.
What shall we
vate property. We rr.
enter them. The allc
tion system. It migr.
standards. It might 1
administered to
They are all objectio
ofthe eommons that
In a reverse wa
lution. Here it is not
putting something l
water; noxious and di
advertising signs int
same as before. The r
diseharges into the el
releasing them. Sinc.
"fouling our own nest
enterprisers. * * *
nmons, 162
rol. His principal
lUch too fast and
e decisions about
dual parents. But
1 decision-making
m population size
field of practical
;) popularized the
his own gain," is,
interest."
and perhaps nei-
nant tendency of
)ased on rational
. individually will,
tption is correct it
n reproduction. If
al fecundity so as
)rrect, we need to
J.sible. * * *
apasture open to
lany cattle as pos-
lbly satisfactorily
e numbers ofboth
Finally, however,
ired goal of social
of the commons
lS gain. Explicitly
~ utility to me of
ltive and one.pos-
,nt of one animal.
e sale of the addi-
.1 overgrazing cre-
)f overgrazing are
ly particular deci-
ersity of California at
l8, American Associa-
"--.. '-."- __ ._--_._--
CHAPTER 3: THE ECONOMICS OF PROPERTY 17?
Adding together the component partial utilities, the rational herdsman
concludes that the only sensible course for him to pursue is to add another an
mal to his herd. And another; and another .... But this is the conclusion reached
by each and every rational herdsman sharing a commons. Therein is the tragedy.
Each man is locked into a system that compels him to increase his herd without
limit-in a world that is limited. Ruin is the destination toward which aH 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 ....
Even at ths late date, cattlemen leasing national land on the western
ranges demonstrate no more than an ambivalent understanding, in constantly
pressuring federal authorities to increase the head count to the point where overo
grazing produces erosion and weed-dominance. Likewise the oceans of the worlcl
continue to suffer from the survival ofthe philosophy ofthe commons. Maritimn
nations still respond automatically to the shibboleth ofthe "freedom ofthe seas."
Professing to believe in the "inexhaustible resources of the oceans," they bring
species after species of fish and whales closer to extinction.
The National Parks present another instance of the working out of thn
tragedy of the commons. At present, they are open to aH, without limito ...
Plainly, we must soon cease to treat the parks as commons or they will be of no
value to anyone.
What shall we do? We have several options. We might sell them off as pr
vate property. We might keep them as public property, but allocate the right to
enter them. The allocation might be on the basis ofwealth, by the use of an auc
tion system. It might be on the basis of merit, as defined by sorne agreed-upoIl
standards. It might be by lottery. Or it might be on a first-come, first-served basis,
administered to long queues. These, I think, are all the reasonable possibilities.
They are al! objectionable. But we must choose-or acquiesce in the destructioIl
of the commons that we call our N ational Parks. * * *
In a reverse way, the tragedy ofthe commons reappears in problems ofpol ..
lution. Here it is not a question of taking something out of the commons, but oJ
putting something in-sewage, or chemical, radioactive, and heat wastes into
water; noxious and dangerous fumes into the air; and distracting and unpleasani;
advertising signs into the line of sight. The caIculations of utility are much tlw
same as before. The rational man finds that his share of the cost of the wastes h f ~
discharges into the commons is less than the cost of purifying his wastes before
releasing them. Since this is true for everyone, we are locked into a system o:'
"fouling our own nest," so long as we behave only as independent, rational, free ..
enterprisers. * * *
1.78 LAW AND ECONOMICS ANTHOLOGY
The next selection, Property in Land, is one of the most ambitious
attempts to write a comprehensive economic theory of property. Unlike
most prior attempts, Professor Ellickson seeks here to elaborate an "effi-
c:iency thesis," which holds that any society will strcture its definition of
property so as to further the efficient use of resources. The thesis implies
that different societies at the same time or that the same society at dif-
ferent times will re-order its definition of property as technological and
other conditions change. Professor Ellickson's article contains sorne inter-
esting examples of the thesis from widely-different societies. Another
important contribution of the pie ce is that it does not hold that one form
of property rights is always and necessarily the most efficient.
JRobertC. Ellickson,* Property in Land, 102 YALE L.J.
1315 (1993)**
Introduction
Because human beings are fated to live mostly on the surface ofthe earth, the
pattern of entitlements to use land is a central issue in social organization ....
[T]his issue has been the subject of fierce ideological controversy. Blackstone's
paean to private property comports with the mainstream Anglo-American exal-
tation of decentralzed ownership of land. This vision underlies the Homestead
Acts, the Jeffersonian wish for a polity of yeoman farmers, and the American
dream of homeownership. Defenders of private ownership of land argue that it
promotes individuallberty, poltical stability, and economic prosperity. Indeed,
sorne economic historians have identified the emergence of freehold land tenure
in Western Europe after the Dark Ages as a major source of the great release of
energy that ensued there.
To commentators such as Marx and Engels, by contrast, the creation of pri-
vate property in land is a fount of evils, particularly inequality in wealth and the
splntering of more organic communities into atomized, untrusting social envi-
ronments of individual competition. The vision of collective living on shared
land has had a broad and enduring appeal. It has inspired, among others, the
Protestant sectarians, secular kibbutzniks, and counterculture experimentalists
who have founded intentional communities. During the past century, skeptics of
private property in land have come into power in a number ~ f nation-states. In
Israel, where the prevailing philosophy holds that land should belong collectively
to the Jewish nation, 93% ofthe land area is state-owned; the Israel Basic Law
ofLands prohibits the government from transferring any ofit except under spe-
cal crcumstances. * * *
*
Robert C. EIlickson is the Walter E. Meyer Professor ofProperty and Urban Law, Yale Law
School.
** Reprinted by permission ofthe Yale Law Journal Company and Fn,d B. Rothman & Com-
pany from The Yale Law Journal, Vol. 102, pages 1315-1400.
.[T]he Articl
propositions abou
propositions, the
group evolve so a
sions that people
game and play it I
rett Hardin's ana
lage's grazing con
In a seminal
propounded a rela
the efficiency thef
arrangements in
nology, demand, a
cited anthropologi
established exclm
development of th
establishing land J
land regimes evol
same substantive I
knit groups genen
broadly dispersed
one another. By pn
they need to engag
ducive to coopera
a close-knit group,
ciency thesis. Howl
powers others, De
institutions, where
rules are not close]
such as the institut
pose problems for 1
This Article d
Demsetz focused st
human concerns cor.
ity, and community.
I.'
The issue that
of private property
term private propert
posites, the first ore
tions. Coordination
users rises; it is thE
number of persons "
property convention
17
Harold Demsetz
most ambitious
property. U nlike
\laborate an "effi-
its definition of
thesis implies
me society at dif-
technological and
ltains sorne inter-
ocieties. Another
old that one form
ficient.
102 YALE L.J.
face of the earth, the
al organization. . . .
>versy. Blackstone's
19lo-American ex al-
'lies the Homestead
, and the American
,f land argue that it
prosperity. Indeed,
reehold land tenure
the great release of
, the creation ofpri-
ty in wea1th and the
;rusting social envi-
ve living on shared
, among others, the
Lre experimentalists
; century, skeptics of
of nation-states. In
d belong collectively
1.e Israel Basic Law
it except under spe-
md Urban Law, Yale Law
'red B. Rothman & Com-
CHAPTER 3: THE ECONOMICS OF PROPERTY 1 ni
[TJhe Article derives and advances a number of positive and normative
propositions about the evolution ofland regimes. The most general of the positivE;
propositions, the efficiency thesis, asserts that land rules within a close-knil;
group evolve so as to minimize its members' costs. This upbeat proposition envi
sions that people on the ground recognize that property in land is a positive-surn
game and play it cooperatively. For example, this thesis asserts, contrary to Gar
rett Hardin's analysis in the "Tragedy of the Commons," that a traditional vil
lage's grazing commons is unlikely to be tragic.
In a seminal article on the economics of property rights, Harold Demset::
propounded a related hypothesis that should be distinguished at the outset frolTi
the efficiency thesis advanced in this Article.
17
Demsetz theorized that property
arrangements in all societies evolve efficiently in response to changes in techo
nology, demand, and other economic conditions. As his major example, Demset::
cited anthropological evidence that the Indians of Canada's Labrador Peninsula
established exclu.sive hunting territories for fur-bearing animals only after tho
development ofthe commercial fur trade with Europeans had made the costs of
establishing lanq. boundaries worthwhile. Demsetz's hypothesis predicts that all
land regimes evolve in a cost-minimizing direction; this Article embraces
same substantive prediction, but restricts its compass to the land rules that close
knit groups generate. A close-knit group is a social entity within which power ii;
broadly dispersed and members have continuing face-to-face interactions with
one another. By providing members with both the information and opportunitiei;
they need to engage in informal social control, conditions in such groups are con
ducive to cooperation. Because the Labradoran tribe that Demsetz discussed wai;
a close-knit group, that particular example supports both versions of the effi
ciency thesis. However, when a nation-state makes laws, or a strong group overo
powers others, Demsetz's thesis anticipates the emergence of efficient lanel
institutions, whereas this Article does not, because the individuals making tlw
rules are not closely knit with those who must obey them. Historical example:;
su eh as the institution of slavery and Stalin's dispossesson of Ukrainian kulalm
pose problems for Demsetz's thesis but not for the one advanced here.
This Article differs from Demsetz's in another significant respecto While
Demsetz focused strictly on efficiency, the analysis below addresses other vital
human concerns conventionally regarded as non-economic: liberty, privacy, equal-
ity, and community ....
1. The Case for Individual Ownership of Land
The issue that Blackstone and Marx contested-the merits of the institution
of private property in land-warrants the priority they gave t. Because
term prvate property, and its counterpart public property, are both formless coro-
posites, the first order of business is to sharpen the vocabulary of land institu-
tions. Coordination among land users becomes more dfficult as the number of
users rises; it is therefore useful to subclassify land regimes according to
number of persons who own routine privileges to enter and use a parcel.
property conventionally refers to a regime in which no more than a small nurn-
17
Harold Demsetz, Toward a Theory of Property Rights, 57 AM. ECON. REV. 347 (1967).
L80 LAW AND ECONOMICS ANTHOLOGY
b<er of persons have access to a resource. When more than a small number do,
public property is presento * * *
[Professor Ellickson considers two broad categories of property ownership:
)rivate and publico Within private property, he considers two possibilities: indi-
'r.i.dual ownership and household ownership. Under public property, he considers
l;hree possibilities: group ownership (covering between 13 and 1,000 owners),
horde ownership (1,000 to millions), and open-access (all). He then turns to con-
:lideration ofthe efficiency ofthree simple land regimes among a c1ose-knit group
I)f 25 people: open-access, group ownership, and individual ownership. He com-
pares these three regimes with respect to three c1asses of event-small events (a
highly localized event, "such as the cultivation of a tomato plant"), medium events
I "such as the building of a small dam to create a pond in a stream"), and large
Iwents ("such as a fire that emits choking fumes over a wide-ranging area").]
.\. Three Simple Land Regimes
... The rational-actor model assumes that an individual calculatingly pur-
:mes his self-interest. This implies that a member of a social group will be
l;empted at times to undertake a land activity that is individually rewarding but
:;ocially wasteful. Whatever the land regime, an individual's self-interested,
,)pportunistic act will create a deadweight loss whenever the costs it inflicts on
I)thers exceed the individual's benefits from the acto When land is group-owned,
group member may be tempted to grab too many of the parcel's assets, to
pollute the property with wastes, and to shirk from useful work that would
Imhance the land's value. Conversely, when land is individually owned, a self-
jnterested owner may be tempted to use it without regard to the costs and ben-
conferred on neighbors or others. Individuals may be able to reduce
deadweight losses by (1) enforcing existing property rights; (2) transferring
property rights to better managers; or (3) redefining property rghts so as to cre-
ate better-tailored incentives for appropr-atEleconomic activity. Each of these
cesponses, however, would give rise tc(transaction costs. Different land regimes
;;herefore involve different combinationsoilras'action costs ancr'deadweight .
:osses. A change in land rules is efficient when it reduces the sumof these two'
:30rts of costs.
B. Small Events: The Relative Ease of Monitoring Boundaries
L. The Genius of Individual Land Ownership
In his classic work, Demsetz showed that individual ownership ofland com-
Jletely internalizes to owners the effects ofwhat thisArticle callssmall events. In
the parcelization of land is a relatively low-transaction-cost method of
:.nducing people to "do the right thing" with the earth's surface, the vernacular for
;lVoiding deadweight losses. Compared to group ownership, not to mention an
I)pen-access regime, private property tends best to equate the personal product of
an individual's small actions with the social product of those actions. * * *
For three basic reasons, monitoring tends to be cheaper under the individ-
ownership regime[.] First, self-control by one person [] by means ofhis own
nervous system is much simpler than the multiperson coordination
rmtailed in intragroup monitoring. When land uses have no spillover effects, indi-
vidual ownership directly and precisely punishes land misuse and rewards pro-
ductive labor.
Second, indi
instances in whicl
pler when it must
ship is that dete(
than evaluating tb
itoring boundary c
uated inside boun
watchmen ....
Third, DemsE
much more highly
carry out any othe
of any loss stemm:
only a fraction. Th(
monitoring tasks,
conscientious agen
C. Medium
* * * Whenm(
First, besides redu<
is a low-transactio
thereby inclining tI
ership changes sI o'
tinuing multipleJ
cooperation. To be e
so close-knit that tI
be even more intim
degree of close-kni'
evening meetings o
ers in a parcelized :
an occasional exch:
transaction costs aL
likely to be lower w
Parcelization 2
events to those per
versy. Asole owner
diate environment "
In short, for ac
vidual ownership is
imizing the sum of
efficiency thesis, thi
lectivized agricultur
shared by groups a:
lowing private-pro}::
members to own, as
intensive activities.
l small number do,
,roperty ownership:
) possibilities: in di-
)perty, he considers
md 1,000 owners),
~ then turns to con-
g a close-knit group
,wnership. He com-
nt-small events (a
1t"), medium events
stream"), and large
ranging area").]
1 calculatingly pur-
lcial group will be
lally rewarding but
il's self-interested,
~ costs it inflicts on
nd is group-owned,
~ parcel's assets, to
.1 work that would
lally owned, a self-
I the costs and ben-
be able to reduce
;s; (2) transferring
r rights so as to cre-
vity. Each of these
'erent land regimes
ts and; deildweight
e sum of these two
~ s
lership ofland com-
llls small events. In
tion-cost method of
" the vernacular for
not to mention an
personal product of
actions. * * *
, under the individ-
y means of his own
~ r s o n coordination
,illover effects, indi-
e and rewards pro-
CHAPTER 3: THE ECONOMICS OF PROPERTY 18]
Second, individual ownership not only greatly reduces the number 01'
instances in which people have to be watched, but it also makes that task sim
pler when it must be performed .... A key advantage of individualland owner
ship is that detecting the presence of a trespasser is much less demanding
than evaluating the conduct of a person who is privileged to be where he is. Mon
itoring boundary crossings is easier than monitoring the behavior of persons sito
uated inside boundaries. For this reason, managers are paid more than night
watchmen ....
Third, Demsetz has recently pointed out that an individual landowner ii!
much more highly motivated than a group member to police boundaries or to
carry out any other sort of monitoring function. Asole owner bears the entirety
of any loss stemming from his slack oversight, whereas a group member bear:>
only a fraction. The institution ofprivate land ownership thus not only simplifie:;
monitoring tasks, but also tends to ensure that those tasks are in the hands of
conscientious agents. * * *
C. Medium Events: A Simple Way to Promote Cooperative Relations
* * * When medium events are at issue, parcelization has two [advantages.]
First, besides reducing the number of persons who must coordinate, parcelization
is a low-transaction-cost device for knitting these individual s closely togetheJ',
thereby inclining them toward cooperative behavior. In most societies, land OWD-
ership changes slowly. Two adjoining landowners therefore usually enjoya COD-
tinuing multiplex relationship-the sort that is most likely to engende r
cooperation. To be sure, a democratic commune of twenty-five members might b ~
so close-knit that the average twosome ofits members, chosen at random, would
be even more intimate than two adjoining individuallandowners. To achieve that
degree of close-knittedness, however, the group might have to convene regular
evening meetings ofthe entire membership. By contrast, two abutting landown-
ers in a parcelized regime may be able to maintain amicable relations with only
an occasional exchange of pleasantries across their common fence. The suro (,f
transaction costs and deadweight losses arising out ofmedium events is therefore
likely to be lower when land is individually owned.
Parcelization also relegates the settlement of disputes arising out ofmedium
events to those persons most likely to be informed about the matter in contl'(I-
versy. Asole owner of a land parcel is apt to have better knowledge of its immfi-
diate environment than virtually anyone else does. * * *
In short, for activities that result in mostly small and medium events, indl-
vidual ownership is better than both open-access and group ownership for min-
imizing the sum of deadweight los ses and transaction costs. According to tb e
efficiency thesis, this insight explains why family farming is ubiquitous, why col-
lectivized agriculture almost always fails, and why virtually no dwelling units are
shared by groups as large as 25. Indeed, the historical record supports the fol-
lowing private-property thesis: a close-knit group virtually always entitles Ls
members to own, as private property, lands used for dwellings, crops, and OthET
intensive activities.
182 LAW AND ECONOMICS ANTHOLOGY
n. The Advantages of Group Ownership of Land
The discussion up to this point has given short shrift to the merits of group
(and other forms of public) ownership of land. Staying entirely within Dem-
setz's general framework, one can enrich his analysis by explicitly incorporating
t.he possibilities of increasing returns to scale and the desirability of spreading
risks. The histories of sorne famous pioneer settlements, presented in the middle
)f this Part, will illustrate these aspects of land institutions.
A. When Returns Inerease with Pareel Size
Bigger land parcels are sometimes better. As tracts increase in area, the
of fencing and other forms of perimeter monitoring drop per acre enelosed.
'rhis mathematical relationship has prompted many traditional societies to graze
l.ivestock on expansive group-owned pastures. A large territory also permits a
landowner to use more specialized equipment and workers and to marshal gangs
,)fworkers for projects for which returns to scale existo .
1. Efficient Boundaries
Decisions on where to set land boundaries are fiendishly complex because
rnost tracts of land are suited to multiple uses for which scale vary.
Por example, suppose that the optimal territorial scale of the Coase Co11ege
given its educational purposes, is 200 acres. But th optimal scale for
of the oil pool beneath Coase is 7777 acres. And when Coase rents liv-
lng space to a sophomore, an optimal space is a one-half undivded interest in a
150-square-foot dormitory room. Clearly, a single set of all-purpose horizontal
boundary lines cannot be optima11y scaled for a11 purposes. * * *
In societies that commodify land, the boundaries of prvate parcels are
ietermined largely by force s of supply and demando Land rules permitting,
landowners can subdivide existing parcels and assemble separate ones together.
Df course, governments may constrain this contracting process, for better or
worse, with measures such as zoning regulations that set mnimum sizes for
parcels. Loosely speaking, unconstrained markets can be expected to generate
parcels of "middling" size-that is, territorial chunks that are overly large for
sorne activities, too sma11 for others, but not bad on average in light ofthe range
'lnd relativeimportance ofvalued land activities.
Because boundary locations are compromises, landowners can be expected
to develop internal institutions for coordinating more fine-grained activities as
well as external institutions for coordinating matters better handled on a larger
territorial scale. Illustrative internal institutions are a household's system for
allocating private bedrooms and an employer's system for assigning spaces in its
employee parking loto External institutions designed to deter negative spillover
effects ofland activities inelude, for example, norms ofneighborliness, common-
law nuisance rules, and government land-use regulations. * * *
2. Large Events
* * * The case for private ownership of farms and homesteads rests on the
plausible assumption that vital agricultural, construction, homemaking, and
child-rearing activities entail mostly sma11 and medium events. For the reasons
.iust suggested, however, industrial activities that cause local air po11ution might
be better placed I
likely to be grou}
ment ownership,
agencies and Cor
often particularly
ficult to regulate.
bluntly, least badl
the value of histo:
[Professor El
of 1607, the Plyrn
Lake in 1847. "In
after a few years
C. Group Owners.
A sole
ued, or unproduct
individuals are ri
advantageous-ev
As alternativ,
ous other risk-spre
ily or social group
comparison, group
spreading losses. 1
sified, asset. Moreo
less efficiently COil(
group land ownersj
The efficiency
lent in situations l
insurance mechani
faced conditions oJ
doubted. AH three :
months away from :
ineluding raids by
learning how to fan
spreading through
government welfare
selves, and one opt:
member sorne shar
Risk analysis a
lands after a period
disaster and be less
prevent tribal raids
passed, the settlers
such as informal m 1
supported governme
group land ownershi
as the shirking that 1
settlers understandl
and
the merits of group
;irely within Dem-
icitly incorporating
lbility of spreading
mted in the middle
c:rease in area, the
l per acre enclosed.
,il societies to graze
:ory also permits a
d to marshal gangs
y complex because
le efficiencies vary.
the Coase College
e optimal scale for
len Coase rents liv-
ivided interest in a
purpose horizontal
* *
,rivate parcels are
rules permitting,
rate ones together.
.cess, for better or
ninimum sizes for
pected to generate
.re overly large for
'1 lightof the range
~ r s can be expected
ained activities as
Landled on a larger
ehold's system for
19ning spaces in its
, negative spillover
lorliness, common-
~ *
;teads rests on the
homemaking, and
ts. For the reasons
air pollution might
CHAPTER 3: THE ECONOMICS OF PROPERTY 183
be better placed on large tracts which, because of the investment required, are
likely to be group-owned. Group ownership does not necessarily imply govern-
ment ownership, of course. The sorry environmental records of federal land
agencies and Communist regimes are a sharp reminder that governments are
often particularly inept managers of large tracts. Large events are inherently dif-
ficult to regulate. Identifying the institutions that govern them best-or, more
bluntIy, least badly-should be an exercise in experience, not logic. This points up
the value of history. * * *
[Professor Ellickson then gives brief histories of the J amestown settlement
of 1607, the Plymouth settlement of 1620, and the Mormon settlement at Salt
Lake in 1847. "In each case, the settlers initially opted for group ownership, but
after a few years switched to private ownership of intensively used lands."]
C. Group Ownershp as a Rsk-Spreadng Devce
Asole landowner bears the entire risk that his land will be damaged, deval-
ued, or unproductive. Group ownership, by contrast, pools risk. Because most
individuals are risk-averse, the risk-spreading feature of group property is
advantageous-even decisive in certain situations.
As alternatives to group ownership ofproperty, a group may employ numer-
ous other risk-spreading mechanisms, including reciprocal altruism within a fam-
ily or social group, insurance markets, and government welfare programs. In
comparison, group ownership of land is in most contexts a mediocre method 01'
spreading losses. It concentrates group investments in a single, highly undiver-
. sified, asset. Moreover, for reasons presented n Part I, intensive uses are usually
less efficiently conducted on group land than on prvate land, a fact thatmakes
group land ownership a comparatively costly insurance vehicle.
The efficiency thesis predicts that group land ownership will be more preva-
lent in situations in which risks are high and a group cannot employ a superior
insurance mechanism. The settlers of the three pioneer communities initally
faced conditions of precisely this sort. That the risks were acute cannot be
doubted. All three pioneer settlements were remote outposts, located weeks 01
months away from civilization. The first parties of settlers faced lethal dangers,
including raids by Indians, infections from exotic diseases, and difficulties in
learning how to farm in their strange environments. Remoteness precluded risI-!
spreading through multigenerational kinship networks, insurance markets, 01
government welfare programs. The settlers could spread risks only among thern
selves, and one option was to have a collective economy that guaranteed each
member sorne share of total group output.
Risk analysis also suggests why the pioneers would begin to parcelize their
lands after a period of time. Settlers would lower their probability estimates o'
disaster and be less attentive to risk-spreading as they gradually learned how te
prevent tribal raids, avoid disease, and grow crops. Moreover, as the monthE
passed, the settlers could develop more efficient social-insurance mechanism:;
such as informal mutual-aid relatonships, tithe-supported churches, and tax-
supported governments. In sum, after a few years, the risk-spreading benefits ni"
group land ownership would no longer outweigh its familiar shortcomings, sucb
as the shirking that notably afflicted Jamestown and Plymouth. At that pont, th
settlers understandably would switch to prvate land tenure, the system tha1
l84 LAW AND ECONOMICS ANTHOLOGY
most cheaply induces individuals to accomplish small and medium events that
alCe socially useful. * * *
II!. Parceling Land Among Owners: Liberty,
Privacy, Equality, and Community
To most observers, land policy involves much more than the seemingly
blloodless considerations of cost-minimization and risk-spreading. The analysis so
far misses, or at least submerges, why land tenure is an issue that sends people
. off to the barricades and into utopian experiments. Land rules literally set the
physical platform for social and political institutions. Economists themselves
agree that the evaluation of a land regime must go beyond its possible contribu-
l;ions to material well-being.
Commentators who unite in urging a broader inquiry are likely to dis-
;lgree, however, on the identity of the other normative criteria to be considered.
Classicalliberals, for example, regard private property in land as an essential
mstrument for promoting political freedom, privacy, and self-determination. On
the other hand, communitarians doubt ifhumans can flourish in atomized social
Communitarians value multi-stranded and enduring social rela-
bionships, something that group ownership of land can plausibly be thought to
Joster. Most communitarians are also egalitarians. Group ownership promises to
help reduce differences in individuals' wealth and possibly in their status and
power as well. An egalitarian may view individualland ownership not only as a
of material inequality, but also as a system that enables haves to build
rnansions that flaunt their successes to the have-nots. In practice, a human
gToup must make tradeoffs between individual liberty and privacy on the one
hand and community and equality on the other. Land tenure is a major battle-
ground on which this conflict is resolved.
An overview of sorne notable communes will provide context for discussion
of these aspects of land regimes. A commune is a residential settlement that is not
kinship based and includes at least a dozen adults. Although a commune may
allocate dwelling units to its members for their exclusive use, it carries out agri-
cultural, industrial, and construction activities on group land that it governs
through participatory processes. * * *
[Professor Ellickson compares Hutterite colonies in the' American Great
Plains and Israeli kibbutzim as examples of intentional communes that sought
to institute group ownership land schemes.J .
B. Systems of Governance of Group Land Activities
These two communal systems have had far more staying power than other
intentional communities that have dotted the sweep of American history. An
overview ofmethods of group governance can help reveal why the Hutterites and
kibbutzniks have been relatively successful at perpetuating their institutions.
1. Hierarchy or Democracy?
When many people use the same piece of land, tragedies of shirking and
grabbing lurk. A group may of course be able to devise internal institutions for
coping with these problems, but, at least according to the analysis in this Article
up to this point, these mechanisms are likely to be far more costly than the sim-
ple monitoring systems associated with individualland ownership. From a trans-
action-cost persI
evening
dishes in the sin
There are n
of group land. A
governance. At tl
chief executive.
nance systems ir
ily housing. Ha
competitive witb
pletely horno gen
members have h
to a manager wh
with selfish inte:
control to a hien
keep managers r
2. Governance 01
This backgr
munards face. To
hierarchical gove:
racy. As noted, tb
kibbutzim meet ,
time-consuming 1
readily circulate i
and summarily E
ostracism, and ex
The surviva:
organized group :
industrial and COl
with shirking, th
Has this be el
of inculcating com
tual1y cooperate i
appears indeed t
proved to be less
hundreds of years
with their intrusi
Hansmann's
regimes to which
member heterogeI
ernance. The Hutt
end. Both generall
all h:mseholds get
form quality. Tedi,
assigned
abroad). U sing sel
steps poltical bai
ment). These strOl
~ d i u m events that
an the seemingly
19. The analysis so
that sends people
lS lterally set the
mists themselves
possible contri bu-
are lkely to dis-
1 to be considered.
ld as an essential
letermination.On
in atomized social
luring social rela-
ibly be thought to
lrship promises to
1 their status and
ship not only as a
:es haves to build
ractice, a human
rivacy on the one
is a major battle-
,ext for discussion
;lement that is not
. a commune may
t carries out agri-
d that it governs
! American Great
LUnes that sought
power than other
rican history. An
he Hutterites and
le ir institutions.
s of shirking and
11 institutions for
'sis in this Article
,tly than the sim-
p. From a trans-
CHAPTER 3: THE ECONOMICS OF PROPERTY 185
action-cost perspective, a commune faces a choice between the Scylla of endless
evening meetings and the Charybdis of an ever-increasing pile of unwashed
dishes in the sink.
There are many mechanisms for governing behavior within the boundaries
of group land. A commune by definition chooses the mechanism of participatory
goveinance. At the opposite pole les hierarchical governance by an autonomous
chief executive. Henry Hansmann has fruitfully compared these two gover-
nance systems in the land-related arenas ofbusiness enterprise and multifam-
ily housing. Hansmann concludes that participatory governance is most
competitive with hierarchical governance when members of a group have com-
pletely homogeneous interests (as corporate shareholders generally do). When
members have heterogeneous interests, they are more likely to delegate power
to a manager who is able to act expeditiously and resist lobbying by members
with selfish interests. A member may be especially amenable to relinquishing
control to a hierarchy in a context where the threat of members' exits helps to
keep managers responsive. * * *
2. Governance of Communes
This background helps highlight the organizational difficulties that com-
munards face. To be true to their egalitarian ideals, they must be willing to forego
hierarchical governance and to bear the transaction costs of participatory democ-
racy. As noted, the Hutterites hold plenary meetings on a daily basis, and most
kibbutzim meet weekly. Both groups prefer to reach decisions by consensus, a
time-consuming process. Because their meetings are frequent, the members can
readily circulate information about individuals' pro-social and antisocial conduct,
and summarily administer organizational sanctions such as negative gossip,
ostracism, and expulsion.
The survival of the Hutterites and kibbutzim indicates that a voluntarily
organized group may indeed succeed in cooperatively conducting agricultural,
industrial and construction activities on common land. Rather than being beset
with shirking, the settlements of both groups are generally beehives of activity.
Has this been the triumph of a self-enforcing ideology? Utopians may dream
ofinculcating communitarian norms ever more deeply so that communards even-
tually cooperate n the absence of third-party monitoring and sanctioning. Th
appears indeed to be a dream. In the kibbutzim, the second generation h3.E
proved to be less ideologically committed than the founding generation. After
hundreds of years of socialzation, the Hutterites have not been able to dispense
with their intrusive methods of social control.
Hansmann's analysis suggests that, to compete with other land-tenure
regimes to which its members might exit, a commune would strive to reducE
member heterogeneity, and thereby reduce the transaction costs of internal gov
ernance. The Hutterites and kibbutzniks both employ a number of (levices to thiE
end. Both generally distribute consumer goods on an all-or-nothing basis; eithm
all households get an item, or none do. Efforts are made to keep housing of uni
form qualty. Tedious tasks are likely to be rotated among members (or, in kih
butzim, assigned to nonmembers such as Arabs or youthful volunteers froID
abroad). Using seniority or rotation rules to allocate leadership positions side
steps poltical battles (although it may also lead to les s competent manage
ment). These strongly egalitarian policies increase homogeneity, but at a price.
186 LAW AND ECONOMICS ANTHOLOGY
I'he absence of material incentives increases the need for pervasive controls
against shirking, and may prompt the most skillful workers to consider pursuing
greater rewards outside the commune.
To stem exodus, long-lasting communes require a member who departs, vol-
llntarily or as a result of expulsion, to forfeit aH, or almost aH, ofhis claim to the
group's joint assets-the social-insurance policy to which he may have con-
tributed for years. By deterring exit, this forfeiture policy encourages members
to make more conscientious use of voice in shaping community policy. Locking
members together also materiaHy motivates members to monitor each other.
When group output is shared, the ground for a culture ofwatchfulness has been
30wn. * * *
[The intentional communes, when measured by survivorship criteria, have
not fared well. Most communes disappear within a few years of their founding.
Moreover, Professor Ellickson points out that it is almost unheard of for neigh-
boring parcel-owners to give up individual ownership in favor of group ownership
like that in an intentional commune. "It is most unlikely--indeed, possibly
llnprecedented-for a handful of unrelated households on contiguous private
parcels to make the Platonic move ofvoluntarily merging their lands and house-
holds to form an intentional commune."]
IV. Standard Bundles of Land Rights: Of Fees and Usufructs
Decisions about other features of land regimes are as momentous as the
C!hoice between private and group entities as owners. A group that is willing to
recognize private property in land must decide what standard bundle of rights to
~ o n f e r on a meritorious occupier of a part of its territory. By recognizing a stan-
dard land bundle, a group can simplify its members' interactions and transac-
tions. * * *
A. A "Blackstonian" Bundle of Land Entitlements
* * * "Blackstonian" can serve as a shorthand to denote a pristine package
)f private entitlements in land that involves:






ownership by a single individual ("that sole and despotic dominion
which one man claims ... ")
in perpetuity
of a territory demarcated horizontally by boundaries drawn upon the
land, and extending from there verticaHy downward to the depths of the
earth and upward to the heavens
with absolute rights to exclude would-be entrants
with absolute privileges to use and abuse the land, and
with absolute powers to transfer the whole (or any part carved out by
use, space, or time) by sale, gift, devise, descent, or otherwise.
Sorne parts of this Blackstonian package are far too draconian to function
even as initial default rules that landowners could be empowered to modify. In
practice, Anglo-American custom and law have generated the fee simple, a stan-
dard bundle of private land rights that is far more nuanced than the pure Black-
stonian package .... This Part takes up the surprisingly complex issues of how
a group might decide to locate the vertical and temporal boundaries of its stan-
dard private land interests. * * *
C. Time Spans (
Both the fel
son ownershi p ri
tival sophisticat:
Historically, the
medium tempon
ited interest on 1
basically entitlei
Other aspects of
sic usufruct can
not transferable
use, at which tirr.
short standard b
also usufructs, t:
blanket spread o
Temporal tr
costs or deadwei,
costs of adminis
eliminate this pa
land sales, but l
jockey for positio
sorts of admin
bundling of land
2. The Usufruct:
In a post-lit
rior to usufructs :
of usufructs tenc
mere usufructua:
exhaust its soils t
porary owners to
N evertheles
prevailed in preh
ducted on a class
ticularly pertine
long-term improv
less reason to prc
society, because i
manent alterati01
time span of own
recognize perpetu
in part on the ext
Second and l
arable land is SCl
short-sighted lanl
rights.
Third, illitel
interests must dE
pervasive controls
consider pursuing
r who departs, vol-
of his claim to the
1.e may have con-
;ourages members
ity policy. Locking
onitor each other.
:hfulness has been
ship criteria, have
of their founding.
leard of for neigh-
f group ownership
-indeed, possibly
ontiguous private
lands and house-
Tsufructs
nomentous as the
. that is willing to
bundle of rights to
a stan-
ions and transac-
l pristine package
espotic dominion
; drawn upon the
, the depths of the
ld
art carved out by
;herwise.
onian to function
to modify. In
ee simple, a stan-
n the pure Black-
,lex issues of how
iaries of its stan-
CHAPTER 3: THE ECONOMICS OF PROPERTY 18!
C. Time Spans of Standard Land Interests
Both the fee simple and the Blackstonian bundle confer upon a mortal pero
son ownership rights that last in perpetuity. Hewing to a commitment to adjec
tival sophistication, let us call the fee an example of a long standard time span.
Historically, the usufruct has been the most important standard land bundle of
medium temporallength. Sorne preliterate groups have bestowed this time-limo
ited interest on a member household growing a crop on group lands. A usufruct
basically entitles its owner to continue his current land use as long as he can.
Other aspects ofusufructuary packages may vary. To simplify discussion, a clas
sic usufruct can be defined as an immutable package ofland-use rights that am
not transferable and that terminate when the usufruct's owner die s or ceases thn
use, at which time the land is again up for grabs among group members. Finally,
short standard bundles of land rights which last no more than a few hours are
also usufructs, typically carved out of public lands such as parks and streets. 11.
blanket spread on the sand of a state beach creates an interest of this sort.
Temporal transitions in land ownership invariably entail either transaction
costs or deadweight losses. Ownership in fee simple, for example, increases
costs of administering the estates of deceased landowners. Classic usufruct:;
eliminate this particular administrative burden and also the transaction costs of
land sales, but may stimulate wasteful rent-seeking as would-be successom
jockey for position in a usufruct's late stages. The relative magnitudes of
sorts of administrative costs are predicted to influence a group's standard
bundling of land rights. * * *
2. The Usufruct: Some Aduantages of Standard Bundles of Medium Length
In a post-literate society, perpetual private land rights are gene rally supe-
rior to usufructs for governing intensive activities such as crop-growng. Owner:;
of usufructs tend to be more short-sighted than owners of fees. A farmer with
mere usufructuary rights in a field is unlikely to clear stones froni it, and may
exhaust its soils too quickly. Empirical studies confirm that usufructs tempt tem-
porary owners to under-invest and to overexploit.
Nevertheless, in certain narrow circumstances, including those that likely
prevailed in prehistoric times, intensive activities may be more efficiently con-
ducted on a classic usufruct than on afee. Three situational variables are pa.r-
ticularly pertinent. First, sorne lands are more susceptible than others tr)
long-term improvement or damage. The more immutable a parcel ofland is, the
less reason to provide its owner with an infinite planning horizon. A preliterate
society, because it has less capacity than an industrialized society to make per-
manent alterations in land, is more likely to employ the usufruct as its standad
time span of ownership. Similarly, whether international organzations shoul:i
recognize perpetualland rights on the Moon or Antarctica's ice-pack should tum
in part on the extent to which these lands are developable and destructible.
Second and relatedly, usufructs for crop-growing are problematic only when
arable land is scarce. When land is plentiful, a group need not be troubled by
short-sighted land practices and uncertainties about succession to usufructuary
rights.
Third, illiteracy breeds usufructs. A group that recognizes perpetualland
interests must develop authoritative systems for proving title to lands whose
:L:38 LAW AND ECONOMICS ANTHOLOGY
Dwners are not currently in possession. A preliterate group may have trouble
tracking titles and may prefer the usufructuary system under which, apart from
trespassing, what you see is what is hado
Consistent with the efficiency thesis, as land becomes scarcer, technology
advances, and literacy improves, a group tends to move away from the classic
u:mfruct and toward the fee. A classic usufruct leads to short-sighted land use not
it limits the owner's time-span ofpossession, but because it fails to iden-
l;ify the successor owner (or owners) until the current pos ses sor has abandoned
bis use. When a successor owner exists, that person is motivated to induce the
I:urrent occupant to consider the long-term value of the parcel. When a tenant
(armer cultivates crops, for example, the lessor holding the reversion has con-
l;ractual and other means of prompting the farmer to take into account the
of farming activities on the value of the lessor's future interest. The evo-
Lutionary way-stations along the path from the classic usufruct to the fee there-
:'ore typica11y involve reforms that serve to identify the owner to fo11ow the
Gurrent one. Many preliterate groups, for example, permit a usufruct to descend
;0 kin whenthe current user dies. By creating potentia11y infinite rights, say in
;1 matrimonialline, this reform cures the classic usufruct's failure to designate an
1gent motivated to act in behalf of future generations. A group can also extend
lsufructuary owners' time horizons by making usufructs alienable. Fina11y, a
.5TOUP capable of acting as a corporate body can designate itself as the successor
,)wner in the event of a usufruct's abandonment. This reform has the effect both
,)f introducing the possibility of bargaining between the group and the current
llser to prevent waste, and also of reducing the likelihood that would-be succes-
30rs will battle when a usufruct terminates.
3. The Fee Simple: The Advantages of Perpetual Land Ownership
As they modernize, however, most close-knit groups move beyond these
mtermediate reforms a11 the way to an institution rather like the fee simple.
Although economic historians have only recently begun to give the fee its due,
Blackstone was able to articulate many of its benefits two centuries ago. Per-
petual ownership rights greatly simplify land-security transactions. But the
preeminent advantage of an infinite land interest is that it is a low-transaction
::ost device for inducing a mortal landowner to conserve natural resources for
future generations.
Although the assertion may seem counterintuitive, the key to land conser-
vation is to bestow upon living persons property rights that extend perpetually
into the future. The current market value of a fee in Blackacre is the discounted
present value ofthe eternal stream ofrights and duties that attach to Blackacre.
A rational and self-interested fee owner therefore adopts an infinite planning hori-
zon when considering how to use his parcel, and is spurred to insta11 cost-justified
permanent improvements and to avoid premature exploitation of resources. The
fee simple in land cleverly harnesses human selfishness to the cause of altruism
toward the unborn, a group not noted for its poltical clout or bargaining power.
An illustration may help convince the skeptical. Suppose that Mae, a self-
ish 80-year old without a bequest motive, owns a house in the Hollywood Hills in
fee simple. Mae is considering installing a screening room that would last, with
luck, for centuries. In making her decision, would Mae consider the room's ben-
efits that would accrue after her death? If private property rights are transfer-
able[,] Mae cou:
dotage. Althoug
and can convey 1
such as Rock, w]
sidering the pun
when it carne t:
younger). By ini
Rock not only b
would add to th
Mae, Rock, and
easy to see that
imagining Demi
and on and on. 1:
into Rock's bid. 1:
Mae would have
value ofits rema
Throughout
that perpetual pl
a preliterate soci
is increasingly lil
homesites upon 1
honor a variety
descendible only
once it develops
unending private
and Greece, two I
tlements on priva
itable. And when
settlers received i
emphatically not
potentially infinil
Nigeria, and the :
ciencies of perpetu
on every continen
V. T:
Any standar
ground are likely 1
usufruct was imml
components. The 1
owner by and laq
impossible to exa
divide-along dim
rights with which
from another p,ersj
purposes. The grOl
those that confer 1
owners from exces
may have trouble
which, apart frorri
carcer, technology
ly from the classic
ghted land use not
use it fails to iden-
;or has abandoned
ated to induce the
el. When a tenant
reversion has con-
: into account the
interest. The evo-
ct to the fee there-
mer to follow the
sufruct to descend
lnite rights, say in
lre to designate an
lp can also extend
lenable. FinaUy, a
lf as the successor
ias the effect both
.p and the current
t would-be succes-
ship
.ove beyond these
:ce the fee simple.
ve the fee its due,
,mturies ago. Per-
sactions. But the
a low-transaction
ural resources for
ey to land con ser-
xtend perpetually
l is the discounted
tach to Blackacre.
:lte planning hori-
lstall cost-justified
l of resources. The
cause of altruism
largaining power.
l that Mae, a self-
-Iollywood Hills in
t would last, with
ar the room's ben-
ghts are transfer-
CHAPTER 3: THE ECONOMICS OF PROPERTY 1 8 ~ )
able[,] Mae could sell her house at any time and use the proceeds during her
dotage. Although she does not expect to live much longer, Mae has a fee simplE:
and can convey perpetual rights. She might well be able to find a younger buyer,
such as Rock, who could enjoy the screening room for several decades. When con.
sidering the purchase, Rock would recognize that this room would be a sales asseL
when it carne time for him to unload the house, say to Demi (someone stil1
younger). By installing the room, Mae would therefore elicit a higher bid from
Rock not only because he could enjoy the facility himself, but also because it
would add to the house's resale value. So far, the screening room's benefits te,
Mae, Rock, and Demi have been capitalized into the house's market value; it ,
easy to see that the same calculations continue in infinite regress, with Rock
imagining Demi taking into account resale value to persons currentIy unborn,
and on and on. In short, benefits and costs from he re to eternity are capitalizec,
into Rock's bid. If the screening room were to be cost-justified over the long haul,
Mae would have an incentive to build it, because she could reap the capitalizec,
value of its remaining net benefits when she sold the house.
Throughout history, many close-knit agricultural groups have recognized
that perpetual private ownership makes for better land stewardship. As land in
a preliterate society becomes scarcer and its economic development advances, it
is increasingly likely to confer potentially infinite entitlements in croplands and
homesites upon kinship lines. Especially until a group masters literacy, it may
honor a variety of non-Blackstonian rules, such as that private parcels are
descendible only to kin, inalienable to outsiders, and forfeitable for nonuse. BuL
once it develops a written language, a group will almost invariably recognizE
unending private rights in sorne ofits lands. For example, the ancients in Egypt
and Greece, two ,cradles of Western civilization, conferred perpetual land enti.
tlements on private owners. In medieval England, farmers' copyholds were inher-
itable. And when private plots were parceled out at Jamestown and Plymouth,
settlers received infinitely long interests. Perpetual private land rights are most
emphatically not a uniquely Western institution, however. Land interests 01'
potentially infinite duration evolved separately among the Japanese, the Ibo oi'
Nigeria, and the Navajo of the American Southwest. In sum, the inherent effi-
ciencies of perpetual private land rights have led to their spontaneous appearance
on every continent.
V. Tailoring Land Interests by Contract and Practice
Any standard bundle of land rights is inherently crude; people on the
ground are likely to want to be able to configure their own packages. The classic
usufruct was immutable because its owner lacked the power to transfer any ofits
components. The fee simple, by contrast, is a default bundle of rights, which its
owner by and large is free to modify by contract, gift, will, or otherwise. It is
impossible to exaggerate how frequently private owners of fee interests do
divide-along dimensions of space, function, and time-the packages of land
rights with which they start. Many of these same modifications can be viewecl,
from another perspective, as efforts to aggregate neighboring parcels for speciaI
purposes. The group rules that govern owners' customization ofland bundles are
those that confer powers to alienate partial interests and those that constrain
owners from excessive decomposition and aggregation. This Article's efficiency
190 LAW AND ECONOMICS ANTHOLOGY
j.hesis predicts that, within a close-knit group, utilitarian considerations ulti-
mately determine the content of these rules. * * *
VI. Alienability of Land Interests
The seemingly technical question of whether land can be bought and sold
li'9s at the core of social organization. The prior discussion has assumed that an
owner possesses an unfettered power to alienate an interest in land by sale, gift,
Ol' mortgage while alive, and by will or descent at death. In many societies the
J'eality is more complexo * * *
Blackstone concisely stated the basic rationale for consensual alienability of
1 and: "[I]t was found that what became inconvenient or useless to one man was
highly convenient and useful to another .... Thus mutual convenience introduced
c:ommercial traffic, and the reciprocal transfer of property by sale." Alienability
has significant advantages beyond engendering gains from trade. As the exarn-
pIe involving Mae illustrated, even afee owner who laeks a bequest motive will
adopt an infinite planning horizon if she has the power to sello The power to mort-
which is essentially a conditional promise to transfer, rnay enable an indi-
',idual with little capital to acquire land and help a current landowner to obtain
credit on favorable terms. * * *
Although alienability generally enhances efficiency of Iand use, group-
jmposed restraints on alienation are defensible when they bar a transfer that
'l\Tould harrn others more than it benefits the parties to the transaction. For
a preliterate group with abundant land might understandably restrict
l;ransfer of village land. Because of internal kinship ties, most of a village's cur-
residents would have in effect offered up their relatives as "hostages," a fact
l;hat would help ensure that the residents would cooperate, say, in defending the
village against enemies. An outsider who acquired land in a village, by con-
lTast, would be less likely to have kin there and therefore would not be as reliably
:oyal. By prohibiting or regulating land sales to strangers, a village can help
Imsure its future close-knittedness.
Modernity, however, fosters alienability. As literacy and engineering
advance, human groups can organize state criminal-justice systems and develop
other social control s ofbroad territorial reach. These innovations make villagers
ess fearful of raids, and better able to screen newcomers and sanction them after
';hey have proven to be uncooperative fly-by-nights. Additionally, land becomes
more valuable as population rises, and this scarcity increases the opportunity
of barring transfers to abler land managers. As groups modernize, they
therefore tend not only to lengthen their standard time-spans ofland ownership,
but also to relax traditional restrictions on transfer. * * *
VII. The Inevitability of a Network of Public Lands
Even nations steadfastly committed to private property allocate a significant
fraction of their territory to streets, sidewalks, parks, and other sites that are
broadly accessible. [T]he economic case for group creation of a network of public
lands is overwhelming. Public, it must be stressed, is not used he re to connote
government ownership, but rather to describe situations in which privileges of
aecess are widely shared. AlI analysts now agree that it is important to distin-
guish, as Hardin did not, between open-access territories that anyone may enter
and tracts that ;
licensees. Exam
fields, village c
streets; and hOI
residents are ac
2. Priuileges to
If decentn
counted on to g
group simply COI
themselves acro
age crops, comn
would underrniI
with which a pe
of an entrant's 1
motion detecton
In practiee,
to a prvate own
ations. The effici
ilege to enter pr
privilege would
These situations
tively value entr:
entry; (2) the ere
inerease a lando'
ditions such as el
for the landowllE
entry. * * *
It should ne
than one would
[E]ven in societie
territories are se'
And then new fe
lands. Human gre
ship together, but
ciency thesis ass.
highly diverse an
Too often, the
reaction. Sorne ob
Marx, have bE
to be more pragml
oped here.
The central p
creat.e, through cu
nsiderations ulti-
~ bought and sold
: assumed that an
land by sale, gift,
lany societies the
,ual alienability of
:s to one man was
nience introduced
;ale." Alienability
ideo As the exam-
quest motive will
'he power to mort-
ly enable an indi-
ldowner to obtain
land use, group-
lr a transfer that
transaction. For
:tandably restrict
of a village's cur-
"hostages," a fact
; in defending the
1 village, by eon-
not be as reliably
village can help
and engineering
tems and develop
ns make villagers
nction them after
lly, land becomes
; the opportunity
modernize, they
fland ownership,
rrds
lcate a significant
ler sites that are
rretwork of public
1 here to connote
b.ich privileges of
Jortant to distin-
lnyone may enter
),
CHAPTER 3: THE ECONOMICS OF PROPERTY 191
and tracts that are accessible only to the members of a limited populace and thel'
licensees. Examples ofthe latter inelude: group-owned lands, such as Hutterites'
fields, village commonses for grazing, and a homeowner association's private
streets; and horde-owned lands, such as a town beach to which only the town'E:
residents are admitted. * * *
2. Privileges to Cross Private Land Without its Owner's Consent
If decentralized negotiations between Blackstonian neighbors cannot bE
counted on to generate an efficient transportation network, why shouldn't a.
group simply confer on its members reciprocal and routine privileges to transpori;
themselves acr08S all private land? The reason is manifest: entrants may dam.
age crops, commit thefts, and do other mischief. Reciprocal rights of passage
would undermine the basic virtue of parcelization, namely, the relative eaSE
with which a person can monitor boundary crossings, as opposed to the quality
of an entrant's behavior. If privileges of passage were routine, guard dogs an.
motion detectors would lose most of their usefulness.
In practice, societies with private property in land do make sorne exceptiom,
to a private owner's general right to exelude, but only in carefully cabined situ.
ations. The efficiency thesis predicts that a trespasser would be granted a privo
ilege to enter private land without consent only in circumstances in which t h E ~
privilege would reduce the sum of deadweight los ses and transaction costs
These situations would be those in which: (1) the would-be entrant would objec ..
tively value entry far more than the landowner would objectively suffer from thE'
entry; (2) the creation of a limited privilege to trespass would not significantly
increase a landowner's general burdens of monitoring boundaries; and (3) con ..
ditions such as emergency or physical distance would make it unusually difficulL .
for the landowner and would-be entrant to negotiate a license or easement oi'
entry. * * *
VIII. The Eclectic Reality of Land Regimes
It should now be evident that actualland systems are far more nuanced.
than one would anticipate from reading armchair philosophies of property
[E]ven in societies nominally committed to private property in land, significant
territories are set aside for streets, parks, playgrounds, and other public uses.
And then new forms of temporary private property emerge on these public
lands. Human groups not only opportunistically mix public and private owner.
ship together, but also vary initial bundles ofrights and transfer rules. The effi.,
ciency thesis asserts that a common maximization principIe underlies thesE
highly diverse arrangements. * * *
Conclusion
Too often, the notion of private property in land has prompted a monolithilc
reaction. Sorne observers, like Blackstone, have been overly boosterish. Others,
like Marx, have been unpardonably hostile. Most contemporary scholars appellLI'
to be more pragmatic and should concur with many of the central themes devel.
oped here.
The central positive thesis ofthis Artiele is that a elose-knit group tends te,
create, through custom and law, a cost-minimizing land regime that adaptively
192 LAW AND ECONOMICS ANTHOLOGY
responds to changes in risk, technology, demand, and other economic conditions.
[11. so doing, the group opportunistically mixes private, group, and open-access
lands. According to the private-property thesis, a close-knit group virtually
invariably entitles its individual members, households, or narrow family lines to
obtain exclusive rights to sites suitable for dwellings, agriculture, and other
intensive uses. The key utilitarian advantage of private land tenure, in compar-
iBon to collective ownership, is that it is far simpler to monitor boundary cross-
ings than to appraise the behavior ofindividuals who are privileged to be where
they are. The Hutterites, kibbutzniks, and others who have succeeded in collec-
tively governing intensive land activities have endured only by developing inter-
nal social controls far more pervasive and intrusive than those required where
land is parcelized.
As a group becomes literate and its lands become more scarce, its standard
bundle of private land rights tends to evolve from the time-limited and inalien-
able usufruct to something like the perpetual and alienable fee simple. * * *
But a private-property regime is not always best. To exploit scale economies,
and perhaps to spread risks, a group may gravitate toward governing sorne ter-
ritories, such as a pasture in a medieval village or a recreation are a in a home-
Dwners' association, as limited-access commonses. Finally, the public-property
thesis asserts that a g ~ o u p invariably embeds its private parcels in an open-
access network of public lands that is dedicated to general circulation and social
interaction. * * *
Notes and Questions
1. How would technological advances in surveying and fencing alter the
costs of marking, defending, and proving boundaries? Would this lead to
more or less parcelization?
2. Professor Ellickson argues that most pioneer settlements initially adopt a
system of group ownership as a risk-spreading device but that as those
risks diminish they switched to a system of individual ownership. As we
have seen, group ownership is likely to be less efficient than individual own-
ership. Some historians have attributed the early inefficiencies in
Jamestown to a "culture of idleness" among the settlers. (They are alleged
to have bowled in the streets while they starved.) Professor Ellickson
argues that there is historical evidence that it was not culture but the inef-
ficiencies of group ownership that accounted for the low agricultural out-
put in Jamestown. In 1609 a ship bound for Jamestown from England was
blown off course and settled in Bermuda instead. Because the risks in
Bermuda were so much less, there was no compelling need to adopt
group ownership. So, the settlers there more quickly turned to individual
ownership: twenty-five acre plots to each member. Agricultural output
was much higher and more stable in Bermuda than in Jamestown, until,
seven years after its founding, Jamestown turned to individual ownership.
3. Professor Ellickson pursues some of the themes of this piece in ORDER
WITHOUT LAw (1991) and in An Hypothesis of Wealth-Maximizing Norms: Evi-
dence from the Whaling Industry, 5 J. LAW, ECON. & ORG. 83 (1989).
c. The Ej
ofPro
Guido'Cah
Rules, LialJ
of,the Cath
* * * The fir
the problem of "e:
interests of two o
which side to favo
will be decided (
shrewder will wir
of the conflicting 1
versus the entitle
tlement to brean
tlement to forbid
Havingmad,
ting the entitleml
mum of state intE
this easy to com p:
The state no
neously make a SE
go to the manner
vidual is allowed 1
pIe, the state mus'
to grant. It is wit
relationship betwc
cerned. We shall c
property rules, en
ments. * * *
An entitleme
who wishes to rerr.
voluntary transad
seller. 1 t is the for
* Guido Calabr
cuit and Sterling Profe:
was a student of Judge
in the early 19705. Mr.
sion, U.S. Department
** Calabresi and
fessor Harry Wellingto
only one of Monet's pal
all ofthem."
*** Copyright 1
:onomic conditions.
p, and open-access
Lit group virtually
TOW family lines to
culture, and other
tenure, in compar-
or boundary eros s-
rileged to be where
ucceeded in collec-
y developing inter-
Ise required where
caree, its standard
mited and inalien-
ee simple. * * *
lit scale economies,
)Verning sorne ter-
m area in a home-
le public-property
3.rcels in an open-
and social
fencing alter the
Nould this lead to
ts initially adopt a
but that as those
)wnership. As we
:in individual own-
inefficiencies in
(They are alleged
:>fessor Ellickson
i1ture but the inef-
'1 agricultural out-
:rom England was
ause the risks in
9 need te adopt
'ned te individual
output
Jamestown, until,
idual ewnership.
s piece in ORDER
1izing Norms: Evi-
83 (1989).
CHAPTER 3: THE ECONOMICS OF PROPERTY
c. The Efficient Enforcement
of Property Rights
Guido Calabresi & A. Douglas Melamed, * PropertJ
'
Rules, Liability Rules, and Inalienability: One View
ofthe Cathedral, ** 85 IIARv. L. REV. 1089 (1972)***
* * * The first issue which must be faced by any legal system is one we call
the problem of "entitlement." Whenever a state is presented with the conflicting
interests of two or more people, or two or more groups of people, it must
which si de to favor. Absent such a decision, access to goods, services, and life itself
will be decided on the basis of "might makes right"-whoever is stronger
shrewder will win. Hence the fundamental thing that law does is to decide which
of the conflicting parties wiIl be entitled to prevail. The entitlement to make
versus the entitlement to have silence, the entitlement to pollute versus the enti-
tlement to breathe clean air, the entitlement to have children versus the enti-
tlement to forbid them-these are the first order oflegal decisions.
Having made its initial choice, society must enforce that choice. Simply set-
ting the entitlement does not avoid the problem of "might makes right"; a mini-
mum of state intervention is always necessary. Our conventional notions
this easy to comprehend with respect to private property. * * *
The state not only has to decide whom to entitle, but it must also simulta-
neously make a series of equaIly difficult second order decisions. These decisioll:3
go to the manner in which entitlements are protected and to whether an indi-
vidual is aIlowed to seIl or trade the entitlement. In any given dispute, for exam-
pIe, the state must decide not only which side wins but also the kind of protectioll
to grant. It is with the latter decisions, decisions which shape the subsequent
relationship between the winner and the loser, that this article is primarily con-
cerned. We shall consider three types of entitlements-entitlements protected by
property rules, entitlements protected by liability rules, and inalienable entitle-
ments. * * *
An entitlement is protected by a property rule to the extent that someone
who wishes to remove the entitlement from its holder must buy it from him in ,3.
voluntary transaction in which the value ofthe entitlement is agreed upon by the
seller. It is the form of entitlement which gives rise to the least amount of state
* Guido Calabresi is now a Judge of the United States Court of Appeals for the Second CiJ'-
cuit and Sterling Professor Emeritus and a former Dean ofthe Yale Law School. A. Douglas Melamed
was a student of Judge Calabresi at the Harvard Law School while Judge Cal abre si was visiting thme
in the early 1970s. Mr. Melamed is now Principal Deputy AssistantAttorney General, Antitrust DivI-
sion, U.S. Department of Justice.
** Calabresi and Melamed explain the title ofthe piece in an early footnote as fol!ows: "As Pro-
fes sor Harry Wellington is fond of saying about many discussions of law, this article is meant to be
only one ofMonet's paintings ofthe Cathedral at Rouen. To understand the Cathedral one must !,ee
al! ofthem."
*** Copyright 1972 by the Harvard Law Review Association. Reprinted with permission.
:lB4 LAW AND ECONOMICS ANTHOLOGY
intervention: once the original entitlement is decided upon, the state does not try
1;(1 decide its value. It lets each of the parties say how much the entitlement is
'North to him and gives the seller a veto if the buyer does not offer enough.
J?roperty rules involve a collective decision as to who is to be given an initial enti-
dement but not as to the value of the entitlement.
Whenever someone may destroy the initial entitlement ifhe is willing to pay
an objectively determined value for it, an entitlement is protected by a liability
::ule. This value may be what it is thought the original holder of the entitlement
would have sold it foro But the holder's complaint that he would have demanded
::nore will not avail him once the objectively determined value is seto Obviously, lia-
bility rules involve an additional stage of state intervention: not only are entitle-
ments protected, but their transfer or destruction is allowed on the basis of a value
determined by sorne organ of the state rather than by the parties themselves.
An entitlement is inalienable to the extent that its transfer is not permitted
between a willing buyer and a willing seller. The state intervenes not only to
ietermine who is initially entitled and to determine the compensation that must
be paid if the entitlement is taken or destroyed, but also to forbid its sale under
sorne or all circumstances. Inalienability rules are thus quite different from
property and liability rules. Unlike those rules, rules of inalienability not only
"protect" the entitlement, they may also be viewed as limiting br regulating the
grant of the entitlement itself.
It should be clear that most entitlements to most goods are mixed. Taney's
house may be protected by a property rule in situations where Marshall wishes
to purchase it, by a liability rule where the government decides to take it by emi-
nent domain, and by a rule of inalienability in situations where Taney is drunk
or incompetent. This article will explore two primary questions: (1) In what cir-
cumstances should we grant a particular entitlement? And (2) In what circum-
stances should we decide to protect that entitlement by using a property, liability,
or inalienability rule? * * *
Whenever society chooses an initial entitlement it must also determine
whether to protect the entitlement by property rules, by liability rules, or by rules
ofinalienability. In our framework, much ofwhat is gene rally called private prop-
erty can be viewed as an entitlement which is protected by a property rule. N o
one can take the entitlement to private property from the holder unless the
holder sells it willingly and at the price at which he subjectively values the prop-
erty. Yet a nuisance with sufficient public utility to avoid injunction has, in
effect, the right to take property with compensation. In such a circumstance the
entitlement to the property is protected only by what we call a liability rule: an
external, objective standard ofvalue is used to facilitate the transfer ofthe enti-
tlement from the holder to the nuisance. Finally, in sorne instances we will not
allow the sale of the property at all, that is we will occasionally make the enti-
tlement inalienable. * * *
Why cannot a society simply decide on the basis of the already mentioned
criteria who should receive any given entitlement, and then let its transfer
occur only through a voluntary negotiation? Why, in other words, cannot society
limit itself to the property rule? To do this it would need only to protect and
enforce the initial entitlements from all attacks, perhaps through criminal sanc-
tions, and to enforce voluntary contracts for their transfer. Why do we need lia-
bility rules at all?
In terms of
cost of establishi
that even thougl
a transfer will n<
instead, the benl
Eminent do
owned by 1,000 I
a neighboring to
willing to pay ar.
owners of the tra
than $10,000,00C
parcels are all t
assumption, the
gone it costs $8,(
well not be estab
in order to get a E
pay over the valu
be more than $1C
to hide their truE
An equally'
sellers of Guidacl
tives and at a far
all losers). It doe
each of 100,000 ci
free-load and say
enough others wi
Again there is no
ing, will cause PE
which all in fact ~
Whenevertb
a property rule to
uation of each tra
holdout problem i
ual citizen's desin
the freeloader pro
the compensation
Of course, tb
at all sure than l ~
is worth $12,000 t
$10,000 does notl:
land. As a result,
actually sell for, e
practice, it is so h,
simply gives him
that this may rest
The example
which society uses
state does not try
he entitlement is
rlot offer enough.
'en an initial enti-
.e is willing to pay
:ted by a liability
}f the entitlement
d have demanded
;et. Obviously, lia-
t only are entitle-
h.e basis of a value
.es themselves.
r is not permitted
yenes not only to
1.sation that must
bid its sale under
te different from
3nability not only
or regulating the
re mixed. Taney's
i MarshaH wishes
to take it by emi-
re Taney is drunk
. s: (1) In what cir-
) In what circum-
property, liability,
;t also determine
r rules, or by rules
llled private prop-
property rule. No
10lder unless the
y values the prop-
njunction has, in
circumstance the
lliability rule: an
ansfer ofthe enti-
;ances we will not
]y make the enti-
lready mentioned
n let its transfer
ds, cannot society
lly to protect and
19h criminal sanc-
ly do we need lia-
CHAPTER 3: THE ECONOMICS OF PROPERTY 195
In terms of economic efficiency the reason is easy enough to see. Often the
cost of establishing the value of an initial entitlement by negotiation is so great
that even though a transfer of the entitlement would benefit all concerned, such
a transfer will not occur. If a collective determination of the value were available
instead, the beneficial transfer would quickly come about.
Eminent domain is a good example. A park where Guidacres, a tract ofland
owned by 1,000 owners in 1,000 parcels, now sits would, let us assume, benefit
a neighboring town enough so that 100,000 citizens of the town would each be
willing to pay an average of $100 to have it. The park is Pareto desirable if the
owners ofthe tracts ofland in Guidacres actually value their entitlements at less
than $10,000,000 or an average of $10,000 a tracto Let us assume that in fact the
parcels are all the same and all the owners value them at $8,000. On this
assumption, the park is, in economic efficiency terms, desirable-in values fore-
gone it costs $8,000,000 and is worth $10,000,000 to the buyers. And yet it may
well not be established. If enough of the owners hold out for more than $10,000
in order to get a share of the $2,000,000 that they guess the buyers are willing to
pay over the value which the sellers in actuality attach, the price demanded will
be more than $10,000,000 and no park will resulto The sellers have an incentive
to hide their true valuation and the market will not succeed in establishing it.
An equally valid example could be made on the buying side. Suppose the
seHers of Guidacres have agreed to a sales price of $8,000,000 (they are aH rela-
tives and at a family banquet decided that trying to hold out would leave them
aH losers). It does not follow that the buyers can raise that much even though
each of 100,000 citizens in fact values the part at $100. Sorne citizens may try to
free-load and say the park is only worth $50 or even nothing to them, hoping that
enough others will admit to a higher desire and make up the $8,000,000 price .
Again there is no'reason to believe that a market, a decentralized system ofvalu-
ing, will cauSe people to express their true valuations and hence yield results
which all in fact agree are desirable.
Whenever this is the case an argument can readily be made for moving froID
a property rule to a liability rule. If society can remove from the market the val-
uation of each tract ofland, decide the value collectively, and impose it, then the
holdout problem is gone. Similarly, if society can value collectively each individ-
ual citizen's desire to have a park and charge him a "benefits" tax based upon it,
the freeloader problem is gone. If the sum of the taxes is greater than the sum of
the compensation awards, the park will resulto * * *
Of course, the problems with liability rules are equally real. We cannot be
at all sure than landowner Taney is lying or holding out when he says his land
is worth $12,000 to him. The fact that several neighbors sold identical tracts for
$10,000 does not help us very much; Taney may be sentimentally attached to his
land. As a result, eminent domain may grossly undervalue what Taney would
actually sell for, even if it sought to give him his true valuation of his tracto In
practice, it is so hard to determine Taney's true valuation that eminent domain
simply gives him what the land is worth "objectively," in the full knowledge
that this may result in over or under compensation. * * *
The example of eminent domain is simply one of numerous instances in
which society uses liability rules. Accidents is another. Ifwe were to give victims
196 LAW AND ECONOMICS ANTHOLOGY
a property entitlement not to be accidenta11y injured we would have to require a11
who engage in activities that may injure individuals to negotiate with them
before an accident, and to buy the right to knock off an arm or a lego Such pre-
accident negotiations would be extremely expensive, often prohibitively so. To
require them would thus prec1ude many activities that might, in fact, be worth
having. And, after an accident, the loser of the arm or leg can always very plau-
sibly deny that he would have sold it at the price the buyer would have offered.
Indeed, where negotiations after an accident do occur-for instance pretrial set-
tlements-it is largely because the alternative is the collective valuation of the
9lamages. * * * .
It is enough for our purposes to note that a very common reason, perhaps
the most common one, for employing a liability rule rather than a property rule
to protect an entitlement is that market valuation of the entitlement is deemed
nefficent, that s, it s ether unavailable or too expensive compared to a col-
lective valuation.
We should also recognize that efficiency is not the sole ground for employ-
ing liability rules rather than property rules. Just as the initial entitlement is
often decided upon for distributional reasons, so too the choice of a liability rule
is often made because it facilitates a combination of efficiency and distributive
results whch would be difficult to achieve under a property rule. * * *
Thus far we have focused on the questons ofwhen society should protect an
entitlement by property or liability rules. However, there remain many entitle-
ments which involve a still greater degree of societal intervention: the law not
only decides who is to own something and what price is to be paid for it if it is
taken or destroyed, but also regulates its sale-by, for example, prescribing pre-
conditions for a valid sale or forbidding a sale altogether. Although these rules of
inalienablity are substantially different from the property and liability rules,
their use can be analyzed in terms of the same efficiency and distributional
goals that underlie the use of the other two rules.
While at first glance efficiency objectives may seem undermined by limita-
tions on the ability to engage in transactions, closer analysis suggests that there
are instances, perhaps many, in which economic efficiency is more closely approx-
imated by such limitations. This might occur when a transaction would create sig-
nificant externalities-costs to third parties.
For instance, if Taney were allowed to sell his land to Chase, a polluter, he
would injure his neighbor Marsha11 by lowering the value of Marshall's land. Con-
ceivably, Marshall could pay Taney not to sell his land; but, because there are
many injured Marshalls, freeloader and information costs make such transactions
practica11y impossible. The state could protect the Marsha11s and yet facilitate the
sale of the land by giving the Marshalls an entitlement to prevent Taney's sale to
Chase but only protecting the entitlement by a liability rule. It might, for
instance, charge an excise tax on a11 sales ofland to po11uters equal to its estimate
of the external cost to the Marshalls of the sale. But where there are so many
injured Marsha11s that the price required under the liability rule is likely to be
high enough so that no one would be willing to pay it, then setting up the
machinery for collective valuation will be wasteful. Barring the sale to polluters
will be the most efficient result because it is clear that avodng po11ution is
cheaper than paying its costs-including its costs to the Marsha11s.
Another in:
when external CI
acceptably objec1
one category of ~
lead us to rules c
If Taney is
becoming pennill
Marshall is a se
persons who die
Taney not to sell
shall is not one bl
transactions pra
intervene by obj
Chase to pay tha1
to an acceptable (
In the case (
priate because w.
benefits to Chase
would come out, 1
hypothesis, out (
external costs to :
tion that gave ris
There are tw
under certain circ
of the first are VI
rights so that t h ~
which they deem 1
sense paternalisn
the notion that m
what is best for hi
in the long run ra'
ing up sorne ShOl
require certain co
it may help explaJ
tracts entered into
ably does not full}
True paterna
tions and those of
of activities by mi:
situations the Ma:
off. Here we are n(
to read pornograpl
Taney was not in
choice for ero tic a (
Finally, just a
ability, so, of cours.
or not often affech
of ba l:>ies makes pi
who t;hrough sorne
L have to require all
with them
or a lego Such pre-
)rohibitively so. To
Lt, in fact, be worth
1 always very plau-
",ould have offered.
stance pretrial set-
ve valuation of the
reason, perhaps
lan a property rule
itlement is deemed
compared to a col-
ground for employ-
itial entitlement is
:e of a liability rule
cy and distributive
rule. * * *
y should protect an
nain many entitle-
mtion: the law not
e paid for it if it is
Le, prescribing pre-
ough these rules of
and liability mIes,
and distributional
ermined by limita-
mggests that there
Lore closely approx-
m would create sig-
lase, a polluter, he
3.rshall's land. Con-
because there are
e such transactions
ld yet facilitate the
Tent Taney's sale to
It might, for
:}ual to its estimate
there are so many
rule is likely to be
.en setting up the
le sale to polluters
oiding pollution is
shalls.
CHAPTER 3: THE ECONOMICS OF PROPERTY 197
Another instance in which external costs may justify inalienability OCCUTE
when external costs do not lend themselves to collective measurement which E
acceptably objective and nonarbitrary. This nonmonetizability is characteristic ol"
one category of external costs which, as a practical matter, seems frequently to
lead us to rules ofinalienability. Such external costs are often called moralisms.
If Taney isallowed to sell himself into slavery, or to take undue risks 01'
becoming penniless, or to sell a kidney, Marshall may be harmed, simply becaUSE
Marshall is a sensitive man who is made unhappy by seeing slaves, paupers, o)'
persons who die because they have sold a kidney. Again Marshall could pay
Taney not to sell his freedom to Chase the slaveowner; but again, because Mar-
shall is not one but many individuals, freeloader and information costs make sucb
transactions practically impossible. Again, it might seem that the state could
intervene by objectively valuing the external cost to Marshall and requiring
Chase to pay that costo But sin ce the external cost to Marshall does not lend itself
to an acceptable objective measurement, such liability rules are not appropriate.
In the case ofTaney selling land to Chase, the polluter, they were inappro.
priate because we knew that the costs to Taney and the Marshalls exceeded thE
benefits to Chase. Rere, though we are not certain of how a cost-benefit analysiE
would come out, liability rules are inappropriate because any monetization is, by
hypothesis, out of the question. The state must, therefore, either ignore thE
external costs to Marshall, or if it judges them great enough, forbid the transac
tion that gave rise to them by making Taney's freedom inalienable. * * *
There are two other efficiency reasons for forbidding the sale of entitlementE
under certain circumstances: self paternalism and true paternalism. Examplm,
of the first are Ulysses tying himself to the mast or individuals passing a bill 01'
rights so that they will be prevented from yielding to momentary temptatiom
which they deem harmful to themselves. This type of limitation is not in any real
sense paternalism. It is fully consistent with Pareto efficiency criteria, based OL
the notion that over the mas s of cases no one knows better than the individual
what is best for him or her. It merely allows the individual to choose what is besi
in the long run rather than in the short run, even though that choice entails giv
ing up sorne short run freedom of choice. Self paternalism may cause us te
require certain conditions to exist before we allow a sale of an entitlement; ane.
it may help explain many situations of inalienability, like the invalidity of con
tracts entered into when drunk, or under undue influence or coercion. But it proh
ably does not fully explain even these.
True paternalism brings us a step further toward explaining such prohib
tions and those ofbroader kinds-for example the prohibitions on a whole rangE
of activities by minors. Paternalism is based on the notion that at least in somE:
situations the Marshalls know better than Taney what will make Taney better
off. Rere we are not talking about the offense to Marshall from Taney's choosing'
to read pornography, or selling himselfinto slavery, but rather the judgment that.
Taney was not in the position to choose best for himself when he made th E
choice for erotica or servitude. * * *
Finally, just as efficiency goals sometimes dictate the use of rules of inalien
ability, so, of course, do distributional goals. Whether an entitlement may be sol .
or not often affects directly who is richer and who is poorer. Prohibiting the salE
of babies makes poorer those who can cheaply produce babies and richer thOSf:
who through sorne nonmarket device get free an "unwanted" baby. Prohibiting
198 LAW AND ECONOMICS ANTHOLOGY
exculpatory clauses in product sales makes richer those who were injured by a
product defect and poorer those who were not injured and who paid more for the
product because the exculpatory clause was forbidden. Favoring the specific
group that has benefited may or may not have been the reason for the prohibition
nn bargaining. What is important is that, regardless ofthe reason for barring a
contract, a group did gain from the prohibition. * * *
[Calabresi and Melamed summarize their discussion as proposing four
rules for assigning and enforcing an entitlement. They consider the nuisance-pol-
lution problem in which Taney is the polluter and Marshall is the pollutee.
Under Rule One, "Taney may not pollute unless his neighbor Chis only neighbor
let us as sume), Marshall, allows it (Marshall may enjoin Taney's nuisance)." This
is an entitlement to Marshall to be free from pollution protected by a property
rule. Under Rule Two, "Taney may pollute but must compensate Marshall for
damages caused (nuisance is found but the remedy is limited to damages.)." This
is an entitlement to Marshall to be free from pollution protected by a liability
rule. Under Rule Three, "Taney may pollute at will and can only be stopped by
Marshall if Marshall pays him off (Taney's pollution is not held to be a nuisance
to Marshall)." This is an entitlement to Taney to pollute protected by a property
rule. Finally, they consider Rule Four, under which Taney has an entitlement to
pollute but that entitlement is protect only by a liability rule: "Marshall may stop
Taney from polluting, but ifhe does he must compensate Taney." Calabresi and
Melamed point out that this rule has gene rally been ignored in the literature and
is extremely difficult to implement judicially.]
Notes and Questions
'1. Another important early reaction to the Calabresi-Melamed article was A.
Mitchell POlinsky, Resolving Nuisance Disputes: The Simple Economics of
Injunctive and Damage Remedies, 32 STAN. L. REV. 107 (1980). Polinsky
argued that Calabresi and Melamed failed to give due weight to the fact
that it is costly to the court to assess the level of damages owed to the
property-owner whose entitlement has been infringed. In fact, it is possi-
ble that those assessment costs are higher than the transaction costs
facing the disputants. If so, then it may be more efficient to use a property
rule than a liability rule. In short, the conventional application of Calabresi-
Melamed compares high transaction costs with an implicitly-assumed
zero damages-assessment costs and, therefore, mistakenly recommends
liability rules over property rules where the choice may be far more difficult.
2. Recently, James Krier and Stewart Schwab, in Property Rules and Labl-
ity Rules: The Cathedral in Another Lght, 70 N.Y.U. L. REV. 440 (1995), have
extended the Polinsky criticism of the common understanding of the Cal-
abresi-Melamed article. The YALE LAW JOURNAL published a symposium
issue on Calabresi-Melamed in 1997 in celebration of the 25th anniversary
of the article's publication.
3. See also Louis Kaplow & Steven Shavell, Property Rules Versus Lablty
Rules: An Economic Analysis, 109 HARV. L. REV. 713 (1996); David D. Had-
dock, Fred
Rationale f(
4. In Prices al
extends thE
tinction bet
hibit and wr
The third 1
Calabresi-Melal
the Calabresi-lY.
and liability rul
the next excerp
sought to corre<
mean restrictiOl
to another and s
(or other consid
the owner's rigr
SusanRose
of Property .
Inalienabilit
note the
dismiss them as o
Calabresi and DOl
theory of entitlem
to paternalism an
On inspectiOl
cept, and one who
combined with a
zenshi p and distri
on the transferabi
ability is pervasivE
the historical past
fuller analysis wou
nomic and sociallij
possible types of r
sorne of thesecons
*
Susan Rose-A
** This article or
- -------- -------------_._---------- ------
o were injured by a
10 paid more for the
lvoring the specific
[l for the prohibition
:eason for barring a
. as proposing four
er the nuisance-pol-
.aH is the pollutee.
r Chis only neighbor
nuisance)." This
ected by a property
msate Marshall for
to damages.)." This
;ected by a liability
only be stopped by
;)ld to be a nUlsance
;ected by a property
lS an entitlement to
"Marshall may stop
ney." Calabresi and
n the literature and
lmed article was A.
'11ple Economics of
)7 (1980). Polinsky
i weight to the fact
nages owed to the
In fact, it is possi-
. transaction costs
1t to use a property
:ation of Calabresi-
mplicitly-assumed
kenly recommends
)e far more difficult.
y Rules and Labil-
:v. 440 (1995), have
tanding of the Cal-
;hed a symposium
le 25th anniversary
les Versus Lability
96); David D. Had-
CHAPTER 3: THE ECONOMICS OF PROPERTY
dock, Fred S. McChesney & Menahem Spiegel, An Ordinary Economic
Rationa/e for Extraordinary Legal Sanctions, 78 CALlF. L. REV. 1 (1990).
4. In Prices and Sanctions, 84 COLUM. L. REV. 1523 (1984), Robert D. Cooter
extends the Calabresi-Melamed framework to an explanation of the dis-
tinction between wrongs that society seeks to "price" correctly but not pro-
hibit and wrongs that society wishes to prohibit through criminal sanctions .
The third possibility for the protection of property entitlements in
Calabresi-Melamed framework is "inalienability." Most of the literature on
the Calabresi-Melamed article has focused on the choice between property
and liability rules. Inalienability has not received the same attention. In
the next excerpt Professor Susan Rose-Ackerman ofthe Yale Law School
sought to correct this lack of attention. She interpreted inalienability to
mean restrictions on the owner's ability to sell or give his or her propert:r
to another and sought to explain the circumstances under which efficienc:r
Cor other considerations) would be increased by imposing restrictions on
the owner's right to dispose of his or her property as he chose.
Susan Rose-Ackerman, * Inalienability and the
of Property Rights, 85 COLUM. L. REV. 931 (1985)**
Inalienability is the stepchild of law and economics. Too often, economists
note the existence of restrictions on transferability, ownership, and use, only to
dismiss them as obviously inefficient constraints on market trades. Even Guido
Calabresi and Douglas Melamed, who give inalienability explicit status in their
theory of treat it as an analytic stepchild to be justified by appeals
to paternalism and moralism.
On inspection, however, inalienability turns out to be a very complex cor.-
cept, and one whose legitimate uses can be clarified through economic analynis
combined with a sensitivity to noneconomic ideas-most notably ideals of cit.-
zenship and distributive justice. Inalienability can be defined as any restrictio [l
on the transferability, ownership, or use of an entitlement. So defined, inalier.-
ability is pervasive in modern, developed societies, in developing nations, and irl
the historical pasto The variety and ubiquity ofthese restrictions suggest that a
fuller analysis would help us better understand the role ofprivate property in eco-
nomic and sociallife. This Article begins such an analysis by first categorizing the
possible types of restrictions, and then developing rationales that may justilfy
sorne of these constraints on prvate ownership. * * *
>1< Susan Rose-Ackerman is Professor of Law and Political Science at Yale U niversity.
>1<>1< This article originally appeared at 85 COLUM. L. REV. 931 (1985). Reprinted with permissi')J\.
2:00 LAW AND ECONOMICS ANTHOLOGY
[Professor Rose-Ackerman offers a taxonomy ofinalienability rules, ranged
along a spectrum. At one extreme is a "pure property rule," under which all vol-
untary transactions are permitted. At the other extreme is a rule of "pure inalien-
ability," undE;:lr which no sale or gift ofthe entitlement is allowed, as is the case with
human slavery. In between these extremes is, for example, a "modified property
rule," under which only sales, generally at market prices, are allowed, but with
restrictions (such as no sale or gift of property prior to bankruptcy). Another inter-
mediate rule is "modified inalienability," which outlaws sales but allows gifts (as
with body parts and babies). What Professor Rose-Ackerman seeks to explain is
where and why certain goods and services should be put on this spectrum.J
The objectives of this Article are primarily normative. I do not attempt to
explain why any particular legal restriction was enacted into law. Instead, I ask
whether plausible justifications can be given for sorne frequently obse'rved legal
patterns. This Part concentrates on three broad normative claims. First, the
existence of transaction costs will frequently make a simple system of property-
liability rules inefficient, so that more restrictive regulations such as inalienability
rules may have merito Second, distributive goals cannot always be achieved by
simple lump sum transfers but may require more intrusive policies. Third, even
when inalienability rules are justified on efficiency grounds, compensation may be
required to avoid imposing concentrated costs on particular individual s or groups.
The efficiency rationales for inalienability rules are second-best responses
to market failures that arise because of externalities, imperfections in informa-
tion, or difficulties of coordination. The straightforward responses of internaliz-
ing the externality through fees or taxes, of subsidizing the provision of
information, and of facilitating joint action may, for one reason or another, be
costly. In such cases, the alternative of restricting market trades becomes a
realistic possibility. Instead of correcting the market failure through policies that
rely on price incentives and market processes, inalienability rules address the dif-
ficulty with a set of prohibited or required actions that make market incentives
less, rather than more, important. I consider each of the three types of market
failure in turno
Externalities figure prominently in discussions of market failure and pro-
vide the most commonly recognized rationale for inalienability rules. Production
and consumption externalities occur when the profits offirms or the satisfaction
levels of individuals are affected by transactions in which they are not directly
involved. These third parties would be willing to pay to obtain the benefits or to
avoid the harms imposed on them, but because they are not part of the transac-
tion, benefits are too low and costs are too high. For example, in the absence of
regulation, a factory may create water pollution as part of its production process
because it need not account for the harm caused by pollution. Economists gen-
erally seek to control externalities by creating market-like incentives through tax
and subsidy schemes that encourage firms and individuals to respond to marginal
shifts in costs and benefits. Economic analysts have also recognized that other
alternatives that involve the definition or rearrangement of property rights may
be equally satisfactory. Thus, externality problems may be sol ved by "internal-
izing" them or by providing "separate facilities" solutions. Under the former, a
single individual is given title to both the property causing the externality and
che property affected by it. So long as this does not create monopoly power, the
new owner wiIl have an incentive to behave efficiently. Under the latter, property
relations are real
who would suffer
UnfortunatE
transaction costs
can most efficien
taxes and subsidi
or inadequate inJ
will be room for I
strong statistical
uct and an extern
in particular caSE
uals may not be ,
tion ofthe class oJ
external costs ma:
from using the p
externalities can
and traffic signals
ligent behavior.
Markets als<
asymmetrical. Th
ognized, rationalE
information asyrn
quality sellers car
may be a general
when two produc1
cannot. For exam}
after a set date b
expect suppliers fr
the legal category
other policy is un<
not sales-may re
Finally, diffi
inefficiently. This
externalities, but 1
arate category. Th
public goods-urb
group. No one ha
because the suppli
fits. Outlawing sal
retaining consider
is the "prisoner's d
absence of coerciOl
problem of coordin
is better off if othel
first settler. To all
tions such as a req
order to perfect th
More narrowl
tunistic behavior o
Jility rules, ranged
nder which all vol-
de of "pure inalien-
, as is the case with
"modified property
! allowed, but with
tcy). Another inter-
but allows gifts (as
seeks to explain is
lS spectrum.]
do not attempt to
law. Instead, I ask
ltly observed legal
claims. First, the
ystem of property-
ch as inalienability
lyS be achieved by
)licies. Third, even
npensation may be
.ividuals or groups.
md-best responses
!ctions in informa-
illses of internaliz-
. the provision of
son or another, be
trades becomes a
rough plicies that
les address the dif-
market incentives
!e types of market
st failure and pro-
T rules. Production
or the satisfaction
ey are not directly
1 the benefits or to
art of the transac-
, in the absence of
)roduction process
l. Economists gen-
ntives through tax
!spond to marginal
)gnized that other
'operty rights may
,lved by "internal-
nder the former, a
le externality and
illopoly power, the
he latter, property
-- ------------ -----
CHAPTER 3: THE ECONOMICS OF PROPERTY 20]
relations are rearranged so that externality producers are separated from thoso
who would suffer from the externality.
Unfortunately, optimality may be difficult to achieve in a world with high
transaction costs. Even a tort law system that places liability on the person who
can most efficiently reduce the harm may not be effective in all situations, ancl
taxes and subsidies may be difficult to implement because of political opposition
or inadequate information. In the second-best world faced by regulators, then)
will be room direct regulation of behavior. For example, suppose there is H
strong statistical relationship between sorne characteristic ofthe user of a prod-
uct and an external cost. Ex post, however, causation may be difficult to establish
in particular cases. Moreover, even if causation can be established, the individ-
uals may not be wealthy enough to pay the claims against them. If a large por-
tion of the class of individuals is involved, then the most effective way of reducin!;
external costs may be to prevent the entire group (e.g., blind people and children)
from using the product (e.g., driving an automobile). Similarly, other types of
externalities can be prevented by regulating the use of a producto Speed limit:3
and traffic signals control driving over and aboye tort law rules that penalize neg-
ligent behavior.
Markets also frequently work poorly because information is imperfect and
asymmetrical. This kind of market failure provides a second, and less widely rec-
ognized, rationale for inalienability rules in particular contexts. First, conside r
information asymmetries. If buyers are unaware of product defects, then high
quality sellers cannot command higher prices than low quality sellers, and therl!
may be a general deterioration in quality. A second information problem arise,
when two products look alike but one can be legally possessed while the othe r
cannot. For example, laws protecting rare birds prohibit the taking of specimen:3
after a set date hut permit possession of those killed in the pasto We can then
expect suppliers fraudulently to claim that their illegal products actually fall into
the legal category. Buyers are not harmed by this misrepresentation but som,!
other policy is undermined. A modified inalienability rule-permitting gifts but
not sales-may resolve both of these problems.
Finally, difficulties of coordination may cause resources to be allocated
inefficiently. This problem is closely related to the more pervasive problem of
externalities, but because it has several distinctive features, I consider it as a sep-
arate category. The coordination problem arises most clearly in the case of PUy,!
public goods-urban parkland, for example-consumed in common by a larg'!
group. No one has an incentive to provide the efficient amount of this good
because the supplier bears all the costs and receives only a fraction of the bene-
fits. Outlawing sales but permitting gifts is one way to achieve conservation
retaining considerable freedom for prvate action. Closely analogous to this ca.sl!
is the "prisoner's dilemma": all would benefit from coordinated action, but in
absence of coercion, independent action is inefficient. Consider, for example, t]}!
problem of coordinating the development of a new geographical region. Everyon,!
is better off if other people have settled first, but no one has an incentive to be th e
first settler. To alleviate this problem, policymakers may attach coercive concli-
tions such as a requirement that owners actually live on and develop the land in
order to perfect their title.
More narrowly focused coordination problems arise in controlling the oppor-
tunistic behavior of a person who purports to act on behalf of another. An inalien-
:W2 LAW AND ECONOMICS ANTHOLOGY
:llbility rule may mitigate these problems when the law that directly control s the
p,arties' relationship is inadequate. The law protects creditors, for instance, by
]Jreventing a person close to bankruptcy from giving away assets. Similarly,
:xlineralleases that require payment ofroyalties equal to a percentage ofthe min-
:.ng profits may include diligence requirements to induce leaseholders to search
resources.
The imposition of restrictions on alienability will, of course, generally have
distributive as well as efficiency consequences. While analysts primarny con-
with efficiency may view a policy's redistributive impact as an unwelcome
:3ide effect, sometimes the distributive effects of a rule will be its primary justi-
lcation. Because restrictions on transferability, ownership, and use single out a
particular type of good or service for special treatment, these restrictions usually
i;annot be justified on broad redistributive grounds. Rather, the distributive
i;ase for inalienability is more narrowly focused. If policymakers wish to benefit
a particular sort of person but cannot easily identify these people ex ante, they
'nay be able to impose restrictions on the entitlement that are less onerous for the
worthy group than for others who are nominally eligible. For example, the coer-
ve conditions imposed on the use ofland under the Homesteading Acts can be
as a means of ensuring that the resource was transferred only to worthy
recipients-in this case, formerly landless people willing to live on and farm the
Jroperty for several years.
Restraints on alienation also may have redistributive effects incidental to
;he primary justification for the policy. Restrictions justified on efficiency grounds
frequently impose costs on a small or concentrated group, such as owners ofland
';hat has been down-zoned or owners of distilling equipment under Prohibition.
'rherefore, policymakers must decide whether to compensate these losers. In sorne
the appropriate response to redistributive effects will be straightforward.
Where policymakers believe that the affected group deserves to bear the costs of
;he policy, there should be no compensation. The group might, for example, be
of people earning monopoly profits. A1though economic discussions of
monopoly power commonly stress the inefficiencies of markets with a single
;3eller, a basic distributive principIe generally seems to lurk behind these analy-
3es. The principIe is this: except as a reward for risk-taking, no one is entitled to
profits that exceed the competitive rate of return because of market imperfec-
tions. Economic rents or earnings aboye this level can be confiscated by the
.3tate for redistribution to others. Compensation is also not justified if the own-
I)rs accepted the risk of the restriction at the time of purchase. This expectation
will have be en reflected in the original purchase price, and it would be redundant
co compensate the owners further. Conversely, compensation will be appropriate
where there is no principled reason for the group to bear the costs of the policy
and where doing so would not undermine the effectiveness of the restriction. For
example, compensating owners ofhistoric buildings for the costs ofmaintaining
the structure's historical value would spread these costs among taxpayers with-
Jut defeating the purpose of the restriction on use.
Fundamental policy conflicts arise, however, when a group does not deserve
to bear the costs of the restraint but where compensation would undermine the
purpose of the restriction. For example, compensating blood donors for the fact
that they cannot seU their blood would convert the process into something sim-
ilar to a market trade and would undermine the use of a modified inalienability
I
/

rule to assure h
to be high in s
inalienability rt
Inalienabil
best response to
sible to conceivE
CO&ts were 10weJ
insulation from
is whether to rel
Thus, even in a
advocate selling
blood rests prim
contamination w
mation and tranl
a weakness of th
inalienability fro
overly enthusias'
1.
One of the n
of inalienabi
The Econorr.
J. Robert Pr
2. The exampl
transactions
reason for ir
would encol
donations gE
THE GIFT REL
3.
See the clas:
343 (1972).
4.
Another mar
Every societ:
transplantab
plant Organs,
Richard Epsti
ENTERPRISE, v.
82 (1997). Si
(1983).
5.
Two example:
vation of the
statutes typic
tain bUildings,
tions of the bl
lirectIy controls the
Irs, for instance, by
r assets. Similarly,
of the min-
seholders to search
rse, generally have
ysts primarily con-
ct as an unwelcome
e its primary justi-
md use single out a
restrictions usually
lr, the distributive
.ers wish to benefit
leople ex ante, they
les s onerous for the
example, the coer-
;eading Acts can be
rred only to worthy
ve on and farm the
ffects incidental to
1 efficiency grounds
rr as owners o: land
under Prohibition.
lese losers. In sorne
)e straightforward.
to bear the costs of
rrt, for example, be
)mic discussions of
kets with a single
'ehind these analy-
10 one is entitled to
f market imperfec-
confiscated by the
if the own-
:l. This expectation
rould be redundant
will be appropriate
costs of the policy
che restriction. For
IStS of maintaining
rrg taxpayers with-
LP does not de serve
uld undermine the
donors for the fact
ltO something sim-
ified inalienability
CHAPTER 3: THE ECONOMICS OF PROPERTY 203
rule to assure high quality blood supplies. If the distributive costs are believed
to be high in such situations, policymakers should consider alternatives to
inalienability rules ....
Inalienability is frequentIy justified not as an ideal policy but as a seconcl-
best response to the messiness and complexity of the world. It is generally P0f-
sible to conceive of an alternative policy that would be superior if transaction
costs were lower. The major exception involves the ideal of citizenship, where
insulation from market forces may be desirable in principIe and the main issu.e
is whether to rely on voluntary donations or on coercion to achieve public goaL3.
Thus, even in a first-best world without transaction costs, few people would
advocate selling political votes. In contrast, if the argument against the sale of
blood rests primarily on quality control grounds, a cheap and effective test f(lr
contamination would undermine the argumento This reliance on imperfect infoJ"-
mation and transaction costs to justify inalienability rules should not be seen CLS
a weakness of the analysis, however. Instead, it is a way to rescue the concept of
inalienability from its simplistic rejection by market-oriented economists or iLs
overly enthusiastic embrace by paternalistic moralists.
Notes and Questions
1. One of the most famous examples of a good or service governed by a rule
of inalienability is adoptions. See Elizabeth Landes & Richard A. Posner,
The Economcs of the Baby Shortage, 7 J. LEGAL STUD. 323 (1978). See also
J. Robert Pritchard, A Market for Babies?, 34 U. TORONTO L.J. 341 (1984).
2. The example most frequently given of a commodity for which markElt
transactions are not allowed is human blood. The classic statement of the
reason for inalienability of that valuable good is that market transactions
would encourage low-quality donors, while voluntary, uncompensated
donations generally encourage high-quality donors. See Richard TitmusB,
THE GIFT RELATIONSHIP: FROM HUMAN BLOOD TO SOCIAL POLlCY (1971).
3. See the classic Kenneth J. Arrow, Gifts and Exchanges, 1 PHIL. & PUB. AFF.
343 (1972).
4. Another market that is not allowed to function is one for human orgarm.
Every society relies upon voluntary donations to satisfy the demand l:or
transplantable organs. See Lloyd eohen, Increasing the Supply of Tram.:-
plant Organs: The Vrtues of a Futures Market, 58 GEO. WASH. L.J. 1 (1989);
Richard Epstein, Organ Transplants: Or, Altrusm Run Amuck, THE AMERICAN
ENTERPRISE, v. 4, n. 6 (Nov. - Dec., 1993); RICHARD EpSTEIN, MORTAL PERIL 23.,'-
82 (1997). See al so Uniform Anatomical Gift Act (UAGA) 8A U.L.A. 15
(1983).
5. Two examples are especially interesting: historical preservation and presHI-
vation of the habitats of endangered species. Historical preservation
statutes typically require that owners preserve at least the facades of CHI"-
tain buildings. Permission is required for any alterations to the affected pOI"-
tions of the building and demolition is permitted only under very restrictl3d
:204 LAW AND ECONOMICS ANTHOLOGY
conditions. For example, the New York City Landmarks Preservation Law
emphasizes the protection and preservation of external architectural fea-
tures and internal features, such as building lobbies or auditoriums, that are
open to the public, and it only rarely allows demolition. Similarly, the
Endangered Species Act may require landowners to avoid destroying the
habitat of an endangered species. 80th of these policies can be justified by
the external benefits of maintaining the affected property in its original formo
6. Some other issues that Professor Rose-Ackerman discusses are the right
to vote and the duty to serve on juries and in the military. Some societies,
such as Australia, make voting a duty, not a right. Is there any help in Pro-
fessor Rose-Ackerman's article on analyzing the efficiency of that duty?
D. The E
Distingu
the general PO]
the general po:
What dist
tion. N ot only J
real property, 1
We will n(
or of trademar
copyright. Non
tions that may
William M
nomic Ana
325 (1989)*
* * * A dist
good" aspecto Wl
for example, a b.
computer s o f t w ~
whether by the c
And once copies
make additional
at or close to ma
the creator's totE
work. Copyright
from making cop
benefits of provi(
correct balance b
law. For copyrigb
must, at least a
works minus bot
copyright protecl
I. 'rhe Basic Ecc
The cost of
ing just about be
components. The
* William La
Chicago Law School.
the Seventh Circuit 1
** Reprinted v
254 LAW AND ECONOMICS ANTHOLOGY
One of the most important recent developments in the law and eco-
nomics of contract law is the investigation of the role of default and
mandatory rules in contracto Default rules are rules that will be in effect
unless the parties agree to something different. That is, these rules may
be changed consensually. An example would be a rule that entitles the
innocent party to expectation money damages in the event of breach.
'I'he parties can agree to waive that rule in favor of sorne alternative, such
1S half the expectation damages or a set amount. Mandatory rules are
Tules that are in effect and may not be changed by the parties, even by
So, a mandatory contract rule is that a contract with a minor is
unenforceable.
The view of contract law that this lterature contempla tes is ane in
which the law provides a menu of off-the-shelf terms that the parties may
3elect and, in sorne cases, modify as they see fit.
The next two selections investigate the economics of default and
mandatory rules in contract law.
[an Ayres & Robert Gertner,* Filling Gaps in Incomplete
Contracts: An Economic Theory of Default Rules, 99
YALE L.J. 87 (1989)**
Introduction
The legal rules of contracts and corporations can be divided into two dis-
cinct classes. The larger class consists of "default" rules that parties can contract
around by prior agreement, while the smaller, but important, class consists of
'immutable" rules that parties cannot change by contractual agreement. Default
rules fill the gaps in incomplete contracts; they govern unless the parties con-
tract around them. Immutable rules cannot be contracted around; they govern
even if the parties attempt to contract around them. For example, under the
Uniform Commercial Code (U.C.C.) the duty to act in good faith is an immutable
part of any contract, while the warranty of merchantability is simply a default
rule that parties can waive by agreement. Similarly, most corporate statutes
require that stockholders elect directors annually but allow the articles of incor-
poration to contract around the default rule of straight voting. Statutory lan-
guage such as "[u]nless otherwise provided in thecertificate ofincorporation" or
"[u]nless otherwise unambiguously indicated" makes it easy to identify statutory
de fault , but common-Iaw precedents can also be divided into the default and
mmutable camps. For example, the common-Iaw holding of Peevyhouse v. Gar-
land Coal & Mining Co., which limited damages to diminution in value, could be
* Ian Ayres is the William Townsend Professor of Law at the Yale Law School, and Robert
Gertner is Professor, University of Chicago Graduate School of Business.
** Reprinted by permission ofThe Yale Law Journal Company and Fred B. Rothman & Com-
pany from The Yale Law Journal, Vol. 99, pages 87-130.
contractually r
requisite of COl
tractually abre
There is
two normative
tifiable if socie
outside the con
externalities. :
justified only i
parties intern:
selves. With rel
over this abstr
cerns or extern
When the prec
analysis devob
attention abou
nomics movem,
of immutable r
theory of defal
choose the wro
second order 01
ories stipulatin
wanted. Frank
wanted" theory
tain the [defau:
arms' -length fo
has argued tha
ing standard ce
express agreer
the default rul,
the parties wit
had the time ar
erature has vig
for in particul
"would have w:
382 P.2d
extremely famous ,
erty, on which they
The lease agreemel
lease expired. Whe
would be inefficien
property would hav
houses the diminut
Several of the justi
19 Frank E
COLUM. L. REV.
20
POSNER,1
21 Baird anc
829, 835-36 (1985).
... _ ... _------
------....... _IIIi""""""-----------------------,----
Le law and eco-
of default and
be in effect
les e rules may
at entitles the
'ent of breach.
ternative, such
Ltory rules are
3.rties, even by
vith a minor is
,lates is one in
he parties may
)f default and
lncomplete
t Rules, 99
ed into two dis-
ies can contract
:lass consists of
Default
parties con-
ad; they govern
lple, under the
s an mmutable
imply a default
porate statutes
lrticles of incor-
Statutory lan-
Lcorporation" or
entify statutory
;he default and
uyhouse u. Gar-
value, could be
School, and Robert
:. Rothman & Com-
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 25[:;
contractually reversed by prospective parties.
8
In contrast, the common law pre
requisite of consideration is largely an immutable rule that parties cannot con
tractually abrogate.
There is surprising consensus among academics at an abstract level OH
two normative bases for immutability. Put most simply, immutable rules are jus
tifiable if society wants to protect (1) parties within the contract, or (2) partieB
outside the contracto The former justification turns on parentalism; the latter OIl
externalities. Irnmutable rules displace freedom of contracto Immutability i:;
justified only if unregulated contracting would be socially deleterious
parties internal or external to the contract cannot adequately protect them-
selves. With regard to immutable rules, the disagreement among academics is nOG
over this abstract theory, but whether in particular contexts parentalistic con-
cerns or externalities are sufficiently great to justify the use ofimmutable rules.
When the preconditions for immutability are not present, the normative legal
analysis devolves to the choice of a default rule. Yet academics have paid
attention about how to choose among possible default rules. The law-and-eco-
nomics movement has fought long and hard to convince courts to restrict the
of immutable rules, but has lost most of its normative energy in constructing a
theory of default choice. Economists seem to believe that, even if lawmakers
choose the wrongdefault, at worst there will be increased transaction costs Ofl
second order of magnitude. Few academics have gone beyond one-sentence thE-
ories stipulating that default terms should be set at what the parties would hay':)
wanted. Frank Easterbrook and Daniel Fischel have championed the "would have
wanted" theory in a number of articles suggesting that "corporate law should COD-
tain the [defaults] people would have negotiated, were the costs ofnegotiating at
arms'-length for every contingency sufficiently low.,,19 Similarly, Richard Posner
has argued that default rules should "economize on transaction costs by supply-
ing standard contract terms that the parties would otherwise have to adopt b 'f
express agreement."20 Douglas Baird and Thomas Jackson have argued that
the default rules governing the debtor-creditor relationship "should provide al
the parties with the type of contract that they would have agreed to if they ha d
had the time and money to bargain over an aspects of their deal.,,21 While this lit-
erature has vigorously examined what particular parties would have contracted
for in particular contractual settings, it has failed to question whether the
"would have wanted" standard is conceptually sound.
382 P.2d 109 (Okla. 1962), cert. denied, 375 U.S. 906 (1963). The Peevyhouse case is an
extremely famous one in contract law. Mr. and Mrs. Peevyhouse leased a portion of their real prop-
erty, on which they lived, to the defendant coal mining corporation for the purpose of strip mining codo
The lease agreement called for Garland to restore the property to its pre-strip-mining state when the
lease expired. When the lease was up, Garland refused to restore the property on the ground that it
would be inefficient to do so. The cost would have been sorne $15,000 and the market value of tre
property would have increased by only about $300. The Oklahoma Supreme Court awarded the Peevf-
houses the diminution in the (market) value oftheir property because ofthe defendant's breach, $30 J.
Several of the justices werelater impeached for taking bribes from coal companies.
19 Frank Easterbrook and Daniel Fischel, The Economic Structure of Corporate Law, f,9
COLUM. L. REV. _ (1989).
20
POSNER, THE ECONOMIC ANALYSIS OF LAW 372 (3d ed. 1989).
21 Baird and Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 VANO. L. REV.
829, 835-36 (1985).
256 LAW AND ECONOMICS ANTHOLOGY
Thus, although the academy recognizes the analytic difference between
default and immutable rules, a detailed theory ofhow defaultsshould be set has
yet to be proposed. Indeed, the lack of agreement over even what to call the
"default" concept is evidence of the underdeveloped state of default theory.
Default rules have alternatively been termed background, backstop, enabling,
fallback, gap-filling, off-the-rack, opt-in, opt-out, preformulated, preset, pre-
sumptive, standby, standard-form and suppletory rules. * * *
1. Penalty Default Rules
A. The Zero-Quantity Default
The diversity of default standards can even be seen in contrasting the law's
tjreatment of the two most basic contractual terms: price and quantity. Although
price and quantity are probably the two most essential issues on which to reach
agreement, the U.C.C. establishes radically different defaults. If the parties
[cave out the price, the U.C.C. fills the gap with "a reasonable price." Ifthe par-
ties leave out the quantity, the U.C.C. refuses to enforce the contracto In essence,
the U.C.C. mandates that the default quantity should be zero.
, How can this be? The U.C.C.'s reasonable-price standard can be partIy rec-
onciled with the received wisdom that defaults should be set at, what the parties
would have contracted foro But why doesn't the U.C.C. treat a missing quantity
term analogously by filling the gap with the reasonable quantity that the parties
would have wanted? Obviously, the parties would not have gone to the expense
Df contracting wth the intention that nothing be exchanged.
We suggest that the zero-quantity default cannot be explained by a "what
the parties would have wanted" principIe. Instead, a rationale for the rule can be
found by comparing the cost of ex ante contracting to the cost of ex post litigation.
rhe zero-quantity rule can be justified because it is cheaper for the parties to
establish the quantity term beforehand than for the courts to determine after the
fact what the parties would have wanted.
It is not systematically easier for parties to figure out the quantity than the
price ex ante, but it is systematically harder for the courts to figure out the quan-
tity than the price ex post. To estimate a reasonable price, courts can largely rely
Dn market information of the type "How much were rutabagas selling for on July
3?" But to estimate a reasonable quantity, courts would need to undertake a more
costly analysis of the individuallitigants of the type "How much did the buyer
and seller value the marginal rutabagas?"
The U.C.C.'s zero-quantity default is what we term a "penalty default."
Because ex ante neither party would want a zero-quantity contract, such a rule
penalizes the parties should they fail to affirmatively specify their desired quan-
tity. Because the non-enforcement default potentially penalizes both parties, it
encourages both of them to inc1ude a quantity termo
B. Toward a More General Theory of Penalty Defaults
Penalty defaults, by definition, give at least one party to the contract an
incentive to contract around the default. From an efficiency perspective, penalty
default rules can bejustified as a way to encourage the productin ofinformation.
rhe very process of "contracting around" can reveal information to parties inside
Dr outside the contracto Penalty defaults may be justified as
e
1. giving
p a r t i e ~
2. giving
tion to
The zero-ql
tives to reveal tl
discover that inf
be cheaper thar:
rule that "for a (
ably certain and
that give incorJ
authorized shar
the state of inco!
out these provis
law's refusal to I
can make these
Lawmaken
social costo WheJ
enforcement def:
to provide least
give each party
penalty default s
both sides to rey,
seller sell at One-
matively fill any
fall. One-sided
non-penalized bt:
ers to enter inde
each party back .
this potential for
In contrast,
tracting party, tl
party. This is es
about the default
a penalty default
In sorne situ
systematically inf
contingency arisi
while the other si
ter informed thar:
brokerage commi
tracts typically ir
given amount of ",
earnest money be
does not address t
would have wantl
seller. We agree w
ker will more likel
ference between
:hould be set has
what to can the
. default theory.
:kstop, enabling,
:ed, preset, pre-
rasting the law's
antity. Although
n which to reach
3. If the parties
,rice." If the par-
:ract. In essence,
a.n be partly rec-
what the parties
o.issing quantity
that the parties
e to the expense
.ined by a "what
r the rule can be
x post litigation.
lr the parties to
ermine after the
lantity than the
re out the quan-
can largely rely
mng for on July
ndertake a more
:h did the buyer
enalty default."
-act, such a rule
ir desired quan-
bothparties, it
the contract an
pective, penalty
1 of information.
co parties inside
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 257
1. giving both contracting parties incentives to reveal information to third
parties, especiany courts, or
2. giving a more informed contracting party incentives to reveal informa-
tion to a less informed party .
The zero-quantity default, for instance, gives both contracting parties incen-
tives to reveal their contractual intentions when it would be costly for a court to
discover that information ex post. This justification-that ex ante contracting can
be cheaper than ex post litigation-can also explain the common law's broader
rule that "for a contract to be binding the terms of the contract must be reason-
ably certain and definite." Similarly, this rationale can explain corporate statutes
that give incorporators an incentive to affirmatively declare the number 01
authorized shares, the address of the corporation for legal process and, indeed,
the state ofincorporation. Statutes that refuse to enforce corporate charters with-
out these provisions create incentives similar to those created by the common
law's refusal to enforce vague or indefinite contracts. In both cases, the parties
can make these contractual choices more efficiently ex ante.
Lawmakers should select the rule that deters inefficient gaps at the least
social costo When the rationale is to provide information to the courts, the non-
enforcement default is likely to be efficient. Non-enforcement defaults are likely
to provide least-cost deterrence because they are inexpensive to enforce and
give each party incentives to contract around the rule. It might seem that a
penalty default set solely against one si de of a contract would be sufficient to get
both sides to reveal information. For example, a penalty default that makes the
seller sell at one-tenth the market price would certainly encourage sellers to affir-
matively fin any price gaps. But one side's penalty may be the other side's wind-
fal1. One-sided penalties can create incentives for opportunism. The
non-penalized buyer in the aboye example would have incentives to induce selI-
ers to enter indefinite contracts in order to extract the penalty rento By taking
each party back to her ex ante welfare, the non-enforcement default eliminates
this potential for opportunism.
In contrast, when the rationale is to inform the relatively uninformed con-
tracting party, the penalty default should be against the relatively informed
party. This is especially true when the uninformed party is also uninformed
about the default rule itself. Ifthe uninformed party does nt know that there iE
a penalty default, she will have no opportunistic incentives.
In sorne situations it is reasonable to expect one party to the contract to bE'
systematically informed about the default rule and the probability of the relevant
contingency arising. If one side is repeatedly in the relevant contractual setting'
while the other si de rarely is, it is a sensible presumption that the former is bet-
ter informed than the latter. Consider, for example, the treatment of real estatE
brokerage commissions whena buyer breaches a purchase contracto Such con
tracts typically include a clause which obligates the purchaser to forfeit somE!
given amount of "earnest" money if she breaches the agreement. How should thE
earnest money be split between the seller and the broker if their agency contrad
does not address this contingency? Sorne courts have adopted a "what the partieE
would have wanted" approach and have awarded all the earnest money to thE,
seller. We agree with this outcome, but for different reasons. The real estate bro-
ker will more likely be informed about the default rule than the seller. Indeed, thE
258 LAW AND ECONOMICS ANTHOLOGY
seller may not even consider the issue ofhow to split the earnest money in case
of default. Therefore, if the efficient contract would allocate sorne of the earnest
money to the seller, the default rule should be set against thebroker to induce her
to raise the issue. Otherwise, if the default rule is set to favor the broker, a seller
may not raise the issue, and the broker will be happy to take advantage of the
seller's ignorance. By setting the default rule in favor ofthe uninformed party, the
courts induce the informed party to reveal information, and, consequently, the
efficient contract results.
Although social welfare may be enhanced by forcing parties to reveal infor-
mation to a subsidized judicial system, it is more problematic to understand why
society would have an efficiency interest in inducing a relatively informed party
to a transaction to reveal information to the relatively uninformed party. Mter all,
ifrevealing information is efficient because it increases the value created by the
contract, one might initially expect that the informed party will have a sufficient
private incentive to reveal information-the incentive of splitting a bigger pie.
This argument ignores the possibility, however, that revealing information might
simultaneously increase the total size ofthe pie and decrease the share ofthe pie
that the relatively informed party receives. If the "share-of-the-pie effect" dom-
inates the "size-of-the-pie effect," informed parties might rationally choose to
withhold relevant information. Parties may behave strategically not only because
they have superior information about the default, but also because they have
superior information about other aspects of the contracto We suggest that a
party who knows that a particular default rule is inefficient'may choose not to
negotiate to change it. The knowledgeable party may not wish to reveal her infor-
mation in negotiations if the information would give a bargaining advantage to
the other side.
How can it be that by increasing the total gains from contracting (the size-
of-the-pie effect) the informed party can end up with a smaller share of the
gains (the share-of-the-pie effect)? This Article demonstrates how relatively
informed parties can sometimes benefit by strategically withholding information
that, if revealed, would increase the size of the pie. A knowledgeable buyer, for
example, may prefer to remain indistinguishable from what the seller wrongly
perceives to be the class of similarly situated buyers. By blending in with the
larger class of contractors, a buyer or a seller may receive a cross-subsidized price
because the other side will bargain as if she is dealing with the average member
of the class. A knowledgeable party may prefer to remain in this inefficient, but
cross-subsidized, contractual pool rather than move to an effieient, but unsubsi-
dized, pool. If contracting around the default sufficiently reduces this cross-sub-
sidization, the share-of-the-pie effect can exceed the size-of-the-pie effect because\
the informed party's share of the default pie was in a sense being artificially
cross-subsidized by other members ofthe contractual class. Under this scenario,
withholding information appears as a kind ofrent-seeking in which the informed
party foregoes the additional value attending the revealed information to get a
larger piece of the contractual pie.
(
C. Penalty De"
1. Uncompensa
An examp
be seen in the
Gloucester cont
Greenwich. Thl
sequential dam
holding that onl
a damage awar
The holdir
informed the ca:
damage insurar
be consistent w
consequential d;
bearer of this ri
them for con se,
default can inst,
more informed J
rier creates vah:
it more efficient:
rier will undou
transaction cosi
will gain from 1
from the carrieI
This is no
response if Had,
pensate for un1
have the incent:
industry, the un
age miller and
expected cost of
contract for les!
gains from cont
of millers with 1
a low-damage m
premium for mi
Thus, ther,
tract for the low
riers may chargl
low-damage mil:
atively low if tl
suggests a simil
of photographic
manufacturer of
he cannot ident
61
9 Ex. 341,
.est money in case
lme of the earnest
'oker to induce her
he broker, a seller
i advantage of the
nformed party, the
consequently, the
les to reveal infor-
o understand why
informed party
ed party. Mter all,
lue created by the
1 have a sufficient
;ting a bigger pie.
:nformation might
1.e share of the pie
le-pie effect" dom-
tionally choose to
y not only because
,ecause they have
Te suggest that a
may choose not to
0 reveal her infor-
1.ing advantage t
tracting (the size-
lIler share of the
how relatively
,lding information
igeable buyer, for
:he seller wrongly
nding in with the
:s-subsidized price
l average member
lis inefficient, but
ient, but unsubsi-
:es this cross-sub-
-pie effect because
being artificially
lder this scenario,
hich the informed
'ormation to get a
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 259
C. Penalty Defaults in Action
1. Uncompensated Damages in Hadley v. Baxendale
An ofhow a penalty default can restrict rent-seeking behavior car,
be seen in the venerable case, Hadley v. Baxendale.
61
In Hadley a miller in
Gloucester contracted with a carrier to have a broken crank shaft transported to
Greenwich. The .shipment was delayed, and the miller sued the carrier for con
sequential damages ofthe profits lost while the mill was inoperative. The court,
holding that only foreseeable consequential damages should be awarded, reversed
a damage award and remanded for a new trial.
The holding in Hadley operates as a penalty default. The miller could hay!!
informed the carrier ofthe potential consequential damages and contracted for full
damage insurance. The Hadley default of denying unforeseeable damages may nol
be consistent with what fully-informed parties would have wanted. The miller':;
consequential damages were real and the carrier may have been the more efficien t
bearer ofthis risk. As a general matter, millers may want carriers to compensatll
them for consequential damages that carriers can prevent at lower costo
default can instead be understood as a purposeful inducement to the miller as the
more informed party to reveal that information to the carrier. Informing the car-
rier creates value because ifthe carrier foresees the loss, he will be able to prevent
it more efficiently. At the same time, however, revealing the information to the cal-
rier will undoubtedly increase the price of shipping. Nonetheless, so long as
transaction costs are not prohibitive, a miller with high consequential damages
will gain from revealing this information and contracting for greater insurance
from the carrier because the carrier is the least-cost avoider.
This is not to say that there could not be an equally efficient market
response if Hadley had gone the other way. If the default required carriers to com-
pensate for unforeseeable consequential damages, low-damage millers woul:l
have the incentive to raise the issue of consequential damages. In a competitive
industry, the uninformed carrier, in effect, as sumes she is facing an average-dalr-
age miller and charges a price accordingly. The market price will reflect the
expected cost of insuring high-damage millers. A low-damage miller will want to
contract for less-than-average insurance and, therefore, a lower price. But tbe
gains from contracting around the default may be insignificant if the pro portio n
of millers with high damages is small. Furthermore, it may be very difficult J'(ir
a low-damage miller to determine how much of the price is an implicit insurance
premium for millers with higher damages.
Thus, there may be situations in which the low-damage millers fal to COIl-
tract for the 10w-insurancellow-price contracto In the resulting equilibrium, ca,-
riers may charge a price representing their average cost of serving both high- and
10w-damage millers and take an average amount ofprecaution (which will be rel-
atively low if there are re1ative1y few high-damage millers). Richard Posrwr
suggests a similar result: Ifthe damage default changes so that manufacturm's
of photographic film were liable for unforeseen consequential damages, "[tJbe
manufacturer of the film wiIl probably take no additional precautions ... becalwe
he cannot identify the film s whose 10ss would be extremely costly, and un1!!Hs
61
9 Ex. 341, 156 Eng. Rep. 145 (1854).
260 LAW AND ECONOMICS ANTHOLOGY
there are many of [the high-damage photographers] it may not pay to take addi-
l;ional precautions on all the films he develops."67 * * *
The main lesson to draw from our discussion of Hadley is that there may be
iltrategic reasons for parties' choosing not to reveal information. If the default rule
awarded all consequential damages, to be sure, the low-damage millers would
want to distinguish themselves from the high-damage millers. But the high-dam-
age millers may intentionally choose to withhold information that would make
their contracts more efficient. An informed party may not realize the full social
'Talue of revealing the information and, hence, her private benefits from reveal-
ing may diverge from the social benefits ofhaving the information revealed. [B]y
not distinguishing themselves, informed parties may be able to free-ride on the
lower-cost qualities of others and therebycontract at a subsidized price. To
counteract this strategic behavior, courts should choose defaults that are differ-
ont from what the parties would have wanted. * * *
Conclusion
This article has suggested how efficiency-minded lawmakers should go
about filling gaps in contracts. The reasons that parties leave gaps in contracts
should strongly inform this decision. Our theory of defaults should, in a sense, be
guided by our theories of why there are contractual gaps. Prior theorists have
argued that parties leave gap s in contracts because the cost ofwriting additional
terms outweighs the benefit. Accordingly, they have suggested that courts should
simply fill in the gap with the term the parties "would have wanted."
This article, however, has articulated a second cause of contractual incom-
pleteness. We have shown that when one party to a contract knows more than
another, the knowledgeable party may strategically decide not to contract around
even an inefficient default. Because the process of contracting around a default
can reveal information, the knowledgeable party may purposefully withhold
information to get a larger piece of the smaller contractual pie. This possibility
of strategic incompleteness leads us to embrace more diverse forms of default
rules. In particular, lawmakers may be able to undercut the incentives for this
strategic rent-seeking by establishing penalty defaults that encourage the better-
informed parties to reveal their information by contracting around the default.
Our analysis does not imply that penalty defaults should be used in all con-
tractual settings. The decision by efficiency-minded courts or legislatures to
impose a penalty, untailored majoritarian, or tailored "what the parties would
have wanted" default in a particular setting is not a trivial one. The first step in
the decision-making process should be to ask "why does the gap exist?" We have
suggested that parties may fail to contract around inefficient defaults for strate-
gic as well as transaction cost reasons. When parties fail to contract because they
want to shift the ex ante transaction cost to a subsidized ex post court determi-
nation, a penalty default of non-enforcement may be appropriate. When strate-
gic considerations cause a more knowledgeable party not to raise issues that
could improve contractual efficiency, a default that penalizes the more informed
party may encourage the revelation of information.
67
R. Posner, EconomicAnalysis ofLaw 81,114 (3d ed. 1986).
(
Lawmakel
Even if strateg
tractual incoml
benefits of pem
induce informat
penalty will in f
cient reliance 01
itly contracting
economic resou:
against the priv
likely to be effi(
penalty default
with low transa
Throughou
statutory rules t
tailored and unt
should be more
sider explicitly t
by alternative dI
pooling and s e p ~
selves into diffe
strategic poolin
weigh these cost
fundamentally, t
different rules a
The analys
range of legal i:
called upon to fil
approach to resc
default by sugge
lation.
82
Macey's
thus force s the lE
has gone the fUl
statutory interp
the Supreme COl;
RIC085 action bE
ity established ~
Justice Scalia ar
"unmoved by the
of our laws'''86 anl
112 Macey, Pron
est Group Model, 86 (
34 483 U.S. 14
85 Racketeer 1
Supp. V 1987).
86 483 U.S. at
355 (1977), quoting A
- .. __ .-.. _ .. _ - ~ _ .... -
pay to take addi-
that there may be
If the default rule
1ge millers would
3ut the high-dam-
that would make
ize the full social
efits from reveal-
lon revealed. [BJy
o free-ride on the
sidized price. To
es that are differ-
.akers should go
5"aps in contracts
lId, in a sense, be
)r theorists have
'riting additional
lat courts should
.nted."
ntractual incom-
:nows more than
contract around
around a default
sefully withhold
This possibility
forms of default
centives for this
urage the better-
md the default.
~ used in all con-
- legislatures to
le parties would
The first step in
exist?" We have
faults for strate-
act because they
t court determi-
;e. When strate-
aise issues that
~ more informed
CI;IAPTER 4: THE ECONOMICS OF CONTRACT LAW 261
Lawmakers should not, however, impose penalty defaults indiscriminately
Even if strategic considerations are established as a significant source of con-
tractual incompleteness, courts or legislatures should consider the costs and
benefits of penalty defaults themselves. Since the goal of a penalty default is t
induce information revelation, lawmakers should consider the likelihood that thE
penalty will in fact result in information being revealed, the benefit (in more effi
cient reliance or precaution) of the revealed information, and the costs of explico
itly contracting around the default. If the private information is acquired witb,
economic resources, the value of information revelation must also be weighed,
against the private incentives to acquire it. Penalty defaults are therefore mOrE'
likely to be efficient if the private information is acquired passively. In sum, a.
penalty default should be used if it results in valuable information revelatioE
with low transaction costs.
Throughout the discussion we have cited examples of common-Iaw and.
statutory rules that are broadly consistent with our theory's categories of penalty
tailored and untailored defaults. But we believe that both courts and legislatureE
should be more sensitive to the process of contracting. Lawmakers should con
sider explicitly the informational as well as the contractual equilibria generateci
by alternative default rules. Different defaults may generate different degrees 0]'
pooling and separating. When heterogeneous contracting parties separate them
selves into different contractual agreements, they reduce the inefficiencies o!'
strategic pooling but at the cost of increased contracting. Lawmakers need l;c.
weigh these costs of pooling and separating in choosing the right rule; but mOrE'
fundamentally, they need to be able to predict how much pooling and separatinr
different rules are likely to generate.
The analysis of the article is quite general and can be applied to a widE'
range of legal issues. For example, courts in interpreting statutes are ofteI'
called upon to fill gaps. A number of scholars have used a "legislation-as-contract"
approach to resolve such questions. Jon Macey has proposed a type of penalty
default by suggesting that statutory gaps be filled with public-regarding legis
lation.
82
Macey's default is not what the legislature would have contracted for and
thus force s the legislature to make their pork-barrel deals publico Justice Scal,
has gone the furthest, however, in articulating a penalty default standard oJ'
statutory interpretation. In Agency Holding Corp. v. Malley-Duff & Assoc.,l(
the Supreme Court was asked to supply a default statute oflimitations for a civil
RIC085 action because the legislation was silent on the issue. While the major
ity established a four-year limitation as what Congress would have wanted
Justice Scalia argued that there should be no statute of limitations. Scalia ww:
"unmoved by the fear that [thisJ conclusion might prove 'repugnant to the genim:
of our laws",86 and even suggested that this penalty default might encourage Con
82 Macey, Promoting Public-Regarding Legislation through Statutory Interpretation: An Inter
est Group Model, 86 COLUM. L. REV. 223, 236-40 (1986).
84
483 U.S. 143, 157 (1987) (Scalia, J., concurring).
85 Racketeer Influenced and COITUpt Organizations Act (RICO), 18 U.S.C. 1964 (1982 &
Supp. V 1987).
86 483 U.S. at 170 (Scalia, J., concurring) (quoting Occidental Life Ins. Co. v. EEOC, 432 U.S
355 (1977), quoting Adams v. Woods, 6 U.S. (2 Cranch) 336, 342 (1805)).
262 LAW AND ECONOMICS ANTHOLOGY
gress to contract around it: "Indeed, it might even prompt Congress to enact a
limitations period that it believes 'appropriate,' a judgment far more within its
competence than ours."87 Ironically, Justice Scalia is arguing for an extreme form
of judicial activism. Only by choosing a default that is wholly at odds with Con-
gressional intent can the Court ensure that Congress will reveal its intento
ScaHa's ultimate message then is that extreme activism can become a form of dis-
empowering judicial restraint. Examples such as these underscore our primary
thesis that efficient defaults may at times deviate from what the parties would
nave wanted. More importantly, they demonstrate that our choice of default
must be informed by an understanding of why contracting parties-such as leg-
ilslatures-leave gaps in their texts.
Finally, we suggest that teachers focus more explicitly On the difference
between default and immutable rules. Often students are able to recite the var-
ious rules learned in a course without knowing whether they are obligatory or
noto Teaching which rules are defaults is not a mere pedagogical conceit. To rep-
lfesent their clients effectively, attorneys need to know not only what the legal
lfules are, hut how, if at all, they can be abrogated to further their clients' inter-
ests. A descriptive knowledge of defaults and how to contract around them is a
prerequisite of effective advocacy.
Jason Scott Johnston,* Strategic Bargaining and
the Economic Theory ofContract Default Rules, 100
YALE L.J. 615 (1990)**
In the economic analysis oflaw, famous cases are often famous not so much
because of how courts have actually interpreted and applied them, but because
they suggest potentially efficient legal rules. In this way, the rule of a famous case
comes to represent a particular set of efficiency arguments, and these argu-
ments become as foundational to the economic analysis of law as are the cases to
doctrine. But economic explanations of doctrinal efficiency are themselves
grounded in certain assumptions and conventions. Indeed, one of the valuable
things about the economic approach to law is its straightforward statement ofthe
assumptions from which analysis proceeds. To treat a particular efficiency argu-
ment as an established "rule" is therefore to treat argument as myth and to lose
what is perhaps most valuable about the economic approach: the potential to pro-
gressively enrich our understanding oflegal rules and institutions by examining
their efficiency under progressively more realistic, if more complex, behavioral
and environmental assumptions. This Article attempts to further the progressive
research program oflaw and economics by questioning the established economic
87 483 U.S. at 170.
* Jason Scott Johnston is Professor ofLaw, University ofPennsylvania School ofLaw.
** Reprinted by permission ofThe Yale Law Journal Company and Fred B. Rothman & Com-
pany from The Yale Law Journal, Vol. 100, pages 615-664.
. _ - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ~
(
analysis of one
limiting the ex
which are "forel
term of a contJ
Because HadleJ
analysis of Hadi
limitation on c(
struction-the i:
gaining from c
established un di
generally. In so
rules, and, at tl:
law and game tI
In the esta
default rule: a n
ing party might
rule is taken to
tialloss. This ru
such as large lo SI
the prospect of
promisee will ha
profits. The prOJ
promisee's loss, J
tracto The promi
information whi(
the optimal, full:
For sorne yE
strategic incenti
promisee who w
breaches is supp'
tant and valuabl
promisor's agreer
talking about ba]
of strategic infor:
persuade the pro
to persuade the 1
gene rally want to
that is, that she
manee. And the p
who will not be fu
virtually a sure tI
also that perform
high price or else
But then thE
directly at odds wi
in Hadley: the prc
9 Ex. 341,15
284 LAW AND ECONOMICS ANTHOLOGY
c. The Economics of Formation Defenses
and Performance Excuses
When one ofthe parties to a contract seeks to be relieved ofthe oblig-
,ltiori to perform, she raises either a formation defense or a performance
The gist ofthe first category of defenses is that the contract was not
validly formed: there was either an imperfection in the procedures by
which the contract was agreed upon, or the substantive terms of the con-
;ract were excessively one-sided. The gist of the second category of defenses
'B that, while there is nothing wrong with either the procedure or sub-
:;tance of the agreement, circumstances have changed since the formation
:;0 that the purpose for which the parties formed the contract is now frus-
Lrated or performance is impossible or commercially impracticable.
The selections in the first section below deal with the formation
defenses. The following section excerpts a piece on commercial impossibility.
1. Formation Defenses
Anthony Kronman, * Mistake, Disclosure, Information,
and the Law ofContract, 7 J. LEGAL STUD. 1 (1978)**
Introduction
This paper attempts to explain an apparent inconsistency in the law of con-
tracts. On the one hand, there are many contract cases-gene rally classified
under the rubric of unilateral mistake-which hold that a promisor is excused
from his obligation to either perform or pay damages when he is mistaken about
:ome important fact and his error is known (or should be known) to the other
party. On the other hand, cases may also be found which state that in sorne cir-
cumstances one party to a contract in entitled to withhold infoimation he knows
1he other party lacks. These latter cases typically rest upon the proposition that
the party with knowledge does not owe the other party a "duty of disclosure."
Although these two lines of cases employ different doctrinal techniques, they
both address essentially the same question: if one party to a contract knows or has
l'eason to know that the other party is mistaken about a particular fact, does the
lmowledgeable party have a duty to speak up or may he remain silent and capic
t alize on the other party's error? The aim of this paper is to provide a theory which
will explain why sorne contract cases impose such a duty and others do noto ...
* Anthony Kronman is the Dean and Edward Phelps Professor at the Yale Law School.
** Reprinted with permission.
CE
Every contra
tions about the W{
contract and sorne
tion is mistaken.
(whether it be the
to the contracting
occurrence of a m:
be devoted to the
There are ba
an optimal level.
mistake from OCCl
either party (or be
insurance from a
In what follo
takes. Although tb
that most mistak(
costo Where a risl
many of the risks
ties"-insurance
cept of insurance
impossibility than
Information i
duce, one individt
than another. If th
the joint costs of a
party who is the b
actually assigned t
ence to trade custe
respected. Where .
a court concerned
information-gathel
way, an efficiency-
process itself.
The most im}
drawn between "rr
be en more reluctal
than where the otl
Viewed broac
makes sense from
mistaken about th
have been better al
regarding the natu
the parties involvE
assurne that he is
error. As we shall SI
ning point for
mutual and unilatl
" t) Al el +(1 Lo a.jl
j L- tl'\
lefenses
eved ofthe oblig-
)r a performance
contract was not
le pro ce dures by
terms of the con-
egory of defenses
roce dure or sub-
lce the form&tion
;ract is now frus-
racticable.
h the formation
impossibility.
nformation,
D. 1 (1978)**
in the law of con-
nerally classified
)misor is excused
s mistaken about
)wn) to the other
that in sorne cir-
'mation he knows
proposition that
. of disclosure."
l techniques, they
ract knows or has
llar fact, does th
:l silent and capi-
:le a theory which
:lers do noto ...
ale Law SchooL
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 285
1. Mistake and the Allocation of Risk
Every contractual agreement is predicated upon a number offactual assump-
tions about the world. Sorne of these assumptions are shared by the parties to the
contract and sorne are noto It is always possible that a particular factual assump-
tion is mistaken. From an economic point of view, the risk of such a mistake
(whether it be the mistake of only one party or both) represents a costo It is a cost
to the contracting parties themselves and to society as a whole since the actual
occurrence of a mistake always (potentially) increases the resources which must
be devoted to the pro ces s of allocating goods to their highest-valuing users.
There are basically two ways in which this particular cost can be reduced to
an optimallevel. First, one or both of the parties can take steps to prevent the
mistake from occurring. Second, to the extent a mistake cannot be prevented,
either party (or both) can insure against the risk ofits occurrence by purchasing
insurance from a professional insurer or by self-insuring.
In what follows, 1 shall be concerned exclusively with the prevention of mis.
takes. Although this limitation might appear arbitrary, it is warranted by the fad
that most mistake cases involve errors which can be prevented at a reasonablE
costo Where a risk cannot be prevented at a reasonable cost-which is true o'
many of the risks associated with what the law calls "supervening impossibili.
ties"-insurance s the only effective means ofrisk reducing. (This is why the con.
cept of insurance unavoidably plays a more prominent role in the treatment ojO
im possibility than it does in the analysis of mistake.)
Information is the antidote to mistake. Although information is costly to pro.
duce, one individual may be able to obtain relevant information more cheaply
than another. If the parties to a contract are acting rationally, they will minimizE
the joint costs ofa potential mistake by assigning the risk of its occurrence to thE:
party who is the better (cheaper) information-gatherer. Where the parties havE:
actually assigned the risk-whether explicitly, or implicitly through their adher.
ence to trade custom and past patterns of dealing-their own allocation must bE:
respected. Where they have not-and there is a resulting gap in the contract--.
a court con cerned with economic efficiency should impose the risk on the bette)'
information-gatherer. This is so for familiar reasons: by allocating the risk in thiH
way, an efficiency-minded court reduces the transaction costs of the contracting
process itself .
The most important doctrinal distinction in the law of mistake is the OIl!!
drawn between "mutual" and "unilateral" mistakes. Traditionally, courts
been more reluctant to excuse a mistaken promisor where he alone is mistaken
than where the other party is mistaken as to the same fact. * * *
Viewed broadly, the distinction between mutual and unilateral mistalu:
makes sensefrom an economic point ofview. Where both parties to a contract
mistaken about the same fact or state of affairs, deciding which of them woulcl
have been better able to prevent the mistake may well require a detailed inquiJ'Y
regarding the nature ofthe mistake and the (economic) role or position of each of
the parties involved. But where only one party is mistaken, it is reasonable to
assume'that he is in a better position than the other party to prevent his OVl'Il
error. As we shall see, this is not true in every case, but it provides a useful begin.
ning point for analysis and helps to explain the generic difference between
mutual and unilateral mistakes. * * *
:286 LAW AND EeONOMles ANTHOLOGY
In the past, it was often asserted that, absent fraud or misrepresentation,
a unilateral mistake never justifies excusing the mistaken party from his duty to
lperform or pay damages .... One well-established exceptiop.. protects the uni-
Jiaterally mistaken promisor whose error is known or reasonably should be known
to the other party. Relief has long been available in this case despite the fact that
the promisor's mistake is not shared by the other party to the contracto
For example, if a bidder submits a bid containing a clerical error or mis-
ealculation, and the mistake is either evident on the face of the bid or may rea-
Bonably be inferred from a discrepancy between it and other bids, the bidder will
typically be permitted to withdraw the bid without having to pay damages (even
after the bid has been accepted and in sorne cases relied upon by the other
party). Or, to take another example, suppose thatA submits a proposed contract
in writing to B and knows that B has misread the documento If B accepts the pro-
posed contract, upon discovering his error, he may avoid his obligations under the
contract and has no duty to compensate A for A's lost expectation. A closely
related situation involves the offer which is "too good to be true." One receiving
such an offer cannot "snap it up"; ifhe does so, the offeror may withdraw the offer
des pite the fact that it has been accepted.
In each of the cases just described, one party is mistaken and the other has
actual knowledge or reason to know of his mistake. The mistaken party in each
case is excused from meeting any contractual obligations owed to the party with
lmowledge.
A rule of this sort is a sensible one. While it is true that in each of the cases
just described the mistaken party is likely to be the one best able to prevent the
mistake from occurring in the first place (by exercising care in preparing his bid
or in reading the proposed contract which has been submitted to him), the other
party may be able to rectify the mistake more cheaply in the interim between its
occurrence and the formation of the contracto At one moment in time the mis-
taken party is the better mistake-preventer (information-gatherer). At sorne
subsequent moment, however, the other party may be the better preventer
hecause ofhis superior access to relevant information that will disclose the mis-
take and thus allow its correction. This may be so, for example, if he has other
bids to compare with the mistaken one since this will provide him with infor-
mation which the bidder himselflacks. Of course, ifthe mistake is one which can-
not reasonabIy be known by the non-mistaken party (that is, ifhe would have to
incur substantiaI costs in order to discover it), there is no reason to assume that
the non-mistaken party is the better (more efficient) mistake-preventer at the
time the contract is executed. But if the mistake is actually.known or could be dis-
covered at a very slight cost, the principIe of efficiency is best served by a com-
pound liability rule which imposes initial responsibility for the mistake on the
mistaken party but shifts liability to the other party ifhe has actual knowledge
or reason to know ofthe error. Compound liability rules ofthis sort are familiar
in other areas of the law: the tort doctrine of "last clear chance" is one example.
The cases in which relief is granted to a unilaterally mistaken promisor on
the grounds that his mistake was known or reasonably knowable by the other
party appear, however, to conflict sharply with another line of cases. These cases
deal with the related problems of fraud and disclosure: if one party to a contract
knows that the other is mistaken as to sorne material fact, is it fraud for the party
el
'-,/
with knowledge t
contract on the tI
always answerec
disclose and in ot
ing disclosure-,
will excuse if the
In the cases
knows or has reB
stand for the prop
will excuse the n
between these tw
II. The
A. General Cons
It is appropl
law with the celE
commission mere
morning of Febn
treaty had been E
ing the War of 18
the transaction il
ing the treaty frOl
news from the Br
doing with the Bl
Knowledge 1
eight o'clock on ti
tence had been pl
of the case), Org
Laidlaw firm ane
tobacco. Before al
there was any nE
article about to b
to this inquiry.
As a result (
blockade of N ew
percent. LaidIaw
Organ subsequen
otherwise disposi
is unclear, it appe
case was appeale
Chief JusticeMaI
cluded that the q
upon the vendor (
"the absoIute inst
famous, however,
26
15 U.S. (2 W
misrepresen;;ation,
.rty from his duty to
m protects the uni-
)ly should be known
lespite the fact that
le contracto
erical error or mis-
the bid or may rea-
)ids, the bidder will
pay damages (even
upon by the other
3. proposed contract
f B accepts the pro-
lligations under the
lectation. A closely
rue." One receiving
. withdraw the offer
1 and the other has
;aken party in each
,d to the party with
ln each of the cases
able to prevent the
II preparing his bid
1 to him), the other
nterim between its
lt in time the mis-
ratherer). At sorne
better preven ter
11 disclose thE mis-
Jle, if he has other
de him with infor-
e is one which can-
if he would have to
,on to assume that
e-preventer at the
Iwn or could be dis-
t served by a com-
he mistake on the
: actual knowledge
.s sort are familiar
:e" is one example.
taken promisor on
vable by the other
cases. These cases
to a contract
fraud for the party
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 28?
with knowledge to fail to disclose the error and may the mistaken party avoid
contract on the theory that he was owed a duty of disclosure? This question is noc
always answered in the same way. In sorne cases, courts typically find a duty tI)
disclose and in others they do noto It is the latter group of cases-those not requir-
ing disclosure-which appear to conflict with the rule that a unilateral
will excuse if the other party knows or has reason to know of its existence.
In the cases not requiring disclosure, one party is mistaken and the other part)'
knows or has reason to know it. Can these cases be reconciled with those which
stand for the proposition that a unilateral mistake plus knowledge or reason to knovr
wi11 excuse the mistaken party? More particularly, can the apparent
between these two lines of cases be explained on economic grounds? * * *
II. The Production of Information and the Duty to Disclose
A. General Considerations
It is appropriate to begin a discussion offraud and nondisclosure in contract
law with the celebrated case of Laidlaw V. Organ.
26
Organ was a New Orleans
commission merchant engaged in the purchase and sale oftobacco. Early on the
morning of February 19, 1815, he was informed by a Mr. Shepherd that a peace
treaty had been signed at Ghent by American and British officers, forma11y end-
ing the War of 1812. Mr. Shepherd (who was himselfinterested in the profits (lf
the transaction involved in Laidlaw V. Organ) had obtained information regard-
ing the treaty from his brother who, along with two other gentlemen, brought th e
news from the British Fleet. (What Shepherd's brother and his companions were
doing with the British Fleet is not disclosed.)
Knowledge of the treaty was made public in a handbill circulated around
eight o'clock on ,the morning of the nineteenth. However, before the treaty's ex:-
tence had been publicized ("soon after sunrise" according to the reported version
of the case), Organ, knowing of the treaty, called on a representative of tbe
Laidlaw firm and entered into a contract for the purchase of l11hogsheads of
tobacco. Before agreeing to seU the tobacco, the Laidlaw representative "asked if
there was any news which was calculated to enhance the price or value of tl:.e
article about to be purchased." It is unclear what response, if any, Organ ma.e
to this inquiry.
As a result of the news of the treaty-which signaled an end to the naval
blockade of New Orleans-the market price of tobacco quickly rose by 30 to E,O
percent. Laidlaw refused to deliver the tobacco as he had origina11y promised.
Organ subsequently brought suit to recover damages and to block Laidlaw from
otherwise disposing of the goods in controversy. Although the report of the ca:e
is unclear, it appears that the trial judge directed a verdict in Organ's favor. Tbe
case was appealed to the United States Supreme Court which in an opinion by
Chief JusticeMarshall remanded with directions for a new trial. The Court COll-
cluded that the question "whether any imposition was practiced by the vendo e
upon the vendor ought to have been submitted to the jury" and that as a result
"the absolute instruction of the judge was erroneous." Marshall's opinion is more
famous, however, for its dictum than for its holding:
26 15 U.S. (2 Wheat.) 178 (1817).
~ ~ 8 8 LAW AND ECONOMICS ANTHOLOGY
The question in this case is, whether the intelligence of extrinsic cir-
cumstances, which might influence the price of the commodity, and
which was exclusively within the knowledge of the vendee, ought to
have been communicated by him to the vendor? The court is of opinion
that he was not bound to communicate it. It would be difficult to cir-
cumscribe the contrary doctrine within proper limits, where the means
of intelligence are equally accessible to both parties. But at the same
time, each party must take care not to say or do anything tending to
impose upon the other.
* * * The broad rule which Marshall endorses has usually beenjustifiedon
three related grounds: that it conforms to the legitimate expectations of com-
mercial parties and thus aqcurately reflects the (harsh) morality of the market-
place; that in a contract for the sale of goods each party takes the risk that his
own evaluation of the worth 'of the goods may be erroneous; or finally, that it
justly rewards the intelligence and industry ofthe party with special knowledge
(in this case, the buyer). This last idea may be elaborated in the following way.
News of the treaty of Ghent affected the price of tobacco in New Orleans.
Price measures the relative value of commodities: information regarding the
treaty revealed a new state of affairs in which the value of tobacco-relative to
other goods and to tobacco-substitutes in particular-had altered. An alteration
of this sort is almost certain to affect the allocation of social resources. If the price
of tobacco to suppliers rises, for example, farmers will be encouraged to plant
more tobacco and tobacco merchants may be prepared to pay more to get their
goods to and from market. In this way, the proportion of society's Climited)
resources devoted to the production and transportation of tobacco will be
increased. Information revealing a change in circumstances which alters the rel-
ative value of a particular commodity will always have sorne (perhaps unmea-
surable) allocative impacto (In addition, of course, information of this sort will
have distributive consequences: the owners oftobacco or ofrights to tobacco will
be relatively wealthier after the price rise, assuming that other prices have not
risen or have not risen as fast.)
From a social point of view, it is desirable that information which reveals a
change in circumstances affecting the relative value of commodities reach the
market as quickly as possible (or put differentIy, that the time between the
change itself and its comprehension and assessment be minimized). * * *
In sorne cases, the individual s who supply information have obtained it by
a deliberate search; in other cases, their information has been acquired casually.
A securities analyst, for example, acquires information about a particular cor-
poration in a deliberate fashion-by carefully studying evidence of its economic
performance. By contrast, a businessman who acquires a valuable piece of infor-
mation when he accidentally overhears a conversation on a bus acquires the infor-
mation casually.
As it is used here, the term "deliberately acquired information" means
information whose acquisition entails costs which would not have been incurred
but for the likelihood, however great, that the information in question would actu-
ally be produced. These costs may include, of course, not only direct search costs
(the cost of examining the corporation's annual statement) but the costs of devel-
oping an initial expertise as well (for example, the cost of attending business
"vJ
Cl
school). If t4e COi
incurred in any c
the information
between delibera
expressing this E
detrmine wheth
way or the other,
I hope to show-e
If informatic
and its possessor
incentive to redue
future. This is in f
mation in the way
by definition have
the prospect of th
benefits, one who
doing what-for l
One effectivE
session of informa
erty right in the I
machinery of the s
benefits of posses
sessor of informat
property right of s
mation is a famili
patented inventiOl
One (seldom
rights in informati
contracts which h:
information to the
able party deprive:
erwise afford. A du
of the information
property right whi<
tection of private E
If we assume
acquired informati
sible economic con:
case-by-case basis (
refusing to im pose
party who has casI
likely to be a bette
whom he deals-r
access to the inforr
mation is also in a 1
the cost to the knov
must inc1ude whatE
the first place. This
extrinsic cir-
nmodity, a'nd
dee, ought to
t is of opinion
ifficult to cir-
!re the means
t at the same
19 tending to
y been justified on
Jectations of com-
lit Y of the market-
s the risk that his
or finally, that it
special knowledge
he following way.
) in New Orleans.
ion regarding the
bacco-relative to
red. An alteration
mrces. Ifthe price
couraged to plant
more to get their
iociety's (limited)
f tobacco will be
lich alters the rel-
(perhaps unmea-
n of this sort will
lts to tobacco will
prices have not
n which reveals a
odities reach the
ime between the
ized). * * *
lve obtained it by
lcquired casually.
a particular cor-
of its economic
ble pie ce of infor-
Lcquires the infor-
)rmation" means
.ve be en incurred
stiop. would actu-
irect search costs
he costs of devel-
;ending business
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 289
school). If the costs incurred in acquiring the information ... would have been
incurred in any case-that is, whether or not the information was forthcoming-
the information may be said to have be en casually acquired. The distinction
between deliberately and casually acquired information is a shorthand way oi'
expressing this economic difference. Although in reality it may be difficult to
determine whether any particular item of information has been acquired in one
way or the other, the distinction between these two types of information has-as
I hope to show-considerable analytical usefulness.
If information has been deliberately acquired (in the sense defined aboye),
and its possessor is denied the benefits of having and using it, he will have an
incentive to reduce (or curtail entirely) his production of such information in the
future. This is in fact merely a consequence of defining deliberately acquired infor-
mation in the way that I have, since one who acquires information of this sort will
by definition have incurred costs which he would h,ave avoided had it not been fOl
the prospect of the benefits he has now been denied. By being denied the same
benefits, one who has casually acquired information will not be discouraged frorn
doing what-for independent reasons-he would have done in any case. * * *
One effective way of insuring that an individual will benefit from the pos-
session ofinformation (or anything else for that matter) is to assign him a prop-
erty right in the information itself-a right or entitlement to invoke the coerciVE
machinery ofthe state in order to exclude others from its use and enjoyment. ThE
benefits of possession become secure only when the state transforms the pos
sessor of information into an owner by investing him with a legally enforceablE
property right of sorne sort or other. The assignment of property rights in infor
mation is a familiar feature of our legal system. The legal protection accordeo.
patented inventions and certain trade secrets are two obvious examples.
One (seldom noticed) way in which the legal system can establish property
rights in information is by permitting an informed party to enter-and enforce-
contracts which his information suggests are profitable, without disclosing thE'
information to the other party. Imposing a duty to disclose upon the knowledge
able party deprives him of a private advantage which the information would oth
erwise afford. A duty to disclose is tantamount to a requirement that the benefi1;
of the information be publicly shared and is thus antithetical to the notion of 2.
property right which-whatever else it may entail-always requires the legal pro
tection of private appropriation. * * *
If we assume that courts can easily discriminate between those who havE:
acquired casually and those who have acquired it deliberately, plau.
sible economic considerations might well justify imposing a duty to disclose on 2
case-by-case basis (imposing it where the information has been casually acquired.
refusing to impose it where the information is the fruit of a deliberate search). A
party who has casually acquired information is, at the time of the transactioll.
likely to be a better (cheaper) mistake-preventer than the mistaken party with
whom he deals-regardless of the fact that both parties initially had equa]
access to the information in question. One who has deliberately acquired infoT"
mation is also in a position to prevent the other party's error. But in
the cost to the knowledgeable party of preventing the mistake (by disclosure), WE:
must include whatever investment he has made in acquiring the information in
the first place. This investment will represent a loss to him ifthe other party can
290 LAW AND ECONOMICS ANTHOLOGY
avoid the contract on the grounds that the party with the information owes him
a duty of disclosure.
If we take this cost into account, it is no longer clear that the party with
lmowledge is the cheaper mistake-preventer when his knowledge has been delib-
erately acquired. Indeed, the opposite conclusion seems more plausible. In this
ease, therefore, a rule permitting nondisclosure (which has the effect ofimposing
1che risk of a mistake on the mistaken party) corresponds to the arrangement the
lparties themselves would have been likely to adopt if they had negotiated an
explicit allocation of the risk at the time they entered the contracto The parties
to a contract are always free to allocate this particular risk by including an appro-
priate disclaimer in the terms of their agreement. Where they have failed to do
BO, however, the object of the law of contracts should be (as it is elsewhere) to
Jreduce transaction costs by providing a legal rule which approximates the
arrangement the parties would have chosen for themselves if they had deliber-
ately addressed the problem. This consideration, coupled with the reduction in
the production of socially useful information which is likely to foIlow from sub-
jecting him to a disclosure requirement, suggests that allocative efficiency is best
served by permitting one who possesses deliberately acquired information to
enter and enforce favorable bargains without disclosing what he knows.
A rule which calls for case-by-case application of a disclqsure requirement
is likely, however, to invoke factual issues that wiIl be difficult (and expensive) to
resolve. * * *
III. Unilateral Mistake and the Duty to Disclose
The rule that a unilaterally mistaken promisor will be excused when his
mistake is known or should be known to the other party is typified by the mis-
taken bid cases and by those in which the mistaken party's error is the result of
his having misread a particular document (usually, the proposed contract itself).
In both instances, the special knowledge of the non-mistaken party (his knowl-
edge of the other party's error) is unlikely to be the fruit of a deliberate search.
Put differently, a rule requiring him to disclose what he knows will not cause him
to alter his behavior in such a way that the production ofinformation ofthis sort
will be reduced.
A contractor receiving a mistaken bid, for example, usually becomes aware
ofthe mistake (ifhe does at all) by comparing the mistaken bid with others that
have been submitted, or by noting an error which is evident on face of the bid
itself. In either case, his knowledge of the mistake arises in the course of a rou-
tine examination of the bid s which he would undertake in any evento The party
receiving the bid has an independent incentive to scrutinize carefuIly each of the
bids which are submitted to him: the profitability ofhis own enterprise requires
that he do so. It is of course true that the recipient's expertise may make it eas-
ier for him to identify certain sorts of error s in bids that have been submitted. But
the detection of clerical mistakes and errors in calculation is not likely to be one
of the principal reasons for his becoming an expert in the first place. A rule
requiring the disclosure of mistakes of this kind is almost certain not to dis-
courage investment in developing the sort of general expertise which facilitates
the detection of such mistakes.
In the first part of the paper, 1 argued that a rule requiring disclosure
where a unilateral mistake is known or reasonably knowable by the other party
Cl
makes economic f
tract is executed-
information has (
is socially useful
place)-the costs
in fact the cheape
support the propc
or reasonably knl
document cases), j
of a deliberate im
of the paper is COl
The unilater
other contract cal
duty to disclose. T
of them the social
unilateral mistak
courage him from
the eases permitti
attempted to sho'
mation and woull
When viewed in tI
lateral mistake ca
(or at least to be c
In the paper,
pro mote
useful information
mation the right te
is in essence a pro
ognize a right of tl
costly search and
acquired. This bas
ory of property rigl
cases and elimina
nondisc1osure and .
will be excused if 1
Although 1 h
rather small part (
the paper may pro'
the law. For examp
rities laws which
(and to be justifie
casuaJly discoverec
principal assumpti
by our securities 1;
proper scope of th
offerr have to pu
ormation owes him
hat the party with
dge has be en delib-
e plausible. In this
e effect of im posing
le arrangement the
had negotiated an
ntract. The parties
including an appro-
!y have failed to do
it is elsewhere) to
approximates the
f they had deliber-
;h the reduction in
co follow from sub-
le efficiency is best
~ e d information to
; he knows.
osure requirement
(and expensive) to
ose
excused when his
rpified by the mis-
Tor is the result of
:ed contract itself).
L party (his knowl-
deliberate search.
will not cause him
mation of this sort
lly becomes aware
d with others that
the face of the bid
'le course of a rou-
'1 evento The party
.refully each of the
nterprise requires
: may make it eas-
~ e n submitted. But
lot likely to be one
first place. A rule
:ertain not to dis-
~ which facilitates
uiring disclosure
by the other party
1 CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 291
makes economic sense because the party with knowledge is-at the time the con-
tract is executed":"-the cheaper mistake-preventer. Ifthe party possessing special
information has deliberately invested in its production-and if the information
is socially useful (so that we regard its production as desirable in the first
place)-the COSh;l ofhis search must be considered in determining whether he is
in fact the cheaper mistake-preventer. In the cases which are most often cited to
support the proposition that a unilateral mistake will excuse where it is known
or reasonably knowable by the other party (i.e., the mistaken bid and misread
document cases), it is unlikely that the special information in question is the fruit
of a deliberate investment. This being so, the conclusion reached in the first part
of the paper is confirmed.
The unilateral mistake cases are indistinguishable, in principIe, from thE
other contract cases, discussed in the second part of the paper, which impose a
duty to disclose. These cases are distinguished as a group by the fact that in eacb
of them the social interest in efficiency is best served by allocating the risk of a
unilateral mistake to the party with knowledge (since this is unlikely to dis
courage him from investing in the production of socially useful information). In
the cases permitting nondisclosure, a similar allocation ofrisk would-as I have
attempted to show-eliminate the private incentive for producing such infor
mation and would therefore work to the disadvantage of society as a whole.
When viewed in this way, both the cases requiring disclosure (including the uni
lateral mistake cases) and those permitting nondisclosure appear to conform te,
(or at least to be consistent with) the principIe of efficiency.
Conclusion
In the paper, 1 have emphasized the way in which one branch ofthe law Ol
contracts promot.es efficiency by encouraging the deliberate search for socially
useful information. It does so, I have argued, by giving the possessor of such infor
mation the right to deal with others without disclosing what he knows. This righ1;
is in essence a property right, and 1 have tried to show that the law tends to rec
ognize a right ofthis sort where the information is the result of a deliberate ancl
costly search and not to recognize it where the information has been casuaHy
acquired. This basic distinction between two kinds of information (and the the
ory of property rights which is based upon it) introduces order into the discloSUl'f!
cases and elimin.ates the apparent conflict between those cases which permi;
nondisclosure and the well-established rule that a unilaterally mistaken promisol'
will be excused if his error is or reasonably should be knowh by the other part,y
Although 1 have confined my discussion to contract law-indeed, to orH!
rather small part ofit-the theoretical approach developed in the second part of
the paper may prove to be useful in analyzing related problems in other areas o f
the law. For example, to what extent can the disclosure requirements in our secll'
rities laws which are aimed at frustrating insider-trading be said to rest UpOIl
(and to be justified by) the idea that inside information is more likely to bn
casually discovered rather than deliberately produced? If this is in fact one ofthn
principal assumptions underlying the various disclosure requirements impose(l
by our securities laws, what conclusions-if any-can be drawn regarding tlw
proper scope of these requirements? For example, how much should a tender
offeror have to publicly disclose concerning his plans for the corporation hn
LAW AND ECONOMICS ANTHOLOGY
hopes to acquire? Does the analysis offered in this paper throw any light on the
requirement of "non-obviousness" in patent law? (Is this perhaps a legal device
for discriminating between information which is the result of a deliberate search
and information which is not?) Do the distinctions suggested he re help us to
understand the proliferation of disclosure requirements in the consumer products
field and to form a more considered judgment as to their desirability? A legal the-
ory which provided a common framework for the analysis of these and other ques-
tions would have considerable appeal.
Notes and Questions
11. See also Richard A. Posner & Andrew M. Rosenfield, Impossibility and
Re/ated Doctrines in Contract Law: An Economic Analysis, 6 J. LEGAL STUD.
83 (1977).
lRichard Epstein, * UnconscionabilitY:i A Critical
Reappraisal, 18 J. LAW & ECON. 293 (1975)**
1. Introduction
The classical conception of contract at common law had as its first premise
the belief that private agreements should be enforced in accordance with their
terms. That premise of course was subject to important qualifications. Promises
procured by fraud, duress, or undue influence were not generally enforced by the
courts; and the same was true with certain exceptions of promises made by
infants and incompetents. Again, agreements that had as their object illegal ends
were usually not enforced, as, for example, in cases of bribes of public officials or
contracts to kill third persons. Yet even after these exceptioJls are taken into
account, there was still one ground on which the initial premise could not be chal-
lenged: the terms of private agreements could not be set aside because the court
found them to be harsh, unconscionable, or unjust. The reasonableness of the
terms of a private agreement was the business ofthe parties to that agreement.
True, there were numerous cases in which the language of the contract stood in
need of judicial interpretation, but once that task was done there was no place for
a court to impose upon the parties its own views about the rights and duties.
"Public policy" was an "unruly horse,"l to be mounted only in exceptional cases
and then only with careo * * *
One of the major conceptual tools used by courts in their assault upon pri-
vate agreements has been the doctrine of unconscionablity. That doctrine has a
*
<:,
Richard Epstein is the James Parker Hall Professor of Law at the University of Chicago.
** Reprinted with permission.
Richardson V. Mellish, 2 Bing. 229, 252; 130 Eng. Rep. 294, 303
Cl
place in contract 1
doctrine should TI
aside those agree:
it should be usel
agreements are fe
of agreements tha
sical defenses of 4
trine of unconscio
first the tradition
show how a doctr:
ther at an acceptl
With a plac{
results achieved '
stantive grounds
unexceptionable
sively that the Sl
can, 1 think, sho"
than good, and sh
The merits e
enforcement is onl
courts could plac4
incompetence, sa)
tend to insure tha1
of the case so war
upon the defendar
proof, he may not
fact applies. If thi;
be appropriate to :
for the defendant 1
the relaxation of 1
increase the num)
defeat the plaintifl
created are low, th
that it reduces tb
thereby eliminatec
The legal sys1
the freedom of con1
agreements be pu
objects. Yet its ap
untainted oral tral
oral (widence to va
The concern
scionability."
25
An Act for Pre
(J
\);"1) S e-H/v\f11 f v L t':fj
332 LAW AND ECONOMICS ANTHOLOGY
The relaxatio.n o.f co.ntract remedies also. has deleterio.us effects o.n the will-
illgness o.f parties to. enter into. mutually beneficial co.ntracts in the first place. If
che legal system impo.ses severe limitatio.ns o.n specific perfo.rmance (irrespective
o:f whether they are based o.n the right to. break the co.ntract theo.ry o.r its mo.dern
"efficient breach" o.ffsho.o.t), it undermines the parties' faith in getting what they
::>argained fo.r, and the co.nsequence in inefficiency and a waste o.f reso.urces. If a
party in need o.f co.ntracting with ano.ther canno.t rely o.n the co.ntract to. guaran-
;ee perfo.rmance, then he may turn to. o.ther mo.re co.stly and less efficient means
IJo.r example, beco.ming a self-supplier o.r vertically integrating with his supplier)
,;0 gain greater assurance that he will get what he seeks. * * * .
[Pro.fesso.r Friedmann then turns to. the issue o.f co.ntracts relating to. future
])ro.ductio.n. He finds that the analysis o.f co.ntracts relating to. current pro.ductio.n
carries o.ver almo.st intact but that there are so.me impo.rtant differences between
1;he two. fo.rms o.f co.ntracts. In neither case do.es he find the no.tio.n o.f efficient
breach helpful. Pro.fesso.r Friedmann also. co.nsiders what co.urtsactually do., to. see
jf the efficient breachtheo.ry is an accurate descriptio.n o.f practice. He finds that
jt is no.t. So., he co.ncludes that efficient breach is neither an adequate no.rmative
dleo.ry no.r po.sitive descrpto.n o.f co.ntract law.]
Thomas S. Ulen, * The Efficiency of Specific Perfor-
Jl'nance: Toward a Unified Theory of Contraet Remedies,
83 MICH. L. REV. 341 (1984)**
Intro.ductio.n
By invo.king the no.tio.n o.f eco.no.mic efficiency, eco.no.mists and legal scho.lars
llave recently made great headway in develo.ping a new and unified theo.ry o.f co.n-
j ractual relatio.nships. The key advance was the eco.no.mists' reco.gnitio.n that
j he re are crcumstances in which at least o.ne party can be made better o.ff,
witho.ut making anyo.ne wo.rse o.ff" by o.ne party's breachng rather than per-
fo.rming a co.ntractual pro.mise. * * *
The bulk o.f the scho.larship o.n efficient remedies has co.ncerned the award
(lf mo.ney damages, and a co.nsensus has been reached o.n the fo.rm o.f damages
that is mo.st likely to. pro.mo.te eco.no.mic efficiency. Alternatives t mo.ney damages
have no.t received the same attentio.n fro.m lawyers and eco.no.mists who. have writ-
ten o.n the efficiency aspects o.f co.ntract law. Fo.r example, specific perfo.rmance,
the mo.st no.table alternative fo.rm o.f co.urt-impo.sed remedy fo.r breach o.f co.ntract,
has o.nly rarely been subjected to. the same so.rt o.f scrutiny uncter the efficiency
criterio.n as has mo.ney damages.
6
No.r has there been sufficient attentio.n paid
to. what might be called party-designed o.r self-help means o.f achieving enfo.rce-
* Thomas s. UJen is AJumni Distinguished Professor, College of Law, and Professor, Institute
of Government and Public Affairs, University o[ Illinois at Urbana-Champaign.
** Reprinted with permission.
6 Two significant instances are Anthony T. Kronman, Specific Performan:::e, 45 U. CH!. L. REV.
351 (1978), and Ajan Schwartz, The Case for Specific Performance, 89 YALE L.J.
CH
ment o.f value-ma
damage clauses, a
the ro.le that marE
might play in mit
The purpo.se
o.ry {Jf co.ntract re
sho.uld sim ply enf
party in the fo.rm
that in the absen(
o.f the usual fo.rma
o.f mo.ney damagef
pro.mises. If specj
stro.ng reaso.ns fo.:
pro.mises will be I
lo.wer Co.st than ur:
perfo.rmance po.st
ner mo.st likely to.
puts the highest '
under any alterm
[The article
explained and crit
Ulen then co.nside
to. the breacher's r
the Teputatio.nal (
more efficient tha
tives to. perfo.rma:
measure is, in the
sure expectation I
designed remedie!
hope fo.r accuratel
may be strategic r
o.n perfo.rmance a1
Damage pay
fo.rmance is the eq
ing the pro.miso.r
perfo.rming the pr
seU a ho.use to. B f
might seek relief
tively, B might asl
B. As a general n
that legal remedie
pensato.ry. The gr:
a demonstratio.n 1
him. The typical
sale o.f 'unique goc
cal reasons, to. be
erwise inno.cent
; effects on the will-
in the first place. If
manee (irrespective
heory or its modern
o. getting what they
te of resources. If a
contract to guaran-
ess efficient means
g with his supplier)
*
;s relating to future
current production
lifferences between
notion of efficient
s actually do, to see
ctice. He finds that
dequate normative
cific Perfor-
:et Remedies,
and legal scholars
ified theory of con-
;' recognition that
! made better off,
rather than per-
lcerned the award
! form of damages
;0 money damages
sts who have writ-
cific performance,
)reach of contract,
,der the efficiency
nt attention paid
lchieving enforce-
ld Professor, Institute
n.
'Ice, 45 U. CH!. L. REV.
J. 271 (1979).
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 33:::
ment of value-maximizing reciprocal promises through, for example, liquidatecl
damage clauses, arbitration,' and bonding. Nor has there been enough written on
the role that market forces, such as a regard for one's future business reputation,
might play in mitigating inefficient breach of contracto
The purpose ofthis essay is to begin the development of an integrated the-
ory of contract remedies by delineating the circtimstances under which court;
should simply enforce a stipulated remedy clause or grant reliefto the innocent
party in the form of damages or specific performance. The conclusion, in brief, i:l
that in the absence of stipulated remedies in the contract that survive scrutiny
of the usual formation defenses, specific performance is more likely than any form
ofmoney damages to achieve efficiency in the exchange and breach ofreciprocal
promises. If specific performance is the routine remedy for breach, there are
strong reasons for believing, first, that more mutua11y beneficial exchanges cf
promises will be concluded in the future and that they will be exchanged at 1
lower cost than under any other contract remedy, and, second, that under specific
performance post-breach adjustments to a11 contracts will be resolved in a man-
ner most likely to lead to the promise being concluded in favor of the party who
puts the highest value on the completed performance and at a lower cost thao.
under any alternative. * * *
[The article then establishes the notion of efficient breach, which is
explained and criticized in the excerpt by Professor Daniel Friedmann. Professcr
Ulen then considers market-based remedies for breach of contract--e.g., damage
to the breacher's reputation-and concludes that there is no reason to believe tha.t
the reputational cost imposed is one that will induce breach only when that is
more efficient than performance. He then considers damages as efficient incen-
tives to performance or breach. He finds that, while the expectation damagEs
measure is, in theory, efficient, it is, in practice, very difficult for a court to men-
sure expectation damages accurately after a breach has occurred. As to party-
designed remedies, he finds that stipulated-damages clauses may not offer much
hope for accurately determining the parties' expectation interestseither. Thel'e
may be strategic reasons why parties may not want to reveal their true valuation
on performance at the time a contract is formed.]
IV. The Efficiency of Specific Performance
Damage payments are the legal remedy for contract breach; specific p,er-
formance is the equitable remedy. Specific performance is a judicial order requir-
ing the promisor to perform his contractual promise or forbidding him from
performing the promise with any other party. If, for example, A has promised 1;0
se11 a house to B for $100,000 but breaches in order to se11 to e for $125,000, B
might seek relif in the form of a court order requiring A to se11 to B. Alterna-
tively, B might ask the court for an injunction forbidding A to se11 to anyone but
B. As a general rule, the court invokes equitable remedies only when it thinks
that legal remedies are likely to offer inadequate relief, that is, to be under-com-
pensatory. The granting of equitable relief is at the discretion of the court upCln
a demonstration by the plaintiff that daml;lges will not adequately compensate
him. The typical cases in which this under-compensation is said to arise are in tite
sale of 'unique goods' (the sale ofland considered by the law, largely for histol'i-
cal reasons, to be a unique good), and long-term input contracts. When an otb.-
erwise innocentparty asks for specific performance, the breacher is permitted to
:334 LAW AND ECONOMICS ANTHOLOGY
:nount defenses that are not usually available against a damage award: insuffi-
l;ient certainty of terms, inadequate security for the innocent party's perfor-
:nance, the breacher's unilateral mistake, and the high level of supervisory costs
;hat the court might incur in enforcing performance. * * *
A. The Role of Transaction Costs in Determining Contract Remedies
To begin the development of an integrated theory of legal and equitable
remedies for breach of contract, it is appropriate to review a proposed approach
;0 choice of remedies in a different area of the law. Professors Calabresi and
Melamed have offered an integrated theory of remedies designed to promote effi-
ent resource use in resolving incompatible property uses, that is, in circum-
;ltances where there are externalities. * Assume that society has already allocated
;he rights, which Calabresi and Melamed call entitlements, to various scarce
,esources, and further as sume that the assignment has been conducted so as to
I,ead to the most efficient use of society's scarce resources. This having been done,
30ciety must next determine what institutions, including rules of law, will most
protect those entitlements. Calabresi and Melamed suggest that,
where feasible, the constraints imposed by voluntary exchange offer the best
method ofboth protecting entitlements and of directing them to their highest
ued use. The court may assign an entitlement and then, through the granting of
injunctive relief, instruct the parties in conflict to use the method of voluntary
to protect that assignment. An injunction, in this framework, is to be
understood as a declaration that the prices arrived at by bargaining in vollmtary
are the best guide to determining which of the conflicting uses is more
This method of protecting entitlements-a method that the authors call
:me of property rules-is the most efficient means when the level of transaction
between the parties in conflict is low. Only in those circumstances is it pos-
3ible for voluntary exchange to determine which of the competing uses is of
higher value.
The market cannot make this determination, however, when the transaction
costs between parties in dispute are high. When voluntary exchange is incapable
of resolving disputes about which of two conflicting uses of entitlements is more
valuable, Calabresi and Melamed propose using judicially supervised exchange to
protect and, possibly, reallocate resources. This is the method of assessing money
damages. Leaving aside the very complicated problems of how to determine the
level of damages, we may understand, following Calabresi and Melamed, legal
relief as being a determination by the court of an objective price at which the enti-
tlement in dispute would have changed hands had transaction costs been very low.
This hypothetical market analysis-a method that Calabresi and Melamed call
protection of an entitlement by a liability rule-is the most efficient way of deter-
mining the most valuable use of an entitlement over which there is a conflict if the
transaction costs between the parties are high. * * *
The Calabresi-Melamed framework has a ready application to the question
of efficient remedies f9r breach of contracto Damages and specific performance, like
damages and injunctive relief in nuisance law, should be seen as alternative
means of achieving efficient resource allocation in the face of different transaction
*
[Ed.: See the excerpt in the chapter on the "Economics ofProperty.") ,,-J)
Cl
costs. When a COl
the court should J
party. If those COI
efficient relief for
tion costs are hi{
determined valm
In general,
should not be hi
breach and the tI;
are entirely abse
gained to provide
have had contact
report progress, ;
of relief in the ev
that has arisen t
facie reason for n
contract remedy.
Certainly, tl
determining wha
lower than they
resolve the dispu
tracting parties,
contract, the mar
evidence on its e:
This is a burdem
courts routinely
stipulate their ow
bargain in the UI
event of breach. )
To see what
already discusse<
has contracted to
C offers A $125,Ol
pose now that wl
than damages. Tl
the person to wh
direct the asset ...
several ways. A rr.
sell to C. Or B mi
In both ofth
values it more th
tribution of the
mance, private r
entitlement to pe.
tant fact is that u
values it the mos'
innocent party al
efficiency standpo
inncent party is
lage award: insuffi-
::ent party's perfor-
of supervisory costs
:emedies
Legal and equitable
proposed approach
:sors Calabresi and
ned to promote effi-
that is, in circum-
as already allocated
>, to various scarce
1 conducted so as to
s having been done,
les oflaw, will most
lmed suggest that,
ange offer the best
to their highest val-
ugh the granting of
lethod of voluntary
framework, is to be
aining in voluntary
Licting uses is more
b.at the authors call
Level of transaction
lmstances is it pos-
mpeting uses is of
b.en the transaction
is incapable
ltitlements is more
exchange to
of assessing money
w to determine the
nd Melamed, legal
e at which the enti-
::osts been very low.
and Melamed call
icient way of deter-
'e is a conflict if the
ion to the question
.c performance, like
een as alternative
fferent transaction
"]
v
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 33!
costs. When a contract has been breached, the question of utmost importance ti)
the court should be the level of transaction costs facing the defaulter and innocen t
party. If those costs are low, then private negotiations are possible and the mos t
efficient relieffor the court to order is specific performance. If, however, transac-
tion costs are high, then the court should compel an exchange at a collectivel:f
determined value; that is, it should assess money damages against the breacher.
In general, the post-breach transaction costs between contractual parties
should not be high. After all, they have established a relationship before the
breach and the things that make for high transaction costs in other legal contexts
are entirely absent here: the parties have identified each other; they have bal'-
gained to provide for many contingencies-including, possibly, breach; they ma y
have had contact after formation and before full performance to clarify detailB,
report progress, and the like. Thus, if the parties did not provide for sorne forra
ofreliefin the event ofbreach, the costs to them of dealing with the contingency
that has arisen to frustrate the contract should be low. This is a strong prim CL
facie reason for making specific performance, rather than damages, the routine
contract remedy.
Certainly, the costs to the parties of resolving their dispute, for example, (lf
determining what the innocent party's expectation interest is, would seem to be
lower than they would be for a court. This is because the court, in order to
resolve the dispute efficiently and to create an efficient rule to guide future COll-
tracting parties, would have to inform itself about all the relevant terms of tre
contract, the market for the commodity involved, the believability of each party's
evidence on its expectancy, the reasonableness of the risks assumed, and so <)]l.
This is a burdensome and expensive duty for the court to take on. If instead tl:,e
courts routinely award specific performance, future parties may be induced 1;0
stipulate their own remedies ifitis efficient for them to do so; otherwise, they will
bargain in the understanding that specific performance will be enforced in t.be
event of breach.:It follows that only efficient breach will then occur.
To see what this means, let us reconsider the example with which we ha,ve
already discussed the efficiency aspects ofvarious legal remedies. Recall that A
has contracted t.o sen a house t.o B for $100,000. Before the promise is completei,
C offers A $125,000, andA breaches his contract with B in order to sell to C. Sup-
pose now that when B sues A, the court awards B specific performance ratlwr
than damages. This does not mean that the house cannot end up with C, who is
the person to whom wealth-maximizing or efficiency considerations urge us co
direct the asset. Indeed, under specific performance the house can pass to C.n
several ways. A might purchase the right to specific performance from B and tlwn
sell to C. Or B might refuse to release A, take possession, and then sell to C.
In both ofthese cases, the house eventually passes to C, who, by assumption,
values it more than does either A or B. What distinguishes the cases is the (lis-
tribution of the gain from that breach. Where the remedy is specific perfor-
mance, private negotiations after the innocent party has been assigned 1the
entitlement to performance are the mechanism for dividing the gain. The imper-
tant fact is that under specific performance the house will pass to the party who
values it the most, regardless of how negotiations between the breacher and the
innocent party apportion the surplus from breaching and selling to C. From an
efficiency standpoint the allocation of this increase in value between breacher and
innocent party is of secondary interest. * * *
336 LAW AND ECONOMICS ANTHOLOGY
El. The Effect of Specific Performance on Formation (Pre-Breach)
Negotiation Costs
One of the claims I have made for specific performance is that it will induce
parties to exchange promises more efficiently. There are two important issues
here: first, is it possible that the law's current restrictions on the availability of
specific performance correspond to the choice between specific performance and
money damages to which contractual parties would stipulate if they were per-
fectly free to do so, and second, would specific performance cause contracting par-
ties to expend resources inefficiently at formation time? If the answer to either
question is yes, then there is reason to doubt the superior efficiency of specific
performance as the routine contract remedy. However, as we shall see, neither of
these questions may be answered affirmatively. The conclusion I draw is that spe-
cific performance, especially when combined with the more liberal attitude urged
aboye for interpreting liquidated damages, will, in general, lower contract for-
mation costs.
1. The Relationship of Current Specific Performance Rules to Stipulations
in Voluntary Exchanges
Let us begin by seeing whether it might not be the case trat the law's cur-
rent rules for awarding specific performance and money damages correspond to
what freely contracting parties would choose to stipulate as their contractual
relief in the event of breach. The importance of the inquiry is this: if current
remedies correspond to what voluntary exchange would stipulate at formation
time as the wealth-maximizing remedies, then that constitutes strong evidence
that the current law of contract remedies is efficient.
In an important article Professor Kronman has suggested that, judged on an
efficiency standard, specific performance is currently being correctly invoked. The
heart of the argument is that, in a contract for the sale of a unique good, promisor
and promisee would agree, ifthe court would recognize their agreement, that the
promisor should perform specifically. By the same token, in a contract for the sale
of a fungible good, promisor and promisee would agree that money damages
would be paid to the promisee in the event of the promisor's breach. Central to
Professor Kronman's thesis that damages and specific performance are cur-
rently being efficiently applied as contract remedies is the cost to the court of
determining the value of a substitute good. * * *
The costs incurred in pre-contract search-those oflocating sellers, obtain-
ing information, comparing quality, and so on-are not generally recoverable if
the contract is breached. In this respect what distinguishes fungible from unique
goods is that, des pite the breach, pre-contract search costs will bear fruit in the
case offungible goods but not in the case ofunique goods. Therefore, money dam-
ages are likely to be under-compensatory in the case of unique goods; * * *
When the contract covers unique goods, the promisee will prefer the remedy
of specific performance to damages, under which he is likely to be under-com-
pensated in the event of breach. The promisor will always prefer damages to spe-
cific performance, regardless of whether the good is unique. The promisor must
therefore be enticed to opt for a clause in favor of his specific performance by the
promisee's offer to paya contract price that is greater than he would pay if he
only wanted money damages. Professor Kronman argues that promisors of
CH
unique goods, faci
specific performal
chances ofhis reCE
non-unique goods
offers before he r
adamant about re
In short, Kronma
tinely apply monl
stances in whicl
negotiations betwl
in case of breach ,
versus equitable r
There is a sel
forceful as it at fi
Kror.man's conclu:
this hypothesis, lE
equitable relief is
is not correcto Spe,
circumstances in
most often cited u:
economically speal
most circumstancE
2. Contract Form,
Stipulated Rern
Almost no att
the routine r e m e d ~
sibilities: formatio
tion costs under m
to which the prom
specific performan
ability ofthe equit
ing around the l
liquidated damage
wants his subjectiv
of insuring agains1
than the other con
mance. This happ
promisor is proba1
might offer to pay t
and the enforceabi
It might be al
ing to protect subjl
of specific perform
goods would be ra
sorne formation ex
formance. The wor:
neous product woul
to inelude a stipula
each)
ls that it wiIl induce
ro important issues
n the availability of
fic performance and
te if they were per-
use contracting par-
he answer to either
!fficiency of specific
sha11 see, neither of
n 1 draw is that spe-
)eral attitude urged
lower contract for-
;0 Stipulations
that the law's cur-
lages correspond to
s their contractual
r is this: if current
lulate at formation
;es strong evidence
l that, judged on an
rectly invoked. The
que good, promisor
greement, that the
ontract for the sale
lt money damages
breach. Central to
formance are cur-
ost to the court of
ing sellers, obtain-
'ally recoverable if
19ible from unique
11 bear fruit in the
efore, money dam-
e goods. * * *
prefer the remedy
to be under-com-
lr damages to spe-
'he promisor must
erformance by the
le would pay if he
;hat promisors of
--------------------------_._-
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 337
unique goods, facing a thin market, will be more willing to accept a provision for
specific performance than would be the case with fungible goods because the
chances ofhis receiving a more attractive third-party offer are not very high. For
non-unique goods and services, the promisor is more likely to receive alternative
offers before he has fulfilled his contractual promise and is, therefore, more
adamant about retaining the flexibility that comes with a money damages rule.
In short, Kronman concludes that the circumstances in which courts now rou-
tinely apply money damages and specific performance are the same circum-
stances in which efficiency dictates those remedies. Moreover, private
negotiations between parties at the time of contract formation covering remedies
in case of breach would also conform to the current judicial guidelines for legal
versus equitable relief.
There is a sense in which this conclusion is perfectly correct and yet not as
forceful as it at first may seem, and there is another sense in which Professor
Kronman's conelusion is incorrecto Before discussing what may be correct about
this hypothesis, let me point out where it goes awry. First, the contention that
equitable relief is reserved in the law only for contracts involving unique goods
is not correcto Specific performance has been applied by the courts to numerous
circumstances in which 'uniqueness' of goods or services is not obvious. The
most often cited unique contracts are those for the conveyance of land, and yet,
economica11y speaking, there is nothing unique about parcels of realty. In fact, in
most circumstances substitutes abound. * * *
2. Contract Formation Costs with Specific Performance Available as a
Stipulated Remedy and as the Routine Court-Imposed Remedy
Almost no attention has been paid to the effect that specific performance as
the routine remedy would have on contract formation costs. There are three pos-
sibilities: formation costs can rise, be unaffected, or fall, as compared to forma-
tion costs under money damages as the routine remedy. For those performances
to which the promisee attaches a subjective valuation the formation costs under
specific performance would probably decrease. This is because the wider
ability of the equitable remedy would relieve the parties of the costs of contract-
ing around the law's unwillingness to enforce either a punitive-seeming
liquidated damages clause or an agreement to perform specifica11y. A party who
wants his subjective valuation protected must currently find alternative methods
of insuring against that frustration. He must, for example, find someone other
than the other contracting party to underwrite his subjective value on perfor-
mance. This happens even in circumstances, as we have seen, in which the
promisor is probably the cheapest provider of that insurance. The promisee
might offer to pay.the promisor a performance bonus, but its specification is costly
and the enforceability of that provision is itself in sorne doubt.
It might be argued that even if the contract formation costs of those seek-
ing to protect subjective valuation would be reduced by the routine availability
of specific performance, the costs for those contracting for the sale of fungible
goods would be raised. This would be the case if the parties had to undertake
sorne formation expenses not currently incurred in order to avoid specific per-
formance. The worst that can be envisioned is that the sale of a purely homoge-
neous product would become more expensive because the parties would be obliged
to inelude a stipulation as to damages. * * *
:338 LAW AND ECONOMICS ANTHOLOGY
Another group whose costs of contracting may be increased by the rou-
tinization of specific performance are those who would prefer stipulated money
damages sufficient to protect their subjective valuation. It is hard, however, to see
how they would be worse off under specific performance than under the regime
of money damages. Let us assume for the moment that courts continue not to
enforce liquidated remedies that contain a seeming in terrorem clause. The best
that this group can do under current contract remedies is to contract around
these restrictions or, if a breach occurs, to persuade the court of the inadequacy
of money damages. Both of those alternatives are expensive. If specific perfor-
mance becomes widely available, the costs to this group of protecting their sub-
jective valuations will be reduced, but not minimized. So, although the
routinization of specific performance is not the best of a11 possible worlds for a11
of those with a subjective valuation to protect, it is better than a system in
which money damages are the routine remedy. * * *
C. Post-Breach Costs and Specific Performance
The literature on the efficiency of specific performance has concentrated on
its post-breach negotiation costs. The consensus seems to be that these costs will
be higher than those under money damages. There are sound reasons for ques-
tioning this conclusion. First, even if post-breach negotiating costs are higher
under specific performance, they may be more productive at guaranteeing only
efficient breach of contracto Second, post-breach costs may be high only during a
transition period during which contractual parties adjust from damages as the
principal contract remedy to specific performance as the routine remedy. As
noted in the previous section, if the equitable remedy becomes widespread, the
process of contract formation will become more efficient, leading, ceteris paribus,
to fewer contract disputes. Third, court costs under specific performance will be
1ess than under money damages. This is because there will be fewer contract dis-
putes and, because the costs to promisees of protecting their subjective valuation
of performance will be reduced, they will not have to make elaborate and expen-
sive showings to the court of the inadequacy of money damages. * * *
2. Court Costs
By "court costs" 1 mean a11 the costs ofusing litigation to resolve a contract
dispute in which the innocent party is asking for specific performance. The pur-
pose of this examination is to compare those costs with the costs of determining
the level of money damages that would make the innocent party just as well off
as ifthe contract had been performed. Thus, the comparison is not between the
court costs of legal and equitable remedies under the current regime in which
money damages are presumed to be adequate unless the breachee makes a con-
vincing showing oftheir inadequacy. Rather, the comparison is between two dif-
ferent systems: in one, money damages is the routine contrad remedy; in the
other, specific performance is the routine remedy. I shall as sume that in both sys-
tems the goal ofthe law is to protect the breachee's expectation interest in order
to induce promisors to breach only when it is Pareto-efficientto breach.
When money damages are the routine remedy for breach of contract, the
information demands on a court in reaching the efficient level of damages are
extremely large. It is agreed that the plaintiff's expectation interest must be pro-
tected in order to guarantee that the contractual performance will accrue to the
.,\,
CE
party who values
difference betwee
tract pricemust
tractuallanguagt
evidentiary task.
gerate his reserv
evidence on the v
a fungible good, i
the good that is d:
less, the court c
expectancy throu
that, even with tl
be frustrated by !
not fungible, the I
Whether the
costs associated ~
ated with assessin
with an exception
breach. Once tha
resolve the matter
damages, the cou
amount of damagt
3. Relative Cover
In the recen1
matter of relative
with whether the
lower cost and wh
efficient remedy. (
son to believe that
for example, that
than can the selle
than is the se11er.
est-valued use are
since he is the par1
it is indeed the bu,
were the remedy,
would inefficiently
On the other hall(
than to have him p
cific performance J
that no general pn
that this cannot bE
cific performance,
He considers
argued that ifbuyE
specific performan
in order to use pos'
themselves. This o
creased by the rou-
'er stipulated money
hard, however, to see
,lll under the regime
urts continue not to
"em clause. The best
i to contract around
rt of the inadequacy
'e. If specific perfor-
lrotecting their sub-
. So, although the
Issible worlds for all
r than a system in
nas concentrated on
that these costs will
ld reasons for ques-
ng costs are higher
t guaranteeing only
high only during a
om damages as the
routine remedy. As
tes widespread, the
ing, ceteris paribus,
Jerformance will be
fewer contract dis-
mbjective valuation
aborate and expen-
ges. * * *
) resolve a contract
formance. The pur-
)sts of determining
lrty just as well off
is not between the
1t regime in which
lchee makes a con-
is between two dif-
act remedy; in the
ae that in both sys-
m interest in order
. to breach.
ch of contract, the
rel of damages are
terest must be pro-
will accrue to the
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 339
party who values it the mosto In the case of seller's breach, this means that the
difference between the buyer's reservation price for the performance and the con-
tract price must be awarded to ensure a Pareto-efficient breach. Absent con-
tractuallanguage specifying what that reservation price is, this is a formidable
evidentiary task. As noted aboye, at trial the buyer has every incentive to exag-
gerate his reservation price. Thus, the court must evaluate the innocent buyer's
evidence on the value to him of the performance. Where the performance involveE
a fungible good, it is true that there is not likely to be a subjective valuation 01"
the good that is different from the contract or market price ofthe good. Nonethe
less, the court concerning itself with efficiency and determined to protect
expectancy through the assessment of money damages must take pains to seE.
that, even with the fungible good, there is not an expectation interest that wiL
be frustrated by an award only of the contract price. Where the performance it:
not fungible, the evidentiary problems multiply.
Whether tha performance concerns a unique or a fungible good, the cour1;
costs associated with specific performance are likely to be less than those associ
ated with assessing money damages. With specific performance the court's inquiry,
with an exception noted below, ends with a determination that there has been El
breach. Once that determination has been made, the parties to the contrac';
resolve the matter ofthe breachee's expectancy through negotiations. With mone)'
damages, the court must determine whether there has been a breach and th(!
amount of damages that will efficiently compensate the innocent promisee. * *
3. Relative Cover Costs
In the recent literature on the efficiency of various contract remedies, tlw
matter of relative cover costs has received much attention. The issue has to do
with whether the seller or the buyer, after a breach, has access to the market Re
lower cost and whether, therefore, damages or specific performance is the mom
efficient remedy. Consider the case of seller's breach. Suppose that there is rea-
son to believe that the buyer is better able to cover than is the seller. It might be,
for example, that the buyer can buy from the seller's competitors more cheapl:r
than can the seBer, or that the buyer is more aware of his idiosyncratic need,)
than is the seller. The total resources consumed in moving the good to its high-
est-valued use are then minimized by making the buyer responsible for
since he is the party who can cover more cheaply. Under a rule ofmoney damage3
it is indeed the buyer who would cover. It is argued that, if specific
were the remedy, then the buyer-here assumed to be the cheaper coverer--
would inefficiently leave to the seller the task offinding substitute performance.
On the other hand, if it is less expensive to have the breaching seller perform
than to have him pay damages to the buyer and to have the buyer cover, then spe-
cific performance may be the preferred remedy. Professor Schwartz has argued
that no general presumption holds: buyers and sellers have similar cover costs Si)
that this cannot be used as a device for deciding which remedy, damages or spe-
cific performance, is more efficient .
He considers four possible objections to this conclusion. First, it mightbe
argued that ifbuyers have generally lower cover costs but the routine remedy is
specific performance, this difference in cover costs could induce buyers to bread1.
in order to use post-breach negotiations to redistribute the gains from breach to
themselves. This objection makes the unwarranted assumption that the differ-
~ 4 0 LAW AND ECONOMICS ANTHOLOGY
ence between seller's and buyer's cover costs is greater than the buyer's lawyer's
fees and other court costs.
Second, it might be objected that specific performance wiIl induce excessive
post-breach negotiation costs in the extreme circumstances in which the seller
cannot cover at all. This might be the case if the seller is a monopolist or if the
contractual good is unique. In those cases, however, the buyer cannot cover
either, so that there is no reason to believe that post-breach negotiation costs wiIl
be higher under one remedy than under the other.
Third, specific performance may generate higher post-breach negotiation
costs when there are two buyers and the first buyer's intended use for the seller's
g:ood is fungible while the second buyer's is noto Consider a contract for the saJe
offarmland. The original buyer intends to use the land to farm, but prior to deliv-
erya second buyer appears with a unique plan for the land and an offer to pay
more than the original buyer. The seller refuses to perform in the hope of selling
to the second buyer. The objection to specific performance in this circumstance is
that, snce the cover costs for the first buyer are low, he should be gven money
damages in order to minimize the post-breach costs of moving the land to the
highest-valued use. Under specfic performance, the first buyer would likely
engage in protracted negotiations in order to capture sorne of the seller's profit
from the sale to the second buyer. Presumably, the suggestion1is that an excep-
ton be made to specific performance as the general rule in these crcumstances.
Yet the litigation costs of determining whether a given fact situation fits this
exception are likely to be hgh-hgher, in general, than the efficency gans from
suspending equtable relief.
Fourth, when there are changed circumstances, the transacton costs of
resolvng a breach through negotatons are hgher under specfic performance
than under money damages. Consder rapid inflation. Professor Schwartz gves
the followng example. A buyer has contracted for constructon of a bulding at
$10,000 from which he will realize a profit of $3,000 upon completion. The con-
tractor anticipated that the construction would cost him $8,000, but because of
unanticipated inflation his costs have risen to $15,000. The promisor would pre-
fer to breach, all other thngs equal, and pay the buyer his expectancy of $3,000,
rather than to incur the additional costs of $7,000. It is cheaper for him to
breach than to perform, and because the buyer can be made just as well off as he
would have been had the contract been performed, breach and the payment of
expectation damages would appear to be Pareto-efficient. However, if specific per-
formance is the routine remedy, the promisee will threaten that remedy in order
to force the contractor to pay him more than his expectancy. The promisor should
be willing to pay up to slightly les s than $7;000 in order to be relieved ofhaving
to perform. The situation will not, however, be materially different under the
damage remedy. Since the standard remedy for breach of a construction contract
is the difference between the contract price and the new market price, the
promisee can still force negotiations because he retains the power to impose a
$7,000 10ss on the contractor, even under damages. This is because the new
market price would be $17,000-the $15,000 costs plus $2,000 profit-which is
$7,000 greater than the contract price of $10,000. Thus, in changed circum-
stances there is no greater post-breach efficiency 10ss under specific perfor-
mance than there is under money damages.
-------------------------------------------------------------------
There are tW(
about relative COVE
contracting partie:
relative advantage
the superior abilit)
terms. If so, then t:
of breach becomes
risk of a particula]
The second pe
tiation costs a dea
tribute wealth. In
such deadweight 1
ciency losses may 1
the future and so p
formance in an ins
who has breached
higher post-breach
Nonetheless, cons:
behavior of future
buyer has lower ce
framing the terms
10wer contract pric
buyer assuming th
willing to assume t:
better off knowing
with negotiating al
formance willlead
exchange of mutua
4. Mitigation
* * * We shou
reliefwith regard 1
With money dama
losses, and it is gel
With specific
easy to see how suc
This raises the COI:
there would be avoi
the duty to mitigat
stitute a strong ar!
remedy. * * *
Consider a COl
pose that B agrees .
S wiIl realize a prof
rateur, has sufferet
the contracto If thE
entitled to his expe
mitigate his los ses
specific performan(
;he buyer's lawyer's
ill induce excessive
in which the seller
nonopolist or if the
lUyer cannot cover
:!gotiation costs will
breach negotiation
l use for the seller's
ontract for the sale
t, but prior to deliv-
and an offer to pay
the hope of selling
his circumstance is
lId be given money
ng the land to the
lUyer would likely
f the seller's profit
n is that an excep-
ese circumstances.
situation fits this
ficiency gains from
'ansaction costs of
ecific performance
lOr Schwartz gives
m of a building at
npletion. The con-
00, but because of
'omisor would pre-
lectancy of $3,000,
J.eaper for him to
st as well off as he
ld the payment of
!ver, if specific per-
lt remedy in order
le promisor should
relieved of having
fferent under the
struction contract
narket price, the
Jow.er to impose a
because the new
:) profit-which is
changed circum-
!r specific perfor-
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 341
There are two further points, not raised by Professor Schwartz, to be made
about relative cover costs and the efficient contract remedy. The first is that the
contracting parties may well have taken into account in the contract price their
relative advantages in access to the market in the event ofbreach. The party with
the superior ability may well have used that fact to offer more attractive contract
terms. If so, then the matter of who should bear liability for covering in the event
of breach becomes a matter of determining the parties' implicit assignment of the
risk of a particular contingency. * * *
The second point is that it is an overstatement to call the post-breach nego-
tiation costs a deadweight efficiency loss in so far as they serve only to redis-
tribute wealth. In some of the circumstances described aboye, there may be
such deadweight losses. It is vital to note, however, that these short-term effi-
ciency los ses may lead to a superior exchange ofmutually beneficial promises in
the future and so pay for themselves. Suppose that the court imposes specific per-
formance in an instance in which the buyer has lower cover costs than the seller,
who has breached. From the discussion aboye we know that this will lead to
higher post-breach negotiation costs than ifthe court awarded money damages.
N onetheless, consider the effect of this award of specific performance on the
behavior of future contracting parties. A future seller aware of the fact that the
buyer has lower cover costs will insist on taking this fact into consideration in
framing the terms of the contracto He should, for example, be willing to offer a
lower contract price, discounted by the probability ofbreach, in exchange for the
buyer assuming the risk of covering in the event of breach. The buyer should be
willing to as sume this risk in exchange for a lower contract price. Both parties are
better off knowing that this assignment of risk will save them los ses associated
with negotiating'about the division of the gains from breach. Thus, specific per-
formance willlead to more efficient contracting by encouraging a more efficient
exchange of mutually beneficial promises in the future. * * *
4. Mitigation
* * * We should like to know the relative efficiency of legal and equitable
reliefwith regard to their ability to induce efficient mitigation after the breach.
With money damages there is an obligation on the breachee to mitigate his
losses, and it is generally conceded that this is an efficient obligation.
With specific performance there is no such obligation to mitigate, nor is i1.
easy to see how sllch an obligation could be imposed under that contract remedy.
This raises the concern that under specific performance as the routine remedy
there would be avoidable inefficiencies in that the promisee would no longer havE'
the duty to mitigate his los ses from nonperformance. If this is true, it may con ..
stitute a strong argument for retaining money damages as the routine contrad
remedy. * * *
Consider a contract for the sale of a perishable product like tomatoes. Sup
pose that B agrees to purchase 100 tons offresh tomatoes from S at $100 per ton,
S wiIl realize a profit of $2,000 on the sale. S secures the produce, but B, a restan ..
rateur, has suffered a financial set-back and announces his intention to breac:h
the contracto If the routine contract remedy is money damages, then S will bE!
entitled to his expectancy, $2,000, plus any incidental costs incurred in trying 1;0
mitigate his losses by selling the tomatoes elsewhere. If the routine remedyifi
specific performance, then there is afear that S will simply allow the tomatoe:
342 LAW AND ECONOMICS ANTHOLOGY
to rot or that, more likely, his incentive to resell them is less than is the case with
money damages. Alternatively, specific performance may induce B to take deliv-
ery ofthe tomatoes, pay S $10,000, and attempt to resell them himself. If Bis less
advantageously placed to resell than is S, then it might be argued that specific
performance has created an inefficiency by placing the duty to cover on the
party with the higher cover costs.
This inefficiency is illusory. B need not take delivery under specific perfor-
mance, nor necessarily pay more in settlement to S that if a court awarded S his
expectancy plus incidental expenses in reselling. If B would rather not be saddled
with the costs ofreselling the tomatoes, then he can purchase S's right to enforce
the contract from S for $2,000 plus S's costs ofresale. This will satisfy S since he
is, by definition, doing as well as if B fully performed. B is better off in paying this
sum than in taking delivery if his resale costs are greater than S's. Note that this
is precisely the outcome that would have resulted if money damages were the rou-
tine remedy. Thus, with regard to perishable commodities, the result of a buyer's
breach is the same whatever the contractual remedy. Neither remedy is more effi-
cient thanthe other. This means that, even without a duty to mitigate under spe-
cific performance, the incentives facing both promisee and promisor willlead to
a mitigation of the losses arising from the buyer's breach.
When we turn to the duty to mitigate when the object of the breach is a non-
perishable commodity, the issues become more complex but the conclusion is the
same. Consider a contract between L, a landlord, and R, a renter, for the rental of
L's property at a fixed monthly rate for a term of five years. After two years R finds
it no longer profitable to continue the rental and announces his repudiation of the
contracto Under a rule of money damages, L is entitled to his expectancy but has
a duty to try to relet the property in order to mitigate his losses. Generally speak-
ing, L may not simply bring an action to collect the remaining three-year's rento
Under the duty to mitigate L may recover any incidental expenses involved in
reletting the property plus the difference between the contract price and the new
rental rateo It is feared that under specific performance L will have no incentive
to mitigate; instead, he will inefficiently holdR to the terms ofthe rental contract
rather than making efforts to move his property to its next best use.
It is not at aH clear that even under money damages L's behavior will be dif-
ferent when he has a duty to mitigate than when the law imposes no such duty.
That is, regardless of the contract remedy and of any duties imposed, L might
want to try to mitigate his losses by reletting his property after R's breach.
Assume that under legal relief L is entitled to the remaining three-years' pay-
ment on his contract and that there is no obligation on him to minimize his losses.
R, who now faces the responsibility ofpaying the remainder ofthe contract, will
attempt to relet the property himself, assuming that he is hot prevented from
doing so by the terms of the contracto R may not be able to relet the property as
efficiently, i.e., as cheaply, as could the landlord. Nonetheless, with no duty onL
to mitigate, R will attempt to mitigate his losses by reletting the property. It is
even possible that, if L has an appreciable cost advantage in reletting the prop-
erty, R will pay L something less than his cover costs but greater than L's cover
costs to induce L to as sume the duty to find another lessee. Both parties would
be better off under such an arrangement than if the nefficient party, R, were to
attempt the reletting alone.
CH
What this m ~
seller to mitigate
breach agreement
Precisely the saml
performance. If L
stand in relation
money damages \\
private settlemen'
occur through a lE
formance there wi
breach through a
to mitigate.
Let us consic
under the conditic
forbidden to sublel
county in which j
makes the sale of;
L sues for specific
R will be inefficier:
R has no right to s
L the right to enfe
that right for less
possibility that R
because L insisted
as a saloon. Suppo
been $600, but thf:
tled to a stream of
to pay him more tl
on the original con
$550 per month ir
of the premises fl
amount if there is
$550 per month pl
5. Consequential
One of the COl
party is not, in gen
derives from the d
celebrated case of
to be held liable
breach, unless he
ages.* * * *
Because ther
those that are r e a ~
itation will be pre
first blush, there ~
*
[Ed.: We h a v ~
than is the case with
duce B to take deliv-
n himself. If B is less
argued that specific
.uty to cover on the
nder specific perfor-
court awarded S his
ather not be saddled
e S's right to enforce
rill satisfy S since he
;ter off in paying this
m S's. Note that this
cmages were the rou-
le result of a buyer's
remedy is more effi-
. mitigate under spe-
lromisor willlead to
the breach is a non-
;he conclusion is the
lter, for the rental of
ter two years R finds
is repudiation of the
expectancy but has
es. GeneraIly speak-
19 three-year's rento
x:penses involved in
~ t price and the new
II have no incentive
f the rental contract
est use.
behavior wiIl be dif-
.poses no such duty.
s imposed, L might
;y after R's breach.
19 three-years' pay-
minimize his losses.
of the contract, will
not prevented from
~ l e t the property as
l, with no duty on L
g the property. It is
reletting the prop-
later than L's cover
Both parties would
nt party, R, were to
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 343
What this means is that, even under money damages without a duty on the
seller to mitiga te, there are strong incentives for a mutually beneficial post-
breach agreement between buyer and seller to minimize the los ses from breach.
Precisely the same sort of conclusion follows when the routine remedy is specific
performance. If L is entitled to that remedy, then after the breach he and R
stand in relation to each other in exactly the same manner as they did under
money damages without a duty on L to mitigate his losses. We saw there that a
private settlement would minimize los ses in precisely the manner envisioned to
occur through a legal duty to mitigate; hence it follows that under specific per-
formance there will also be an incentive for L and R to minimize the losses from
breach through a private negotiation that is indistinguishable from a legal duty
to mitigate.
Let us consider an extreme case: R has rented L's premises for five years
under the condition that he use the property only as a saloon; furthermore, he is
forbidden to sublet the premises during the term ofthe lease. After two years, the
county in which R has been operating his saloon suddenly and unexpectedly
makes the sale of alcoholic beverages illegal. R breaches his contract with L, and
L sues for specific performance. Under that remedy, might it not be the case that
R will be inefficiently bound to pay L the remaining three-years' rental? Although
R has no right to sublet, he does have at his disposal the opportunity to buy from
L the right to enforce the decree of specific performance. Clearly, L will not sell
that right for les s than R is obliged to pay him under the contracto Consider the
possiblity that R paid a lower than market rental rate for L's property precisely
because L insisted on the limitations that it not be sublet and that it be used only
as a saloon. Suppose that without those restrictions the monthly rent would have
been $600, but that with them it was $500. Under specific performance L is enti-
tled to a stream ofincome of $500/month for another three years. Only if R is able
to pay him more than that wiIl L consent to release him from specific performancE
on the original contracto There is every reason to believe that R will pay him, say
$550 per month in return for L's waiving the restrictions on subletting and USE
of the premises for another purpose. R will be willing to pay that increaseo.
amount ifthere is an alternative use ofthe property that makes the payment 01'
$550 per month profitable to him. * * *
5. Consequential Damages
One of the common rules in assessing contract damages is that the innocen1;
party is not, in general, entitled to coIlect for his consequential damages. The r u l E ~
derives from the doctrine offoreseeablity of contract damages enunciated in the
celebrated case of Hadley v. Baxendale. That doctrine holds that the breacher in
to be held liable only for the reasonably foreseeable losses arising from hin
breach, unless he was notified of and agreed to accept liablity for remote dam
ages.* * * *
Because there is an efficiency reason for limiting a breachee's losses to
those that are reasonably foreseeable, the question arises as to whether this lim-
itation will be preserved under specific performance as the routine remedy. At
first blush, there would appear to be no such limitation: the breachee, in his pOEt-
*
[Ed.: We have seen this rule in the Ayres & Gertner and Johnston excerpts above.)
344 LAW AND ECONOMICS ANTHOLOGY
breach negotiations, would seek to recover all his losses, foreseeable or noto
Without limitation imposed by the court, specific performance would seem to lead
to the possibility of the innocent party's inefficiently recovering too mucho
This conclusion would be incorrecto First, while it might be true that in the
initial instances of awards of specific performance as the routine remedy the
breachee would press for more than he would have recovered under money dam-
ages as tempered by foreseeability or a duty to mitigate, this over-recovery
would not persist for future contracting parties. If it were known that the
breachee could, under specific performance, hold out for foreseeable and extra-
ordinary losses, then a limitation would likely become a part ofthe contract itself,
either in the form of a waiver of liability for consequential damages or as speci-
fied in a liquidated damages clause. Bargaining at contract formation time about
either ofthose alternatives would lead to an efficient assignment ofliability: ifthe
potential breacher were the superior risk-bearer for aU the potential breachee's
losses, he should be willing to assume liability for aU losses in exchange for a
slightly higher contract price. If, on the other hand, the breachee is better placed
to insure against or prevent sorne but not alllosses, then responsibility for those
different types of loss should be exchanged in a value-maximizing way.
Second, the situation in which the breachee recovers both foreseeable and
extraordinary los ses under specific performance is never likely to arise. This is
because, in the situation in which losses have already be en incurred and there is
no physical way in which performance can be completed by the breacher, specific
performance would not be a viable remedy. Money damages will have to do. * * *
D. Defenses
When, under current law, an aggrieved contractual party asks for specific
performance, the defendant is allowed to invoke certain defenses that would not
normally be available if the innocent party were asking for money damages. He
may claim an inadequacy of consideration, a lack of sufficient security for the
promisee's performance, and unilateral mistake by the promisor. There is no
sound economic reason for any of these defenses in the economic analysis of con-
tract law. Since none ofthem have found favor as formation defenses, there is no
good reason to offer them to defendants for use in specific performance actions.
I shall not discuss these.
There are two additional defenses, however, to which there is sorne economic
content: difficulty of supervision and impossibility. * * *
1. Impossibility
* * * When performance by the breacher is literally impossible, economic
efficiency is not served by awarding the breachee specific performance. Specific
performance is, in those circumstances, of infinite worth: it is the sum for which
a promisee to whom the court has awarded specific performance will seU his right
to have the contract enforced .... Money damages will have to suffice to protect
the expectancy of the clients.
2. High Supervisory Costs
One of the most troubling issues in making specific performance the routine
remedy for breach of contract is that there may be circumstances in which the
costs to the court of supervising the performance of the breacher may be ineffi-
r--li
Cl
ciently high ....
effective
ater and subseql
requiring A to a
whether, after B 1
contractual oblig
narily high. For E
mance as the PriJ
dispute with B 1:
embarrass B by t
Should it specify
is a real one that
The contenti
of using specific p
ages are more att:
may be relieved o
supervision costE
where it may be i
igation, it might
mance more expe:
A further content
assumed involve 1
the routine contr,
While there
considered. For tl
sion costs must a1
the most efficien1
these matters car
First, the se
high may be a rl
point of excluding
vices, presumabl)
costs are high. Yel
believe that the CI
make economic se
those cases, like p
be high.
Second, even
that would follow
two reasons for t
promisor's regard
temper the incent
The presum]
result in
cific performance,
to the litigants to
There is every reE
manee against A 1
dispute, with A PI
, foreseeable or noto
would seem to lead
too mucho
ht be true that in the
routine remady the
,d under money dam-
l, this over-recovery
ere known that the
reseeable and extra-
of the contract itself,
damages or as speci-
time about
lent ofliability: ifthe
potential breachee's
es in exchange for a
chee is better placed
;ponsibility for those
mizing way.
)oth foreseeable and
{ely to arise. This is
ncurred and there is
he breacher, specific
will have to do. * * *
rty asks for specific
,nses that would not
money damages. He
ent security for the
)misor. There is no
mic analysis of con-
lefenses, there is no
erformance actions.
re is sorne economic
lpossible, economic
rformance. Specific
3 the sum for which
ce wiIl seU his right
to suffice to protect
rmance the routine
ances in which the
may be ineffi-
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 34Ei
ciently high .... [T]he performance contemplated may be so complex as to
effective supervision. Suppose thatA contracts with B to play Hamlet at B's the
ater and subsequently A refuses to perform. A court will not give B a
requiring A to acto It is no doubt true that the costs to the court of judging
whether, after B has received a specific performance decree, A had discharged hi!;
contractual obligation, including the quality of his performance, are extraordi
narily high. For example, how should the court assure the quality of A's perforo
mance as the Prince of Denmark? Perhaps because A is in such a pique about hi:;
dispute with B he might, without stringent supervision by the court, seek to
embarrass B by the shoddiness of his Hamlet. But how far should the court go?
Should it specify gestures, grimaces, smiles, tones of declamation? The problem
is a real one that the design of efficient remedies must seriously confronto
The contention is, in part, that high supervision costs will increase the costs
ofusing specific performance as the routine remedy to the point that money dam-
ages are more attractive. Consider, for example, that if defendants know that the:r
may be relieved of specific performance when they are able to demonstrate high
supervision costs, then they have an incentive to raise that defense in cases
where it may be inappropriate. Since this would, in general, raise the costs of lit-
igation, it might make the otherwise more efficient remedy of specific perfor-
mance more expensive and, therefore, less clearly efficient than money damageE.
A further contention is that since a far wider set of contracts than is commonl)!
assumed involve high supervision costs, specific performance is inappropriate as
the routine contract remedy.
While there is something creditable to this criticism, it must be carefuJIy
considered. For this criticism of specific performance to hold true, high superVJ-
sion costs must attend a large number of contracts, and money damages must be
the most efficient means of resolving the breach of those contracts. Neither cf
these matters can be demonstrated.
First, the set of contracts in which supervisory costs are most likely to be
high may be a relatively small class of contracts. The Restatement makes a
point of excluding from relief by specific performance contracts for personal seJ'-
vices, presumably on the grounds that for those contracts a court's supervisor y
costs are high. Yet for nearly every other sort of contract, there is little reason to
believe that thecourt faces high supervisory costs. Thus, at first blush, it would
make economic sense to make specific performance the routine remedy except in
those cases, like personal service contracts, where supervisory costs are likely to
be high.
Second, even where supervisory costs are likely to be high, the inefficiencies
that would follow from granting specific performance are exaggerated. There 8.r e
two reasons for this: the contract may never be performed, and if it is, the
promisor's regard for his professional reputation and future employability wi II
temper the incentive to misperform the contracto
The presumption that an award of specific performance will necessarily
result in performance of the contract is incorrecto We have seen aboye that SIHl-
cific performance, like injunctive relief, should be understood as an instruction
to the litigants to use the market, rather than the court, to solve their
There is every reason to believe that if B is awarded a decree of specific perfo'-
mance against A to play Hamlet, the two will begin negotiations to resolve tLe
dispute, with A presumably willing to pay B not to exercise his right to the COJl-
346 LAW AND ECONOMICS ANTHOLOGY
tractual promise. B, for his part, may be willing to exchange that right rather
than run the risk of incurring large expenses in policing A's portrayal of Hamlet.
I'hat is, it may be mutually beneficial to promisor and promisee to bargain out of
performance. Although it is difficult to know a priori when this will happen, the
possibility that there will be no performance in circumstances in which supervi-
sion costs ofthe performance would be high should lessen the concern about the
inefficiencies that might resulto Indeed, it may be that the proper way to consider
the problem ofhigh supervision costs is not that it puts extraordinary burdens on
the legal system but rather that it merely gives the breacher a much better bar-
gaining position in the post-breach negotiations than would be the case under a
::ontract in which the quality of the breacher's performance was not solely in the
breacher's hands. If that is the proper economic analysis of the matter of high
3Upervision costs, then it may well be that specific performance is the preferred
remedy there, too. Assuming that the promisor makes a credible threat that
3Upervising the quality of his performance will be high, then the worst that can
happen to the promisee is that he accepts, in return for not enforcing his right to
s pecific performance, a price that reflects the contract price less the anticipated
supervision costs. Such a conclusion would serve as an inducement for future con-
tracts regarding personal services, or other high supervisory cost activities, to
include liquidation clauses specifying responsibility for the costs of monitoring
performance. Alternatively, promisees in situations of high supervision costs
will discount the contract price they are willing to give a promisor by the proba-
bility of breach and by the level of anticipated supervision costs.
Even ifthere is no exchange oftheright to performance results, the force of
::ompetition may temper the defendant's urge to misperform in sorne manner. A,
for example, must take care for his future employability on the stage-with
::>ther promoters, if not necessarily B-and this fact may spur him to produce as
c:reditable a Hamlet as ifhe were acting for the sheer love ofit, rather than under
threat of contempt of court.
Thirdly, and lastly, the high supervisory costs of equitable relief are objec-
tionable in large part because they are incurred at public expense. This objection
would be mitigated if the costs were borne by the litigants, not by taxpayers in
general. The use of court-appointed special masters to oversee equitable decrees
is one means of achieving this privatization, but one that, despite its attraction
to economists, does not find much favor in the legal fraternity. * * *
Notes and Questions
1. Another article that also held that specific performance ought to be the
default remedy for breach was Alan Schwartz, The Case for Specfc Per-
formance, 89 YALE L.J. 271 (1979).
2. There have been numerous articles exploring the economics of money
damages for breach of contract. For example, see Robert D. Cooter &
Melvin A. Eisenberg, Damages for Breach of Contract, 73 CAL. L. REV.
1432 (1985); David Friedman, An Economc Analyss of Alternatve Damage
Rules for Breach of Contract, 18 J. LEGAL STUD. 281 (1989); Steven Shavell,
Damage Measures for Breach of Contract, 11 BELL J. ECON. 466 (1980);
\-/
CH
Richard A. E
Law of Cont
Breach ofCe
GERS L. REV. ;
of Contract F
age Measure
Craswell, Co
Breach, 61 ~
cock, Punitiv
REV. 741 (191:
~ e that right rather
lortrayal of Harnlet.
lee to bargain out of
lis will happen, the
!s in which supervi-
e concern about the
Iper way to consider
'rdinary burdens on
a rnuch better bar-
be the case under a
ras not solely in the
the rnatter of high
lce is the preferred
redible threai; that
the worst that can
lforcing his right to
ess the anticipated
nent for future con-
y cost activities, to
~ o s t s of rnonitoring
l supervision costs
nisor by the proba-
'sts.
results, the force of
.n sorne rnanner. A,
In the stage-with
. hirn to produce as
, rather than under
)le relief are objec-
nse. This objection
lot by taxpayers in
! equitable decrees
spite its attraction
y. * * *
e ought to be the
3 for Speeifie Per-
nomies of money
lbert D. Cooter &
t, 73 CAL. L. REV.
Itemative Damage
~ ) ; Steven Shavell,
EeoN. 466 (1980);
CHAPTER 4: THE ECONOMICS OF CONTRACT LAW 347
Richard A. Epstein, Beyond Forseeability: Consequential Damages in the
Law of Contraet, 18 J. LEGAL STUD. 105 (1989); Robert L. Birmingham,
Breaeh of Contraet, Damages Measures, and Eeonomie Effieieney, 24 RUT-
GERS L. REV. 273 (1970); A. Mitchell Polinsky, Risk Sharing Through Breaeh
ofContraet Remedies, 12 J. LEGAL SruD. 427 (1983); Steven Shavell, Dam-
age Measures for Breaeh of Contraet, 11 BELL J. ECON. 466 (1980); Richard
Craswell, Contraet Remedies, Renegotiation, and the Theory of Effieient
Breaeh, 61 S. CAL. L. REV. 629 (1988); Bruce Chapman & Michael Trebil-
cock, Punitive Damages: Divergenee in Search of a Rationa/e, 40 ALA. L.
REV. 741 (1989).