Optional Law The Structure of Legal Entitlements
by Ian Ayres
University of Chicago Press, 2005
Cloth: 978-0-226-03346-4 | Electronic: 978-0-226-03348-8
DOI: 10.7208/chicago/9780226033488.001.0001
ABOUT THIS BOOKAUTHOR BIOGRAPHYREVIEWSTABLE OF CONTENTS

ABOUT THIS BOOK

Spurred by the advances in option theory that have been remaking financial and economic scholarship over the past thirty years, a revolution is taking shape in the way legal scholars conceptualize property and the way it is protected by the law. Ian Ayres's Optional Law explores how option theory is overthrowing many accepted wisdoms and producing tangible new tools for courts in deciding cases.
Ayres identifies flaws in the current system and shows how option theory can radically expand and improve the ways that lawmakers structure legal entitlements. An option-based system, Ayres shows, gives parties the option to purchase—or the option to sell—the relevant legal entitlement. Choosing to exercise a legal option forces decisionmakers to reveal information about their own valuation of the entitlement. And, as with auctions, entitlements in option-based law naturally flow to those who value them the most. Seeing legal entitlements through this lens suggests a variety of new entitlement structures from which lawmakers might choose. Optional Law provides a theory for determining which structure is likely to be most effective in harnessing parties' private information.
Proposing a practical approach to the foundational question of how to allocate and protect legal rights, Optional Law will be applauded by legal scholars and professionals who continue to seek new and better ways of fostering both equitable and efficient legal rules.

AUTHOR BIOGRAPHY

Ian Ayres is the William K. Townsend Professor of Law at Yale Law School. He is a columnist for Forbes magazine and a regular commentator on public radio's Marketplace. He has authored or coauthored seven previous books, most recently Why Not? How to Use Everyday Ingenuity to Solve Problems Big and Small.

REVIEWS

"Optional Law is a tour de force. Ian Ayres shows us how option theory can connect a set of important legal concepts with a breadth that spans areas of contracts, property, and torts. Through the course of this book, Ayres works from a treasure trove of methodology that includes finance theory, game theory, and auction theory."
— Barry E. Adler, Barry E. Adler

"Ian Ayres is one of the great innovators of our time in the legal academy. In Optional Law, he firmly establishes options theory as a valuable tool of legal analysis, and uses it to reveal the underappreciated potential of liability rules to improve both the efficiency and fairness of legal outcomes. True to form, Ayres marries theoretical creativity, clear exposition, and a sense of practical feasibility, in a product that will have a profound impact on the way we understand legal rights."
— George Triantis, George Triantis

"Options theory has many potential applications to law, and with his new book Ian Ayres, a pioneer in the field, seeks to bring the concepts into practice. Ayres demonstrates that legal remedies structured like options can effectively reveal parties' personal valuations, an insight that could help courts to achieve more efficient allocations of entitlements."
— Pul G. Mahoney, Paul G. Mahoney

TABLE OF CONTENTS

Preface

- Ian Ayres
DOI: 10.7208/chicago/9780226033488.003.0001
[option theory, liability rules, options, legal entitlements, calls, puts, asset value, courts, allocative choice]
Advances in option theory count as some of the most important and pragmatic developments in economic thought in the last twenty-eight years. One of the most important contributions of option theory to our understanding of asset value is that options become more valuable as the volatility in the underlying asset increases. This book uses option theory to illuminate the different ways that policymakers can protect legal entitlements. There are six take-home lessons. First, where there are calls, there must be puts. Second, courts can decouple distributive and allocative concerns. Third, the option perspective illuminates how liability rules allow imperfectly informed courts to delegate the allocative decision to disputants with private information. Fourth, while traditional liability rules delegate the allocation choice to a “single chooser” (either the plaintiff or the defendant), it is also possible for courts to create an option that delegates the allocative choice to both parties—by allowing either disputant to veto a particular allocation. Fifth, liability rules can mimic auctions. Sixth, liability rules allow bargainers to reveal information credibly. (pages 1 - 10)
This chapter is available at:
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PART ONE: BILATERAL DISPUTES

- Ian Ayres
DOI: 10.7208/chicago/9780226033488.003.0002
[put options, call options, legal entitlements, permanent-nuisance doctrine, numerosity problem, property rules, liability rules, property rights, deterrence, compensation]
Guido Calabresi and Douglas Melamed began a scholarly revolution by showing that legal entitlements have two readily distinguishable types of protection: property rules and liability rules. These two archetypal forms protect an entitlement holder's interest in markedly different ways—via deterrence and compensation. Property rules protect entitlements by trying to deter others from taking. Liability rules protect entitlements not by deterring, but by trying to compensate the victims of nonconsensual takings. Understanding liability rules as a distinct category of entitlement allowed Calabresi and Melamed to see that there was a missing category in the ways courts resolved nuisance disputes. This chapter discusses put options and call options. Call options when exercised give rise to “forced sales,” whereas put options give rise to “forced purchases.” The chapter first looks at the normative case for puts and then describes their descriptive prevalence. It also analyzes the permanent-nuisance doctrine, the numerosity problem, and the costs of determining property rights. (pages 13 - 38)
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    University Press Scholarship Online

- Ian Ayres
DOI: 10.7208/chicago/9780226033488.003.0003
[allocative efficiency, courts, allocative choice, liability rules, single-chooser rules, optimal damage, defendant-choice rules, distribution, allocation]
To date, there has been little analysis of a very basic question: to whom should courts give the initial entitlement? Most authors suggest that courts should grant the initial entitlement to the litigant it believes to have the higher valuation. To maximize allocative efficiency, courts should focus on delegating the allocative choice to the litigant who is the more efficient chooser. From the perspective of the initial entitlement holder, liability rules seem to have compensation as their central aim, whereas from an efficiency perspective liability rules are a means by which an imperfectly informed court can delegate allocative choice to private litigants who potentially have superior allocative information. The allocative efficiency of single-chooser rules is maximized when damages are set equal to the nonchooser's expected value. This chapter discusses single-chooser rules and how courts should determine (allocatively) optimal damage amount for the defendant-choice rules. It demonstrates that the court can decouple questions of distribution from questions of allocation. (pages 39 - 53)
This chapter is available at:
    University Press Scholarship Online

- Ian Ayres
DOI: 10.7208/chicago/9780226033488.003.0004
[plaintiff-choice allocations, defendant-choice allocations, liability rules, dual-chooser rules, allocative authority, plaintiff, defendant, legal entitlement]
Beyond put options there are a dizzying array of “Pay or Be Paid” and “Pay or Pay” rules. But our understanding of liability rules is simultaneously simplified since it is shown that this double infinity of rules gives rise to just two potential allocations: plaintiff-choice allocations (which delegate allocative authority solely to the plaintiff) and defendant-choice allocations (which delegate allocative authority solely to the defendant). This chapter shows that there are two further foundational ways for courts to use liability rules to delegate allocative authority. These are “dual-chooser” rules in contradistinction to the single-chooser rules, because both the plaintiff and the defendant have a potential impact on how the entitlement is ultimately allocated. One class of allocation rules, known as “plaintiff-presumption” dual-chooser rules, presumptively allocates the entitlement to the plaintiff unless both parties opt to shift it (for a court-determined price) to the defendant. The other class of allocations are the “defendant-presumption” dual-chooser rules, which concern rules that presumptively allocate the legal entitlement to the defendant unless both parties opt to shift it to the plaintiff. (pages 54 - 72)
This chapter is available at:
    University Press Scholarship Online

- Ian Ayres
DOI: 10.7208/chicago/9780226033488.003.0005
[higher-order liability rules, reciprocal takings, second-order liability rules, allocative efficiency, internal auctions, dispositive-takings principle, damages]
This chapter analyzes higher-order liability rules that allow a series of reciprocal takings by the litigants. It shows that second-order liability rules (sometimes also referred to as “unconstrained dual-chooser” rules) can harness information of both litigants in more refined ways than either the single or dual-chooser rules. Indeed, if the takings are costlessly implemented, a sequence of reciprocal takings can mimic an auction that produces first-best allocative efficiency—even in the presence of asymmetric information. The chapter illustrates how courts can optimally tailor second- and higher-order damages, explains how one can view liability rules with reciprocal-takings options as forming a class of “internal” auctions, discusses the relative efficiency of second- and higher-order liability rules, and describes how to apply the “dispositive-takings principle” to optimally select damages. Finally, it provides an application of second-order rules to the problem of the efficient dispositive-takings principle. (pages 73 - 100)
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PART TWO: EXTENSIONS

- Ian Ayres
DOI: 10.7208/chicago/9780226033488.003.0006
[correlated values, liability rules, property rules, legal entitlements, Calabresi, transaction costs, tangibility, lemons model, private information, George Akerlof]
Scholars have often conceived the core difference between property rules and liability rules as the difference between protecting by deterrence and protecting by compensation. Property rules protect legal entitlements by deterring non-consensual takings, while liability rules compensate entitlement holders if a non-consensual taking occurs. This chapter reorients the debate by showing how the various forms of liability rules are allocative devices that harness the litigants' private information when a court is imperfectly informed as to their valuations. This “harnessing” result clarifies and formalizes the pioneering work of Guido Calabresi and Douglas Melamed. It overthrows one of the most basic tenets of law-and-economics scholarship—the idea (distilled from Calabresi and Melamed) that property rules are presumptively more efficient than liability rules when transaction costs are low. This chapter first distinguishes the empirical and theoretical aspects of the tangibility thesis. It then argues that George Akerlof's celebrated “lemons” model shows how correlated values can inefficiently strand legal entitlements protected by property rules with low-value owners and how the lemons (correlated-value) problem might be mitigated by liability rules. (pages 103 - 124)
This chapter is available at:
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- Ian Ayres
DOI: 10.7208/chicago/9780226033488.003.0007
[liability rules, multiple takings, legal entitlements, numerosity, pollution, private information, property rules, allocations, reciprocal takings]
Liability rules applied to tangible legal entitlements might give rise to problems of reciprocal takings in which a plaintiff and defendant engage in a protracted (and potentially endless) series of destructive takings of the same entitlement from one another. Moreover, liability rules might induce multiple takers to threaten taking, thus undermining the incentives of an initial entitlement holder to bargain to retain her entitlement with any individual potential taker. This chapter argues that the potential for multiple takings poses a real problem, but that enlightened courts can structure liability rules to economize on the litigants' private information. It considers the “numerous-takers” problem in which the use of an entitlement by one person (or multiple people) affects the welfare of numerous others. The plume of pollution provides a classic example where one factory's smoke can damage numerous residents. Numerosity makes it harder for courts to use a liability rule to harness the private information of the residents. However, numerosity also cuts against the likely efficiency of property rules, as it will be harder to bargain for efficient allocations. (pages 125 - 132)
This chapter is available at:
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- Ian Ayres
DOI: 10.7208/chicago/9780226033488.003.0008
[non-consensual takings, transfer of ownership, liability rules, cognitive bias, wealth effects, unintentional takings, litigants, allocational authority, probability distributions, valuations]
Real-world non-consensual takings may impose costs—real social costs—not just of administration (in courts calculating the damages and private parties litigating a dispute), but also in terms of what would broadly be considered switching costs. Each non-consensual transfer of ownership might in some contexts impose costs on one party or the other. Property rules tend to deter non-consensual takings and thus avoid the costs of administering a liability-rule regime. This chapter examines whether alternative administrative, informational, or cognitive assumptions qualify the ultimate implication that liability rules can often be used as a way for the law to delegate allocational authority so as to harness the information of private litigants. It considers three assumptions: the litigants are imperfectly informed about their own valuations, the litigants' probability functions are not common knowledge, and courts systematically misestimate the probability distributions of the litigants' value. It also discusses cognitive bias and wealth effects, along with unintentional takings. (pages 133 - 141)
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- Ian Ayres, Eric Talley
DOI: 10.7208/chicago/9780226033488.003.0009
[bargaining, liability rules, property rules, private information, Guido Calabresi, Douglas Melamed, transaction costs, Ronald H. Coase, single-chooser rules]
Liability rules have decided advantages over property rules in harnessing private information when bargaining is not possible. This “non-consensual” advantage of traditional liability rules can be found in Guido Calabresi and Douglas Melamed's Cathedral article itself and has been neatly formalized by Louis Kaplow and Steven Shavell. The harnessing result can be accomplished by a wide variety of allocatively equivalent (but distributionally different) single-chooser rules. This chapter shows that liability rules may induce both more contracting and more efficiency than property rules, and that liability rules possess an “information-forcing” effect that property rules do not. Ronald H. Coase showed that when transacting is costless, the choice between property and liability rules does not affect efficiency. Calabresi and Melamed followed by showing that when transaction costs make consensual transfer prohibitively expensive, liability rules (because of the harnessing effect) are likely to dominate property rules. (pages 142 - 165)
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- Ian Ayres
DOI: 10.7208/chicago/9780226033488.003.0010
[liability rules, property rules, bargaining, private information, information-forcing effect, allocative efficiency, high-value plaintiffs, low-value plaintiffs]
As a matter of theory, liability rules might be more efficient than property rules even when bargaining is possible. But there are reasons to be skeptical of the result. This chapter describes the results of experiments conducted in seven different classes at five law schools. The students were divided into pairs of bargainers and assigned to play the roles of a drive-in owner and a racetrack owner in a dispute inspired by a real case. The dispute concerned the external effect of a racetrack on a neighboring drive-in theater. In the bargaining game, the only issue for negotiation was whether the racetrack would operate at night. The track could increase its profits by operating at night, but doing so would decrease the profits of the adjacent drive-in (because the lights diminish the clarity of the picture). The disputants had private information about their valuations. The results show that liability rules evince a strong information-forcing effect, with high-value plaintiffs trying to bribe and low-value plaintiffs trying to sell. More important, liability rules produce slightly higher allocative efficiency. (pages 166 - 182)
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- Ian Ayres
DOI: 10.7208/chicago/9780226033488.003.0011
[liability rules, property rules, private information, harnessing, bargaining, Guido Calabresi, Douglas Melamed, transaction costs, correlated values, multiple takings]
Most of this book has been concerned with discovering new types of liability rules and identifying which ones are likely to be most efficient in particular contexts. This chapter explores a more traditional question: when are liability rules more efficient than property rules? Liability rules delegate allocational authority—allocational options—to privately informed disputants. The delegation effect gives us strong reasons to believe that liability rules do a better job than property rules in harnessing the private information of disputants. Liability rules are not only options, but those delegated options can also be seen as a specialized form of auction. This harnessing effect can persist in the shadow of bargaining, especially because liability rules have information-forcing qualities unknown to property rules. Guido Calabresi and Douglas Melamed opened our eyes to the fact that both property- and liability-rule protections have had enduring and widespread (but not all-encompassing) usage in virtually every field of law. The chapter shows that transaction costs, investment incentives, correlated values, multiple takings, speculative values, and behavioral theories do not withstand closer analysis. (pages 183 - 200)
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Notes

Index