Thomas J. Miceli and Kathleen Segerson
Department of Economics
University of Connecticut
© Copyright 1998 Thomas J. Miceli and Kathleen Segerson
A. The Economics of Eminent Domain
2. The Justification for Eminent Domain
5. Eminent Domain and Land Use Incentives
6. Justifications for Government Regulation
7. The Nature of the Government Action
8. The Impact of the Regulation on the Landowner
9. Government Incentives versus Land Use Incentives
Bibliography on Takings (6200)
This essay provides an overview of the law and economics literature ongovernment takings of private property under eminent domain. The first partof the essay addresses questions pertaining to physical acquisitions ofproperty, including the meaning of the public use and just compensationrequirements, and the impact of takings for development decisions of landowners. The second part of the essay turns to the question of whether orwhen a land use regulation ever becomes so burdensome to the landowner asto require compensation under the takings clause. Regulations that cross thisthreshold are referred to as regulatory takings. The essay first discusses theeconomic justification for government (public) control of externalities, and thenconsiders factors that affect the compensation question, including the intent ofthe regulation, the impact of the regulation on the landowner, incentives forefficient land use, fairness considerations, and whether capitalization nullifiesthe need for compensation.
JEL Classification : K11, K32, Q24
Keywords : Eminent Domain, Compensation, Regulatory Takings, Police Power,Land Use.
This essay provides an overview of the law and economics literature ongovernment "takings" through acquisition or regulation of private property.Unlike private individuals who must bargain with owners when they wish toacquire property, the government can acquire private property for public usewithout the owner's consent provided that it pays just compensation. In theUnited States, this authority is granted by the "takings clause" of the FifthAmendment of the Constitution, which states: "nor shall private property betaken for public use, without just compensation." In addition, nearly all stateconstitutions contain takings clauses (Fischel, 1995b, p. 180) . The law andeconomics literature has addressed a number of issues relating to thegovernment's taking power, including the economic justification for thegovernment's power of eminent domain, the meaning of the public use and "just"compensation requirements, and the implications of eminent domain for the landdevelopment decisions of property owners. In the first part of this essay, weprovide an overview of these issues and the related literature.
In contrast to physical acquisitions or intrusions for which compensation isnearly always paid, government regulation of private property generally doesnot require compensation. Instead, it is viewed as a legitimate exercise of thegovernment's police power. There is a long-standing question, however, aboutwhether or when a regulation ever becomes so burdensome to a property owneras to require compensation under the takings clause. Regulations that cross thisthreshold are referred to as "regulatory takings." In the second part of thisessay, we review the law and economics literature on regulatory takings. Webegin by discussing economic justifications for government regulation, and thenturn to factors that affect the compensation question, including the nature of thegovernment action and the impact of the regulation on landowners. We arguethat various "rules" for determining whether or not compensation should bepaid, which appear at first to be different, are in fact consistent under certainconditions. We conclude by proposing compensation rules that balance theincentives of regulators against the incentives of landowners.
A. The Economics of Eminent Domain
The Fifth Amendment to the U. S. Constitution guarantees, in part, that thegovernment shall not take private property for public use without paying "justcompensation". This seemingly straightforward protection of private propertyfrom arbitrary government seizure has generated a large literature attempting tointerpret and justify its various components.
2. The Justification for Eminent Domain
Eminent domain gives the government the power to acquire property fromprivate individuals through non-consensual transfers. Thus, a privateindividual's property is protected by a liability rule, rather than a property rule,vis-a-vis the government (Calabresi and Melamed, 1972) . A common justificationfor this power is that it prevents individuals from refusing to sell their propertyto the government at a "reasonable" price. This argument is faulty, however,because the subjective value an individual attaches to his or her property isworthy of protection in economic exchange--indeed, an important reason forprotecting property by a property rule is to allow individuals to refusetransactions that do not make them better off (Posner, 1992, Ch. 3; Munch, 1976) .
Since subjective value is important, and property rules protect subjectivevalue, there must be another justification for eminent domain. The answer is that,when the government is assembling a large amount of land to build a publicproject like a highway, individual owners whose land is necessary for the projectacquire monopoly power in their dealing with the government. That is, they canhold-out for prices in excess of their true (subjective) valuation of the land giventhat it would be costly, once the project is begun, for the government to seekalternative locations (Cohen, 1991) . Although the government theoreticallycould solve this problem by acquiring all the necessary land prior toconstruction, it would be difficult to conceal the project as the pattern ofacquisitions was revealed. Moreover, because the project is publicly funded, itusually is public knowledge well in advance due to the need to appropriatefunds. Private developers assembling a large number of properties clearly facethe same problem. One argument for why they do not have eminent domainpower is that it would be easier for them to acquire the property while disguisingtheir ultimate intent, e.g., through the use of "dummy" buyers.
The real justification for eminent domain, then, is the need to prevent hold-outs, which is a form of transactions cost. This justification is therefore a specialcase of the argument that property rules are desirable when transactions costsare low and liability rules are desirable when transaction costs are high (Calabresi and Melamed, 1972 ; Krier and Schwab, 1995 ; Kaplow and Shavell,1996) .
The government's eminent domain power is restricted by the public userequirement included in the Fifth Amendment (Merrill, 1986a ; Paul 1987b ; Rubenfeld, 1993 ; LaCroix and Rose, 1995) . One interpretation of this requirementis that the government can only use its taking power to acquire property for theprovision of public goods (Ulen, 1992). While this seems to be a naturalinterpretation of "public use," the economic theory of public goods does notimply that acquiring the inputs for public goods creates a hold-out problem (Cornes and Sandler, 1986, Ch. 5 ; Cohen, 1991) . While coerced contributions tothe funding of public goods is necessitated by the free-rider problem, coerced acquisition of the resources used to produce them is not.
Another interpretation of the public use requirement is that it is synonymouswith the hold-out problem. This view, however, implies that private individuals faced with the hold-out problem also ought to have eminent domain power. Fischel (1995b, pp. 71-73) in fact suggests that private interests (e.g., railroads)have often been granted the taking power by legislatures, and courts have beendeferential (though not universally so) to this practice. Bouckaert and De Geest(1995) provide a transactions cost justification for private takings.
Epstein (1985, Ch. 12) argues that the presence of a hold-out problem shouldbe a necessary, but not sufficient condition for the public use limitation to besatisfied. In addition, some provision should be made to prevent privateinterests from acquiring all of the surplus from a forced sale. The basis for thisadditional requirement is that forced acquisitions with compensation set atmarket value prevent the owner of the acquired property from realizing both hissubjective value, and a share of the gains from the sale (the value of the propertyin its proposed use minus the owner's subjective value). To prevent this, Epsteinproposes as the second prong of a two-pronged public use test something likethe above public goods requirement in order to ensure that the gains from aforced sale accrue widely to the public rather than to a private interest endowedwith taking power.
Epstein does not, however, use this second prong to argue that privateinterests should never have taking power. Private interests can legitimately havetaking power under Epstein's public use test if, in addition to facing the hold-outproblem, they make some effort to pay a share of the surplus from the taking tothe victim of the taking. An example is the Mill Acts, which granted privateindividuals the right to erect dams for purposes of operating mills provided thatthey paid flooded upstream owners compensation equal to 150 percent of theirmarket value. Note that this sharing of the surplus, while serving the interest offairness, also helps to counteract the tendency to overtake under market valuecompensation (see the next section).
The Fifth Amendment allows the government to take private property for publicuse if it pays just compensation. Courts generally define just compensation tobe "fair market value". However, this amount almost certainly undercompensateslandowners, possibly by a large amount, since owners do not generally viewland and wealth as perfect substitutes, whereas market value compensates themas if they did. Fair market value is not only unfair to landowners, it alsopotentially leads to an excessive transfer of private property to public usebecause the government does not have to pay the true opportunity cost of theresources it acquires. (We pursue this point in more detail in the discussion offiscal illusion below.) Thus, while the hold-out problem precludes the efficientassembly of property through market exchange, eminent domain with marketvalue compensation potentially leads to too much assembly (Munch, 1976; Fischel, 1995a) .
Of course, the takings clause does not define just compensation to be fairmarket value, so it is not a necessary feature of eminent domain that it result inundercompensation. However, the problem with setting compensation equal tothe owner's true valuation is that this amount is unobservable, and ownerswould clearly have an incentive to overstate it (Knetsch and Borcherding, 1979) .Thus, taking measurement costs into account, fair market value may be the bestproxy for just compensation.
A related issue, suggested by Epstein (1985: Ch. 18) , is that money raised tofinance compensation is a "taking" from taxpayers for which they receive "in-kind" compensation in the form of benefits from the public project. Based on thisinsight, Fischel (1995b, 211) suggested that market value compensation may bethe best way to balance "the undercompensation of the market-based ruleagainst the greater loss incurred by higher taxes and [foregone] public worksthat full, consensual compensation would require."
5. Eminent Domain and Land Use Incentives
The feature of eminent domain that has drawn the most attention fromeconomists, especially recently, is its impact on land use incentives. Inparticular, how does the possible threat of condemnation affect a landowner'sincentive to invest in developing his land? The first formal analysis of thisquestion was by Blume, Rubinfeld, and Shapiro (1984) . The principal result thatthey derived (or at least the one that has received the most attention) was thatfull compensation for takings results in inefficient investment decisions bylandowners while no compensation results in efficient incentives. Intuitively,compensation that is positively related to the value of the property, and hencethe level of investment in that property, creates a moral hazard problem byproviding the landowner insurance against the possibility of a taking. When ataking occurs, a social cost is incurred because an irreversible investment is lost.An efficient investment decision must therefore reflect the likelihood that thiscost will be incurred (i.e., the probability that a taking will occur). However, asis true of unlimited expectation damages for promisees in contract cases (Cooter1985) , if the landowner is guaranteed full compensation, he will not incur anyprivate loss if a taking occurs. Hence, he will ignore the possibility of a takingwhen making his investment decision and overinvest.
Blume, Rubinfeld, and Shapiro (1984) show that this overinvestmentincentive can be eliminated by making the compensation lump-sum, i.e.,independent of the amount of investment in the property. Since lump-sumcompensation is the same regardless of how much the landowner invests,increases in the level of investment lead to increased losses if a taking occurs.Thus, under lump-sum compensation the landowner is not fully insured andhence considers the possibility of a taking when making his investment decision.He thus chooses an efficient level of investment. Note that a special case oflump sum compensation is no compensation. Thus, Blume, Rubinfeld, andShapiro (1984) conclude that a rule of never paying compensation will lead toefficient landowner investment decisions. Kaplow (1986 , 1992 ) has also endorsedthe no compensation result for government takings, and more broadly for manyforms of legal change that have distributional and allocative implications.
Although no compensation is consistent with efficient land use incentives,several arguments have been made against it. The first and most commonobjection is that a rule of no compensation allows the government to acquireresources at no cost. This is not a problem if the government is unswervinglydevoted to acquiring resources only when it is efficient to do so. Fischel andShapiro (1988 , 1989) refer to such a government as "Pigouvian." However,modern public choice theory suggests that this is unlikely to be the case (Mueller, 1989) . A more realistic view treats the government like any othereconomic agent who responds to economic incentives. If compensation is zeroin this case,
The resources under the control of the central authority will be perceivedto be costless. The opportunity costs will be ignored, and land useregulation without compensation will lead to overproduction ofenvironmental amenities... (Johnson, 1977: p. 65).
Such a government is said to have "fiscal illusion" (Blume, Rubinfeld, andShapiro (1984) . In the current setting, this implies that the government will makeits taking decision by comparing the benefit of the public good to the amountof compensation it must pay to the owners of the land that it takes. If it is notrequired to pay any compensation, it will tend to take property too often sinceit will view the taking as having positive benefits but no costs. Thus, a rule ofzero compensation creates a moral hazard problem for the government. Fullcompensation can solve this problem and at the same time protect the rights ofpolitically under-represented groups (Paul, 1987a ; Epstein, 1985 , 1995: Ch. 7 ; Burrows, 1991 ; Farber, 1992 ; Fischel, 1995b ; and Yandle, 1995) .
As noted above, full compensation for takings results in inefficientinvestment because it allows landowners to ignore the social costs that resultif a taking occurs. At the same time, full compensation is necessary to preventoverregulation by the government. In the presence of this trade-off, Fischel andShapiro (1989) examined a compensation rule under which the level ofcompensation would be proportional to the value of the property, and theyshowed that the optimal (second-best) solution requires partial compensation.In contrast, Hermalin (1995) showed that the first-best outcome is attainableunder a pair of compensation rules. Under the first, the government pays thelandowner compensation equal to the social value of the taking. Note that thisrule has the same effect as a property rule in that the owner receivescompensation in excess of his value of the land (assuming that the taking isefficient), implying that the transfer is essentially consensual. The efficiency ofthis rule is thus consistent with the efficiency of property rules as discussed by Fischel and Shapiro (1988, p.275).
Under Hermalin's second rule, the landowner has the option to buy back theland for a price equal to its social value. As noted above, actual compensationrules tie payment to the fair market value of the land to the owner rather than itsvalue in public use, and owner's do not ordinarily have a buy-back option. Thusboth of Hermalin's are purely normative in that they do not explain the actualpractice of courts.
Breach of contract remedies suggest yet another solution to the trade-offbetween moral hazard and fiscal illusion, namely, limit compensation to the fullvalue of the land to the owner, evaluated not at the actual level of investmentbut rather at the efficient level of investment (Cooter, 1985 ; Rose-Ackerman,1992) . Note first that this rule will induce efficient behavior by the governmentbecause it requires full compensation. In addition, in equilibrium it will induce alllandowners to choose an efficient level of investment because compensation isstill lump-sum.
Even when the government does not have fiscal illusion, there is anargument for paying compensation for takings if the likelihood of a takingdepends on the value of the property (Miceli, 1991 ; Trefzger and Colwell, 1996) .The model in Blume, Rubinfeld, and Shapiro (1984) assumed that landownersview the probability of a taking as independent of their investment decision.However, in reality, the government may be less likely to take land that is morevaluable in private use. For example, by taking undeveloped rather thandeveloped land, it can reduce the social cost of the taking. If landownersanticipate that by increasing their investment in land they can reduce the chancethat their land will be taken, they will adjust their investment decisionsaccordingly. To avoid this problem, Miceli (1991) shows that, even in theabsence of fiscal illusion, compensation must be equal to the full value of theland at the optimal level of investment, net of any compensation tax. Theintuition for this result is as follows. When the landowner expects zerocompensation (or, generally, undercompensation), he will overinvest in order toreduce the probability of a taking. On the other hand, if he expectsovercompensation he will underinvest in order to increase the probability of ataking. Only full compensation at the efficient level of investment eliminatesthese incentives to over- or underinvest.
The question is whether landowners in fact view the probability of a takingas being a function of their level of investment. This is unlikely in the context ofphysical acquisitions of land, which rarely occur. Indeed, the probability of aphysical taking is probably near zero for most landowners. However,government regulations preventing certain land uses such as zoning andenvironmental restrictions are widespread and generally apply to all plots in agiven area. In that case, the probability of a land use restriction that reducestheir property values is not necessarily small, and it may be possible forlandowners to affect its magnitude by their land use decisions (Miceli andSegerson, 1996: Chs. 7 and 8) . Thus, this issue is likely to arise in the context ofregulatory takings discussed below.
The preceding discussion has shown that a compensation rule that payslandowners the full value of their land at the efficient level of investment resultsin both efficient investment in land and efficient takings decisions when thegovernment has fiscal illusion. One problem with this rule is that it requirescourts to be able to calculate the efficient level of investment, a task that mayprove difficult in practice. However, this problem has not prevented courts fromadopting rules in other areas of the law that require similar calculations. Forexample, negligence rules require calculation of due standards of care in accidentsettings (Landes and Posner, 1987: Ch. 4; Cooter and Ulen, 1988: Ch. 8 ; U.S. v.Carroll Towing , 159 F.2d 169 (1947)) . Moreover, existing community standardsfor "normal" land use can often provide a good proxy for efficient developmentlevels (Fischel, 1985: Ch. 8).
Two additional arguments against the no compensation result have beenmade in the literature. The first was by Michelman (1967) in perhaps the mostinfluential article on takings to date. Michelman used a utilitarian standard fordeciding, first, when a government should enact a taking, and second, when itshould pay compensation. The standard is based on three factors: efficiencygains, demoralization costs, and settlement costs. Efficiency gains simplyrepresent the social benefits minus the costs of a public project. A necessary condition for enactment of the project under Michelman's standard is that theproject generates efficiency gains.
In addition to efficiency gains, Michelman introduced two types of costs.The first is the demoralization costs associated with non-payment ofcompensation. Demoralization costs represent the total of (1) the dollar valuenecessary to offset disutilities which accrue to losers and their sympathizersspecifically from the realization that no compensation is offered, and (2) thepresent capitalized dollar value of lost future production (reflecting eitherimpaired incentives or social unrest) caused by demoralization ofuncompensated losers, their sympathizers, and other observers disturbed by thethought that they themselves may be subjected to similar treatment on someother occasion (Michelman, 1967: p. 1214) .
The second type of cost are the settlement (or transaction) costs associatedwith payment of compensation. Settlement costs represent "the dollar value oftime, effort, and resources which would be required to reach compensationsettlements adequate to avoid demoralization costs" (Michelman, 1967: p. 1214) .Michelman's standard for compensation is that it should be paid if settlementcosts are less than demoralization costs, and not paid if the reverse is true.Further, the public project should be enacted if and only if the efficiency gainexceeds the lower of the settlement and demoralization costs. Note that thisstandard is intermediate between the Pareto and Kaldor-Hicks criteria forefficiency. It is more permissive than Pareto since a project should be enactedwithout compensation if the efficiency gains exceed the demoralization costs andthe demoralization costs are less than the settlement costs. However, it is lesspermissive than Kaldor-Hicks since even if there are efficiency gains, the projectshould not be enacted if those gains are less than the lower of the settlementand demoralization costs (Fischel and Shapiro, 1988: p. 280).
The final argument against the no compensation result is based on the ideathat compensation acts as a form of public insurance for risk-averse landownersagainst the possibility of government expropriation of their property (Blume andRubinfeld, 1984 , 1987 ; Rose-Ackerman, 1992) . The need for public rather thanprivate insurance is that moral hazard and adverse selection problems, and theinfrequency of takings, prevent formation of a private insurance market fortakings risk. Because of the administrative costs and incentive effects ofcompensation, however, it should only be paid when landowners are very risk-averse and losses are large.
Thus far we have focused on physical acquisitions of private property, whichhave been universally accepted by courts as compensable government takings.There has been much more controversy, however, both in the courts and in theacademic literature, over government regulations that reduce private propertyvalues and the extent to which these should be compensable (Knetsch, 1983 ; Epstein, 1985 ; Paul, 1987a ; Fischel, 1995b ; and Yandle, 1995). Courts havegenerally granted the government broad powers to regulate private property inthe interest of protecting public welfare. However, some government regulationscan become so restrictive as to cause a substantial reduction in the value ofprivate property. When this happens, courts have occasionally found theregulation to be a taking and ordered payment of compensation. The problem isto determine where to set the threshold that separates non-compensableregulations (police power actions) from compensable ones (regulatory takings).We begin our discussion of this question by considering the rationale for theexistence of the government's regulatory power. We then provide an overviewof the issues that have arisen in trying to define a threshold for compensableregulatory actions.
6. Justifications for Government Regulation
One of the principal uses of the government's regulatory power is in the contextof externalities, or incompatible uses of property (Cornes and Sandler, 1986: Chs.3 and 4 ). There are, however, private (common law) remedies available for dealingwith such incompatibilities. Thus, prior to addressing the question of whetherthe government should pay compensation for a regulation, we first need toanswer the question of why government (public) intervention is economicallyjustified at all.
Trespass and nuisance are the principal common law remedies available toproperty owners faced with violations of their property rights. Trespassordinarily allows owners to exclude, or enjoin, future intrusions regardless of thebenefits to the intruder, whereas under nuisance law the court generally enjoinsthe intrusion or awards damages only after determining that the victim's harm issubstantial and the nuisance-creating activity is unreasonable (Keeton, et al.,1984, p. 622-623) . According to Merrill (1985) , this distinction can be explainedin terms of transactions costs. Specifically, when transactions costs between theintruder and the victim are low, trespass is the efficient remedy because it forcesthe parties to resolve the incompatibility through a voluntary transaction--asolution that guarantees a mutually beneficial outcome. When transactionscosts are high, however, nuisance law is the appropriate remedy because theparties may be unable to resolve the dispute through bargaining. In that case,the court conducts a sort of cost-benefit analysis before determining if the victimis entitled to relief. In a sense, the court coerces an efficient exchange (a "privatetaking") or prohibits an inefficient one when bargaining is expected to fail. Thecase of Boomer v. Atlantic Cement (309 N.Y.S.2d 312 (1970) ) illustrates thiscommon law (private) approach to externalities.
The preceding theory implies that private remedies initiated by the victim ofan externality are available for both low and high transactions cost cases. Thequestion then is where direct government regulation of externalities fits into thisscheme. One answer is that if the external cost is dispersed across a largenumber of victims, then no one victim may have an incentive to seek a privateremedy, even when the aggregate cost outweighs the benefit of the injurer'sactivity. In that case, the government acts as an "agent" of the victims byregulating the injurer's activity directly. The government thereby overcomes acollective action problem among victims (Landes and Posner, 1987, Ch. 2).
While many regulations are designed to address externality problems,government intervention can be justified on other grounds as well, such asprotection of individual rights. For example, laws designed to protect the rightsof disabled people, to guarantee free speech, or to ensure equal access oropportunity, can result in requirements that impose costs on property ownersand reduce the value of private property. Alternatively, government regulation(such as public utility regulation) can arise in response to other market failures,including imperfect competition and imperfect information. Regulatory takingsissues have arisen in these contexts as well.
The preceding discussion identifies situations in which governmentregulation of private property may be justified, but it does not address thequestion of whether the landowner should be compensated for the resultingprivate loss. Although from an economic perspective the distinction betweenphysical invasions and value-reducing regulations is not a meaningful one (Rose-Ackerman, 1992, p. 29) , courts have routinely denied compensation for thelatter (with some notable exceptions). In the following sections, we review thekey issues relating to the question of when compensation should be paid forregulations that reduce the value of private property without physicallyacquiring it.
7. The Nature of the Government Action
As noted, courts have historically granted governments wide powers to regulatewithout paying compensation, provided that the regulation somehow protectsthe public interest. This justification for non-payment of compensation thusfocuses on the nature of the government action.
7.1. Regulation of "Harmful" or "Noxious" Uses
An early case that established the nature of the government action as relevantfor the compensation question is Mugler v. Kansas (123 U.S. 623 (1887)) . Thecase concerned a law passed by the State of Kansas prohibiting the operationof breweries because they were public nuisances. The plaintiff argued thatoperation of his brewery predated the law, and further, that it did not constitutea nuisance. The Court nevertheless upheld the law based on the state's right toregulate, without compensation, land uses that are injurious to public welfare.Specifically, the Court held that there is no taking if a regulation is aimed atpreventing uses that are "injurious to the health, morals, or safety of thecommunity" ( Mugler v. Kansas , 1887, 668-669) . This argument has becomeknown as the "noxious use" doctrine and remains an important basis forgovernment regulations under the police power.
Concern with the nature of the government's action was re-affirmed in PennCentral Transportation Co. v. City of New York (438 U.S. 104 (1978)) . Echoingthe noxious use doctrine from Mugler , the court noted that "... in instances inwhich a state tribunal reasonably concluded that 'the health, safety, morals, orgeneral welfare' would be promoted by prohibiting particular contemplated usesof land, this court has upheld land-use regulations that destroyed or adverselyaffected recognized real property interests" ( Penn Central v. City of New York ,1978, p; 125) . Thus, according to the Court, if the public benefit of the regulationis sufficiently large, it may not constitute a taking even when the landownersuffers a significant loss.
Finally, in Lucas v. South Carolina Coastal Council (112 S. Ct. 2886 (1992)) ,the Court introduced a provision that would allow the government to avoidpaying compensation if it could show that the activity a landowner planned topursue would be prohibited under the state's common law of nuisance. Thus, theCourt recognized that government actions consistent with nuisance law are non-compensable. This provision of the Lucas decision is known as the "nuisanceexception."
The academic literature has also looked to the nature of the governmentaction to determine if a regulation should be compensable. Much of the literatureis based on property rights principles. Property rights approaches to the takingsquestion typically begin by implicitly defining a distribution of property rightsthat the law protects. If a government action deprives a property owner of a rightprotected by this distribution, compensation is due, whereas if it deprives himof an unprotected right, no compensation is due.
The "harm-benefit" rule exemplifies this approach (Fischel, 1985, p 154-155). According to this rule, compensation is not due for regulations that prevent alandowner from imposing an external cost on society (e.g., pollution), butcompensation is due for regulations that compel the landowner to provide anexternal benefit (e.g., open space). The underlying basis for this distinction isthat landowners do not have the right to impose costs, but they do have theright to withhold conferral of benefits.
Joseph Sax has offered two theories of takings that fall within this propertyrights approach. His first theory (Sax, 1964) argues that the government owescompensation when it acquires property rights for use as an enterprise--forexample, when it provides a public good; but it does not owe compensationwhen it merely arbitrates private disputes--for example, when it regulates anexternality. (Rose, 1983) advances a similar argument.) According to this view,regulatory takings for the most part fall within the category of non-compensableactions since, as noted above, they generally are aimed at preventing an externalcost or correcting a market failure or inequity.
Sax's second theory (Sax, 1971) suggests that the government does not owecompensation for any action that involves the internalization of spillover effects(negative externalities). Bromley adopts a similar view, arguing thatcompensation for regulations that prevent externalities would represent"...indemnification for an inability to continue to impose unwanted costs onothers" (Bromley, 1993, p. 677) . Like the harm-benefit rule, this view is based onthe idea that the law does not protect an individual's property right when thatright infringes on other individuals' rights. Note that a similar delineation ofproperty rights underlies the noxious use doctrine (Mercuro, 1992, p. 3) and the Lucas nuisance exception. The nuisance exception is also a fundamental featureof Richard Epstein's view of takings law (Epstein, 1985: Ch. 9; 1992; Epstein, et.al., 1992), which holds that landowners should generally receive compensationfor regulations except when the offending land use would have been prohibitedby the state's common law of nuisance.
Property rights approaches to the compensation question are not necessarilyconsistent with economic theory, especially those based on the harm-benefitapproach. For example, it is well-known that there does not exist a meaningfuleconomic distinction between a harm imposed and a benefit conferred, giventhat a harm is equivalent to a foregone benefit, and a benefit is equivalent to anavoided harm (Coase, 1960; Fischel, 1985, p. 158) . What is lacking is a"benchmark of neutral conduct" for defining the threshold between harms andbenefits (Michelman, 1967, p. 1197) . The basis for harm-benefit rules can be madeconsistent with economic logic, however, by appealing to administrative, ortransaction, costs as a way of identifying such a neutral point.
7.2. Standards of "Normal" Behavior
Fischel employs a transactions cost approach in proposing a rule based on a"normal behavior" (Fischel, 1985: Chapter 8; 1995b; Ellickson, 1973 , 1977) . Thisrule resembles the harm-benefit rule in that it says that no compensation is duefor regulations that prevent "subnormal" land uses, but compensation is due forregulations that compel "super-normal" land uses. The rule differs from theharm-benefit rule in that "normal" behavior is defined according to localcommunity standards based on what a landowner could reasonably expect to dowith his land without government restriction. A reasonableness standard forland use thus replaces the arbitrary distinction between a harm and a benefit.
The importance of transactions costs to this rule is that, by using normalbehavior as the "zero compensation" point, the transactions costs of compellingnormal behavior are minimized. In particular, since most people will engage innormal behavior without state intervention, only a few transactions will beneeded to fine those who engage in subnormal behavior and to compensatethose who undertake supernormal behavior. Wittman (1984) uses a similartransactions cost approach to distinguish compensable from non-compensableregulations. He argues that administrative costs are minimized if compensationis paid only when the government acts inefficiently since "we would expect thegovernment to act efficiently more often than not" (Wittman, 1984: 74).
In addition to minimizing transactions costs associated with payingcompensation, Fischel's normal behavior standard avoids what he views as amajor problem with a rule that conditions compensation solely on the loss invalue to the owner (the diminution of value rule)--namely, the possibility ofpaying compensation for regulations that restrict truly inappropriate land useswhile imposing substantial losses on the landowner, for example, prohibitingpulp mills in residential neighborhoods. Fischel recognizes, however, the needto balance the costs of regulations against their benefits. He therefore arguesthat forcing "super-normal" behavior on landowners need not requirecompensation if the benefits of the regulation exceed the cost to the privatelandowner and the transactions costs are excessive (Fischel, 1985, p. 165) . Sincethe presumption is that requiring landowners to conform with social normswould generate benefits in excess of its costs, Fischel's rule is essentially one ofpaying compensation for inefficient regulations and not paying compensationfor efficient ones.
To the extent that noxious uses and nuisances represent subnormal(inefficient) uses, non-compensation for regulation of these types of activitiesis consistent with Fischel's and Wittman's rules for minimizing transactionscosts. Moreover, all of these rules are essentially versions of the harm-benefitapproach to defining compensable regulations in that they rely on a distinctionbetween "good" and "bad" behavior by the landowner, which in turn defines athreshold for determining compensation. Thus, while these various theoriesappear at first to be quite different, they are in fact consistent with each otherwhen the thresholds are defined on the basis of economic principles. In addition,they are consistent with the threshold-based rules proposed by Miceli andSegerson (1994 , 1996) (see section 9 below).
7.3. The "Essential Nexus" Requirement
While the foregoing suggests that the nature of the government action canjustify uncompensated regulations, courts have required that those actions mustbear at least some relationship to the regulated land use. In particular, thedoctrine of "unconstitutional conditions" holds that "the government may notrequire a person to give up a constitutional right ... in exchange for adiscretionary benefit conferred by the government where the property rightsought has little or no reasonable relationship to the benefit" ( Dolan v. City ofTigard , 114 S.Ct. 2309, 2317 (1994)). This condition arises in takings cases whenthe government requires a landowner to dedicate some property to public usewithout just compensation in exchange for a permit to develop.
In Nollan v. California Coastal Comm'n (438 U.S. 825 (1987)) , the Court heldthat in order for a permit condition to be valid, there must exist an "essentialnexus" between the condition (i.e., the required dedication of property) and theproposed development for which the permit is sought. The case concerned astate requirement that the Nollans allow public access to their beach in return fora permit to replace an existing beachfront bungalow with a three bedroom house.The State's interest in imposing the condition of beach access was purportedlyto counteract the fact that the larger house proposed by the Nollans woulddiminish the view of the ocean from the roadway. However, the Court held thatthe essential nexus requirement was not met in this case because access to thebeach did not serve to enhance the view of the ocean from the road; that is, itdid not counteract the impact of the proposed development.
The Court re-examined this issue in Dolan v. City of Tigard (1994). While theCourt reaffirmed the essential nexus requirement, it also found that mere existence of a nexus was not enough to validate the permit condition. Inaddition, "...the degree of the exactions demanded [must] bear the requiredrelationship to the impact of the petitioner's proposed development" ( Dolan v.City of Tigard , 1994, p. 2318) . The Court adopted a "rough proportionality" testto assess this relationship. When the court applied this test to the facts of Dolan , it concluded that the government's conditions did not bear the required"reasonable relationship" to the impact of the proposed development.
Miceli and Segerson (1996, Chapter 4) argue that the essential nexusrequirement represents a generalized condition for determining whether or nota government regulation is efficient in cases where landowners have the abilityto mitigate the external costs of their proposed development. The regulatorydecision is assumed to have two separate components: first, the governmentdecides whether or not to attach conditions to the permit if it is granted, andsecond, it decides whether or not to grant the permit given those conditions. Inthis context, the efficiency of the regulatory decision includes efficiency of boththe decision of whether or not to grant the permit, and the efficiency of anyconditions attached to the permit. The essential nexus and rough proportionalitytests in combination can be viewed as an attempt to ensure the efficiency of thepermit conditions.
In contrast to Miceli and Segerson (1996) , Innes (1995, 1997) argues that theessential nexus and proportionality requirements should not be applied intakings cases. He argues instead that the focus should be on providing equalprotection to owners of similarly situated land (the equal protectionrequirement). This argument, however, is based on consideration of theincentives of landowners rather than the efficiency of the regulatory decision(see section 8.3 below).
8. The Impact of the Regulation on the Landowner
In addition to the nature of the government action, the other major factor usedto evaluate regulatory takings cases is the impact of the regulation on thelandowner. This criterion is best exemplified by Holmes's diminution of valuetest.
8.1. The Diminution of Value Test
The impact of the regulation on the landowner was first advanced as a test forcompensation in Pennsylvania Coal Co. v. Mahon (260 U.S. 393 (1922)) , whichis one of the most influential takings cases in U.S. history. This case challengeda Pennsylvania statute, the Kohler Act, which prohibited coal companies fromany mining that threatened the safety of surface owners due to cave-ins. Themajority opinion, written by Justice Oliver Wendell Holmes, found the regulationto be a taking requiring compensation because it went "too far" in reducing thelandowner's rights. Specifically, Holmes's ruling provided that the governmentcan regulate private property without compensation unless the regulation goestoo far in diminishing the value of the property to the owner. This rule is thusreferred to as the "diminution of value" test. Holmes did not articulate a generaltest for establishing when a regulation had gone too far, however, leaving itinstead to be determined on a case by case basis.
Holmes's ruling in Pennsylvania Coal marked a watershed in takings lawbecause, prior to this case, takings were usually limited to physical acquisitionsof property by the government; most efforts to obtain compensation for "mereregulations" failed, due in large part to the noxious use doctrine (Friedman 1986) ,1The diminution of value test broke with this tradition by introducing the lossin value to the owner into the equation. It thus "put the police power on acontinuum with the power of eminent domain" (Mercuro, 1992, p. 4) .
Holmes did not argue for a general rule of compensation because herecognized that the government "could hardly go on if to some extent valuesincident to property could not be diminished without paying for every suchchange in the law" ( Pennsylvania Coal v. Mahon , 1922, p. 413) . At the sametime, however, he acknowledged that a rule of no compensation for regulationswould, given "the natural tendency of human nature", result in overregulationuntil "at last private property disappear[ed]". Thus, Holmes recognized thefundamental trade-off between the costs of compensation (a stifled government)and the benefits of compensation (protection of private property and a limitationof government excess): "The general rule at least is that while property may beregulated to a certain extent, if regulation goes too far it will be recognized as ataking" ( Pennsylvania Coal v. Mahon , 1922, p. 415).
Most takings cases since Pennsylvania Coal have generally applied someform of Holmes's diminution of value test. An example is the previously citedcase of Lucas v. South Carolina Coastal Council (1992) , which concerned adeveloper (Lucas) who had purchased two beachfront lots in South Carolinawith the intent of developing them for residential use. Although developmentwas permitted at the time Lucas purchased the lots, the State subsequentlypassed a law, the Beachfront Management Act, that prohibited development.Lucas acknowledged the state's right to impose such a law, but he argued thatit reduced the value of his property so much that it constituted a taking forwhich compensation was due. The South Carolina Supreme Court ruled in favorof the State, based on the broad regulatory powers that have been granted tostate and local governments. However, the U.S. Supreme Court reversed thedecision and found that compensation was due.
Environmental groups had feared such a decision in the belief that the needto pay compensation would greatly reduce the ability of governments to protectthe environment against the unrestrained actions of private property owners.However, the decision in Lucas awarded compensation on narrow grounds. Inparticular, the Court found that compensation was due because
...when the owner of real property has been called upon to sacrifice all economically beneficial uses in the name of the common good, that is toleave his property economically idle, he has suffered a taking ( Lucas v.S. Carolina Coastal Council , 1992, p. 2895).
Thus, the Court found that the regulation had clearly crossed the thresholdset by the diminution of value test and that a taking had therefore occurred.However, the opinion offered no guidance as to the exact location of thethreshold.
While the diminution of value test has been widely applied, it has beencriticized on efficiency grounds. As noted above, for example, if only the loss inproperty value is considered when deciding whether to compensate, then theresulting outcome may be inefficient since the benefit of the regulation will notbe balanced against the cost (the loss in private property value) (Fischel, 1985,pp. 156-157) . Similarly, if compensation is not required when the reduction inproperty value is small, then a government that considers only actual costoutlays rather than social costs, i.e., a government with fiscal illusion, will viewsuch regulations as costless and thus overregulate. If some balancing betweenthese two effects is to take place, as proposed in the original Holmes ruling, thena standard for deciding when a regulation has gone "too far" must be available.We will propose such a standard below.
8.2. Investment-Backed Expectations
In Penn Central Transportation Co. v. City of New York (1978) , the U.S.Supreme Court faced the question of whether the City of New York couldprevent the owners of Grand Central Terminal from erecting an office tower overthe terminal by declaring it an historical landmark. The Court held that it couldwithout being obliged to pay compensation. In reaching its decision, the Courtidentified several factors to be weighed in determining whether a regulationconstitutes a taking, including the nature of the government action and theeconomic impact of the regulation on the claimant. The former reflects thenoxious use doctrine from Mugler and the latter the diminution of value rulefrom Pennsylvania Coal . While Holmes did not offer any criterion fordetermining when a regulation goes too far under the diminution of value rule,the Penn Central court did. Specifically, the Court said that a regulation "... mayso frustrate distinct investment-backed expectations as to amount to a taking" ( Penn Central v. City of New York , 1978, p. 127) , whereas it is not a taking if itdoes "... not interfere with interests that [are] sufficiently bound up withreasonable expectations of the claimant to constitute 'property' for 5thamendment purposes" ( Penn Central v. City of New York , 1978, p. 124-125). Thus, a relevant factor for determining whether a regulation requirescompensation is whether the regulation interferes with distinct investment-backed expectations by the claimant.
Justice Brennan's majority opinion in the Penn Central case relied heavilyon Michelman's (1967) view that, in order for a landowner to put his land toproductive use, he must have a reasonable expectation of being allowed to retainthe fruits of his investment (Mandelker, 1987, p. 10-13). Nevertheless,Michelman asserts that compensation is not due in every case of investment-backed expectations (Michelman, 1967, p. 1213). For example, compensationwould not be due if demoralization costs are low and settlement costs are high(see the discussion of Michelman above).
Miceli and Segerson (1996, Chapter 7) also argue that a rule of payingcompensation if and only if the landowner's expectations are investment-backedwill be inefficient. In particular, they show that it can lead to overinvestment.However, they also show that efficient land use decisions will be made under a"good faith" rule based on "reasonable" (efficient) land use decisions. Inparticular, in the event of a regulation, such a rule would require compensationfor landowners who acted in good faith, either by investing when it was efficientto do so or not investing when investment was inefficient, and it would notrequire compensation for those who did not act in good faith (Mandelker, 1987) .
8.3. Singling Out and Equal Protection
An additional factor identified in the Penn Central case for determining whena taking occurs was proposed by Justice Rehnquist in a dissenting opinion. Thisfactor concerns whether the government action applies to a broad class oflandowners or whether it "singles out" individuals. Rehnquist noted that "Evenwhere the government prohibits a noninjurious use, the court has ruled that ataking does not take place if the prohibition applies over a broad cross sectionof land and thereby 'secure[s] an average reciprocity of advantage'"( PennCentral v. City of New York (1978, p. 147) , Rehnquist dissent, quoting from Pennsylvania Coal v. Mahon (1922, p.415). ) In contrast, regulations that single-out landowners are more likely to be judged a taking according to this criterion.In Agins v. Tiburon (447 U.S. 255 (1980)) , the Court similarly held that alandowner subject to a zoning ordinance "will share with other owners thebenefits and burdens of the city's exercise of its police power. In assessing thefairness of the zoning ordinances, these benefits must be considered along withany diminution in market value that the appellants might suffer" ( Agins v.Tiburon , 1980, p. 262). Even Epstein (1995, p. 134-137), who argues generally infavor of compensation, recognizes that regulations that spread benefits andcosts over the same population offer in-kind compensation.
The singling out criterion also forms the basis for Michelman's (1967) proposedfairness standard for compensation:
A decision not to compensate is not unfair as long as the disappointedclaimant ought to be able to appreciate how such decisions might fit intoa consistent practice which holds forth a lesser long run risk to peoplelike him than would any consistent practice which is naturally suggestedby the opposite decision (1223).
Such a rule can be defended by a "veil of ignorance" argument thatlegitimizes rules that people would have approved prior to learning of theiractual position in society (Rawls, 1971, p. 136-142; Posner, 1980). This ruleprevents landowners from being singled-out to bear costs for society as a whole,as when a single landowner is compelled to give up his property withoutcompensation to provide a public good (Rose-Ackerman, 1992). At the sametime, it allows uncompensated regulations that potentially apply equally to alllandowners, such as broadly-based zoning laws. Such a rule therefore dependson the extent to which a regulation applies to few versus many landowners.
Singling out can also occur when compensation is not paid for restrictionsthat are placed on undeveloped land if comparable developed land is exemptedfrom the restriction, i.e., when there is not "equal protection" for developed andundeveloped land. In addition to the fairness implications of an equal protectionrequirement, it can also have efficiency effects. Specifically, because it is oftenefficient for the government to take undeveloped land before developed land,uncompensated takings can provide an incentive for landowners to develop"too early" in an effort to reduce the likelihood that their land will be taken (Innes, 1995, 1997) . For example, a developer might begin construction in aneffort to beat an anticipated downzoning (Dana, 1995) . This is consistent withthe result discussed above that zero compensation will not be efficient iflandowners can influence the probability of a taking (Miceli, 1991 ; Miceli andSegerson, 1996: Chs. 7 and 8).
Compensating owners of undeveloped land that is taken, or affording equalprotection to both developed and undeveloped land can offset the incentive forpremature development (Innes, 1995; Miceli and Segerson, 1996, p. Ch. 8) . Thus,such a rule can achieve both equity and efficiency objectives. However, Miceliand Segerson (1996, p. Ch. 8) show that, while equal protection is sufficient forefficient incentives, it is not necessary. Other rules are capable of simultaneouslysatisfying efficiency and equity goals as well.
In some cases, a developer will begin investing in a project only to find thata change in the zoning regulations prevents its completion. While recognizingthat local governments need to have some freedom to revise their zoning lawsin response to changing circumstances, landowners also need some protectionof their sunk investments when a zoning change occurs (Mandelker (1993, pp.234-244; Kaplow, 1986) . The courts have provided a basis for such protection inthe form of "vested rights." A vested right allows the landowner to proceed withthe project despite the zoning change under certain conditions.
In order for a landowner to acquire a vested right, he generally must havemade a "substantial" investment in the property in reliance on a valid buildingpermit. In this sense, his expectations must be "investment-backed" (see therelated discussion above). How much investment is necessary to be deemedsubstantial is not clear. Generally courts engage in a balancing test that weighsthe costs and benefits of the zoning change. For example, in addition to makingsubstantial investments, the landowner must have acted in "good faith" by notrushing the development process in an effort to beat an impending zoningchange. More generally, the good faith test asks "... whether a landowner'sconduct was consistent with how a reasonable property owner would haveacted in the same circumstances" (Mandelker, 1993, p. 239) . Miceli and Segerson(1996, Chs. 7 and 8) show that, if "good faith" or "reasonableness" are judgedon efficiency grounds, then a good faith rule can induce efficient land usedecisions by awarding a vested right if development was efficient but notawarding one if development was not efficient.
Note, however, that the threat to withhold a vested right if the landownerdeveloped prematurely is only effective if the development is reversible -- thatis, only if the development process can be halted and the resulting external costavoided or eliminated if the landowner developed inefficiently. This will notalways be possible, as when a landowner harvests timber prematurely, ordestroys wildlife in order to avoid the imposition of regulations aimed atpreserving the habitat of an endangered species (a practice known as "shoot,shovel, and shut up") (Epstein, 1995, p. 294). In such cases, it may be necessaryto promise compensation for the threatened regulation in order to offset theincentive for preemptive development or destruction of wildlife and habitat. Themagnitude of compensation cannot be too large, however, for then landownersmay have an incentive to delay development inefficiently. One way to ensureefficient incentives is to condition the payment of compensation on efficiencyof the landowner's decision--that is, on whether his decision either to developor to postpone development was efficient (Miceli and Segerson, 1996, Ch. 8)
8.4. The Role of Capitalization
As noted above, an important factor in evaluating the fairness of a regulation isthe extent to which it interferes with the landowner's reasonable expectations.One issue that arises in this context is whether the threat of a regulation wasknown to the landowner when he first purchased the land. A frequent argumentmade against paying compensation for regulations is that when landownerspurchased land subject to the threat of a regulation, they paid a price thatdiscounted (or "capitalized") the possibility of that regulation. Consequently,they have already received "implicit" compensation (Posner, 1980) . Althoughthis argument owes much to Michelman (1967) , courts understood it as far backas 1823 when, in the case of Callender v. Marsh (1 Pick. 417, 430 (1823)) , thecourt said:
Those who purchase house lots ... are supposed to calculate the chanceof [regulations]..., and as their purchase is always voluntary, they mayindemnify themselves in the price of the lot which they buy.
If the purchase price discounted (or capitalized) the threat of regulation, thenthe case for compensation is weakened because the landowner "... got exactlywhat [he] meant to buy." Michelman concludes that compensation in this casewould be analogous to refunding the price of a losing lottery ticket (Michelman,1967, p. 1238; Rose-Ackerman, 1992) . This is a persuasive argument that hasfound its way into fairly recent judicial decisions defending rulings againstcompensation ( HFH Ltd. V. Superior Court , 542 P.2d 237 (1975)).
Several authors have suggested, however, that the capitalization argumentagainst compensation is flawed (Fischel, 1985, p. 184-186; Epstein, 1985, p. 151-158; Fischel and Shapiro, 1988; Miceli and Segerson, 1996, Ch. 6) . The reason isthat, even if the purchaser had full knowledge of the threat of a regulation whenhe bought the land (and therefore paid a discounted price), the threat had toarise at some previous point in time, and the owner at that point suffered acapital loss. The only way that the original landowner is fully protected againstthis capital loss is if any subsequent owner who is regulated expects to receivefull compensation, i.e., compensation equal to the difference between the valueof the property with and without the regulation. Compensation based on othermeasures, such as the purchase price of the land or reliance expenditures, willnot eliminate landowner losses (or gains) even when capitalization occurs (Miceli and Segerson, 1996, Chapter 6).
9. Government Incentives versus Land Use Incentives
The above discussion of land use incentives in the presence of a takings threatidentified a moral hazard problem associated with compensation. Specifically,paying compensation for the full value of the confiscated land will generally leadto overinvestment by landowners. While this result was first demonstrated in thecase of physical takings (Blume, Rubinfeld, and Shapiro 1984) , the basic logicapplies to regulatory takings as well (Miceli and Segerson, 1996, p. Ch. 3) .Specifically, with full compensation landowners will act as if they are fullyinsured against the risk of a regulation and hence will overinvest. To remedy thisproblem, compensation must be lump sum, or independent of the amount thatwas invested in the land. Since a special case of lump sum compensation is zerocompensation, an implication of the Blume, Rubinfeld, and Shapiro (1984) modelis that zero compensation will lead to efficient land use decisions in the case ofregulatory takings as well.
If regulatory agencies have fiscal illusion, however, then a rule of nocompensation potentially leads to excessive regulation (Epstein, 1985: Ch. 17; Johnson, 1977) . This threat is especially severe for groups who areunderrepresented in the political process or owners of immobile assets whocannot escape uncompensated regulations (Farber, 1992; Yandle, 1995; Fischel,1995). Hence, there is a potential trade-off between two effects: the moral hazardproblem--which argues against compensation--and regulatory fiscal illusion--which argues for compensation.
Miceli and Segerson (1994) explicitly examine the trade-off between moralhazard and fiscal illusion in the context of regulatory takings by considering acompensation rule that conditions the amount of compensation on whether ornot the regulator acted in an efficient manner. They show that a rule under whichcompensation must be paid if and only if the government made an inefficientregulatory decision (the "ex post" rule) will lead to efficient incentives not onlyfor the regulator but also for the landowner. Under this rule, compensation is fullwhen it is inefficient to impose the regulation ex post, but zero when it is efficientto impose the regulation ex post. This definition of the threshold forcompensation induces the regulator to act efficiently because by doing so hecan "avoid" paying compensation. Moreover, since compensation is zero forefficient regulations, landowners will make the correct land use decisions as well.
In light of this conclusion, Miceli and Segerson (1996, p. Ch. 5) argue that,under appropriate definitions of "noxious use" and "nuisance," the ex post ruleis consistent with both the noxious use doctrine and the nuisance exception. Inaddition, it is consistent with Fischel's (1985, Ch. 8) rule of paying compensationfor inefficient regulations and not paying compensation for efficient ones (seethe discussion above). Finally, it defines a threshold for determining when aregulation goes too far under the diminution of value test.
While compensation under the ex post rule hinges on the nature of thegovernment action, Miceli and Segerson (1994, 1996, Ch. 4) show that efficientincentives for both regulators and landowners can also be achieved under analternative rule that determines compensation on the basis of the efficiency ofthe landowner's decision (the "ex ante" rule). Under this rule, compensation ispaid if and only if the landowner made an efficient land use decision at the timethe that the original investment was made. Note that both the ex post and ex anterules induce efficiency by both parties for the same reason that negligence ruleswork in bilateral care accident cases (Landes and Posner, 1987, Ch. 4; Cooter andUlen, 1988, Ch. 8) . Specifically, they specify a threshold for one of the partiessuch that, by acting efficiently, that party can "avoid liability." As a result, theother party bears "full liability" in equilibrium and therefore also acts efficiently.
Since Miceli and Segerson (1994, 1996, Ch. 4) identify two alternative rules thatare efficient, factors other than efficiency can be used to choose between them.Two such factors are fairness and transactions costs. Fairness generally arguesfor payment of compensation in equilibrium (the ex ante rule), whereastransactions cost considerations argue against compensation (the ex post rule).Note that these options mirror Michelman's (1967) comparison of demoralizationand settlement costs for determining compensation.
As noted above, Hermalin (1995) also proposed rules that solve the moralhazard and fiscal illusion problems in the context of full takings. However, incontrast to Hermalin's proposals, the rules proposed by Miceli and Segersonpermit attainment of the first-best outcome even when compensation is tied tothe value of the land to the landowner, and the landowner does not have a buy-back option. Thus, while both the Miceli-Segerson rules and those of Hermalininduce efficient behavior by both landowners and regulators, the former are moreclosely linked to actual takings law and hence have greater positive significance.
Fischel and Shapiro (1989) also proposed a resolution to the trade-offbetween moral hazard and fiscal illusion in the context of a constitutional choice(veil of ignorance) model. They concluded that partial compensation forregulations optimally balances the costs of these two problems. However, apartial compensation rule only achieves a second-best solution. In addition, itfails to explain actual decisions of courts, which typically award either zero orfull compensation. Note, however, that to the extent that compensation is basedon fair market value, which is often less than the subjective value of the property(see section 4 above), courts might in fact be awarding partial compensation fortakings that are found to be compensable. Under this form of partialcompensation, the rules proposed by Miceli and Segerson (1994 , 1996) wouldyield second-best outcomes as well.
We acknowledge the very helpful comments of two reviewers.
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