Law and economics

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Law and economics or economic analysis of law is the application of economic theory (specifically microeconomic theory) to the analysis of law that began mostly with scholars from the Chicago school of economics. Economic concepts are used to explain the effects of laws, to assess which legal rules are economically efficient, and to predict which legal rules will be promulgated. [1]

Contents

History

Origin

The historical antecedents of law and economics can be traced back to the classical economists, who are credited with the foundations of modern economic thought. As early as the 18th century, Adam Smith discussed the economic effects of mercantilist legislation. David Ricardo opposed the British Corn Laws on the grounds that they hindered agricultural productivity. And Frédéric Bastiat, in his influential book The Law , examined the unintended consequences of legislation. However, to apply economics to analyze the law regulating nonmarket activities is relatively new. A European law & economics movement around 1900 did not have any lasting influence. [2]

Harold Luhnow, the head of the Volker Fund, not only financed F. A. Hayek in the U.S. starting in 1946, but he shortly thereafter financed Aaron Director's coming to the University of Chicago in order to set up there a new center for scholars in law and economics. The University was headed by Robert Maynard Hutchins, a close collaborator of Luhnow's in setting up this "Chicago School". The University already had Frank Knight, George Stigler, Henry Simons, and Ronald Coase—a strong base of libertarian scholars. Soon, it would also have not just Hayek himself, but Director's brother-in-law and Stigler's friend Milton Friedman, and also Robert Fogel, Robert Lucas, Eugene Fama, Richard Posner, and Gary Becker.

The historians Robert van Horn and Philip Mirowski described these developments, in their "The Rise of the Chicago School of Economics" chapter in The Road from Mont Pelerin (2009); and historian Bruce Caldwell (a great admirer of von Hayek) filled in more details of the account in his chapter, "The Chicago School, Hayek, and Neoliberalism", in Building Chicago Economics (2011). The field began with Gary Becker’s 1968 paper on crime (Becker also received a Nobel Prize). In 1972, Richard Posner, a law and economics scholar and the major advocate of the positive theory of efficiency, published the first edition of Economic Analysis of Law and founded the Journal of Legal Studies, both are regarded as important events. Gordon Tullock and Friedrich Hayek also wrote intensively in the area and influenced to spread of law and economics.

Founding

In 1958, Director founded TheJournal of Law & Economics, which he co-edited with Nobel laureate Ronald Coase, and which helped to unite the fields of law and economics with far-reaching influence. [3] In 1960 and 1961, Ronald Coase and Guido Calabresi independently published two groundbreaking articles, "The Problem of Social Cost" [4] and "Some Thoughts on Risk Distribution and the Law of Torts". [5] This can be seen as the starting point for the modern school of law and economics. [6]

In 1962, Aaron Director helped to found the Committee on a Free Society. Director's appointment to the faculty of the University of Chicago Law School in 1946 began a half-century of intellectual productivity, although his reluctance about publishing left few writings behind. [7] He taught antitrust courses at the law school with Edward Levi, who eventually would serve as Dean of Chicago's Law School, President of the University of Chicago, and as U.S. Attorney General in the Ford administration. After retiring from the University of Chicago School of Law in 1965, Director relocated to California and took a position at Stanford University's Hoover Institution. He died September 11, 2004, at his home in Los Altos Hills, California, ten days before his 103rd birthday.

Later development

In the early 1970s, Henry Manne (a former student of Coase) set out to build a center for law and economics at a major law school. He began at the University of Rochester, worked at the University of Miami, but was soon made unwelcome, moved to Emory University, and ended up at George Mason. The last soon became a center for the education of judges—many long out of law school and never exposed to numbers and economics. Manne also attracted the support of the John M. Olin Foundation, whose support accelerated the movement. Today, Olin centers (or programs) for Law and Economics exist at many universities.

Important scholars

Forerunners

Founders

Important figures

Other important figures include:

Positive and normative law and economics

Economic analysis of law is usually divided into two subfields: positive and normative.

Positive law and economics

'Positive law and economics' uses economic analysis to predict the effects of various legal rules. So, for example, a positive economic analysis of tort law would predict the effects of a strict liability rule as opposed to the effects of a negligence rule. Positive law and economics has also at times purported to explain the development of legal rules, for example the common law of torts, in terms of their economic efficiency.

Normative law and economics

Normative law and economics goes one step further and makes policy recommendations based on the economic consequences of various policies. The key concept for normative economic analysis is efficiency, in particular, allocative efficiency.

A common concept of efficiency used by law and economics scholars is Pareto efficiency. A legal rule is Pareto efficient if it could not be changed so as to make one person better off without making another person worse off. A weaker conception of efficiency is Kaldor–Hicks efficiency. A legal rule is Kaldor–Hicks efficient if it could be made Pareto efficient by some parties compensating others as to offset their loss.

Relationship to other disciplines and approaches

As used by lawyers and legal scholars, the phrase "law and economics" refers to the application of microeconomic analysis to legal problems. Because of the overlap between legal systems and political systems, some of the issues in law and economics are also raised in political economy, constitutional economics and political science.

Approaches to the same issues from Marxist and critical theory/Frankfurt School perspectives usually do not identify themselves as "law and economics". For example, research by members of the critical legal studies movement and the sociology of law considers many of the same fundamental issues as does work labeled "law and economics," though from a vastly different perspective.

The one wing that represents a non-neoclassical approach to "law and economics" is the Continental (mainly German) tradition that sees the concept starting out of the governance and public policy (Staatswissenschaften) approach and the German Historical school of economics; this view is represented in the Elgar Companion to Law and Economics (2nd ed. 2005) and—though not exclusively—in the European Journal of Law and Economics. Here, consciously non-neoclassical approaches to economics are used for the analysis of legal (and administrative/governance) problems.

Law and economics is closely related to jurimetrics, the application of probability and statistics to legal questions.

Applications


Influence

The economic analysis of law has been influential in the United States as well as elsewhere. Judicial opinions use economic analysis and the theories of law and economics with some regularity, in the US but also, increasingly, in Commonwealth countries and in Europe. The influence of law and economics has also been felt in legal education, with graduate programs in the subject being offered in a number of countries. The influence of law and economics in civil law countries may be gauged from the availability of textbooks of law and economics, in English as well as in other European languages (Schäfer and Ott 2004; Mackaay 2013).

Many law schools in North America, Europe, and Asia have faculty members with a graduate degree in economics. In addition, many professional economists now study and write on the relationship between economics and legal doctrines. Anthony Kronman, former dean of Yale Law School, has written that "the intellectual movement that has had the greatest influence on American academic law in the past quarter-century [of the 20th Century]" is law and economics. [38]

Criticisms

Despite its influence, the law and economics movement has been criticized from a number of directions. This is especially true of normative law and economics. Because most law and economics scholarship operates within a neoclassical framework, fundamental criticisms of neoclassical economics have been drawn from other, competing frameworks, though there are numerous internal critiques as well. [39] Yet other schools of economic thought have emerged and have been applied to the work of law and economics in, for example, the work of Edgardo Buscaglia and Robert Cooter on "Law and Economics of Development". [40]

Rational choice theory

Critics of the economic analysis of legal questions have argued that normative economic analysis does not capture the importance of human rights and concerns for distributive justice. Some of the heaviest criticisms of law and economics come from the critical legal studies movement, in particular Duncan Kennedy [41] and Mark Kelman. Jon D. Hanson, of Harvard Law School, argues that our legal, economic, political, and social systems are unduly influenced by an individualistic model of behavior based on preferences, instead of a model that incorporates cognitive biases and social norms. [42]

Pareto efficiency

Additional criticism has been directed toward the assumed benefits of law and policy designed to increase allocative efficiency when such assumptions are modeled on "first-best" (Pareto optimal) general-equilibrium conditions. Under the theory of the second best, for example, if the fulfillment of a subset of optimal conditions cannot be met under any circumstances, it is incorrect to conclude that the fulfillment of any subset of optimal conditions will necessarily result in an increase in allocative efficiency. [43]

Consequently, any expression of public policy whose purported purpose is an unambiguous increase in allocative efficiency (for example, consolidation of research and development costs through increased mergers and acquisitions resulting from a systematic relaxation of antitrust laws) is, according to critics, fundamentally incorrect, as there is no general reason to conclude that an increase in allocative efficiency is more likely than a decrease.

Essentially, the "first-best" neoclassical analysis fails to properly account for various kinds of general-equilibrium feedback relationships that result from intrinsic Pareto imperfections. [43]

Another critique comes from the fact that there is no unique optimal result. Warren Samuels in his 2007 book, The Legal-Economic Nexus, argues, "efficiency in the Pareto sense cannot dispositively be applied to the definition and assignment of rights themselves, because efficiency requires an antecedent determination of the rights (23–4)".

Responses to criticism

Law and economics has adapted to some of these criticisms and been developed in a variety of directions. One important trend has been the application of game theory to legal problems. [44] Other developments have been the incorporation of behavioral economics into economic analysis of law, [45] and the increasing use of statistical and econometrics techniques. [46] Within the legal academy, the term socio-economics has been applied to economic approaches that are self-consciously broader than the neoclassical tradition.

Property rights, which are analyzed using economic analysis, are seen as fundamental human rights by defenders of law and economics. [47] [48]

See also

Related Research Articles

Ronald Coase American economist and author

Ronald Harry Coase was a British economist and author. He was the Clifton R. Musser Professor of Economics at the University of Chicago Law School, where he arrived in 1964 and remained for the rest of his life. He received the Nobel Memorial Prize in Economic Sciences in 1991.

Pareto efficiency or Pareto optimality is a situation that cannot be modified so as to make any one individual or preference criterion better off without making at least one individual or preference criterion worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian engineer and economist, who used the concept in his studies of economic efficiency and income distribution. The following three concepts are closely related:

In the social sciences, the free-rider problem is a type of market failure that occurs when those who benefit from resources, public goods, or services of a communal nature do not pay for them or under-pay. Free riders are a problem because while not paying for the good, they may continue to access or use it. Thus, the good may be under-produced, overused or degraded.

Market failure in economics, inefficient resource allocation resulting in a net loss of value

In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient– that can be improved upon from the societal point of view. The first known use of the term by economists was in 1958, but the concept has been traced back to the Victorian philosopher Henry Sidgwick. Market failures are often associated with public goods, time-inconsistent preferences, information asymmetries, non-competitive markets, principal–agent problems, or externalities.

Kaldor–Hicks efficiency

A Kaldor–Hicks improvement, named for Nicholas Kaldor and John Hicks, is an economic re-allocation of resources among people that captures some of the intuitive appeal of a Pareto improvement, but has less stringent criteria and is hence applicable to more circumstances. A re-allocation is a Kaldor–Hicks improvement if those that are made better off could hypothetically compensate those that are made worse off and lead to a Pareto-improving outcome. The compensation does not actually have to occur and thus, a Kaldor–Hicks improvement can in fact leave some people worse off.

In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market.

Oliver E. Williamson American economist

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In law and economics, the Coase theorem describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are sufficiently low transaction costs, bargaining will lead to a Pareto efficient outcome regardless of the initial allocation of property. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasean bargaining. This 'theorem' is commonly attributed to Nobel Memorial Prize in Economic Sciences winner Ronald Coase during his tenure at the London School of Economics, SUNY at Buffalo, University of Virginia, and University of Chicago.

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Armen Alchian American economist

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Aaron Director, a professor at the University of Chicago Law School, played a central role in the development of the field Law and Economics and the Chicago school of economics. Together with his brother-in-law, Nobel laureate Milton Friedman, Director influenced some of the next generation of jurists, including Robert Bork, Richard Posner, Antonin Scalia and Chief Justice William Rehnquist.

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"The Problem of Social Cost" (1960) by Ronald Coase, then a faculty member at the University of Virginia, is an article dealing with the economic problem of externalities. It draws from a number of English legal cases and statutes to illustrate Coase's belief that legal rules are only justified by reference to a cost–benefit analysis, and that nuisances that are often regarded as being the fault of one party are more symmetric conflicts between the interests of the two parties. If there are sufficiently low costs of doing a transaction, legal rules would be irrelevant to the maximization of production. Because in the real world there are costs of bargaining and information gathering, legal rules are justified to the extent of their ability to allocate rights to the most efficient right-bearer.

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Further reading