Ex Ante Investments and Ex Post Externalities

Whenever the use of an asset by one party imposes an externality on another party’s use of an asset, entitlements must be allocated. Does an upstream firm have a right to use a river’s water or does a downstream firm have a right not to have the water used? And if the downstream firm is to be protected, should the protection come in the form of a property right or a liability rule? This paper focuses on how the allocation of entitlements affects ex ante investments and actions. Even when ex post bargaining is easy, the ex post allocation of entitlements, by affecting the distribution of ex post value, can have significant efficiency effects ex ante. By identifying the ex ante effects of alternative rules, the analysis provides a framework for determining allocations of entitlement that would perform best from the perspective of ex ante efficiency. As far as ex ante effects are concerned, liability rules are not generally superior to property rights. The analysis has implications for a broad range of legal and policy questions.