When Do Rules of Procedure Matter?

Some years ago the economist Harold Demsetz (1972) asked, "When does the rule of liability matter?" He sought to address an important issue in the law and economics of externalities. Specifically, suppose there is a market failure in which a paper producer pollutes, thereby spoiling the water used by a farmer downstream. Does the resolution of the externality problem depend on the legal rule of liability that designates which party must assume the burden of the externality?' The surprising answer Demsetz provided an application of Coase's Theorem (see Coase, 1960) was that so long as transactions costs between the parties are trivial, the relevant parties will resolve the externality regardless of the particular liability rule.2 In general, so long as the parties can negotiate agreements between themselves costlessly, resources will flow to their highest valued uses, implying that externalities will be optimally internalized. Conversely, if transactions costs are not negligible, then the form of liability is crucial for the resolution of the externality problem. The point of this paper is not to develop the logic of liability but rather