Application in United States Contract and Tort Law
The Coase Theorem has been used by jurists and legal scholars in the analysis and resolution of disputes involving both contract law and tort law.
In contract law, Coase is often used as a method to evaluate the relative power of the parties during the negotiation and acceptance of a traditional or classical bargained-for contract.
In modern tort law, application of economic analysis to assign liability for damages was popularized by Judge Learned Hand of Second Circuit Court of Appeals in his decision, United States v. Carroll Towing Co. 159 F.2d 169 (2d. Cir. 1947). Judge Hand's holding resolved simply that liability could be determined by applying the formula of B < PL, where B = the burden (economic or otherwise) of adequate protection against foreseeable damages, P = the probability of damage (or loss) occurring and L = the gravity of the resulting injury (loss). This decision flung open the doors of economic analysis in tort cases, thanks in no small part to Judge Hand's popularity among legal scholars.
In resultant scholarship using economic models of analysis, prominently including the Coase theorem, theoretical models demonstrated that, when transaction costs are minimized or nonexistent, the legal appropriation of liability diminishes in importance or disappears completely. In other words, parties will arrive at an economically efficient solution that may ignore the legal framework in place.
For example, two property owners own land on a mountainside. Property Owner #1's land is upstream from Owner #2 and there is significant, damaging runoff from Owner #1's land to Owner #2's land. Four scenarios are considered:
- If a cause of action exists (i.e. #2 could sue #1 for damages and win) and the property damage equals $100 while the cost of building a wall to stop the runoff equals $50, the wall will probably exist. Owner #1 will build the wall, or pay Owner #2 between $1 and $50 to tolerate the runoff.
- If a cause of action exists and the damage equals $50 while the cost of a wall is $100, the wall will not exist. Owner #2 may sue, win the case and the court will order Owner #1 to pay #2 $50. This is cheaper than actually building the wall. Courts rarely order persons to do or not do actions: they prefer monetary awards.
- If a cause of action does not exist, and the damage equals $100 while the cost of the wall equals $50, the wall will exist. Even though #2 cannot win the lawsuit, he or she will still pay #1 some amount between $51 and $99 to build the wall.
- If a cause of action does not exist, and the damage equals $50 while the wall will cost $100, the wall will not exist. #2 cannot win the lawsuit and the economic realities of trying to get the wall built are prohibitive.
The Coase theorem considers all four of these outcomes logical because the economic incentives will be stronger than legal incentives. Pure or traditional legal analysis will expect that the wall will exist in both scenarios where #2 has a cause of action and that the wall will never exist if #2 has no cause of action.
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