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Fractured Markets and Legal Institutions

43 Pages Posted: 1 Mar 2014 Last revised: 4 Nov 2014

Herbert J. Hovenkamp

Univ. of Pennsylvania Law and Wharton Business

Date Written: November 4, 2014


This article considers how we can improve legal outcomes of conflicts that occur in very small arenas. The conflicts can be of many kinds, including a nuisance dispute between neighbors, an impending collision between two moving vehicles, a joint decision between spouses about whether or on what terms to continue their marriage, or a disagreement between managers and shareholders within a firm.

The prevailing literature typically refers to these small environments as “markets.” Thinking of them as markets, however, averts our attention from larger environments that should be considered but that often do not function well as private markets. For example, efficiency queries typically look at the wealth created (or destroyed) only in the micromarket at hand, treating gains or losses to others only as externalities to the extent that they are not internalized by bargaining or adoption of the appropriate legal rule. Stepping back and looking at a larger arena often permits superior solutions, particularly when extraction from previous commitments is costly.

Focusing on the larger rather the smaller environment can enable an increase in social wealth or welfare but may also require greater State intervention. As the environment becomes larger bargaining works less well. As a result, we may have to abandon the language of markets or constrain its use, particularly when instability (cycling) or behavioral issues are prominent. In these settings the “market” is often little more than a metaphor. One way to think of the problem is as institutional fracture, or the cost of breaking the arenas in which people interact into excessively small pieces.

A comparison of the law and economics of common law nuisance and that of automobile accidents illustrates the differences. The Coasean literature focused on neighbors whose interests were in place and where bargaining was conceivable. As a result, two people sharing a single building in London came to be regarded as the “market” for legal analysis. By contrast, bargaining metaphors completely failed in the law of automobile accidents, where bargaining is a much less promising resolution to conflict problems. This forced the analysis to step back and consider the full arena in which motor vehicles operate rather than individual pairwise conflicts. As a result, outcomes in cases involving traffic disputes are inherently superior to outcomes in cases involving nuisance disputes between neighbors.

The article also develops a theory of useful default rules for avoiding or controlling institutional fracture. The literature on private default rules has not done an adequate job of differentiating their use in different institutional settings. A complete theory of private default rules must address three important issues. The first is How should the legal policy maker select a default rule? The second is When should the rule be a “default” and when should it be absolute? Third is What kind of bargaining coalition is needed to reverse the default?

Finally, often it makes sense to “stack” a contractual mechanism, together with appropriate default rules, on top of a regulatory mechanism. For example, an optimal land use policy would use an underdeterrent zoning law, which eliminates more severe conflicts before they occur, but stack on top of this a set of private contract rules for dealing with more narrowly focused and idiosyncratic land use conflicts.

A well designed system for allocating resources necessarily involves the heavy use of markets, but markets must be properly designed. Coase’s suggestion that the legal system would be unimportant but for transaction costs could literally apply only to a social contract formed during some initial position when people had made no resource commitments whatsoever. As soon as the first investment is made, however, all bets are off. From that point the movement of resources can be costly with or without transactions, and a well designed legal system must minimize the costs of movement by both transactional and nontransactional means. To be sure, while bargaining over the price of moving a smokestack might be costless and perfect, someone still has to tear the smokestack down and rebuild it in a different place.

Keywords: common law, coase, transaction costs, pigou, costs of movement, default rules, bargaining

Suggested Citation

Hovenkamp, Herbert J., Fractured Markets and Legal Institutions (November 4, 2014). Iowa Law Review, Vol. 100, 2014; U Iowa Legal Studies Research Paper No. 14-08. Available at SSRN:

Herbert J. Hovenkamp (Contact Author)

Univ. of Pennsylvania Law and Wharton Business ( email )

3501 Sansom Street
Philadelphia, PA 19104
United States
319-512-9579 (Phone)

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