Solomonic Bargaining: Dividing a Legal Entitlement To Facilitate Coasean Trade, 104 Yale Law Journal 1027 (1995) (with Eric Talley)
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CONTENTS

  1. INTRODUCTION
  2. THE INFORMATION-FORCING EFFECT OF UNTAILORED LIABILITY RULES
    1. Information Revelation in the Shadow of Liability and Property Rules
    2. A Formal Model of Untailored Liability and Property Rules
      1. Defining the Game
      2. Deriving the Equilibrium
        1. Bargaining Under an Undivided Property Rule
        2. Bargaining Under a Liability Rule
      3. Liability Rules Can Facilitate Coasean Trade
      4. Reverse Liability Rules and Compensated Injunctions
    3. The Perverse Effects of Tailoring Liability
      1. Tailored Damages
      2. Tailored Liability (a.k.a. The Negligence Standard)
  3. "FRACTIONAL" PROPERTY ENTITLEMENTS AND COASEAN IDENTITY CRISES
    1. Probabilistic Divisions
    2. Activity-Level Divisions
    3. Temporal and Physical Divisions
  4. {HEADING MISSING}
    1. Divided vs. Undivided Entitlements: Four Factors Militating Against the Use of Entitlement Division
      1. The Underinvestment Trade-Off
      2. The Hold-Up Problem
      3. The Disabling Effects of Correlated Valuations and Tailored Rules
    2. Choosing Among Divided Entitlements
    3. Specific Legal Applications
      1. Intellectual Property and Compulsory Licenses
      2. Mistake, Impossibility, Frustration, and Bargaining over Efficient Breach
      3. Concurrent Ownership and Dissolutions
  5. CONCLUSION
  6. APPENDIX
    1. Derivation of Liability Rule Results
    2. The Perverse Effects of Tailoring
      1. Tailored Damages
      2. Tailored Liability
    3. Derivation of Fractional Property Rule Results

I. INTRODUCTION

It is a common argument in law and economics that divided ownership can create or exacerbate strategic behavior. For instance, when several persons own the land designated for a proposed stadium, individual sellers may "hold out" for a disproportionate share of the gains from trade. Alternatively, when building a public library would benefit multiple residents, individual buyers may "free ride" on the willingness of others to pay for its construction. Such transaction costs of collective action fall under a variety of analytic rubrics, including the "tragedy of the commons" and the theory of "public goods." Nonetheless, each example of market failure shares a common attribute: The division of a single legal entitlement, or of rivalrous entitlements, among joint sellers or joint buyers may prevent socially efficient transactions, particularly when the parties possess private information about their preferences.

This Article explores a different way of dividing an entitlement. Rather than analyzing divisions among buyers or among sellers, we consider the effects of splitting an entitlement between the two groups. Our core insight is Solomonic in character: Dividing a legal entitlement between rivalrous users can facilitate efficient trade. More specifically, we show that when two parties have private information about how much they value an entitlement, endowing each party with a partial claim to the entitlement can reduce the incentive to behave strategically during bargaining, thereby enhancing economic efficiency.

Private information is a particularly pernicious form of transaction cost, especially in legal contexts where, for procedural or other reasons, parties must negotiate within "thin" markets. In such contexts, self-interested bargainers have a strong incentive to misrepresent their private valuations so as to capture a larger share of the bargaining "pie." These incentives often lead to predictable opportunistic strategies: Sellers tend to overstate the value they place on the bargained- for item, while buyers tend to understate their desire to purchase it. As a result of such strategic behavior, the parties may fail to detect and exploit a mutually beneficial trade, and even when they can it is usually after considerable and costly delay.

In this Article, we argue that divided entitlements can facilitate trade by inducing claim holders to reveal more information than they would under an undivided entitlement regime. Owners of divided, or "Solomonic," entitlements must bargain more forthrightly than owners of undivided entitlements, because the entitlement division obscures the titular boundary between "buyer" and "seller." More precisely, endowing each bargainer with a share of the underlying entitlement creates the possibility of two different types of Coasean trade: A bargainer might buy the other party's claim, or, alternatively, she might sell her own. During negotiation, each party is likely to be uncertain about whether she will ultimately emerge as a seller or a buyer. This strategic "identity crisis" can strongly mitigate each party's incentive to misrepresent her respective valuation; each party must balance countervailing interests in shading up her valuation, as one would qua seller, and shading down her valuation, as one would qua buyer. This form of rational ambivalence, we argue, can lead the bargainers to represent their valuations more truthfully.

To illustrate this identity crisis with a traditional type of property division, consider a negotiation between Smith and Jones about who should develop Blackacre as a mall. Assume it is commonly known that Blackacre's most valuable use is as a mall, and that either Smith or Jones is the most efficient developer. But assume also that the parties' private valuations make it unclear who is the more efficient developer. Blackacre is divided so that Smith owns Blackacre in fee simple, subject to an executory interest in Jones that becomes possessory if Blackacre is ever used for any purpose other than a horse buggy factory. Because of the low demand for horse buggies, Blackacre's value as a buggy factory is negligible. Under these circumstances, the mall might only be built if one of the parties agrees to sell her estate in the land to the other. Imagine what would go through Smith's mind in considering how much to offer to purchase Jones' interest. Smith, as a buyer, would want to offer a low price, but the possibility that Smith could become a seller complicates Smith's decision. If Smith offers too low a price, Jones is liable to turn the tables by suggesting that Smith should sell her own claim. In essence, Jones would be saying: "Where did you get that price? If that's all you think Blackacre is worth, I'll buy your claim." Thus, when ownership is so divided, a party's explicit or implicit representation about the entitlement's value might be used by the other side to propose the other type of transaction.

This example illustrates how a particular type of division can facilitate efficient trade. Throughout this Article, we compare bargaining in the shadow of an absolute, undivided entitlement to bargaining in the shadow of a number of such Solomonic divisions. Our analysis, however, revolves around two broad axes of division. The first axis represents the degree of protection accorded a given entitlement, and the second axis represents the explicit ownership structure of the entitlement.

With respect to the first axis of division, the law may effect a Solomonic division through the degree to which it protects one's ownership interest in the underlying entitlement. Our discussion of this axis centers predominantly on the distinction-first analyzed by Calabresi and Melamed - between "liability rules" (i.e., remedies at law) and "property rules" (i.e., equitable relief). Protecting an "owner" of an entitlement with a liability rule is a type of Solomonic division, because a liability rule endows "nonowners" with an option to take the entitlement nonconsensually and pay the damage amount. Property protection, on the other hand, does not represent a division, since the nonowner lacks power to appropriate the underlying entitlement nonconsensually.

We show that liability rules possess an "information-forcing" quality that property rules do not. Under a liability rule regime, a nominal entitlement owner has an incentive to reveal truthfully whether her valuation is above or below the damage amount. We demonstrate that the entitlement owner's choice between two different kinds of Coasean transactions acts as a credible signal whether she has a relatively high or relatively low valuation. This credible signal of valuation decreases the aggregate amount of private information by "partitioning" the entitlement holders into two discrete sets, thereby facilitating more efficient trade. In contrast, property rule protections render such credible signaling impossible.

Our argument that liability rules can catalyze consensual trade challenges various common wisdoms in law and economics. Many scholars have argued that clear property rights are appropriate when transaction costs are low, because property rights encourage people to bargain. For example, Judge Posner has captured the common wisdom by asserting that in "low-transaction- cost settings ... the law should require the parties to transact in the market; it can do this by making the present owner's property right absolute (or nearly so), so that anyone who thinks the property is worth more has to negotiate with the owner." These scholars often assert that property rules are "market-encouraging," while liability rules are "market-mimicking." Although a few strands of the law-and-economics literature-particularly the literature on efficient breach of contract- have allowed for parties to bargain in the shadow of liability rules as well as in the shadow of property rules, we are the first to show that liability rules may induce both more contracting and more efficient contracting than property rules.

Viewing liability rules as market catalysts, rather than substitutes, can also lead to other contradictions of the accepted wisdom in law and economics. For instance, the common assertion that liability rules are market-mimicking has led numerous scholars to conclude that the best liability rules are the ones that carefully "tailor" the damage amount to the plaintiff's valuation. Only in this way, many argue, can a court replicate the terms for which parties would have bargained had they been able to negotiate. Because Calabresi and Melamed were so successful in showing that tailored liability rules are appropriate when parties do not have an opportunity to contract, subsequent scholars have overlooked the possibility that untailored rules-which fix damages at one size to fit all plaintiffs regardless of plaintiffs' actual valuation-may promote trade when contracting is possible. And, in fact, we find that when parties have the opportunity to contract, untailored liability rules can be more effective in channeling bargainers toward consensual trade, where the parties tailor the terms of trade themselves. Indeed, tailoring legal rules to give parties private information about the consequences of nonconsensual taking can severely undermine the incentives to trade consensually. When dividing entitlements to facilitate trade, courts should therefore avoid tailoring that creates additional informational asymmetries that amplify strategic behavior. Untailored liability rules represent a largely missing category of entitlement protection that may facilitate trade without the judicial costs of tailoring.

The second axis of division we analyze is the actual ownership structure of an entitlement, focusing explicitly on the benefits of ownership that is "fractional" in nature. Following Professor Ellickson's analysis of land divisions, we show that the identity crisis can facilitate trade whenever an entitlement is divided in any of the traditional ways-"by use, space or time." As in the earlier Blackacre example, each of these species of division can facilitate consensual trade by endowing the respective parties with a partial claim to the underlying entitlement. Scholars have previously recognized that blurring the consequences of decision making can mitigate strategic inefficiencies when partners invoke a buy-sell agreement or when children decide how to cut a cake. But we show that a similar countervailing incentive can exist whenever parties bargain in the shadow of such fractional ownership structures and hence are uncertain whether they might ultimately buy or sell a Solomonic claim.

In addition to the traditional forms of divided ownership structure, we examine one nontraditional division with similar benefits. Legal uncertainty or ambiguity about who owns property can constitute a probabilistic division in that more than one person has a contingent claim to the enjoyment of the underlying right or privilege. Returning to our Blackacre example, if there is a 50% chance that the court will award Blackacre in fee simple to Jones or Smith, then each party has a probabilistic claim. Bargaining in the shadow of this uncertainty might result again in two different types of transactions: buying the other side's claim or selling one's own claim. Once again, the Solomonic division can make it more difficult for either side to offer a price that diverges from her private valuation: One can easily imagine a conversation in which Smith offers to sell her probabilistic share (relinquish all rights to Blackacre) for an inflated price, and Jones responds, "If you think a 50% chance at Blackacre is worth that much, I'll relinquish my rights to you for that price." Foreseeing the possibility of this response, Smith would inflate her selling price by a lesser amount than if she had unambiguous ownership. Accordingly, we predict that parties with private information may be able to bargain more efficiently when property rights are uncertain. This finding contradicts the accepted wisdom that unambiguous property rules encourage contracting. Thus, while Robert Cooter and Tom Ulen merely restate the consensus view in opining that "bargainers are more likely to cooperate when their rights are clear, and less likely to agree when their rights are ambiguous," we extend the seminal insights of Jason Scott Johnston to show in a rigorous model how ambiguity can induce bargainers to act more cooperatively.

This Article focuses on a specific type of transaction cost: private information. When private information is the predominant form of market failure that impairs the operation of the Coase theorem, Solomonic divisions are likely to facilitate efficient allocations through trade. Consequently, Solomonic entitlements may not always facilitate trade if other transaction costs are primarily responsible for Coasean inefficiency. In such cases, Solomonic divisions may even exacerbate such inefficiencies by impeding competition, exacerbating hold-up problems, or weakening investment incentives. These contraindications make clear why undivided property rules are still efficient in many settings. And, in fact, an overarching "Coasean" theme of our analysis is that the type of transaction cost matters: It is inadequate to think of "transaction costs" as some sort of composite good whose components imply similar policies. Nevertheless, this Article shows that claims about the efficiency of property rules cannotbe justified by the common, unqualified assertion that property rules encourage trade.

The Article is divided into three parts. Part II describes the information-forcing effect of liability rules and shows how conditioning either liability or damages on private information can exacerbate the inefficiencies of bargaining under asymmetric information. Part III explores the identity crisis that can be created by other types of entitlement divisions, including probabilistic, physical, temporal, and activity-level divisions. Part IV discusses some limiting principles and examines the legal implications of our analysis.


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