And Now For Something Completely Different — Options instead of Property

Larry Lessig has led the charge in showing that the IP law has gone overboard in extending property rights. In lots of contexts, we would do better with mandated licensing fees that give non-owners the option to use and pay a fee.

I’ve just published a book called Optional Law: The Structure of Legal Entitlements (University of Chicago Press) that not only formalizes the advantage of optional licenses but also shows there’s a dizzying array of optional entitlement structures that can dominate traditional notions of property. The book suggests a variety of new mechanisms for protecting IP and shows how many of them have been used in unnoticed ways in traditional common law decisionmaking.

Conceptually, this book asks how a court might want to allocate entitlements among individuals when the court is imperfectly informed about the individuals’ values. Imagine that a court is trying to decide which of two disputants should control a particular entitlement. Each disputant knows her own value for the entitlement, but the court sees only an unbiased probability function of each disputant’s value. The court, among other things, wants the entitlement controlled by the higher-valuing disputant.

How should the court structure the parties’ legal entitlements? A first intuition is that the court should simply give the entitlement to the individual with the higher expected value. This “mean” allocation rule would make a great deal of sense if the court were merely choosing among property rules; but we will see — through the lens of option theory — that giving the initial entitlement to the disputant who is, on average, lower-valuing can at times produce higher allocative efficiency.

Imagine for example that a court’s best guess is that a plaintiff’s value is equally likely to take on any value between 5 and 105 and that a defendant’s value is equally likely to take on any value between 40 and 60. You might think that the court would do better to give the entitlement to the plaintiff (who has a higher average valuation of 55 instead of 50). But it turns out that efficiency is substantially increased if we give the entitlement initially to the defendant but give the plaintiff the option to take for a price of 50 dollars.

This result is, of course, counter intuitive. But there are a bunch of others as well:

Where there are calls, there must be puts. Once traditional liability rules are seen as “call” options, it is natural to ask whether “put” options are or should be used by the law. Calabresi and Melamed saw that defendant polluters might pay for the right to pollute or that plaintiff pollutees might pay for the right to stop pollution, but they did not focus on who gets to decide whether payment would be made. Traditional liability rules are more like call options because they give the payor the option of forcing a sale. But it is also possible to give payees the put-like option of forcing a purchase. Instead of giving a polluter the option to pay for the right to pollute, the law might give a pollutee the option to be paid for giving up her entitlement to clean air. Put-like protections for pollutees seem startling, but they in fact are the normal “election of remedies” granted to a plaintiff whose property rights have been infringed upon. For example, if the polluter instead builds an encroaching fence on the pollutee’s land, it would be normal to give the pollutee the choice of injunction or permanent damages for the encroachment.

Courts can decouple distributive and allocative concerns. Appreciating the possibility of put options is the first step in expanding a courts’ choice set. Allowing a defendant to pollute if she chooses to pay a million dollars should produce the same allocative equilibrium as giving the defendant a put option to sell her pollution right for a million dollars, but very different wealth distributions. Indeed, there are an infinite number of option implementations that produce the same allocative equilibrium, but merely divide the expected payoffs differently between the disputants. For example, asking the defendant to choose between paying $800,000 to pollute and receiving $200,000 to forego polluting should produce an identical allocation as the foregoing call and put implementation but provides an intermediate distribution of payoffs. Enlightened courts are thus free to maximize allocative efficiency (by delegating the allocative choice to the more efficient litigant) without sacrificing concerns of equity or ex ante investment incentives.

Two heads can be better than one. While traditional liability rules delegate the allocation choice to a single-chooser (either the plaintiff or the defendant), it turns out that it is also possible for courts to create an option that delegates the allocational choice to both parties — by allowing either disputant to veto a particular allocation. For example, a court might grant an initial entitlement to the plaintiff but give the defendant a call option to take the entitlement for $X, and give the plaintiff an entitlement to take back for $X or for $X + Y. “Dual chooser” rules of this kind can produce, under certain conditions, systematically higher expected payoffs than more traditional single-chooser rules. They give both parties a hand in deciding who will ultimately control the entitlement and thus can harness both sides’ information. And as with put option rules, it turns out that dual chooser rules are already being used in the common law.

Property protection has been with us for a long time. But optional protections have a lot going for them. They can better harness the parties’ private information, they can better promote equity and they might can even better promote trade.

You can read the first chapter here for free or (gulp) buy a copy of the book here and read comments on a earlier Balkinization post here.

Ian Ayres