Ntroductory Ooks: Bibliography Collected by The Editors
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INTRODUCTORY BOOKS
Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest
Bibliography Collected by the Editors
Adams, Michael (1981), Oekonomische Analyse des Zivilprozesses (Economic Analysis of Civil
Procedure), Koenigstein, Athenaeum-Verlag.
Algra, N.E. (1991), The Relations Between Law and Economics, Cahiers Rechtstheorie en
Encyclopedie van het recht, Nr. 2.
Arruada, Benito (1996), Analisis contractual de la empresa: Una introduccion aplicada
(Contractual Analysis of the Firm: An Applied Introduction), 5(3) Revista Europea de
Direccion y Economia de la Empresa.
Barnes, David W. and Stout, Lynn A. (1992a), Economic Foundations of Regulation and Antitrust
Law, Minneapolis, West Publishing.
Barnes, David W. and Stout, Lynn A. (1992b), Economics of Property Rights and Nuisance Law,
Minneapolis, West Publishing.
Barnes, David W. and Stout, Lynn A. (1992c), Economics of Constitutional Law and Public
Choice, Minneapolis, West Publishing.
Barnes, David W. and Stout, Lynn A. (1992d), Economic Analysis of Tort Law, Minneapolis, West
Publishing.
Barnes, David W. and Stout, Lynn A. (1992e), Cases and Materials on Law and Economics,
Minneapolis, West Publishing.
Barnes, David W. and Stout, Lynn A. (1992f), Economics of Contract Law, Minneapolis, West
Publishing.
Bergel, J.-L. (1989), Thorie Gnrale du Droit (General Theory of Law), Dalloz, Coll. Mthode
du droit.
Bowles, Roger A. (1982), Law and the Economy, Oxford, Martin Robertson, 239 p.
Cabrillac Remy (1995), Introduction Gnrale au Droit (General Introduction of Law), Dalloz, 23
p.
Cheung, Steven N.S. (1987), The Words of an Orange Seller (in Chinese), Taipei: Yuan-Liou
Publishing Company, Ltd..
Chiancone, Aldo and Porrini, Donatella (1996), Lezioni di Analisi Economica del Diritto (Lessons
of Economic Analysis of Law), Torino, Giappichelli.
Cooter, Robert D. and Ulen, Thomas S. (1988), Law and Economics, Scott Foresman. Reprinted in
Japanese translation by Prof. Shozo Ota, introduction by Prof. Koji Shimdo, published by
Shoji-Homu in 1989.
Crafton, Steven M. and Brinig, Margaret F. (1994), Quantitative Methods for Lawyers, Durham
(NC), Carolina Academic Press.
Dnes, Antony W. (1996), Economics of Law, London, Sweet & Maxwell.
Gallo, Paolo (1998), Analisi Economica del Diritto (Economic Analysis of Law), Torino,
Giappichelli.
Gemtos, Petros A. (1995), Oikonomika kai Dikaio: Oikonomika gia Nomikous, tomos:
Methodologika kai Oikonomika Themelia (Law and Economics: Economics for Lawyers, vol.
I: Methodological and Economic Foundations), Athens-Komotini, Ant. N. Sakkoulas
Publications.
1
2 Introductory Books 0000
Ghestin Jacques (1994), Trait de droit civil (Treat of Civil Law), 84-85.
Hirsch, Werner Z. (1979), Law and Economics: An Introductory Analysis, San Diego, Academic
Press, 275 p.
Holzhauer, Rudi W., Teijl, Rob et al. (1995), Inleiding Rechtseconomie (Introduction to Law and
Economics), Arnhem, Gouda Quint.
Holzhauer, Rudi W., Teijl, Rob et al (1989), Inleiding Rechtseconomie (Introduction to Law and
Economics), Arnhem, Gouda Quint, 345 p.
Hondius, E.H. et al. (1991), Rechtseconomie en Recht: Kennismaking met een Vakgebied in
Opkomst (Law and Economics and Law: Getting to Know an Emerging Discipline), Zwolle,
Tjeenk Willink, 201 p.
Hwang, Chun-Sin and Kan, Steven S. (1994), Principles of Economics Cooperating for Mutual
Prosperity and Progress, Taipei, Shin Lu Bookstore.
Jovanovic, Aleksandra (1998), Uvod u Ekonomsku Analizu Prava (Introduction to Economic
Analysis of Law), Belgrade, Pravni fakultet.
Kan, Steven S. (1994), Principles of Economics Cooperating for Mutual Prosperity and
Progress, Taipei, Shin Lu Bookstore.
Kanniainen, Vesa and Mtt, Kalle (eds) (1996), Nkkulmia Oikeustaloustieteeseen
(Perspectives on Law and Economics), Helsinki, Gaudeamus.
Kaplow, Louis (1987), Optimal Transition Policy: Replacing Horizontal Equity with an Ex Ante
Incentives Perspective, Dissertation accepted by Harvard University Department of
Economics.
Labus Miroljub (1995), Osnovi ekonomije: Savremene Teorije i Primena (Foundation Economics:
Contemporary Theories and Application), Jugoslovenska knjiga, Belgrade.
Lande, Robert H., Lafferty, Ronald N. and Kirkwood, John (1984), Impact Evaluations of Federal
Trade Commission Vertical Restraints Cases, FTC Publication. Nineteen Journal Reprints for
Antitrust Law and Economics 1 (1986).
Lehmann, Michael (1983), Buergerliches Recht und Handelsrecht - eine juristische und
oekonomische Analyse, Stuttgart, Poeschel.
Lemennicier, Bertrand (1991), Economie du Droit (Economics of Law), Paris, Ed. Cujas, 177 p.
Mackaay, Ejan (1982), Economics of Information and Law, Dordrecht, Kluwer, 293 p.
Markovits, Richard S. (1982), Law and Economic Theory, Oxford, Centre for Socio-Legal Studies.
Mercado Pacheco, Pedro (1994), El Anlisis Econmico del Derecho. Una reconstruccin terica
(Law and Economics. A Theoretical Reconstruction), Madrid, Centro de Estudios
Constitucionales.
Mercuro, Nicholas and Ryan, Tim (1984), Law, Economics, and Public Policy, Greenwood, JAI
Press.
Miceli, Thomas J. (1996), Economics of the Law: Torts, Contracts, Property, Litigation, Oxford,
Oxford University Press.
Murphy, Jeffrie G. and Coleman, Jules L. (1984), The Philosophy of Law: An Introduction to
Jurisprudence, Totowa, Rowman and Allenheld.
Nagel, Bernhard (1993), Wirtschaftsrecht I, Grundrechte und Einfhrung in das Brgerliche
Recht, 3 edn (Basic Rights and an Introduction into the Private Law), Mnchen, Lehrbuch.
0000 Introductory Books 3
Nagel, Bernhard (1994), Wirtschaftsrecht III (Unternehmens-und Konzernrecht) (Law of Firms
and Conglomerates), Mnchen, Lehrbuch.
Nentjes, Andries (1993), Elementaire Rechtseconomie (Basic Law and Economics), Groningen,
Wolters-Noordhoff, 139 p.
Oliver, J.M. (1979), Law and Economics, London, Allen and Unwin, 108 p.
Pardolesi, Roberto (1986), Una introduzione allAnalisi Economica del Diritto con Postfazione
(Translation of A. Mitchell Polinskys Introduction), Bologna, Zanichelli, 149 p.
Pardolesi, Roberto (1992), Postfazione a Polinsky, Mitchell A., Una Introduzione allAnalisi
Economica del Diritto (Afterword to Polinsky, Mitchell A., An Introduction to Economic
Analysis of Law), Il Foro Italiano, 179-199.
Phillips, A. (1962), Market Structure, Organization and Performance, Cambridge (MA), Harvard
University Press.
Phillips, A. (1971), Technology and Market Structure: A Study of the Aircraft Industry, Lexington
(MA), Heath.
Phillips, A., Phillips, A.P. and Phillips, T.R. (1994), Biz Jets: Technology and Market Structure in
the Corprate Jet Aircraft Industry, Boston, Kluwer Academic Publishers.
Polinsky, A. Mitchell (1983), An Introduction to Law and Economics, Boston, Little Brown, 183
p.
Polinsky, A. Mitchell (1989), An Introduction to Law and Economics (2nd edn), Boston, Little,
Brown and Company, 153 p.
Posner, Richard A. (1973), Economic Analysis of Law, Boston, Little Brown, 415 p. (1st edn),
1977, 572 p. (2nd edn), 1986, 666 p.
Reumer, Andrs (1996), Anlisis Econmico del Derecho (Economic Analysis of Law), Mexico,
Fondo de Cultura Econmica, Sociedad Mexicana de geografa y Estadstica, e Instituto
Technolgico Autnome de Mxico.
Roemer, Andrs (1994), Introducin al Anlisis Econmico del Derecho (Introduction to Law and
Economics), Mexico, Fondo de Cultura Econmica, Sociedad Mexicana de geografa y
Estadstica, e Instituto Technolgico Autnome de Mxico.
Rubin, Paul H. (1983), Business Firms and The Common Law.
Rubin, Paul H. (1990), Managing Business Transactions, New York, Free Press.
Ryssdal, Stray A.C. (1995), Legal Realism and Economics as Behavior - A Scandinavian Look at
the Economic Analysis of Law, Oslo, Juridisk Forlag.
Schfer, Hans-Bernd and Ott, Claus (1995), Lehrbuch der konomischen Analyse des Zivilrechts,
2. Aufl. (Textbook on Economic Analysis of Private Law), Berlin.
Stankovic Vladeta (1985), Privredni Sistem (Economic System), Belgrade, Pravni fakultet.
Stankovic Vladeta (1995), Pravo Privrednog Sistema (Law of the Economic System), Belgrade,
Pravni fakultet.
Stephen, Frank H. (1988), The Economics of the Law, Ames, Iowa State University Press, 224 p.
Streit, Manfred E. (1991), Theorie der Wirtschaftspolitik 4. neubearb. u. erweiterte Aufl. (Theory
of Economic Policy), Dsseldorf.
Tang, Yu-Min (1987), Translation of Richard A. Posners Economic Analysis of Law, Taipei,
Commercial Press.
Theeuwes, Jules J.M. et al. (1992), Recht en Economie, Amsterdam, Addison-Wesley, 301 p.
4 Introductory Books 0000
Torres Lopez, Juan (1987), Anlisis Econmico del Derecho. Panorama doctrinal (Survey on
Law and Economics), Madrid, Editorial Tecnos.
Tullock, Gordon (1971), The Logic of the Law, New York, Basic Books, 278 p.
Van Velthoven, Ben C.J., Van Wijck, Peter W. et al. (1997), Recht en Efficintie (Law and
Efficiency), Deventer, Kluwer, 337 p.
Veljanovski, Cento G. (1990), The Economics of Law - An Introductory Text, London, Institute of
Economic Affairs, 95 p. (Hobart Paperback).
Vodinelic, V. Vladimir (1991), Gradjansko Pravo - Uvodne Teme (Civil Law - Introductory
Themes), Belgrade.
Weise, Peter, Eger, Thomas, Brandes, Wolfgang and Kraft, M. (1993), Neue Mikrokonomie (New
Microeconomics), Heidelberg, Physica.
0010
INTRODUCTORY ARTICLES
Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest
Bibliography Collected by the Editors
Adams, Michael (1986), Der Irrtum ber knftige Sachverhalte - Anwendungsbeispiel und
Einfrhung in die konomische Analyse des Rechts, RECHT, Zeitschrift fr juristische
Ausbildung und Praxis, 14-23.
Albert, Hans (1986), Law as an Instrument of Rational Choice, in Daintith, Terence and Teubner,
Gunther (eds), Contract and Organisation: Legal Analysis in the Law, Berlin, Walter de
Gruyter, 25-51.
Alpa, Guido (1983), Interpretazione economica del Diritto (Economic Interpretation of Law), in X
(ed.), Voce del Novissimo Digesto Italiano, Torino, UTET, 315-324.
Alpa, Guido (1984), Diritto e Analisi Economica (a proposito di un recente libro di R. Bowles)
(Law and Economic Analysis, With Regard to a Recent Book by R. Bowles), Diritto dell
impresa, 111-120.
Aprile, Ercole (1989), Regolamentazione dei Fenomeni Economici e Analisi Economica degli
Strumenti Giuridici: Spunti per una Riflessione (Regulation of Economic Phenomena and
Economic Analysis of Legal Instruments: Hints for a Reflection), Nuovo Diritto, 505-521.
Arruada, Benito (1991), Nobel al Giro Coasiano (Nobel to the Coasian Turn), 41 Revista de
Economa, 122-126.
Assmann, Heinz-Dieter (1989), Kommentar on Ott, Allokationseffizienz, Rechtsdogmatik und
Rechtsprechung, in Ott, Claus and Schfer, Hans-Bernd (eds), Allekationseffizienz in der
Rechtsordnung, Berlin, Springer, 45-49.
Bakker, Luit M. et al. (1996), Economie en Recht: van Confrontatie naar Integratie (Economics
and Law: From Confrontation to Integration), in Van de Hoek, M.P. (ed.), Opstellen
aangeboden aan prof. dr. C. Rijnvos, Groningen, Wolters-Noordhoff, 102-111.
Barbera, Salvador (1989), Los derechos individuales en el anlisis econmico (Individual rights
and economic analysis), 38 Economistas.
Behrens, Peter (1981), Aspekte einer konomischen Theorie des Rechts (Aspects of an Economic
Theory of Law), 12 Rechtstheorie, 472-490.
Behrens, Peter (1988), ber das Verhltnis der Rechtswissen schaft zur Nationalkonomie: Die
konomischen Grundlagen des Rechts (On the Interrelationship between Law and
Economics), in Boettcher, Erik, Herder-Dorneich, Philipp and Schenk, Karl-Ernst (eds),
Jahrbuch fr neue politische konomie 7, Tbingen, Mohr, 209-228.
Bongaerts, Jan C. (1986), Inleiding tot de Economische Analyse van het Recht met Toepassing op
het Contractenrecht en het Aansprakelijkheidsrecht, Inzonderheid de Milieuramp te Bhopal
(Introduction to Economic Analysis of Law, with Applications to Contract and Tort Law, and
in Particular to the Environmental Disaster in Bhopal), in Van Den Bergh, Roger (ed.),
Verslagboek Eerste Werkvergadering Recht en Economie, Antwerpen, Leerstoel A. Van
Melkebeke, Handelshogeschool, 5-20.
5
6 Introductory Articles 0010
Bouckaert, Boudewijn (1984), Efficintie of Rechtvaardigheid: het Onvermijdelijk Dilemma?
(Efficiency or Justice: the Unavoidable Dilemma?), 29 Tijdschrift voor Sociale
Wetenschappen, 101-133.
Bouckaert, Boudewijn (1988), LAnalyse Economique du Droit: vers un Renouveau de la Science
Juridique? (Economic Analysis of Law: Towards a Renewal of Legal Science?), 18 Revue
interdisciplinaire dtudes juridiques, 7-47.
Braden, John B. and Bromley, Daniel W. (1981), The Economics of Cooperation Over Collective
Bads, 8 Journal of Environmental Economics and Management, 134-150.
Bromley, Daniel W. (1978), Property Rules, Liability Rules, and Environmental Economics, 12
Journal of Economic Issues, 43-60.
Bromley, Daniel W. (1989a), Entitlements, Missing Markets and Environmental Uncertainty, 17
Journal of Environmental Economics and Management, 181-194.
Bromley, Daniel W. (1989b), Institutional Change and Economic Efficiency, 23 Journal of
Economic Issues, 735-759.
Bromley, Daniel W. (1989c), Property Relations and Economic Development: The Other Land
Reform, 17 World Development, 867-877.
Bromley, Daniel W. (1992), The Commons, Common Property, and Environmental Policy, 2(1)
Environmental and Resource Economics, 1-17.
Bromley, Daniel W. (1993a), Regulatory Takings: Coherent Concept or Logical Contradiction,
17 Vermont Law Review, 647-682.
Bromley, Daniel W. (1993b), The Law, Agency, and Global Climate Change, 3 International
Journal of Environment and Pollution, 250-268.
Bromley, Daniel W. (1993c), Reconstituting Economic Systems: Institutions in National Economic
Development, 11 Development Policy Review, 131-151.
Bromley, Daniel W. (1994), The Enclosure Movement Revisited: The South African Commons,
28 Journal of Economic Issues, 357-365.
Bromley, Daniel W. (1995), Property Rights and Natural Resource Damage Assessment, 14
Ecological Economics, 129-135.
Bromley, Daniel W. (1996), The Social Construction of Land, in Hagedorn, Konrad (ed.),
Institutioneller Wandel und Politische Okonomie von Landwirtschaft und Agrapolitik,
Frankfurt am Main, Campus Verlag.
Bromley, Daniel W. and Hodge, Ian (1990), Private Property Rights and Presumptive Policy
Entitlements: Reconsidering the Premises of Rural Policy, 17 European Review of
Agricultural Economics, 197-214.
Bruinsma, J.F. and Huls, N.J.H. (1995), Recht in de Broze Vernislaag van een Booming Industry
(Law as the Fragile Coat of Varnish of a Booming Industry), 70 Nederlands Juristen Blad,
1625-1631.
Brunt, Maureen (1984), The Economics of Law: Economic Imperialism in Negligence Law, No
Fault Insurance, Occupational Licensing and Criminology: Comment, 67 Australian
Economic Review, 113-119.
Bulcha, Mekuria, Kibreab, Gaim and Nobel, Peter (1987), Sociology, Economy and Law: Views in
Common, in Nobel, Peter (ed.), Refugees and Development in Africa, Stockholm, Almqvist
and Wiksell International, 93-103.
Burow, Patrick (1993), Einfhrung in die konomische Analyse des Rechts (An Introduction into
Law and Economics), 1 Juristische Schulung, 8-12.
0010 Introductory Articles 7
Cabrillo, Francisco (1987), ?Por Qu un Anlisis Econmico del Derecho? (Why an Economic
Analysis of Law?), 58 Revista de Occidente, 37-46.
Cabrillo, Francisco (1990), Una Nueva Frontera: El Anlisis Econmico del Derecho (A New
Frontier: Law and Economics), 687 Informacin Comercial Espaola, 9-22.
Calsamiglia, Albert (1988), Justicia, Eficiencia y Derecho (Equity, Efficiency and the Law), 1
Revista del Centro de Estudios Constitucionales, 327 ff.
Campbell, C. and Wiles, P. (1976), The Study of Law in Society, 10 Law and Society Review,
547-578.
Casas Pardo, Jos, Las Estructuras Federal y Fiscal de las Democracias Representativa y Directa
como Modelos para una Union Europea Federal (Federal and Fiscal Structures in
Representative and Direct Democracies as Models for a Federal European Union), in X (ed.),
Actas de las Jornadas de Estudio sobre La Constitucion espaola y el ordenamineto
comunitario europeo (II), Direccin General del Servicio Juridico del Estado, Ministerio de
Justicia.
Casas Pardo, Jos, Algunas Consideraciones sobre la Teora de la Eleccin Pblica (Some
Considerations on Public Choice Theory), in Beltran, Lucas, Libro Homanaje, Madrid,
Editorial Moneda y Credito.
Casas Pardo, Jos, The Spanish Transition to Democracy: a Public Choice Approach, in
Backhaus, Jrgen G. (ed.), The Political Economy of Structural Change, Cheltenham, Edward
Elgar.
Casas Pardo, Jos (forthcoming), El Contractualismo-Constitucionalismo Liberal de James M.
Buchanan (James M. Buchanans Liberal Contractualism-Constitutionalism), in Cortina, A.
(ed.), tica de los Negocios, Bancaja, Valencia, Fundacin Etnor.
Casas Pardo, Jos (1979), El Control de los Efectos Econmicos Externos por Medio de la
Imposicin (Controlling Externalities with Taxation), Revista de Derecho Financiero y
Hacienda Pblica.
Casas Pardo, Jos (1984), Estudio Introductorio (Introductory Study), in Buchanan, James M. and
Tollison, Robert D. (eds), Anlisis Econmico de los Polticos (Economic Analysis of the
Politicians), Madrid, Instituto de Estudios Econmicos.
Casas Pardo, Jos (1987), Laudatio Academica, in Casas Pardo, J. and Bru Parra, S. (eds),
Economa y Poltica (Economics and Politics), Valencia, Servei de Publicacions, Universitat de
Valencia.
Casas Pardo, Jos (1991), Sobre la Relevancia de la Economa Constitucional (About the
Relevance of Constitutional Economy), in X (ed.), Homenaje al Prof. D. Carlos Otero Daz,
Universidad de Santiago de Compostela.
Casas Pardo, Jos (1993), Anlisis Econmico de las Instituciones y de las Reglas (Economic
Analysis of the Institutions and Rules), in Puy Fraga, P. (ed.), Anlisis econmico del
Derecho y de la Poltica, Santiago de Compostela, Fundacin Alfredo Braas.
Casas Pardo, Jos (1995a), Introduccin (Introduction), in Casas Pardo, J. and Schneider, F. (eds),
Current Issues in Public Choice, Cheltenham, Edward Elgar.
Casas Pardo, Jos (1995b), Does Ethical Proceduralism Underly Buchanans Constitutional
Contractualism?, in Casas Pardo, J. and Schneider, F. (eds), Current Issues in Public Choice,
Cheltenham, Edward Elgar.
Casas Pardo, Jos and Brennan, Geoffrey (1978), A Reading of the Spanish Constitution, 1
Constitutional Political Economy.
8 Introductory Articles 0010
Casas Pardo, Jos and Brennan, Geoffrey (1990), La Constitucin espaola a la luz de la
Economa poltica de las constituciones (The Spanish Constitution from the Political Economy
of Constitutions Approach), 116-3 Hacienda Pblica Espaola.
Casas Pardo, Jos and Fernndez Cainzos, J., Las Contituciones Econmica y Fiscal en la
Constitucin Espaola de 1978 (The Economic and Fiscal Constitutions into the Spanish
Constitution of 1978), in Alvarez Conde, E. (ed.), La Constitucin espaola de 1978 diez
aos despues, Madrid, Tecnos.
Casas Pardo, Jos and Fernndez Cainzos, J. (1995), La Imposicin a Traves de la Regulacin en
Espaa: Un intento de medir la imposicin implicita en el sistema financiero espaol en la
dcada 1977-1987 (Taxation Through Regulation in Spain: An Effort to Measure Implicit
Taxation in the Spanish Financial System between 1977-1987), in X (ed.), Estudios de
Derecho Mercantil en Homenaje al Prof. Manuel Broseta Pont, Tirant lo Blanch, Valecia.
Casas Pardo, Jos and Navarro, Puchades M. (forthcoming), La Perspectiva de la Public Choice
en el Anlisis de la Actuacin de los Entes Pblicos (Public Choice Approach and the
Behaviour of Public Enterprises), in X (ed.), Actas del II Congreso Espaol de Ciencia
Politica y de la Administracin.
Casas Pardo, Jos and Sainz Snchez, E. (1995), La Coaccin de las Instituciones Colectivas
(Compelling Collective Institutions), in Sainz Snchez, E. (ed.), Las Organizaciones como
sistemas Constitucionales, Granada, Ensayos sobre el Modelo de Gestin Burocratica de la
Universidad Pblica, Mtodo Ediciones.
Cherot, Jean-Yves (1987a), Trois Thses de lAnalyses Economique du Droit (Three Theses of
Economic Analysis of Law), Revue de la Recherche Juridique.
Cherot, Jean-Yves (1987b), Trois Thses sur lAnalyse Economique du Droit - Quelques Usages
de lApproche Economique des Rgles Juridiques (Three Theses on Economic Analysis of Law
- Some Uses of the Economic Approach to Legal Rules), 2 Revue de la Recherche Juridique.
Cooter, Robert D. (1982a), The Cost of Coase, 11 Journal of Legal Studies, 1-33. Reprinted in
Donahue, Charles Jr, Kauper, Thomas E. and Martin, Peter W., Property: An Introduction to
the Concept and the Institution, 1992. Reprinted in Ackerman, Bruce, Ellickson, Robert and
Rose, Carol, Foundations of Property Law, 1995. Reprinted in Medema, Steven G. (ed.), The
Legacy of Ronald Coase in Economic Analysis, Aldershot, Edward Elgar Publishing, 96-128.
Cooter, Robert D. (1982b), Law and the Imperialism of Economics: An Introduction to the
Economic Analysis of Law by Reviewing Some Major Books, 29 UCLA Law Review,
1260-1269.
Cooter, Robert D. (1985), Prices and Sanctions, 84 Columbia Law Review, 1523-1560.
Cooter, Robert D. (1993), Diritto ed Economia (Law and Economics), Istituto DellEnciclopedia
Italiana, Fondata Da Giovanni Treccani, 98-106.
Cooter, Robert D. (1994), Laws and Prices: How Economics Contributed to Law By
Misunderstanding Morality, 3 Iuris: Quaderns de Poltica Jurdica, 35-36.
Cooter, Robert D. (1995), Law and Unified Social Theory, 22 Law and Society, 50-67. Reprinted
in Galligan, D.J. (ed.), Socio-Legal Studies in Context: The Oxford Centre Past and Future,
Blackwell Publishers, Oxford, 1995, pp. 50-67.
Cooter, Robert D. and Rubinfeld, Daniel L. (1989), Economic Analysis of Legal Disputes and
Their Resolution, 27 Journal of Economic Literature, 1067-1097.
0010 Introductory Articles 9
Reprinted in Posner, Richard A. and Parisi, Francesco (eds), Law and Economics, Edward
Elgar, 1996 forthcoming.
Cooter, Robert D. and Rubinfeld, Daniel L. (1990), Trial Courts: An Economic Perspective, 24
Law and Society Review, 533 ff.
Cortenraad, Wouter H.F.M. (1996), Rechtseconomie Bestaat Niet (Theres no Such Thing as Law
and Economics), 71 Nederlands Juristen Blad, 963-967.
Cosentino, Fabrizio (1990), Analisi Economica del Eiritto: Ritorno al Futuro? (Economic Analysis
of Law: Back to the Future?), 5 Foro Italiano, 153-156.
Crombach, H.F.M. and Van Dun, Frank (1990), Recht en Economie in Utopia: een
Rechtsfilosofisch Gedachtenexperiment (Law and Economics in Utopia: a Mental Experiment
in Legal Philosophy), 4 Rechtsgeleerd Magazijn Themis, 167-176.
De Bock, Ruth (1990), Inleiding (Introduction), 39(10) Ars Aequi in Bock, Ruth de et al. (eds),
Themanummer Rechtseconomie, 607-613.
De Bock, Ruth et al. (1990), Themanummer Rechtseconomie (Special Issue Law and Economics),
39(10) Ars Aequi, 607-804.
De Geest, Gerrit (1990), Public Choice en Rechtseconomie (Public Choice and Law and
Economics), 39(10) Ars Aequi in Bock, Ruth de et al. (eds), Themanummer Rechtseconomie,
666-673.
Dnes, Antony W. (1992), Franchising, in Eatwell, John, Milgate, Murray and Newman, Peter
(eds), The New Palgrave Dictionary of Money and Finance, London, Macmillan.
Dnes, Antony W. (1994a), Law and Economics, 10 Policy, 39-42.
Dnes, Antony W. (1994b), Legal Economics, 2 Hume Papers on Public Policy, 56-62.
Dooyeweerd, H. (1949), De Sociologische Verhouding tussen Recht en Economie en het Probleem
van het Zogeheten Economisch Recht (The Sociological Relationship Between Law and
Economics and the Problem of So-called Economic Law), in Dooyeweerd, H. (ed.),
Opstellen op het gebied van Recht, Staat en Maatschappij, Amsterdam, Bakker, 221-264.
Dorndorf, Eberhard (1995), Modelle des Rechtssystems in der konomischen Analyse des Rechts
(Models of the Legal System in Law and Economics), in X. (ed.), konomie und Gesellschaft.
Jahrbuch 11, Markt, Norm und Moral, Frankfurt/New York, 127-159.
Duggan, A.J. (1989a), New Directions in Legal Theory: Law and Economics, 63 Law Institute
Journal, 852-853.
Duggan, A.J. (1989b), Law and Economics in Australia, 1 Legal Education Review, 37-41.
Eger, Thomas (1989), Einfhrung in die konomische Analyse des Rechts (Introduction to the
Economic Analysis of Law), in Nagel, B. (ed.), Wirtschaftsrecht II, Mnchen, Oldenborg,
18-35.
Eide, Erling (1992), Rettskonomi - en Introduksjon (Law and Economics - an introduction), 4
Jussens Venner, 193-224.
Fezer, Karl-Heinz (1986), Aspekte einer Rechtskritik an der Economic Analysis of Law und am
Property Rights Approach (Critcal Aspects of the Economic Analysis of Law and the Property
Rights Approach from a Lawyers Viewpoint), 41 Juristenzeitung, 817-824.
Fezer, Karl-Heinz (1988), Nochmals, Kritik an der konomischen Analyse des Rechts (More
Critics on Law and Economics), 43 Juristenzeitung, 223 ff.
10 Introductory Articles 0010
Field, A.J. (1991), Do Legal Systems Matter?, 28(1) Explorations in Economic History, 1-35.
Fluet, Claude (1990), LAnalyse Economique du Droit (Economic Analysis of Law), 43(3)
conomie Applique, 53-66.
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0010 Introductory Articles 13
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14 Introductory Articles 0010
Paz-Ares, Cndido (1985), Seguridad Jurdica y Seguridad del Trfico (Legal Certainty and
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0010 Introductory Articles 15
Phillips, A. (1972a), An Econometric Study of Price-Fixing, Market Structure and Performance in
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Phillips, A. (1974b), Commenatry, in Goldschmid, H., Mann, H.M. and Weston, J.F. (eds),
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Phillips, A. (1974c), Regulatory Reform for the Deposit Financial Institutions: Retrospect and
Prospects, Journal of Financial and Quantitative Analysis, 795-802.
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Promoting Competition in Regulated Markets, Washington, Brookings Institution, 329-366.
Reprinted in 5 Journal of Reprints for Antitrust Law and Economics, 1975. Reprinted in
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Homewood, IL, Richard D. Irwin.
Phillips, A. (1976), Schwinn Rules and the New Economics of Vertical Relations, 44(3)
Antitrust Law Journal, 573-580.
Phillips, A. (1978), Regulation and its Alternatives, in X (ed.), Regulating Business: The Search
for an Optimum, San Francisco, Institute for Contemporary Studies Press, 157-172. Reprinted
in The Economics of Antitrust, ALI-ABA Course of Study Materials, American Law Institute -
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Considerations, in Sahal, D. (ed.), Perspectives on Research, Development and
Technological Innovation, Lexington, MA, Lexington Books, 105-125.
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Phillips, A. (1985), Unreasonable Rules and Rules of Reason: Economic Aspects of Vertical
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Phillips, A. (1986), Market Concentration and Performance: A Survey of the Evidence, 61(5)
Notre Dame Law Review.
Phillips, A. (1990), Antitrust Principles and Regulatory Needs, 35 Antitrust Bulletin. Reprinted in
Kovaleff, T.P. (ed.), The Antitrust Impulse, Vol. II, New York, M.E. Sharpe, 1994.
16 Introductory Articles 0010
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18 Introductory Articles 0010
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0020
MONOGRAPHS
Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest
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0020 Monographs 29
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30 Monographs 0020
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0030
BOOK REVIEWS
Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest
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34 Book Reviews 0030
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0030 Book Reviews 35
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0040
SYMPOSIA
Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest
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0040 Symposia 37
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0050
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0060
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0080
DOCTORAL OR MASTERS THESES
Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest
Bibliography Collected by the Editors
Adams, Michael (1981), Oekonomische Analyse des Zivilprozesses (Economic Analysis of Civil
Procedure), Koenigstein, Athenaeum-Verlag.
Evangelopoulos, Panagiotis (1996), E Analyse ton Periousiakon Dikaiomaton kai e Ideologia tes
Eleutheres Agoras (Property Rights Analysis and Free-Market Ideology), 6 Aissymnetes.
Fabre-Magnan Muriel (1990), De lObligation dInformation dans les Contrats (The Obligation
of Information in Contracts), L.G.D.J.
Freyer, Susanne (1994), Umwelthaftung aus der Sicht der konomischen Analyse des Rechts
(Environmental Liability from a Law and Economics Perspective), Doctoral Dissertation.
Garoupa, Nuno (1997), Essays on the Theory of Optimal Law Enforcement, University of York,
Phil. Thesis.
Hatzis, Aristides N. (1998), An Economic Theory of Greek Contract Law, PhD Thesis, University
of Chicago Law School.
Manitakis, Antonios (1975), LAntinomie entre la Libert du Commerce et de lIndustrie et la
Rgulation Administrative de lconomie: En Droit Belge et en Droit Franais, Bruxelles,
Centre Interuniversitaire de Droit Public.
McGee, Robert W. (1993), Explorations in Law and Economics from a Rights Perspective, The
Union Institute, 221 p.
Moine, I. (1997), Les choses hors commerce. Une approche de la personne humaine juridique
(Things Apart from Commerce. An Approach of Juridical Humane Persons), L.G.D.J.
Poughon, Jean-Michel (1987), Histoire doctrinale de lchange, (Doctrinal History of Exchange),
L.G.D.J.
Raaschou-Nielsen, Agnete (1988), Institutionel ndring og konomisk Teori (Institutional
Change and Economic Theory), Kbenhavn, PhD thesis, Det Statsvidenskablige Fagrd.
Riis, Thomas (1996), Ophavsret og retskonomi (Copyright and Law and Economics), Gadjura,
PhD thesis.
Roemer, Andrs (1994), An Interdisciplinary Approach to Federal Waters and Institutions: The
Mexican Case, UP/Michigan Publishers.
Ryssdal, Stray A.C. (1995), Legal Realism and Economics as Behavior - A Scandinavian Look at
the Economic Analysis of Law, Oslo, Juridisk Forlag.
Sevic, Zeljko (1994), Pravni Status Centralne Banke u Savremenoj Trzisnoj Privredi (Status of
the Central Bank in a Contemporary Market Economy), Belgrade, Faculty of Law, University
of Belgrade.
Zenati, F. (1981), Essai sur la Nature Juridique de la Proprit, Contribution la Thorie
Juridique du Droit Subjectif, (Essay on the Juridical Nature of Property, Contributions to the
Juridical Theory of Subjective Rights).
49
0100
ORGANIZATION OF RESEARCH AND
TEACHING
Claus Ott
Professor of Law at theUniversity of Hamburg
Tina Neuling
Research Assistant at theUniversity of Hamburg
Copyright 1999 Claus Ott and Tina Neuling
Abstract
Law and economics is quite a new field of research but there is a noticeable
increase in its influence in both legal and economic scholarship. In the
following chapter information is given about different aspects of the
organization of research and teaching in this area, in particular about the
institutions, the current state of law and economics in academic life all over the
world, the basic publications providing more detailed information, Law and
Economics Associations, and law and economics on the Internet.
JEL classification: K00
Keywords: law and economics, Academic Programs, Teaching, Research,
Research Institutes, law and economics Associations
1. Introduction
Law and economics is a relatively new field of research, and therefore it is only
slowly becoming an established part of the curricula at universities and colleges
throughout the world. However, there is a clear movement towards employing
the tools of law and economics in academic programs and in special research
institutes more and more. While most of the literature describing and
discussing these influences concentrates on developments at law schools, the
field is also being explored in traditional departments of economics. Overall,
there is a noticeable increase in the influence of law and economics in both
legal and economic scholarship. Nevertheless, the relative importance of the
field is still heavily debated. For example, it is often discussed whether or not
the economic analysis of law can or cannot provide for a new understanding of
the law, and how economic tools have changed the classical study of the law.
One extensive discussion about the role of law and economics in legal
education has been published in the Journal of Legal Education. In that
edition, various opinions are presented in fourteen articles covering about 200
50
0100 Organization of Research and Teaching 51
pages. The original debate was held at a symposium in 1983 entitled The Place
of Economics in Legal Education (Symposium, 1983). The primary focus of
the articles is the relevance of economics on legal thought in general (see
Becker, 1983, Breyer, 1983; Calabresi, 1983; Cooter, 1983; Hansmann, 1983;
Michelmann, 1983; and Priest, 1983). However, some of the authors also
discuss the practical application of law and economics in teaching (see Doyle,
1982; Gelhorn and Robinson, 1983; Klevorick, 1983; Schwartz, M., 1983;
Schwartz W., 1983; Summers, 1983; and Trebilcock, 1983). In 1981 a similar
symposium was held at Yale University, and in the papers presented at that
conference (published in the Yale Law Journal) the authors - among them
Ackerman (1981), Posner (1981) and Priest (1981), analyzed the current state
of legal scholarship. Law and economics was only one of the focuses of
discussions there, and the influence of other disciplines which were noticeable
in legal scholarship was also discussed. One example of a similar symposium
convened outside of the United States is that of the 1991 symposium Economic
Analysis in Civil Law Countries: Past, Present, Future (see Cooter and
Gordley, 1991). There, scholars from different countries provided information
about the influence of law and economics in their respective home countries.
See Mattei and Pardolesi (1991) report on Italy, Kirchner (1991) report on
Germany, Hertig (1991) report on Switzerland (pointing out the apparent lack
of a law and economics movement in Switzerland), Ota (1991) report on Japan,
Pastor (1991) report on Spain, Skogh (1991) report on Sweden, and Weigel
(1991) report on Austria.
One interesting approach to measuring the actual influence of law and
economics has been taken by Landes and Posner (1993). In their article, the
authors present a quantitative study in which they analyze citations to show the
extent to which economics has in fact influenced legal scholarship.
The following chapters will provide a short overview over different methods
of teaching law and economics, and how the research in this area continues to
be promoted throughout the world. Since academic programs are constantly
changing and many different programs and institutions are still in their
developmental stages, only representative examples will be presented here.
Much information concerning specific programs or classes can be obtained in
detail from the home pages of the respective universities/institutions on the
Internet, and can be located through the main search engines. Greater detail
about specific countries can furthermore be found in chapters 0305-0395 of this
volume, in which the law and economics movements in different countries are
presented.
52 Organization of Research and Teaching 0100
2. Teaching of law and economics - An Overview
Though law and economics is also part of the curricula of many departments
of economics, most programs in law and economics are organized by private
and public law schools. However, economics scholars often actively participate,
and several law schools and departments of economics or business work
together in joint programs. Quite often, professors of economics are asked to
join law school faculties and to teach there on a permanent basis. Furthermore,
there are numerous special institutes formed of both law and economics faculty
members.
There are a variety of possibilities to study and teach law and economics at
different academic levels and to different audiences. As stated above, it can be
taught in law schools, in university-based departments of economics, or at
special research institutes. At universities, law and economics can be taught at
an undergraduate, graduate or postgraduate level. Finally, law and economics
can either be integrated into regular law school courses, or there can be special
course offerings either as optional courses or within a separate program.
3. Integration of law and economics into Law or Economics Courses
At law schools, law and economics may be integrated into the traditional law
school curriculum. This can be accomplished by first providing an introduction
into the basic principles of economics, and later on by encouraging the use of
the economic tools learned. This approach is favored by some American law
schools where the law and economics approach is an essential tool for
understanding the law courses offered in subsequent years. In such programs,
basic economics courses and later on economic analysis of different areas of the
law are often mandatory requirements.
The most progressive steps so far have been taken by the American George
Mason University School of Law in Arlington, Virginia (George Mason
University School of Law, 3401 North Fairfax Drive, Arlington, VA
22201-4498, USA). This program emphasizes application of the law and
economics approach to the entire study of the law. Almost all of the courses at
George Mason use economic theory as their primary method of analysis.
More commonly, however, law schools employ economic tools only
within the framework of certain specific courses. Law and economics ideas can
and are - at least in the United States - typically treated in the classic law and
economic courses (for example antitrust law or corporate law). These courses
have served as the traditional forum for the application of the law and
economics approach. There exists, however, a growing tendency towards
employing law and economics in more and more non-traditional law courses
(for example torts, real property, contracts or civil procedure). Today, law and
0100 Organization of Research and Teaching 53
economics is being integrated more and more into the traditional core curricula
of legal studies. This expansion is often referred to as the New Law and
economics. A brief description of the so-called New Law and economics can
be found in Calabresi (1983), and Veljanovski (1982) also gives a good
overview over this approach. On the other hand, Kirchner (1991) refers back
to the previous tradition in Germany of interdisciplinary research in the field
of law and economics which was more or less confined to cartel law, and traces
the introduction of new law and economics into legal research and teaching
back in the 1970s.
A detailed exposition on what law and economics scholars and economists
currently think lawyers should know about economics can be found in Whaples,
Morriss and Moorhouse (1998). In preparing this report the authors conducted
a survey to find out which concepts the scholars interviewed deemed to be
necessary in the teaching of law and economics courses, and what major
articles they would recommend for a required reading list.
Law and economics can, of course, be integrated into classical economics
courses. However, this approach is more rare and less information about it is
available.
4. Special law and economics Courses at Law Schools or in Departments
of Economics
As opposed to integrating economic analysis of the law into law or economics
courses, there also exist special law and economics courses which are elective
in nature and which concentrate more on the fields theoretical aspects. This
approach is mostly favored by universities which do not integrate economic
analysis of the law into their regular classes. These specialized classes can be
found at many American universities as well as elsewhere in the rest of the
world.
For example, in Germany such courses can sometimes be found as one of
several electives relating to the foundations of the law, the so-called
Grundlagenveranstaltungen. It is still, however, rare to find true law and
economics lectures. The University of Hamburg is one of the rare exceptions.
In Hamburg, fully integrated courses in law and economics are offered to law
students as optional classes as part of the regular law school curriculum.
Schfer (1990) explains and discusses the Hamburg model. An early outline of
an integrated law and economics course is given by Ktz (1977). At other
German Law Schools it is more common to offer classes where pure economics
is taught. Kirchner (1991) provides an instructive overview of the general
situation in Germany up until the 1990s.
In other countries law and economics classes can be found more often. For
example, in Europe such classes are regularly offered in Austria, Belgium,
54 Organization of Research and Teaching 0100
France, Italy, the Netherlands, Spain, and the United Kingdom. In Austria the
University of Innsbruck offers a course in Economic Analysis of Law in
addition to fundamental classes in economics for law-students. At the
Katholieke Universiteit Leuven in Belgium an English language course entitled
Economic Analysis of Law is offered which is based upon a microeconomics
and game-theory methodology. Also, the University of Ghent in Belgium offers
a course entitled Rechtseconomie to both law and economics students. In
France, the University of Montpellier also offers special classes in law and
economics. The University of Trento in Italy has an optional class called
Topics of Economic Analysis of the Law. All of these are simply examples of
current courses being offered in Europe.
The early situation in the Netherlands is described in more detail by
Holzhauer and Teijl (1989). Recently, the growing influence of law and
economics in the Dutch legal education has become noticeable. Nowadays, law
and economics is often offered as a basic introductory course. Examples can be
found at the relevant Internet home sites of the Erasmus University of
Rotterdam. The earlier status of law and economics at Spanish law schools is
described in Pastor (1988) as well as Pastor (1991).
Other countries where the study of law and economics is especially
emphasized include the United States, and also Israel, Canada, Australia and
New Zealand. Gelhorn and Robinson (1983) review the development of
economic science in US law schools and comment on that developments
relevance. Lovett (1974) also addresses the role of economics in American law
schools and closely examines the curricula at several law schools in the United
States. The Buchmann Faculty of Law at Tel-Aviv University has classes where
law and economics are combined at the undergraduate level as well as at the
graduate level. Trebilcock (1983) provides information about the changes at
law schools in Canada. He points out that the influence of law and economics
in Canadian legal education is limited as compared to the United States and
presents possible explanations for this. The author himself, however, actively
participates in promoting law and economics scholarship in Canada. Doyle
(1982) extensively examines lecture courses in law and economics offered at an
undergraduate level in Australia.
The most recent developments regarding law and economics in various
countries are described in the chapter 0300 Survey of Non-English Language
Publications. One example of a course in law and economics offered to students
of economics is the course Analisis Economico del Derecho at the
Universidad Carlos III de Madrid in Madrid, Spain. Professor Santos Pastor,
who teaches this class, also wrote the above-cited article Teaching Economics
to Law Students (Pastor, 1988).
0100 Organization of Research and Teaching 55
5. Specific law and economics Programs for Lawyers and Economists
Still another possibility exists, namely the teaching of law and economics in a
separate program specializing in law and economics. The ERASMUS
Programme in law and economics is a one-year European postgraduate
program for lawyers and economists leading to the academic degree of
European Master in Law and Economics. It is jointly organized by 19 partner
universities within the European Union. The University of Haifa, Israel is also
an associate member. Special courses in law and economics are offered at ten
of the partner universities. The programs partners (T = partner and teaching
unit) are the universities of Aix-en-Provence (T), Berlin, Copenhagen, Ghent
(T), Glasgow, Haifa, Hamburg (T), Leiden (T), Linkping (T), Madrid (T),
Manchester (T), Milan, Paris, Rome, Rotterdam (T), Stockholm (T), Tampere,
Thessaloniki, Valladolid, and Vienna (T). The ERASMUS Programme in law
and economics is presently coordinated from the University of Hamburg
(C.Ott).
The University of Utrecht is an example of a law school offering a
postgraduate program leading to a degree in law and economics (Utrecht LLM
Office, Faculty of Law, Utrecht University, Janskerhof 3, 3512 BK Utrecht, The
Netherlands). This program is open to both law school and economics program
graduates. Students of economics may complete specialized legal courses and
are able to obtain a Master of Sciences title.
In the United States, one of the most important programs is the John M.
Olin Program in law and economics at the University of Chicago. In that
program law and economics ideas have been taught for over 50 years. The
significant achievements of that program are described by Coase (1993). At the
American College of Law at Syracuse University in New York (Syracuse
University College of Law, Office of Admissions and Financial Aid, Suite 212,
Syracuse, NY 13244-1030, USA) another form of specialization can be found.
Students are able to participate in a program of studies offering a special Law
and Economics Concentration. During their normal studies of the law, students
are required to take five core courses involving law and economics topics and
three elective courses. Once these requirements have been met the students are
awarded a special certificate in recognition that they have completed this
special concentration.
At the Faculty of Law at the University of Toronto (Faculty of Law,
University of Toronto, 78 Queens Park, Toronto, Ontario, Canada, M5 S 2
C5), where Professor Trebilcock teaches, instructors from the Faculty of Law,
the Department of Economics and the Faculty of Management work together.
The program offers students special study and research opportunities in a
variety of courses, and brings to the Faculty important law and economics
scholars through the programs law and economics Workshops and the Visiting
Professorship in Law and Economics.
56 Organization of Research and Teaching 0100
A brief description about an international summer school in law and
economics offered in Saarbrcken is presented by Meyer and Mller (1990). In
1988 and in 1989 the Center for the Study of the New Institutional Economics
at the University of Saarbrcken organized two international summer schools
in cooperation with the University of Texas in Arlington.
The National Law School of India University in Bangalore (Prof. N.L.
Mitra, Director, National Law School of India University, Nagarbhavi,
Bangalore-560072, India) organizes seminars in law and economics for
teaching staff members from Indian law schools and departments of economics.
There are also courses in law and economics available for legal practitioners
and professors. A special training program for postgraduates, judges, lawyers,
law professors, and academic economists, is offered by the law and economics
Center (LEC) founded by Henry Manne in 1974 and located at the George
Mason University in Arlington, Virginia. The program is privately funded and
offers educational institutes, seminars, and conferences in close cooperation
with the Universitys law school.
6. Teaching Materials
The basic teaching materials for all law and economic classes are the two
classic textbooks: Posner, Economic Analysis of Law (1998), now in its fifth
edition, and Cooter and Ulen, Law and Economics (1996), now in its second
edition. In addition, other textbooks intended to provide a basis for academic
studies in law and economics have been published. Recent examples include
Schfer and Ott, Lehrbuch der konomischen Analyse des Rechts (1995),
now in its second edition and also available in Spanish, Miceli, The Economics
of the Law (1998), Katz, Foundations of the Economic Approach to Law
(1998), Dau-Schmidt and Ulen, Law and Economics Anthology (1998),
Posner, and Parisi, Law and Economics (1997) a three volume set, Mercuro
and Medema, Economics and the Law: From Posner to Post-Modernism
(1997), and Dnes, The Economics of Law (1996). Earlier examples of such
works include Manne, The Economics of Legal Relationships (1975),
Tullock, The Logic of the Law (1971), and Bowles, Law and the Economy
(1982). These textbooks all share the common characteristic that they are
specifically designed to serve as textbooks for law-students. Other literature -
of course - can and is also applied in classrooms. The literature identified above
can be found in the bibliography in Chapter 0000 Introductory Books.
Examples of how the law and economics approach can be used to analyze
specific cases in the classroom are Schfer and Strck (1983) and Walz and
Wienstroh (1983), both published in Walz and Rascher-Friesenhausen (1983),
and Wehrt and Mohr (1995).
0100 Organization of Research and Teaching 57
7. Research in law and economics - An Overview
Research in the area of law and economics is becoming more and more
noticeable. There exists an expanding body of literature (books, theses,
dissertations, working papers, and journals), and researchers from all over the
world regularly meet at academic conferences, workshops and through various
law and economics associations. Universities all over the world also host
periodic conferences and discussion groups which have a law and economics
focus. At several universities special research centers dedicated to law and
economics exist.
8. Academic Research in Europe
In Germany there exist two prominent academic research institutes focusing on
the topic of law and economics. One is located in the city of Saarbrcken and
the other in Hamburg. The Forschungsstelle zur konomischen Analyse des
Rechts at Saarbrcken (Center for the Study of law and economics, Prof. D.
Schmidtchen, Forschungsstelle zur konomischen Analyse des Rechts,
Universitt des Saarlandes, Fachbereich Wirtschaftswissenschaft, Gebude 31,
Postfach 151150, D-66041 Saarbrcken) was founded in 1993 in the
Department of Economics of the Universitt des Saarlandes. The Center
organizes conferences, for example in Wallerfangen, and workshops, invites
scholars from all over the world, and provides consultations and advice to
numerous private and public authorities. It also publishes a series of theoretical
discussion papers. Its particular focus of research is the law and economics of
international transactions, constitutional economics, the legal protection of
intellectual property, and the evolution of legal rules and conventions in the
shadow of the law. The Center also organizes an annual meeting for
researchers in the field of New Political Economy. Papers presented at the
Centers various conferences are published in the Jahrbuch fr Neue
Politische konomie.
In Hamburg, the Institute of law and economics (Universitt Hamburg,
Fachbereich Rechtswissenschaft, Edmund-Siemers-Allee 1, 20146 Hamburg)
founded by Prof. C. Ott and Prof. H.-B. Schfer as part of the Law Facultys
focus on interdisciplinary research and teaching activities, serves as a forum for
guest lecturers, workshops, and seminars. The Institute also publishes a regular
series of discussion papers. Since 1988, the Institute has organized a biannual
conference of various topics in the field of law and economics at Travemnde
(See Conference Volumes (6), edited by C. Ott and H.B. Schfer). In October
1998, the Institute established a PhD program (Graduiertenkolleg) for 15
postgraduate students of law and economics which hosts doctoral candidates
from both Europe and the US. (For information regarding other teaching and
58 Organization of Research and Teaching 0100
research centers and academic conferences in Germany please refer to Kirstein
0330 law and economics.)
Another European center for interdisciplinary studies which provides
information concerning fundamental topics in law and economics is the Center
dtudes Interdisciplinaire Walras Pareto which is part of the Universit de
Lausanne of Switzerland. An example of a research center located in France is
the Department of law and economics within the Laboratoire de Droit Priv
of the University of Montpellier (Laboratoire de Droit Priv, 14, rue Cardinal
de Cabrires, 34060 Montpellier Cedex 0467615452). That center hosts
meetings and conferences in order to promote the exchange of ideas in law and
economics. In the Netherlands regular workshops are held in Maastricht,
organized by Jrgen Backhaus. In the United Kingdom the David Hume
Institute promotes discourse and research on economic and legal aspects of
public policy questions. The Hume Institute was founded in Edinburgh in 1985.
It publishes a quarterly academic journal and various paper series, and
organizes conferences and other events (Contact David Hume Institute, 21
George Square, Edinburgh EH8 9LD, Scotland).
9. Academic Research in Other Countries
In the United States - the birthplace of law and economics - research centers in
law and economics are quite common. The universities identified above which
offer law and economics courses also maintain extensive research facilities.
Thus, at Yale, the University of California-Berkeley or at the University of
Chicago research in the field of law and economics is strongly supported and
promoted. Workshops and conferences are also currently being offered at the
Georgetown University Law Center in Washington, DC. At Georgetown, a law
and economics Workshop exists in which students, faculty, and outside
speakers regularly present their work. In addition, special academic conferences
are organized on a regular basis. Another prominent center of research in the
US is the Business, law and economics Center of the John M. Olin School of
Business at Washington University in St. Louis, Missouri. The Olin Center,
which was founded in 1991, focuses its research on how law, economics, and
politics converge to influence private business.
10. Non-University Research
Research in the field of law and economics is not only undertaken at certain
universities or law schools. For example, the Institute for Civil Justice in the
United States, which is an independent research program within RAND (1700
0100 Organization of Research and Teaching 59
Main Street, PO Box 2138, Santa Monica, CA 90407-2138, USA), is also
known for its interdisciplinary and empirical approach to public policy issues,
including economic analysis of the law. RAND is a non-profit institution
formed with the goal of improving public policy and public decision making
through better research and analysis. The RAND organization employs more
than 500 research professionals.
Conferences and other professional meetings which provide researchers
from across the world the opportunity to meet and interact are also an
important way of ensuring the flow and exchange of ideas and opinions, and
provide researchers with the chance to catalog and compare their results with
those of other research programs. Annual or biannual conferences are held at
several locations throughout the world in order to promote research in the area
of law and economics. One such annual international gathering is the mid-term
meeting of the Erasmus Program in law and economics. Papers presented at
that meeting are published in a series of special publications entitled Essays
in law and economics. In Germany, the biannual Travemnde Symposium
provides another opportunity to meet and confer with world class scholars.
Internationally, there exist six distinct professional associations in the area
of law and economics. All of these associations organize meetings on a regular
basis where working papers are presented and discussed. Thus, they provide a
conduit for ongoing exchange and communication amongst professors, research
assistants and students. The six existing organizations are: the American Law
and Economics Association (ALEA), the Australian Law and Economics
Association, the Canadian Law and Economics Association (CLEA), the
European Law and Economics Association (EALE), the Latin American Law
and Economics Association (LALEA), and the Law and Economics Association
of New Zealand Law (LEANZ). Most of these associations can be easily
contacted via their home pages on the world wide web.
The American Association of Law and Economics, with its offices located
at the Yale Law School in New Haven, Connecticut, organizes numerous
conferences. The European Association of Law and Economics was founded in
1984 for the purpose of providing professional assistance to law and economics
scholars. It distributes a periodic newsletter, arranges seminars and
conferences, and has published several conference volumes in the International
Review of Law and Economics. In 1994, the New Zealand Association of Law
and Economics was established in order to promote law and economics studies
in New Zealand. LEANZ also publishes a monthly newsletter and organizes
seminars on a regular basis. The Latin-American Law and Economics
Association has held its annual meetings since 1995. The Australian Law and
Economics Association also organizes regional conferences and meetings.
The growing interest in the field of law and economics can also be
measured by the increase in academic publishing. More and more doctoral
60 Organization of Research and Teaching 0100
students are publishing theses emphasizing law and economics. This is a trend
which is recognizable throughout the world (see 0080 Doctoral or Masters
Theses). The number of professional journals dealing with law and economics
topics is also constantly increasing. Some of these journals are now being listed
in the world wide web, making it possible for a much larger audience to scan
through the publications table of contents with just a few mouse clicks. The
Internet also allows researchers and scholars to exchange information in real
time and at a comparably low cost. Since 1994, the George Mason University
has established an on-line discussion forum on law and economics topics called
Econlaw. Forum participants can easily exchange opinions and download the
work of their colleagues from their respective web-sites. All of these
developments demonstrate that research as well as teaching in the field of law
and economics is becoming more and more a global phenomenon.
Acknowledgements
The authors gratefully acknowledge additional information contributed to this
paper by an anonymous referee and the editors. The authors are also grateful
to Andre M. Ross, MA (Econ.), Attorney at Law (California), Hamburg,
Germany, for improving their English.
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0200
HISTORY OF LAW AND ECONOMICS
Ejan Mackaay
Professor of Law
University of Montreal
Copyright 1999 Ejan Mackaay
Abstract
The idea of applying economic concepts to gain a better understanding of law
is older than the current movement, which goes back to the late 1950s. Key
insights of law and economics can already be found in the writings of the
Scottish Enlightenment thinkers. The Historical School and the Institutionalist
School, active on both sides of the Atlantic between roughly 1830 and 1930,
had aims similar to the current law and economics movement.
During the 1960s and 1970s the Chicago approach to law and economics
reigned supreme. After the critical debates in the United States between 1976
and 1983, other approaches came to the fore. Of these, the neo-institutionalist
approach and the Austrian approach, both corresponding to schools within
economics proper, are worth watching.
Law and economics has progressively found its way to countries outside the
United States. From the mid 1970s onwards it reached the English speaking
countries, then other countries as well. In no country has law and economics
had as much impact as it has in the United States.
JEL classifications: K00, B10, B20
Keywords: law and economics in General, History, Institutions
1. Introduction
The economic analysis of law, or law and economics, may be defined as the
application of economic theory and econometric methods to examine the
formation, structure, processes and impact of law and legal institutions
(Rowley, 1989b, p. 125). It explicitly considers legal institutions not as given
outside the economic system but as variables within it, and looks at the effects
of changing one or more of them upon other elements of the system. In the
economic analysis of law, legal institutions are treated not as fixed outside the
economic system, but as belonging to the choices to be explained.
This approach is advocated not merely for legal rules with an obvious link
to economic realities such as competition, economic organisation, prices and
profits, and income distribution, which translate into competition law,
65
66 History of Law and Economics 0200
industrial regulation, labour law and tax law. Law and economics has the
ambition of applying the economic approach not merely to these areas of
economic regulation readily associated with economics, but to all areas of law,
in particular to the core of the common law.
The current incarnation of law and economics originated in the United
States in the late 1950s and found acceptance amongst the legal community
from the 1970s onwards, as a result, in particular, of the writings of Richard A.
Posner. It has been presented at times as an altogether novel introduction of
concepts and methods of a neighbouring science into law, in that it addresses
questions across the entire range of legal subject matter, including much
non-market behaviour (Posner, 1975a, p. 759).
This view may overstate the originality of the movement. Recent historical
research has shown that already in nineteenth century Europe, there existed a
broad scholarly movement whose ambition was to show how a better
understanding of law could be gained by using economic concepts and methods
(Englard, 1990; Pearson, 1997). Holmess oft-cited exhortation to legal
scholars, in 1897, to turn to economics and statistics: For the rational study of
the law the black-letter man may be the man of the present, but the man of the
future is the man of statistics and the master of economics (Holmes, 1897, p.
469) may have pulled the American branch into the limelight. But if
Hovenkamp (1990) is to be believed, Holmes merely gave voice to a
development which had already reached the United States in the 1880s and
continued well into the twentieth century. This movement is known - rather too
little as Pearson contends (1997, pp. 159-161) - as institutional economics
(Duxbury; 1995; Pearson, 1997, p. vii; Medema, 1998). But this is not the only
connection between law and economics prior to the current movement. At the
University of Chicago, where the current movement originated, there was, from
1940s onwards, an earlier infusion of economic ideas into law, associated with
the name of Aaron Director.
It is instructive to look at these earlier branches of law and economics to
understand the reasons for both their initial attraction and their ultimate
decline. In a broader context, the question has recently been raised why the
winds turned and intellectual leadership in legal theory moved from
Continental Europe to the United States (Mattei, 1994c). For the current
movement, a deeper historical perspective should make one wary of the belief
that present understanding provides a definitive account of the legal system.
Such caution is in order at a time when, in one scholars words (Ellickson,
1989, p. 26), law and economics is no longer growing as a scholarly or
curricular force within the leading American law schools. Instead, it is simply
holding previously won ground. Study of the earlier movements may point us
to the research agenda to adopt if we wish the current one to continue.
Law and economics borrows concepts and methods from economics proper. It
inherits the controversies to which they are subject in the mother discipline. In
0200 History of Law and Economics 67
economics proper, the question has recently been raised of what has gone
wrong in the discipline (Boettke, 1997): even half a generation ago the
neoclassical model reigned supreme and virtually unquestioned; now
economists appear divided on their theoretical framework.
This debate spills over into the economic analysis of law. Since the 1980s,
gone is the beautiful consensus about method and agenda, generated by the first
editions of Posners textbook (1972b, 1977) solidly based on neoclassical
economic insights. Besides the Chicago approach, various shades of
institutional (Benson, 1994; Mercuro and Medema, 1997, chs 4 and 5;
Samuels, 1990, 1998a, 1998b, 1998c; Samuels and Mercuro, 1984; Samuels
ans Rutherford, 1998; Samuels and Schmid, 1981; Schmid, 1989a, 1989b,
1994; Teijl and Holzhauer, 1990) or neo-institutional (Alston, Eggertsson and
North, 1996; Coase, 1984, 1992; Eggertsson, 1990; Furubotn, 1989, 1993;
Furubotn and Richter, 1992, 1997; Knight, 1992; Langlois, 1986; Medema,
1989; Mercuro, 1989; North, 1984, 1986, 1991, 1993, 1994, 1995, 1996;
Williamson, 1985, 1986, 1996) approach to law and economics have come to
the fore, as has the Austrian approach (Barnett, 1992, 1998; Benson, 1994;
Boettke, 1994; Bouckaert, 1984; Boudreaux, 1994; Hayek, 1973, 1976, 1979;
Kinsella, 1995; Leoni, 1991; Lepage, 1985; Ogus, 1989; Rizzo, 1979b, 1980a,
1980b, 1980c, 1980d, 1981, 1982a, 1982b, 1985, 1987; Rizzo and Arnold,
1980, 1987; Rowley, 1989a, 1989b; Rowley and Brough, 1987; Schmidtchen,
1993; Teijl and Holzhauer, 1997; Thornton, 1991; Vanberg, 1998a; Voigt,
1992; Wonnell, 1986). These approaches emphasise the interest of historical
studies, which received a powerful endorsement when the 1993 Nobel prize for
economics was awarded to two economic historians, Douglass North and
Robert Fogel (North, 1994).
Since Posners initial impetus, the sources from which the law and
economics movement may draw inspiration have broadened. They now also
include the public choice school, bringing an economic approach to political
processes, and game theory, which has become a rallying point for the social
sciences in that it applies rational choice ideas to the interaction of two or more
actors, or indeed a multitude of them with the attendant opportunities for free-
rider and hold-out strategies.
For the purpose of exposition, it will be helpful to divide the history of law
and economics into phases. Duxbury (1995, p. 340) cautions against the danger
of historical reductionism in such periodisation. Simplicity of exposition makes
it nonetheless worthwhile in my view.
2. Precursors
Economics as a science may be considered to go back to the late eighteenth
century, when Adam Smith wrote his Inquiry into the Nature and Causes of the
68 History of Law and Economics 0200
Wealth of Nations as part of what later came to be called the Scottish
Enlightenment (Robertson, 1987). Well before his time one finds writings in
which human behaviour is analysed as the result of rational choice, or which
undertake rational calculation of the costs and benefits of particular policies or
rules, and offer practical economic policy advice to rulers of the day. In this
light Macchiavelli (1961; see Pearson 1997, p. 19) should count as an early
precursor of law and economics, as should the Cameralists active in Germany
from the fifteenth untill the early nineteenth century (Backhaus and Wagner,
1987; Pearson 1997, p. 11). Ridley (1997, p. 54) submits that Hobbes already
clearly understood the prisoners dilemma.
In Adam Smiths own time, David Hume had a clear grasp of the intricacies
of human interaction such as game theory formalises them in our day. In his
Treatise ([1740] 1978) he presents law as a set of conventions which humans
have learned to conform to in order to make co-operation possible in a world
of scarcity and limited foresight. He understands the paradox of collective
action, in his example of the draining of the meadow (Hume, [1740] 1978, Bk
3, Pt 2, Sec. 7) and uses it to justify the provision of some collective goods by
the State. Humes Idea of a Perfect Commonwealth provides keen insights in
the dynamics of a federal system, as public choice articulates it today ([1777]
1987). Rousseau similarly understood the game of prisoners dilemma in his
description of the stag hunt ([1755] 1971, p. 207).
Adam Smith himself, in his Inquiry, saw the crucial role of speculators and
the effects of government intervention in the price system and of protectionist
policies ([1776] 1937, Bk IV, Ch. 5, p. 493). Speaking of a company of
merchants establishing a new trade, who are granted a temporary monopoly,
he observes that [a] temporary monopoly of this kind may be vindicated upon
the same principles upon which a like monopoly of a new machine is granted
to its inventor, and that of a new book to its author ([1776] 1937, Bk V, Ch.
I, Pt III, Art. 2nd, p. 712). Law is seen here, in utilitarian fashion, as
contributing to the public good, indeed as an instrument for promoting it. The
incentive effect of law is obvious in the following passage: For if the
legislature should appoint pecuniary rewards for the inventors of new
machines, etc., they would hardly ever be so precisely proportiond to the merit
of the invention as this is. For here, if the invention be good and such as is
profitable to mankind, he will probably make a fortune by it; but if it be of no
value he also will reap no benefit (Smith, [1776] 1982, p. 83).
Other thinkers of the late eighteenth century also displayed insights now
considered part of law and economics. Prominent amongst these are Beccaria
and Bellamy ([1764] 1995), for the dissuasive effect of criminal sanctions, and
Bentham, in his calculus of pains and pleasures, applied to a variety of legal
questions (Bentham, [1789] 1948). But all of these writings did not amount to
a systematic understanding of law through a rational choice model.
0200 History of Law and Economics 69
3. The First Wave
Such an understanding was the ambition of what may be called the first wave
of law and economics. This movement, if indeed it may be properly called that,
given the relative heterogeneity of viewpoints, was European in origin, but
reached the United States through the (older) institutionalist movement. It has
been given prominence in a recent historical study entitled Origins of Law and
Economics by Heath Pearson, with the subtitle The Economists New Science
of Law Movement 1830-1930 (Pearson, 1997, p. 44, referring to earlier studies).
What follows relies mainly on this study to describe the movement(see also
Hutter, 1982; Englard, 1990). For the American branch, the (old)
institutionalist school, useful sources are Duxbury (1995, pp. 316-330), who
questions whether it is proper to speak of a movement (Duxbury, 1995, p. 318),
as well as Hovenkamp (1990), Medema (1998) and Mercuro and Medema
(1997, Ch. 4).
The key question the proponents of the movement addressed was how
property and other rights were determined, historically and functionally, across
different societies. The earlier answer of sixteenth and seventeenth century
philosophers, that these rights were given as a matter of natural law, logically
prior to any positive legal system, seemed to them unsatisfactory. It could not
account for the variations of rights in time and space. Changes in property
rights, in their view, should be expected to reflect changes in economic
conditions. What they were seeking to develop was an explanatory science of
rights (Pearson, 1997, p. 33).
The movement originated amongst economists. Prominent amongst them
were the Germans belonging to what came to be known as the German
Historical School (Pearson, 1997, p. 95). The conjunction of political economy
and law in the discipline called Staatswissenschaft may have stimulated their
contribution. There were contributions in many other countries as well: Austria,
Belgium, England, France, Italy, the Netherlands, the United States. Pearson
(1997, p. 170-175) lists more than one hundred names of participants in the
movement. Only some of these are still remembered today: John R. Commons,
Gustave de Molinari, Carl Menger, Gustav Schmoller, Werner Sombart,
Adolph Wagner (Hutter, 1982).
The core thesis of the movement, that rights were contingent upon
economic and social conditions, came to be widely accepted. When Marx
insisted on it in his writings from 1859 onwards, he was expressing accepted
wisdom. By the 1870s the movement gained foothold amongst legal scholars:
Wilhelm Arnold, Otto von Gierke, Rudolph von Jhering, to mention a few in
Germany, and Henry Maine ([1861] 1977), in England. Englard (1990) has
drawn attention to the contribution of the Austrian scholar Victor Mataja to the
economic analysis of liability for damages a century ago. Scholars in other
70 History of Law and Economics 0200
countries were drawn to the movement as well and one may properly consider
it cosmopolitan (Pearson, 1997, p. 33).
The adherents of this approach engaged in a variety of historical studies of
rights in land and contractual arrangements for its exploitation. The studies
showed how the institutions varied, for instance according to the density of
population, the quality of the soil and the type of exploitation. They
investigated what was subject to individual rights, what was left as commons
and what sharing rules were applicable to the latter. One finds here
considerations of relative transactions costs familiar in current law and
economics studies, but also acceptance of the wisdom embodied in institutions
which have evolved in the course of history, a theme reflected in Hayeks work
in our day (Pearson, 1997, pp. 43-70). The explanations proposed may be
properly called economic in that they rely on costs and benefits to individuals,
who choose rationally in an environment of scarce resources. These are to this
day the pillars of economic reasoning.
What caused the decline of the movement? Pearson (1997, p. 131) attributes
it mainly to two factors. One is the increasing specialisation amongst social
scientists, which led economists to restrict their attention to matters
unquestionably related to markets. They studied the workings of the economy
within a framework of given legal institutions.
The other factor were the excessive claims made for the movement and the
increasing fuzziness of the economic methodology on which it relied. In part,
this may be due to the poor state of development of economic science itself: the
marginalist revolution took place only in the last part of the nineteenth
century. Perhaps as a result, some members of the movement let themselves be
tempted to explore explanations that strayed increasingly away from the strictly
individualist rational choice model to holist concepts such as national spirit,
socio-psychic motives and collective will (Commons) or to the
psychological-moral life of nations (Schmoller) (Pearson, 1997, pp. 72, 153,
158). As the economics profession specialised, such explanations seemed more
and more heretical to economists (Pearson, 1997, p. 153).
The difficulty is well expressed in what Blaug has to say on institutionalism,
which is at the root of the American branch of the first wave of law and
economics: A much better description of the working methodology of
institutionalists is storytelling ... Storytelling makes use of the method that
historians call colligation, the bundling together of facts, low-level
generalizations, high level theories, and value judgements in a coherent
narrative, held together by a glue of an implicit set of beliefs and attitudes that
the author shares with his readers (Blaug, 1980, p. 126). Coase is even more
dismissive: The American institutionalists were not theoretical but
anti-theoretical, particularly where classical economic theory was concerned.
0200 History of Law and Economics 71
Without a theory they had nothing to pass on except a mass of descriptive
material waiting for a theory, or a fire (Coase, 1984, p. 230).
The movement fared no better with the legal community than it did with
economists. The conclusions which its proponents were able to draw from their
model and from their historical investigations did not convince lawyers. The
legal community remained of the view that economic factors alone could not
account for the fullness of the tendencies and aspirations of the human soul
reflected in the law (Pearson, 1997, p. 144, quoting Del Vecchio). This is surely
a misreading of the essence of economics (methodological individualism and
instrumental rationalism), but one whose persistence must be laid at the
doorstep of the proponents of the movement, be it the historical school
(Germany) or the (old) institutional school (USA).
By the 1930s, the movement faded away as a distinct contribution of
economics to the understanding of law, to make room for the sociology of law
and legal realism. Some of its contributions nonetheless live on: Mengers
through Hayek in modern neo-Austrian thinking and in the evolutionist theory
of Nelson and Winter (1982); Commons ideas find an echo in Williamsons
work (1985, 1996) and live on in that of modern institutionalists such as
Samuels (1971, 1972, 1974, 1975, 1976a, 1998a), Samuels and Schmid (1981)
and Schmid (1978, 1989). The importance of institutions as constraints on
economic activities has been underscored in the 1991 and 1993 Nobel prize
lectures in economics: Ronald Coase (1992) and Douglass North (1994).
4. The Second Wave
It will be helpful, in dealing with the current law and economics movement, to
distinguish several periods: the beginnings, paradigm proposed (1958-1973),
paradigm accepted (1973-1980), paradigm questioned (1976-1983) and the
movement shaken (from 1983 onwards).
4.1 Beginnings
As early as the 1930s, there are studies pointing to a revival of the link between
law and economics on a different footing. Some of these have remained part of
modern day law and economics. In the UK, Arnold Plant looked at the
economics of intellectual property (1934a, 1934b and 1953); Ronald Coase, his
pupil (Coase, 1994, pp. 176 f.) and one of the founders of the current
movement, published as a young researcher his famous study on the nature of
the firm (Coase, 1937). But the veritable revival of law and economics occurred
at the University of Chicago, in 1940s, under the inspiring leadership of Aaron
Director (Duxbury, 1995, p. 341; Levi, 1966; Meltzer, 1966). Economic science
72 History of Law and Economics 0200
itself was by that time undergoing change which led to the neo classical
synthesis. The finest overview of this period is unquestionably Duxburys
(1995, Ch. 5).
Aaron Director was in the unusual position of an economist appointed to the
Chicago Law School, to succeed Henry Simons, who was also an economist. At
the Department of Economics at Chicago, he had a number of remarkable
colleagues, amongst whom one counts Frank Knight, George Stigler and
Milton Friedman. The Chicago group came to adopt a distinct approach to
economic analysis, which insisted on generating testable predictions and on
conducting empirical research for the purpose of such tests (Reder, 1987).
Indeed, the defining traits of Chicago neo-classicals - the suspicion of
government and the insistence that markets protect rational individual choice
and self-determination - reflect a distinctively American style of individualist
ideology (Duxbury, 1995, p. 418).
Directors problem at the Law School was how to turn his lawyer colleagues
round to taking economic analysis seriously. Director, a brilliant economist,
applied economic insights to legal cases, in particular in antitrust law
(Duxbury, 1995, pp. 343-344; Manne, 1993, p. 5 f.). Accepted wisdom at the
time, stemming from the depression and the New Deal, held that in order to
achieve effective competition, industry had to be closely supervised and
regulated. Director showed this conclusion in most cases to be unwarranted,
indeed counterproductive: monopoly was more often alleged than it was
effectively present and detrimental to consumer interests. The field has
continued to interest Chicagoans (Bork, 1978; Bowman, 1973; Posner, 1976).
The battle about the role of antitrust law continues to this day; McChesney and
Shughart II (1995) consider the debate in 1997-1998 over the pressure being
put on Microsoft for its alleged monopolisation of the computer software
market by tying its web browser, called Internet Explorer, with its already
domineering Windows operating system. Directors efforts led, during the
1940s and 1950s, to a variety of studies of other legal subjects with clear
economic connotations: corporate law, bankruptcy, securities regulation, labour
law, income tax, public utility regulation and torts.
Posner and others, writing the history of law and economics at Chicago
years later, designate this period as the old law and economics (Posner,
1975a, p. 758; also Ackerman, 1984, p. 63; Kitch, 1983a; Mercuro and
Medema, 1997, p. 193; Veljanovski, 1982, p. 7). They contrast it with the
new law and economics emerging in the 1960s, whose research agenda was
to apply economics to core legal doctrines and subjects such as contract,
property, tort and criminal law (Duxbury, 1995, p. 340). About the new
movement, Rowley (1989b, p. 125) observes its distinctive feature is the
application of market economics to legal institutions, rules, and procedures
which in certain areas (notably in tort and in crime) are not conventionally seen
to influence market behavior, but which indeed are defined in terms of market
failure.
0200 History of Law and Economics 73
The contrast between the old and the new economics is perhaps
overblown (Duxbury, 1995, pp. 340-341), but contains a grain of truth. Several
events mark the overstepping of traditional boundaries of economics,
characteristic of the new law and economics. One influence is surely Gary
Beckers initiatives to analyse non-market behaviour with economic tools:
starting with his 1955 doctoral dissertation on Discrimination in the Market
Place and broadening in his later work on the economics of crime, of the
family, on human capital and alleged (ir)rational behaviour (Becker, 1957,
1962, 1975, 1976, 1981). Years later, he summarised his approach as follows:
Indeed, I have come to the position that the economic approach is a
comprehensive one that is applicable to all human behavior, be it behavior
involving money prices or imputed shadow prices, repeated or infrequent
decisions, large or minor decisions, emotional or mechanical ends (Becker,
1976, p. 8).
After initial indifference, Beckers thesis came gradually to be seen as a
significant contribution to economics and indeed was the justification for the
Nobel prize in 1992. Posner is of the view that Beckers insistence on the
relevance of economics to a surprising range of nonmarket behavior (including
charity, love, and addiction), as well as his specific contributions to the
economic analysis of crime, racial discrimination, and marriage and divorce,
opened to economic analysis large areas of the legal system not reached by
Calabresis and Coases studies of property rights and liability rules (Posner,
1998, p. 26; quoted by Duxbury, 1995, p. 396; Posner, 1993).
During the same period - the late 1940s and the 1950s - several other
studies opened up fields which later became part of law and economics. For the
public choice movement one could point to Duncan Blacks writings (1948a,
1948b, 1958) on committees and elections in Britain. In 1954 Scott Gordon
(1954, 1958) published a study on the economics of managing a scarce resource
in common property, the fisheries, from which the economics of the
environment later developed. The next year, Tiebout (1956), studying
competition amongst local authorities through expenditures appealing to their
taxpayers, unwittingly laid the foundation for what later became the economics
of federalism as a system of competition amongst governments. Downs (1957),
with his economic theory of democracy, opened the field of the economics of
political institutions more broadly and was followed shortly by Buchanan and
Tullocks (1962) classic Calculus of Consent, which started the public choice
school.
Duxbury (1995, pp. 379, 417) emphasises that law and economics should
not be considered a direct descendant of American legal realism. While it
shares with that movement the view that for a better understanding of law one
must rely on the social sciences and on empirical study, practitioners of law and
economics are much more precise than were the realists about where to borrow
- from economics; from other social sciences to the extent that they adopt the
rational choice model - and about the agenda for empirical research flowing
74 History of Law and Economics 0200
from that position. The canons for conducting empirical research have also
been considerably refined since the time when the realists were active.
4.2 Paradigm Proposed: Economics into the Main Areas of Law (1958-1973)
A visible step in the emergence of law and economics at Chicago was the
creation, in 1958, of the Journal of Law and Economics, with Aaron Director
as its first editor. Soon afterwards, Coase moved to Chicago and became its
editor. In 1960 he published his seminal article on social cost in that journal
(Coase, 1960). Demsetz was amongst the earliest scholars realising the
significance of the article. He underscored it in a series of perceptive articles
(Demsetz, 1964, 1966, 1967, 1972a, 1972b). He first used the term the Coase
theorem (1972b, Pt II).
The article is usually taken to stand for the proposition that externalities are
no ground for government intervention, but merely indicate that property rights
are not adequately specified. When they are, and provided parties to the
externality can costlessly negotiate, specification of rights is sufficient for
attaining the optimal (efficient) outcome; the particular way in which the
rights are allocated between the parties is indifferent to the economic outcome.
The article is also important for drawing attention to the concept of transaction
costs. In Coases examples the concept was simple enough: transaction costs
encompass the cost of identifying potential contract partners, of coming to an
agreement with them and of policing the solution. Transaction costs prevent
apparently profitable deals from being consummated. They concern both
information problems and problems of strategic behaviour resulting from the
impossibility to fully supervise ones contract partner or from difficulties of
collective action. The concept has been extended to regulatory contexts and
to the operation of government itself. Its meaning has thereby been singularly
expanded. Precisely what is now meant by transaction costs is a matter of
debate. One may expect the reduction of transaction costs to be an important
concern in law and changes in legal institutions to reflect the discovery of ways
to lower transaction costs.
A second seminal article was a paper by Alchian, then at the Rand
Corporation in California, on the rationale for property rights, which was
circulated in the late 1950s but published only several years later (Alchian,
1965). It looked at the effects of differences between private and public
ownership and treated them as economic variables that could be manipulated.
Calabresi, at Yale, published a third, equally fundamental, paper on tort law as
a system for inducing the proper level of caution in activities liable to cause
damage to other persons, considering the cost of the damage as well as the cost
of administering the system (Calabresi, 1961).
These papers struck the fancy of a number of economists and became the
seeds for a flurry of articles on legal subjects such as property rights, torts,
contracts and procedure, for example Alchian and Demsetz (1969, 1972, 1973);
0200 History of Law and Economics 75
Calabresi (1965a, 1965b, 1970); Calabresi and Melamed (1972); Calabresi and
Hirschoff (1972); Cheung (1968, 1969a, 1969b, 1972, 1973); Dales (1968a,
1968b); De Alessi (1969); Demsetz (1964, 1966, 1967, 1968, 1969, 1972a,
1972b); Furubotn and Pejovich (1972, 1974); Landes (1971); McKean (1970a,
1970b); Oi (1973); Pejovich (1971, 1972); Peltzman (1973); Posner (1972a,
1973a, 1973b); Stigler (1970). The University of Chicago Law Review
published the proceedings of a symposium on product liability in its 1970 issue.
Manne (1962, 1965, 1966a, 1966b, 1967) published books and papers on
corporation law, controversially taking the defence of insider trading. Samuels
(1965, 1973) published two extensive bibliographies of publications dealing
with law and economics, broadly casting his net, but showing nonetheless how
much literature had been generated in the space of a decade.
The literature in this period was mostly the work of economists. The focus
on property rights earned it amongst economists the label property rights
approach, even where it dealt with contractual practices, products liability or
forms of industrial regulation. The term faded away in later years for the more
encompassing one of economic analysis of law.
Most contributors in the early days subscribed to the views of the Chicago
school of neoclassical economics (Duxbury, 1995, p. 369; Mercuro and
Medema, 1997, Ch. 2). The contributions of the Chicago group altogether
overshadowed those by economists of other persuasions, such as Leoni, ([1961]
1991); Samuels (1971, 1972); Schmid (1965) or Stewart Macaulay, a
lawyer-sociologist, who published a remarkable study on informal contractual
relations, which has since become a classic (Macaulay, 1963). The success of
the Chicago approach persisted in later periods. Hayeks Law, Legislation and
Liberty (1973, 1976, 1979) for instance, published contemporaneously with
Posners textbook on law and economics (Posner, 1972b, 1977), went
essentially unnoticed at the time amongst the law and economics community,
even though Hayek received the Nobel prize for economics in 1974. In
retrospect this may seem a regrettable example of tunnel vision; looked at in the
perspective of the time, it testifies to the intense enthusiasm generated by the
research agenda the Chicago School proposed and to the dynamism and
persuasiveness of its proponents.
A few contributors in this early period were lawyers. The names of
Calabresi and Manne come to mind. Participation of lawyers is essential since,
as we saw above, convincing lawyers turned out to be the critical point in the
evolution of the first wave of law and economics, a century earlier. Calabresi
played a key role here: The distinctive quality of Calabresis work was to show
the power of simple economic principles to rationalise a whole body of law, and
to develop a coherent basis for its reform (Veljanovski, 1990, p. 21). Manne
contributed in a different way by organising, from 1971 on, short intensive
training seminars in economics for lawyers and judges, and in law for
economists (Manne, 1993, p. 10; Duxbury, 1995, p. 359).
76 History of Law and Economics 0200
4.3 Paradigm Accepted: law and economics into the Law Schools (1973-1980)
Three events signal a change in the movement in the direction of capturing the
hearts and imagination of lawyers: the foundation, in 1972, of the Journal of
Legal Studies; the first publication, of Posners (1972b; second edition 1977)
introduction to the economic analysis of law, both at the Law School of the
University of Chicago; the organisation, from 1971 on, of Henry Mannes
already mentioned Economics Institutes for Law Professors, short intensive
seminars in economics for lawyers, be they judges, practitioners or law teachers
(Manne, 1993, p. 10). Together, one might say, they mark the entrance of law
and economics into law schools in the United States.
Posners book was written by a lawyer for lawyers in a clear and
straightforward style. It steered clear of economic jargon and adopted the
lawyers well-known distinctions amongst fields of law. It analysed well-known
legal doctrines across the entire spectrum of the law. Posners Economic
Analysis of Law, which first appeared in 1973, sounded most explicitly the
modern theme of economic imperialism: You name the legal field, and I will
show you how a few fundamental principles of price theory dictate its implicit
economic structure (Epstein, 1997, p. 1168). While these features no doubt
contributed to its success, the decisive factor may well have lain in the
substance of the book: the efficiency thesis of the common law.
In earlier contributions, law and economics scholars had shown that
different institutions - property rights, contractual arrangements, liability rules
- could be looked at as in some sense the best option, that is the efficient
solution in neo-classical economic terminology. Private property rights
generally create better incentives for husbanding scarce resources than do
common property or freely available objects. Owners of orchards might be
thought to profit freely from the activity of bees pollinating their trees, an
externality which some used as a textbook example to show the need for
government regulation; closer study showed, however, a practice of contracts
between bee keepers and tree owners, making it profitable for both to place
beehives near the orchard as needed (Cheung, 1973). Liability rules in tort
could be shown not merely to redress the balance disturbed by the tort, but also
to create the proper incentives for those whose activity might cause damage to
others, to observe care to the extent that its cost is lower than that of the
damage thereby prevented (Posner, 1972a).
Posner generalised this idea across the spectrum of the law. Already in the
first edition of his book, he put forth the thesis that all rules of the traditional
common law reflected such an efficiency logic and that, as a matter of
normative judgement, it was desirable that they do so: pursuit of efficiency,
here as elsewhere, aims at avoiding waste or maximising the wealth of society.
The thesis yields an alluring research agenda: to tease out, using concepts
borrowed from neoclassical economics, what would be the efficient rules
throughout the domains of the traditional common law and to determine
0200 History of Law and Economics 77
whether the common law in fact conforms to this logic. The research
programme was attractive to lawyers because the neoclassical machinery as it
was presented in Posners book looked easy enough to learn and to apply to
legal problems.
It is essentially this research programme which has occupied the law and
economics community through the 1970s, it is difficult to say whether it is the
descriptive or the normative component which provided the greater attraction.
Posner himself has been amongst the most ardent defenders of his own thesis.
He maintains it, in only slightly weakened form, in the fourth edition of his
book, in 1992, presenting the common law as a system of rules for inducing
people to behave efficiently, not only in explicit markets but across the whole
range of social interactions. In settings in which the cost of voluntary
transactions is low, common law doctrines create incentives for people to
channel their transactions through the market. ... In settings where the cost of
allocating resources by voluntary transactions is prohibitively high, making the
market an infeasible method of allocating resources, the common law prices
behavior in such a way as to mimic the market. (Posner, 1992a, p. 252; quoted
by Duxbury, 1995, pp. 410-411).
4.4 Paradigm Questioned (1976-1983)
Already during the 1970s, the Chicago approach to law and economics was
criticised, in particular by the institutionalists (Goldberg, 1976a; Liebhafsky
1976; Samuels, 1976a; Schmid, 1976). Schmid (1976), for instance, made the
important point that, since for any distribution of property rights there is a cost-
minimising allocation of resources, cost minimisation itself - and by extension
the efficiency logic - cannot provide the foundation for the way in which
property rights are distributed. Indeed, the allocation of property rights
determines what is a cost of what, a conclusion which implicitly follows from
the Coase theorem.
These early criticisms went largely unnoticed. The critics made more
inroads at the end of the decade, when several symposia were held to examine
what law and economics had to contribute to the theory of law (Rizzo, 1980a;
Hofstra Symposium 1980; Posner, 1981a; Pennock and Chapman, 1982;
Cramton, 1983). The debates brought together the best American minds
supporting law and economics and those critical of it. Posner defended law and
economics against attacks from legal philosophers such as Dworkin and Fried
and critical legal studies thinkers such as Horwitz and Kennedy, and friendlier
criticism from lawyers in the Yale tradition such as Calabresi and Kronman
and Austrian economists such as Rizzo.
The debates brought out weaknesses of the efficiency thesis as Posner has
proposed it (Duxbury, 1995, p. 391; Veljanovski, 1980, pp. 182-187). The first
is the point, already mentioned, that efficiency cannot be the foundation of the
distribution of property rights, since for any distribution, an efficient allocation
78 History of Law and Economics 0200
of resources can be found. Hence the efficiency thesis is circular. It may be
called the circularity thesis and is underscored by several writers besides
Schmid (1976) already mentioned: (Baker, 1980; Hart, 1977; Michelman,
1980, p. 448; Samuels and Mercuro 1984, p. 112).
A second difficulty is that the efficiency thesis appears to be non-falsifiable.
Where an apparently inefficient arrangement is found, hitherto unnoticed costs
can be called in to account for it. This may be useful as a heuristic, but as a way
of theory testing, it does not pass muster. To test a theory and expose it to the
risk of refutation, one must delimit the set of costs which will be taken into
consideration.
A third question pertains to the ahistorical character of the efficiency thesis.
(Veljanovski, 1982, p. 97). The thesis suggests that for any given problem there
is one efficient solution. Once discovered, there is no reason to move away from
it. Yet law tends to evolve over time; a solution considered satisfactory
yesterday may no longer seem so today. What explains the change? And what
explains that in full knowledge of efficient solutions, we move away from
them, as we do in various forms of regulation, such as rent control, minimum
wages or environmental regulation? Along similar lines, in the light of the
efficiency thesis, persistent differences amongst modern legal systems are
puzzling: if there is a tendency towards efficiency and the efficient solution to
any legal problem is unique, legal systems should converge. Law and
economics needs to address such questions.
A fourth question, raised in particular by Austrian economists, concerns the
subjectivity of values. To determine efficient solutions as Posner envisages
them requires that the gains resulting from a change of rule are weighed
against the losses, in order to choose the rule which promises the optimal
result. On what scale are gains and losses occurring to different people to be
weighed? Where people transact, their transaction makes such gains and losses
comparable, putting them, as it were, for an instant on a single scale which we
can observe. In practice, gainers and losers from a particular project do not
necessarily transact and compensation of losers by gainers, leading to a Pareto
improvement, rarely take place. To arrive nonetheless at policy conclusions,
Posner must resort to the Kaldor-Hicks criterion, whereby a rule change is
considered an improvement if the gains it procures would be sufficient to offset
the losses, both being measured by real or presumed willingness to pay.
Such interpersonal comparisons of value take place all the time in the
practice of the law. The judge must put a figure on the losses suffered by a tort
victim. If tort rules must serve to induce potential tortfeasors to take proper
care, accident costs falling on the side of the victim must be compared to
prevention costs falling on the side of the tortfeasor. Common sense
accomplishes such comparisons in practice, but, critics argue, they are suspect
nonetheless in a scientific sense. This makes problematic, for instance, the
0200 History of Law and Economics 79
policy recommendations Posner derives from the Hand-test in tort law as
maximising welfare (Rizzo, 1980b). The criticism has later been amplified by
Trebilcock (1987, 1989). Incentive logic and risk-spreading logic do not lead
to unambiguous policy conclusions for welfare maximisation: Indeed, why not
allow the victim to sue anyone who ostensibly is a superior risk-bearer to him
or to the chairmaker, for example, the latters banker, law firm, accounting
firm, securities underwriter, timber supplier, trucking operator, or indeed a
large, well-endowed, well-insured, or well-diversified enterprise totally
unconnected to either party? At the limit, it is not clear why, if the courts are
committed to spreading accident costs as thinly as possible, there is any logical
stopping point short of rendering the state liable for all accident costs ...
(Trebilcock, 1987, pp. 955-956). And he adds a little further down: This might
be taken to mean, in economic terms, that in cases like the above, accident costs
should be internalized to the activity whose level or supply is likely to be most
responsive to cost increases (price elastic). While perhaps correct in theory, this
criterion seems hopelessly non-operational in all but the most extreme
examples (p. 988).
A fifth question deals with the origin of the perceived efficiency logic. If the
common law reflects an efficiency logic, as Posner submits it does, it ought to
be possible to formulate a theory accounting for the emergence of that logic.
Various attempts have been made to articulate such a theory (Cooter and
Kornhauser, 1980; Goodman, 1978; Hirshleifer, 1982; Hollander and Mackaay,
1982; Landes and Posner, 1976, 1979, 1980; Priest, 1977, 1980; Priest and
Klein, 1984; Reese, 1989; Rizzo, 1980d; Rubin, 1977, 1982; Terrebonne,
1981). None so far has found general acceptance. It is submitted that the judges
operating during the formative years of the common law doctrines a century
ago were imbued with laissez faire values congenial to efficient legal rules
(Posner, 1992a, p. 255), or that given the constraints in judicial procedure
under which judges operate, they are not, unlike Parliament, at liberty to pursue
redistributive policies, nor are they subject to intense interest group pressure
(Posner, 1992a, p. 524). Yet the judicial policies pursued by modern courts in
deciding on the scope to be given to human rights proclaimed in constitutions
clearly has distributive effects and their efficiency in Posners sense would not
be easy to demonstrate. Consider also Jules Colemans observation that what
parties demand of the courts is not the imposition of an efficient rule, but ...
the imposition of any rule that will reduce uncertainty. For such a rule
facilitates rational contracting, the long term consequences of which will be
efficient (Coleman (Jules), 1989, p. 190). On this question it is well to
remember Sir Arthur Eddingtons admonition that [i]t is also a good rule not
to put overmuch confidence in the observational results that are put forward
until they are confirmed by theory (Anonymous, 1978, p. 132).
A final point concerns distributive questions. Even if one grants that the
core common law rules reflect an efficiency logic, much modern legislation
80 History of Law and Economics 0200
has an obvious redistributive purpose, and indeed citizens usually seek
redistribution through policies they demand from their elected representatives.
How this process operates and what its limits are ought to be part of the
research agenda of law and economics.
4.5 The Movement Shaken (From 1983 Onwards)
The debates, with their ferocious attacks from all quarters on law and
economics, might seem to have left Chicago style law and economics in tatters.
But they did not. On the contrary, Posner continues to publish books (Posner,
1981b, 1988a, 1990a, 1990b, 1992a, 1992b, 1992c, 1995a, 1996a, 1996b, 1998;
Posner and Silbaugh 1996; Posner and Parisi, 1997). His textbook is currently
in its fifth edition (1998). Its closest competitor, by Cooter and Ulen (1996), is
in its second edition. The Journal of Law and Economics and the Journal of
Legal Studies continue to flourish. A series of annual research reports, The
Research in Law and Economics (Carroll, 1979), started in 1979, continues to
this day. The main early proponents of law and economics, Bork, Breyer,
Calabresi, Easterbrook, Posner and Scalia - some no longer recognising an
allegiance to the movement - have been elevated to the bench. About Posner
himself, Duxbury muses: As he continues to develop and promote his faith in
the principle of wealth-maximization, those who stand resolutely opposed to
that principle continue, with equal vigour, to demonize him (Duxbury, 1995,
p. 416). For law and economics as a whole, the 1980s have been described as
a period of maturation and consolidation in the USA (Veljanovski, 1990, p.
26).
Yet something has changed. The confidence with which the Chicago
research agenda for law and economics was taken for granted as the only game
in town appears shaken. The debates have allowed viewpoints dissonant from
strict neoclassical economics to come out of the shadows. Recent overviews
(Mercuro and Medema, 1997; Teijl and Holzhauer, 1990) deal with Chicago
Law and Economics, Public Choice Theory, Institutional Law and Economics
and Neo-institutional Law and Economics, as well as Austrian Law and
Economics.
In 1981, a new journal, the International Review of Law and Economics,
was created at the initiative of Ogus and Rowley, then at Newcastle-upon-Tyne.
Four years later, in 1985, yet another periodical saw the light, at Yale
University, the Journal of Law, Economics, and Organization. In their opening
statement, the editors observe that law and economics has expanded ... to take
account of the institutional forms within which legal rules and transactions take
place (Leo, 1985, p. 4). In recent issues, this focus is maintained, since the
editors hold the study of institutions - especially economic, legal and political
institutions - to be specifically important and greatly in need of careful analytic
study. (Leo 1997, p. 0)
0200 History of Law and Economics 81
5. Trends and Themes
Can one discern a pattern amongst the many viewpoints now represented
within law and economics broadly written? I venture to list a few common
themes, most of them proposed as enrichments of the Chicago law and
economics research agenda, rather than as alternatives to it: the role of
institutions; historical studies; strategic behaviour in human interaction; limited
rationality of human actors; uncertainty and entrepreneurship; the contributions
of public choice and game theory; the relationship between the law and
economics and the sociology of law.
In considering these possible enrichments, it is well to keep in mind the
causes of the decline of the first wave of law and economics. They justify
Posners admonition that too many bells and whistles will stop the analytic
engine in its tracks. ... A commitment to a relatively simple economic model,
one that does not supply a facile explanation for every regularity (or peculiarity)
in human behavior, forces the analyst to think hard before discarding the
possibility that the behavior under scrutiny may indeed be rational in a
straightforward sense. By the same token, a too-great readiness to abandon the
simple model in favor of alternative approaches to behavior at the first sign of
difficulty carries the risk of overlooking promising avenues for economic
analysis (Posner, 1989, pp. 60, 62). But against it Backhaus and Stephen
(1994, pp. 6-7) argue, presenting the new European Journal of Law and
Economics in 1994, that considerable disappointment with the lack of
usefulness for practical economic policy of much rigorous theoretical work in
economics has resulted in a resurgence of institutionally rich economic work.
5.1 Institutions
The important role of institutions has been stressed in many corners: the older
institutionalists such as Samuels (1971, 1972, 1974, 1975, 1976b), Samuels and
Schmid (1981) and Schmid (1965, 1976, 1978); and the newer ones such as
Williamson (1985, 1986, 1996), Eggertsson (1990, 1993, 1996), Alston,
Eggertsson and North (1996) and Komesar (1997), the economic historians
(Bouckaert, 1996, 1997; Libecap, 1986, 1989, 1992, 1993a, 1993b; Milgrom,
North and Weingast, 1997; North, 1984, 1986, 1991, 1993, 1994, 1995; North
and Wallis, 1994; North and Weingast, 1996; Weingast, 1993, 1995), the
management literature (Knight, 1992; Knight and Sened, 1995; Miller, 1992;
Gomez, 1996), Austrian economists linking to Carl Mengers contributions
(Langlois, 1986, p. 247; Rizzo, 1985), political scientists (Elster, 1989, p. 147).
Coase himself, whose 1937 article on the firm may be considered the first
contribution in modern law and economics insisting on the role of institutions,
has explicitly sided with these concerns (1937, 1992, 1993): It makes little
sense for economists to discuss the process of exchange without specifying the
82 History of Law and Economics 0200
institutional setting within which the trading takes place since this affects the
incentives to produce and the costs of transacting. I think this is now beginning
to be recognised and has been made crystal clear by what is going on in Eastern
Europe today. (Coase, 1994, p. 12). Indeed one may consider that all of law
and economics, in as much as it seeks to elucidate the rationale of existing legal
rules, engages in institutional analysis.
To understand what an institution is, start with the neoclassical model. The
model supposes that agents are informed about potential trades, that profitable
agreements are reached without delay or posturing and that deals are faithfully
performed. These are, to be sure, simplifying assumptions to make the model
manageable. They allow one to construct arguments about how social optimal
arrangements (efficiency) come about.
In this model there is no need for the fixity that institutions provide.
Because most of the formal economic models of competition, exchange, and
equilibrium have ignored ignorance and lack of costless full and perfect
information, many institutions of our economic system, institutions that are
productive in creating knowledge more cheaply than otherwise have been
erroneously treated as parasitic appendages. The explanation of use of money,
expertise with dealing in a good as a middleman specialist with a trademark or
brand name, reputability or goodwill, along with advertising of ones wares
(and even unemployment) is often misunderstood. All these can be derived
from the same information cost factors that give rise to use of an intermediary
medium of exchange (Alchian, 1977, p. 123). If human beings were
omniscient, most markets would make no sense. After all, theres no reason to
trade stocks if everyone knows the true value of every company. But people are
not omniscient. And markets are the best way yet devised to overcome human
limitations in deciding what to build, buy, or sell (Browning and Reiss, 1998,
p. 100).
Institutions answer the observation that in reality, situations are often too
complicated for ordinary economic actors to find the theoretically optimal
arrangement and are simplified to be manageable. When it is costly to
transact, then institutions matter. And it is costly to transact. ... Institutions are
the humanly devised constraints that structure human interaction. They are
made up of formal constraints (e.g., rules, laws, constitutions), informal
constraints (e.g., norms of behavior, conventions, self-imposed codes of
conduct), and their enforcement characteristics (North, 1996, p. 344).
Institutions simplify the decision problem for economic actors, by imposing
restraints on each persons conduct which render it substantially predictable to
others. Institutions are, in an important sense, congealed social knowledge. By
following institutionally-sanctioned patterns of behavior, separate individuals
are able to coordinate more completely their actions and plans. This is because
institutions often limit the options available to an individual thereby reducing
0200 History of Law and Economics 83
the uncertainty about what others are going to do (ODriscoll Jr and Rizzo,
1996, p. xxii).
Institutions are rules in a broad sense. Heiner (1983) has attempted to
formalise the reasons for using rules, both heuristic rules in individual decision
making and social rules in human interactions. Their virtue lies in the relative
fixity they provide. But the fixity is also their weakness. At the time of its
creation, an institution may be chosen so as to provide generally the best
trade-off in the face of the circumstances of the moment. As circumstances
change, institutions may come to represent less than optimal trade-offs and yet
their fixity prevents them from being instantly adjusted. The benefit of fixity
and predictability is bought at the risk of ill fit over time.
Institutions constitute an enrichment of the law and economics agenda. The
research programme they imply is not radically incompatible with the
optimisation (efficiency) idea inherent in the neo classical agenda. But
rather than assuming immediate optimisation to be the goal of all decisions
within the economic system, an institutional agenda would admit institutions
as constraints on optimisation and would consider change of institutions an
independent goal. The general effort to take account of information asymmetry
and other transaction costs, while preserving the assumption that individuals
maximize utility, is coming to be called neoinstitutional economics (Riker
and Weimer, 1993, p. 84)
5.2 History
The institutional agenda sketched above quite logically leads to an increased
interest in historical studies: institutions provide fixity in the short run and
evolve in the longer run. They leave a trace which we can study. Change of
institutions points to a change in the relevant transaction costs visible to
interested parties. North (1981, 1986, 1989, 1994, 1995) has explicitly drawn
attention to the connection between institutions and history.
Historical studies give an empirical dimension to law and economics work,
which may have been lacking in earlier law and economics work, which
focused on the function of different legal rules. Law and economics has been
too theoretical, says Becker (Roundtable, 1997, p. 1137). To this Epstein (1997,
p. 1173) adds that the easy conquests of theory and practice have already been
made. ... But precisely because knowledge is so great, the law of diminishing
returns explains why new advances are so hard to come by. For Epstein, the
greatest hope for advancement, barring any major unforeseen conceptual
breakthrough, is from more attentive study to the evolution - be it by growth or
decline, or both - of particular institutions and social arrangements (Epstein,
1997, p. 1174)
Quite a few historical studies in law and economics have appeared over the
past few years, such as Aftalion (1987, 1990); Alston, Eggertsson and North
84 History of Law and Economics 0200
(1996); Baechler (1995a, 1995b); Bailey (1992); Beito (1990); Bouckaert
(1996, 1997); Ekelund, Hbert and Tollison (1989); Epstein (1994); Green and
Shapiro (1994); Greif (1989, 1993, 1997); Greif, Milgrom and Weingast
(1994); Hovenkamp (1983); Libecap (1986, 1993b); Mackaay (1997); Milgrom,
North and Weingast (1997); North and Weingast (1996); Roe (1994);
Rosenberg and Birdzell Jr (1986); Rosenthal (1992); Secretan (1990); Simpson
(1975, 1979, 1985, 1988); Umbeck (1977a, 1977b, 1981a, 1981b); Webber and
Wildavsky (1986); Weingast (1993, 1995).
5.3 Comparative Law
The reasons for engaging in more comparative work are similar to those for
doing historical work. If the economic theory of law is solid, it ought to hold
up when applied to the law of different countries, as much as to the law of
different epochs. Mattei (1997, pp. ix, 69) complains about severe
American-centric provincialism of the law and economics literature and
observes poignantly that American law and economics has been remarkably
parochial, unable to question the presumed need and immutability of a legal
process patterned after the American one. ... In the legal context, the mistake
is that of accepting the American legal process as an undisputed background
and building up models and/or generalizing observations about the efficiency
of the law without considering the contingency and relativity of such
background. In Europe, the same lack of comparative understanding has
prevented committed law and economics scholars from developing original
insights capable of shedding new light on the civilian legal process (ibid., p.
69). Duxbury (1995, p. 409) echoes this concern in observing that by and
large, however, modern law and economics remains rooted in the common law
tradition. Coase (Roundtable, 1997, p. 1163), in a slightly different context,
has also called for more comparative work.
The International Review of Law and Economics regularly gives space to
comparative studies (Cooter and Gordley, 1991; Mattei and Pardolesi, 1991)
and surveys of law and economics in civil law countries. Levmore (1986, 1987)
has published detailed comparative studies of particular institutions. Mattei
(1994a, 1994b, 1994c, 1995, 1996) and Ajani and Mattei (1995) have focused
on the broader aspects of the comparative approach. Scully (1987) purports to
develop a general argument that civilian countries, being generally more
positivist than those in the common law tradition, offer their citizens less
freedom than the latter.
Scullys conclusion points to the question of the reception of law and
economics outside of the United States. From the mid 1970s, it reached other
English speaking countries and Sweden (Attiyah, 1970; Skogh, 1978; Harris,
Ogus and Phillips, 1979; Ogus, 1980; Veljanovski, 1980, 1981, 1982; Burrows
1980; Burrows and Veljanovski, 1981; Ogus and Veljanovski, 1984). By the
0200 History of Law and Economics 85
end of the decade, it had found its way to the German speaking (Horn 1976;
Assmann, Kirchner and Schanze, 1978; Opp, 1979; Lehmann, 1983; Schller,
1983; Behrens, 1984) and the Benelux countries (Mackaay, 1980, 1982;
Bouckaert, 1984). Mattei and Pardolesi (1991) mention interest for law and
economics comparative law scholars in Italy already in the early 1960s, but
without much practical echo until decades later. France has lagged behind,
because, most unfortunately, an early contribution to law and economics (Rosa
and Aftalion, 1977) became labelled as right-wing ideology without proper
claim to scientific status (Andreff et al. 1982; Mackaay 1987). Peculiarities of
the French higher education system with its centralised administration and
control of appointment and promotion of law professors, providing little
incentive for the reception of intellectual ideas originating outside France, may
have reinforced this unfortunate development. Remarkable law and economics
publications such as Lepage (1985) and Lemennicier (1988) have been by and
large ignored by the legal community.
The reception in these countries appears to follow a common pattern. An
early sparkling publication triggers broader interest amongst legal scholars. In
England (Attiyah, 1970) introduced the British reader to Calabresis
economics, igniting interest among lawyers in the reform of the tort system and
the efficiency of accident compensation schemes (Veljanovski, 1990, p. 25).
In Germany, this role was played by a small book of readings produced by three
young scholars, who spent a year in the US (Assmann, Kirchner and Schanze,
1978). Perhaps reception in Germany was helped by the earlier Ordo-liberal or
Freiburg school of law and economics, founded in the 1930s and influential
after the Second World War, which included well-known scholars and
politicians such as Walter Eucken, Wilhelm Roepke, Ludwig Erhard, Franz
Bhm (Backhaus, 1996; Behrens, 1984, p. 8 f., 1993; Grossekettler, 1996;
Lenel, 1996; Streit, 1992; Vanberg, 1998b).
Consolidation takes place as law and economics is taught in the law schools
(and not only in the economics departments) and young scholars choose a law
and economics subject for their thesis. The Erasmus exchange programme in
law and economics has probably exerted a positive influence in Europe. So have
the European Law and Economics Association and, in its sphere, the Canadian
Law and Economics Association.
One must wonder whether law and economics generates outside the United
States as much interest as it had earlier on and continues to do in the US. In
1991, Kirchner answered this question in the negative for Germany, in spite of
the substantial literature in German on the subject. Looking to the future,
Cooter and Gordley (1991, p. 262) conclude that [b]oth Kirchner and Mattei,
however, see the economic approach to law as the opponent of what remains
of nineteenth-century formalism. For the economic approach to be successful,
then, it must convince its critics that it can avoid the evils of formalism without
86 History of Law and Economics 0200
causing new evils of its own. Its success, then, may require not only openness
by traditional legal scholars to a new method, but also creative adaptation of
that method by its practitioners.
5.4 Strategic Behaviour
Williamson (1985, 1986, 1996) in particular has drawn attention to the
question of strategic behaviour. The neoclassical model assumes such conduct
to be absent. Yet the rules for decision making within corporations or
associations of condominium owners or the rules for dealing with conflicts
between owners of neighbouring properties are explicable in an economic
analysis of law as means to foreclose, or at least reduce, strategic behaviour in
these settings of bilateral monopoly. Coleman observes that all rules attempt
to correct some form of perceived market failing (Coleman (Jules), 1989, p.
182). Strategic behaviour may be considered a form of market failing and it is
a fruitful heuristic for lawyer-economists to consider the threat of such
behaviour as the explanation for observed legal institutions. This is a
refinement of the institutional agenda (see also Katz, 1998).
5.5 Limited Rationality
Psychologists observe that human reasoning does not in fact conform to the
postulates of rational choice in a number of ways (Booth, Booth and Meadwell,
1993; Cook and Levi, 1990; Elster, 1986; Green and Shapiro, 1994; Hahn and
Hollis, 1979; Hargreaves Heap, Hollis et al., 1992; Hogarth and Reder, 1986;
Hollis, 1987; Hollis and Nell, 1975; Kahneman, Slovic and Tversky, 1982;
Mackaay, 1982, Ch. 6; March, 1986; Simon, 1959, 1972, 1979, 1986a, 1986b;
Tversky and Kahneman, 1974, 1986a,, 1986b; Tversky, Slovic and Kahneman,
1990). We do not, for instance, intuitively draw the proper statistical inference
from a series of occurrences of some event, but attach undue weight to the more
recent ones; we ask more for something we sell than we would be willing to pay
to acquire it (Kahneman, Knetsch and Thaler, 1991; Knetsch and Sinden,
1984a, 1984b; Knetsch, 1989). Should these observations lead one to reject the
rational choice model? That conclusion is generally considered premature. In
part this is because market forces induce rationality by penalising random or
otherwise irrational choices (Becker, 1962). Until we know how to formalise
the bounds on our rationality, Posners admonition about too many bells and
whistles seems apposite.
5.6 Uncertainty, Discovery and Entrepreneurship
Uncertainty, discovery and entrepreneurship are at the heart of the Austrian
economics research agenda. They lead to a view of competition law which is
distinctly different from that derived from the equilibrium model at the centre
of neoclassical economics. The equilibrium model translates a situation in
0200 History of Law and Economics 87
which all knowledge and know-how is presumed given and all potential
transactions are presumed to have been considered. For the Austrians, all this
knowledge is not given, but must be discovered. The essence of the economic
problem is the discovery of new products, services and ways of doing things.
The Austrians are concerned to determine the conditions required for that
discovery process. This has consequences for the scope of competition law.
The advantage secured by a superior product may initially give a firm
something of practical monopoly in its market. In the Austrian view, this is no
cause for intervention. So long as the monopoly is contestable, in the sense that
no legal impediment stops a newcomer from offering a new product which
consumers accept as a substitute for the supposedly monopolistic product, the
very success of the apparent monopoly is the carrot which draws competition
and drives innovation. Austrians see competition as a discovery process and,
one may add, the reverse as well: discovery will most readily take place through
competition.
Development of a niche through an innovation and subsequent imitation
and dissipation of the niche and search for new ones is the essence of the
competitive discovery process. Breaking up such monopolies because of
excessive market share would, on an Austrian analysis, have the effect of
stifling innovation. The literature on competition law, at least in the United
States, is coming round to this dynamic view of competition and innovation,
giving credence to the Austrian ideas (Barnett, 1992; Kirzner, 1973, 1979,
1985, 1997; McChesney and Shughart II, 1985; Nelson and Winter, 1982;
Schmidtchen, 1993).
The Austrian views differ from the neoclassical synthesis in other important
respects as well. Hayek has insisted on the subjective nature of information
economic actors use in making their plans and reaching their decisions (Hayek,
1948; Kirzner, 1984; ODriscoll Jr and Rizzo, 1996; Barnett, 1998).
Information about production and consumption plans is revealed and
continuously updated through the price mechanism. One cannot correctly gauge
this information outside the transactions in which it is revealed through the
market. This is no less true for the judges in our system, than it was, fatally, for
government officials running the former socialist republics. Austrians generally
take a dim view of judicial re-engineering of contracts.
How much Austrian and Chicago neoclassical economics actually differ is
a matter of debate. Paqu (1985) submits that the distance is smaller than it
appears to be. Boettke (1997) sees neoclassical economics as the product of a
set of simplifying assumptions about innovation and competition introduced in
classical political economy, which made possible the rapid mathematisation of
the discipline, but entailed a lack of realism which, in his view, is fatal.
Austrian economics has, in his eyes and those of Behrens (1984, p. 22),
remained faithful to the older but richer tradition of political economy.
88 History of Law and Economics 0200
The consequences of the Austrian views for law and economics differ
significantly from those reached in a neoclassical perspective (Rizzo, 1980c,
1985; Bouckaert, 1984; Teijl and Holzhauer, 1997). For instance, comparisons
of prevention costs for tortfeasors with accident costs for victims, as the Hand
test for negligence law would require, are without a foundation on an Austrian
view, which for that reason tends to favour strict liability or no liability. The
implications of Austrian views for civil law have been explored in some detail
and compared to those of Chicago neoclassical views in a recent doctoral thesis
in Rotterdam (Teijl and Holzhauer, 1997).
5.7 Public Choice
Public choice is the application of the rational choice model to political
phenomena, the field of political science and of public law. It is, to put it
another way, a general theory of how private interests operate in the public
domain (Ogus, 1994, p. 58). Its core ideas can be traced back at least to
Machiavelli. For the current movement the immediate beginnings are works by
Duncan Black in the UK and Anthony Downs in the USA (Black, 1948a,
1948b, 1958; Downs, 1957). They were followed by seminal contributions
dealing with collective decision making through Parliament, with bureaucracy
and with the problems of collective decision making (Buchanan and Tullock,
1962; Olson, 1965; Niskanen, 1971, 1994). There is now a substantial literature
on public choice. Readable surveys for lawyers are De Clerq and Naert (1985);
Farber and Frickey (1991); Mercuro and Medema (1997, pp. 84-100); Mitchell
and Simmons (1994); Stearns (1997); Wagner (1990). Other important surveys
can be found in Mueller (1979, 1989, 1997).
Implicit in the neoclassical model underlying mainstream law and
economics is the view that governments role is to correct market failure. It is
consonant with the broadly held public interest view of government: the
government acts as the impartial umpire of social relationships, stepping into
the fray to correct whatever has gone astray in the workings of market and
other social forces.
Public choice casts doubts on this view. Its proponents question the
underlying assumption that actors presumed selfish in private dealings would
behave selflessly upon assuming public office. Public choice proposes a private
interest view of politics, a world in which actors in political roles act to
maximise something of direct interest to them, but defined in ways particular
to their roles: politicians are assumed to maximise their chances of re-election;
bureaucrats, the size and mandate of their bureaux (Niskanen, 1971; Dunleavy,
1991); voters, the benefits they draw from government programmes and interest
groups, the programmes conferring benefits upon their members.
A startling conclusion of public choice is the thesis of the rational ignorance
of voters. Since voters cannot expect their individual vote to make a difference
between one political programme and another, they have no interest in
0200 History of Law and Economics 89
informing themselves properly on the differences between the two. Political
discourse directed at such voters deals in general slogans and in the image of
politicians. By contrast, where opposing politicians in an election are divided
on a programme which directly affects a particular group of voters, such as
farmers, these voters very much have an interest in informing themselves on
where the politicians stand on that issue and in promising their vote to those
who will benefit them most. Lobby groups channel this interest for their
constituents. Olson (1965) has shown that the difficulties of organising lobby
groups vary directly with the size and cohesion of the constituent group.
Compact groups, as a consequence, are expected to have a disproportionate
influence on politicians. Public choice predicts that politicians will generally
want to adopt programmes whose benefits are visible and fall upon
concentrated groups, while their cost is dispersed as widely and imperceptibly
as possible. The actions by interest groups designed to get their members
benefits not available in the market have since become known as rent-seeking
(Buchanan, Tollison and Tullock, 1980; Krueger, 1974; McChesney, 1997;
Posner, 1975b; Rowley, 1988; Rowley et al., 1988a, 1988b; Tollison, 1982,
1987, 1997; Tullock, 1987, 1989, 1993). There is a lively literature on the
economics of federations (Breton, 1987, 1989, 1996; Breton and Scott, 1978,
1980; Hamilton, 1987; Kendall and Louw, 1989; Migu, 1993, 1997; Tiebout,
1956; Weingast, 1993, 1995).
5.8 Economic Regulation
Public choice enriches the economic analysis of law in that it provides an
understanding of the forces controlling redistribution and of economic
regulation. Economic regulation denotes legal restraints upon market actors
behaviour, elaborated by legislators, courts or administrative agencies (Ogus,
1994, p. 1; Hgg, 1997, p. 337). Examples are regulation of state-run utility
companies, regulation of transportation, airlines, telecommunications
industries, environmental protection, safety and drug regulation, consumer
protection, but also price-fixing, taxes, subsidies, tariffs, quotas, merger
control (Hgg, 1997, p. 339). All these forms of regulation were seen until the
1960s as attempts to correct market failings, the main justification of
government in the neoclassical model.
The question is whether economic regulation in fact improves overall
welfare. Within law and economics the answer came increasingly to be seen as
negative, in particular with respect to what was until then considered to be the
most telling case for government intervention: natural monopoly (Priest, 1993,
p. 292). Regulated monopolies were shown often to capture the regulatory
agency supervising them, to the detriment of the public, which faced higher
than necessary prices. The empirical and theoretical research of these issues
centred around the Journal of Law and Economics. Coases article on social
cost may be read in this light: the thesis that any form of externality calls for
90 History of Law and Economics 0200
government correction (through liability or taxes) was shown to be mistaken;
externalities correct themselves if property rights are properly specified and
provided no significant transaction costs stand in the way of negotiations
between parties to the externality. Coase (1974) showed, similarly, that
lighthouses, thought to be the public good par excellence, were in fact for a
long time privately run in the UK. Cheung (1973) found that pollination by
bees, presumed to be a positive externality and hence source of market failure,
was in fact the object of a lively market between beekeepers and farmers.
Burton argues more generally that uncontracted or external effects are a
pervasive phenomenon of social life (Burton, 1980, p. 56) and cannot by
themselves be sufficient reason for government intervention. What counts as
an actionable externality depends on how the boundaries of property rights are
defined in a society. There is a lively literature tending to show that the
presumed market imperfections are not in fact fatal to the market process or
otherwise are circumvented by the ingenuity of market participants (Cowen,
1988). Deregulation of transportation, communication, energy and financial
industries in the United States and privatisation of public enterprise from the
late 1970s onwards has generally brought benefits to consumers in the form of
lower prices and wider diversity of products, lending credence to the private
interest view of regulation and casting doubts on the beneficence of
government intervention.
If government interventions are not ipso facto beneficent, we need a theory
to explain how they come about and which are beneficent, which are not.
Initially this theory was articulated by Stigler (1971); Posner (1971, 1974) and
Peltzman (1976, 1989) at Chicago in terms of interests groups getting their way
with politicians. Their approach was consonant with the teachings of the public
choice school (Priest, 1993, p. 293). The upshot of this view was that under no
circumstances could economic regulation be viewed as beneficent.
From the 1980s onwards, this altogether pessimistic view came to be
questioned. Becker showed in two articles that the privileges sought by interest
groups would trigger their own counterweight for other interest groups and
concluded that the only enduring forms of regulation would benefit all actors
at large, rather than specific groups. (Becker, 1983, 1985).
The prevailing view now appears to be that regulation need not always be
detrimental to the public interest. Defining and enforcing property rights and
contracts and developing tort liability rules sustain the market, rather than
hamper it. They are law just as much as the economic regulation of the kind
discussed above. Ogus (1994, p. 75) sums up the debate thus: public choice
theory, and its various offshoots, rightly focus our attention on the way in
which regulation affects a variety of private interests. The distributional impact
of interventionist measures may be concealed behind the public interest rhetoric
0200 History of Law and Economics 91
which usually accompanies them, but it remains crucial to normative
evaluation (see also Hgg, 1997, p. 356-357).
5.9 Game Theory
Game theory is a mathematical tool for studying interactions amongst people,
in which one persons choice depends on what others choose and vice versa. It
has been used in economics and in moral philosophy for quite some time, but
has been introduced in legal analysis only recently (Barnett, 1989, p. 9). One
use is to detect recurrent patterns in human interaction, leading humans to
adopt norms which are models for property rights and contracts. Game theory
then provides an understanding of spontaneous order (Axelrod, 1984; Benson,
1994; Birmingham, 1968; Mackaay 1988b, 1991; Parisi, 1995; Picker, 1997;
Sugden, 1986, 1989; Ullmann-Margalit, 1977, 1978). Game theory has also
been used to shed light on bargaining situations. A helpful overview of the uses
of game theory in law is given in (Baird, Gertner and Picker, 1994). There is
an ample literature on what game theory can teach with respect to the social
contract and the foundation of the state, but this lies outside of law and
economics proper (Kerkmeester 1989; Voigt, 1996, 1997).
5.10 Links with the Sociology of Law
In recent years, several authors have called for closer links between law and
economics, and the sociology of law. Ellickson for one, in several writings
(Ellickson, 1987, 1989, 1990, 1991), with a comment by Posner (1989), pleads
for overture to various forms of human frailty, a sensibility readily attributed
to sociologists, whom he criticises, however, for engaging in much
observational work without a proper theory to guide those observations. Others
have called for this rapprochement as well: Bouckaert (1994), Cooter (1995),
Daintith and Teubner (1986), De Geest (1995), Donohue III (1988) with a
comment by Posner (1988b), Johnston (1990). Entire issues of the European
Journal of Law and Economics (EJLE) and of the Wisconsin Law Review
(Wisconsin) have been devoted to the matter. The link would seem only natural
to sociologists such as Boudon (1977), James Coleman (1987, 1988, 1990a,
1992) and Opp (1979, 1982, 1983, 1988, 1991), who subscribe to the postulate
of methodological individualism.
Posner (1988b, 1989, 1995b) is not impressed with what legal sociologists
have offered by way of understanding legal phenomena: The theories proposed
by American sociologists of law, when they propose theories, which is not
often, tend to be partial and ad hoc and difficult to test empirically, and modern
methods of statistical inference are only rarely in evidence. He adds that the
sociology of law is characterised by a dearth of arresting hypotheses to set off
against the Coase theorem, the Hand formula, the efficiency theory of the
common law, the Modigliani-Miller thesis, the human-capital explanation of
92 History of Law and Economics 0200
employment at will, Ramsey pricing, agency costs, rent-seeking, the selection
hypothesis (that plaintiffs tend to win 50 percent of cases litigated to judgment),
the concept of complete contingent contracts, the economics of property rights
versus liability rules, the activity level theory of strict liability, the
efficient-market hypothesis ... (Posner, 1995b, p. 273). In line with his
observation on too many bells and whistles (Posner, 1989, pp. 60, 62), he has
little use for the introduction of sociological ideas into the economic analysis
of law. Some sociologists (Cranston, 1977; Griffiths, 1995) are critical of the
link between the sociology of law and the economic analysis of law as well, but
for different reasons. As Coase (1978) reminds us, only experience will tell
whether the economic approach as it is has the comparative advantage it claims
over other approaches, or whether enriched forms of it do better.
6. Conclusion
This survey leads to two major findings. The first is that the idea of applying
economic concepts to gain a better understanding of law is much older than the
current movement, which its proponents date back to the late 1950s. The
second finding concerns the current movement. After virtually unquestioned
dominance and astonishing success of the Chicago approach in the 1960s and
1970s, since about 1980 practitioners of law and economics no longer sing in
a single voice.
With respect to the earlier attempts at law and economics, it should be
observed that they had declined by the 1930s and find no clear echo in the
current movement, outside the work of modern institutionalists such as Samuels
and Schmid. Various reasons are given: their methodology became increasingly
fuzzy; in the end they failed to convince lawyers, in the absence of a
straightforward methodology and telling insights into the nature of legal
phenomena. Perhaps, too, the problems they addressed and the solutions they
proposed - generally more government intervention - no longer appeared
relevant to the legal community.
These observations feed into the second finding, the astounding variety of
viewpoints now represented within law and economics broadly written. Will
this cacophony drive law and economics into oblivion? It ought not to, since
law and economics of whatever stripe still offers insights into a broad range of
legal phenomena from contracts, torts and property to commercial law,
constitutional law, criminal law and even family law. The task is to convince
lawyers that this is a useful, indeed an essential, supplement to traditional
lawyering skills. Where law changes rapidly, as it does in our day, lawyers are
inevitably involved in policymaking of some sort. The record of lawyers
managing such change on the strength of legal skills and legal practice alone
is disappointing at best (Posner, 1987b, pp. 769-771).
0200 History of Law and Economics 93
But can the policy advice proffered by lawyer-economists be relied on? De
Alessi (1996, 1997) has formulated a scathing attack on the use of the potential
compensation (Kaldor-Hicks) criterion in applied studies and the use of the
neoclassical equilibrium model for policy recommendations: Actual market
solutions in a world of limited private property rights and positive transaction
costs always appear to be inefficient relative to some ideal. The result is a bias
toward government action to impose rules that, supposedly, move the system
toward the ideal. As the application of economics to the analysis of public
choices has shown, generations of economists have provided the rhetoric used
by rent-seekers in both the private and the public sectors to coopt government
regulation and redistribute income to themselves (De Alessi, 1996, pp.
115-116). To the traditional lawyer, no more is needed to discredit law and
economics. For law and economics to prosper, the mainspring of ideas, which
is economics proper, must get its house in order (Boettke, 1997).
What then should be the agenda? On the theory of law and economics,
Beckers sombre observation is that lately, there has been less excitement, less
novelty (Roundtable, 1997, p. 1137). But that, in his view, may be part of the
life cycle of scientific theories. In the meantime basic ideas should be absorbed
by the practitioners of the discipline. And here lawyers may well ask of law and
economics the question Becker put earlier in his remarks: What have you done
for me lately? (Roundtable, 1997, p. 1137).
Lawyer-economists must convince lawyers, and even more judges, of the
promise of their discipline. They must do this while avoiding being mere
rent-seekers on a fad; they must establish the credibility of law and economics
as an accurate description of how legal institutions actually work, as well as a
generator of hypotheses and insights about law. Cutting through the thicket of
established legal doctrine and proposing simpler explanations is one way of
doing this. Epstein (1995) is a fine example of that approach. Engaging in
empirical work, some of it in the form of historical and comparative studies, is
the complementary approach. Only such studies will sort out the debates raging
between the various schools of law and economics, as they must be.
Lawyer-economists must distil a straightforward method for applying the
economic analysis of law to given legal institutions. Perhaps the method is not
always simple and may require a serious learning effort. It should be teachable
as a more or less scientific process rather than as a mere art (Katz, 1998, p. v).
The benefits of climbing the learning curve should be clear from applications
which are telling to lawyers (rather than to economists alone).
One of the remarkable insights coming out of law and economics is that
many institutions essential to the functioning of civil society have a claim to
validity which is independent of specific enactment (Barry, 1996, p. 617). The
institutions produced in the course of evolutionary processes need not be the
best conceivable and we may consider reforming them (Buchanan, 1977, p.
94 History of Law and Economics 0200
131). But unnecessary and ill-timed interference can do great harm; reform
should be undertaken warily and on the basis of the best knowledge available.
All theories may turn out to be misguided in the face of later research. Practical
policy decisions must be made on the basis of such imperfect knowledge. How
essential law and economics is may be gleaned from the experience in Middle
and East European countries after the restoration of democracy. Advice about
what institutions to create appears to have been given often by economists
without appreciation for the dynamics of the law and by lawyers with too little
knowledge of the workings of the economy. The pains of transition have been
prolonged as a result.
Lawyer-economists should only presume to offer policy advice to minister
to the ills of society as the discipline acquires solid empirical bearings. It is not
sufficient to criticise accepted wisdom and to propose plausible enrichments of
the theory, as the debates around 1980 have done. The crucial point is for the
discipline to engage in empirical work capable of disproving false tenets. Only
in this way can we hope to discover what is indisputable in law and economics,
and make its message last. We shall see whether Coase was right in his
assessment that [i]ndeed, work is going forward at such a pace that I do not
consider it overoptimistic to believe that the main outlines of the subject will
be drawn within five or ten years. (Coase, 1994, p. 12).
Acknowledgements
Writing the history of law and economics has turned out to be an arduous task.
Sustenance as well as helpful suggestions were provided by Boudewijn
Bouckaert, Gerrit De Geest and Frdrick Charette in particular. Eric Schanze,
Ronald Kirstein, Stphane Rousseau, Stefan Voigt and two anonymous referees
provided constructive comment. I assume nonetheless full responsibility for the
structure of the text and the weight given to different periods and movements.
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0305
LAW AND ECONOMICS IN AUSTRIA
Wolfgang Weigel
University of Vienna
Copyright 1999 Wolgang Weigel
Abstract
This note concentrates on the state of law and economics in Austria after the
emergence of the economic analysis of law. The long tradition of research in
bringing together legal and economic aspects particularly in the field of
regulation and dating back to the eighteenth century is also adressed. Moreover,
some reasons why modern law and economics have encountered a fairly weak
reception for almost two decades are suggested. Finally, the quite encouraging
development both in teaching and research during the 1990s is emphasized.
JEL classification: A12, K00
Keywords: Austria, law and economics, Paradigms, Teaching, Research
1. General Observations
In Austria, the mutual dependence of economics and law has been recognized
literally for more than two hundred years. However, from the beginning, public
law and, more specifically, regulation - or Wirtschaftsverwaltungsrecht, to use
the appropriate German term - received much more attention than civil law.
Evidence for this assertion is provided by a textbook, entitled The Principles of
Police, Action and Finance, written by one of the most influential counsellors
to the sovereign of the Austrian empire, Joseph von Sonnenfels, which was
published in three volumes beginning in the year 1765, where the term police
refers to public administration, action to private trade and finance to fiscal
issues of government. Here, and in most of the later work treating these issues,
however, there was no common denominator in terms of a distinct
methodology. On the contrary, one of the particular features of modern law and
economics is that legal issues are approached by means of the tools of
microeconomic theory. Taking the latter characteristic as the essential feature
of law and economics, as it is understood nowadays, contrary to the general
concern about economic issues in legal reasoning, the interest in that field of
research in Austria is not very great.
Its reception in the academic sphere is, however, considerably ahead of that
in the secular world. Among scientists, lawyers appear to be more concerned
than economists. This is not surprising, since it is mainly for lawyers that the
118
0305 Law and Economics in Austria 119
methodology involved gives rise to a radical change in the way of approaching
legal problems, whereas economists are traditionally more accustomed to
deriving policy conclusions from their analysis, which may very well comprise
changes in prevailing regulations. A typical example is the work on opening
hours of shops by the economists Clemenz and Inderst (1989). Following the
said tradition, among lawyers those working in the field of public law
(constitutional law, administrative law as well as regulation) are generally more
interested than those in private law. In the latter, the main attitude is scepticism
if not prejudice, as can be seen from quotations by, for example Mayer-Maly
(1991, p. 220, note to p. 129) and Bydlinski (1988, pp. 282 passim). This
conclusion rests upon three sources: first, the examination and classification of
existing literature; second, quotations by leading scientists; and third, the
response to a mail survey in the course of the preparation for this paper.
The information which follows will illustrate and explain the views
expressed above.
2. Predominant Paradigms
One reason for the weak impact of law and economics both in the academic
sphere and civil practice of law seems to be the predominant role of distinct
paradigms in educational training. Legal scholars are basically brought up in
the spirit of legal positivism. Even more recent ideas such as that of a
value-related understanding of law (Bydlinski, 1982) leave hardly any space for
the economic approach to law. Dissenting approaches are rarely considered.
Even in applied research conventional juridical craftsmanship is used; one
typical example is that by the lawyers Aicher and Lessiak (1989) on discount
and competition, which does not contain even one single reference to the
economic analysis of law.
Economists in turn are mainly trained in neoclassical economic theory, as
far as microeconomics is concerned, whereas late Keynesian views predominate
in macroeconomics until recently at least (see Frey and Kirchgssner, 1994, p.
477). Nevertheless, the research programs suggested by scholars of modern law
and economics are occasionally adopted. This can be inferred from the lists of
publications submitted to the present author following a call for submission: in
many of the accompanying letters it is stated that the publications enlisted are
understood as being related to law and economics, without taking into account
the methodology underlying the economic approach to law.
120 Law and Economics in Austria 0305
3. Professional Structure
Lawyers play a predominant role in the Austrian economy. They still hold most
of the leading positions in public administration and in private business. More
recently economists have caught up to some extent, but most of them received
their degrees in business administration, not in economics proper.
However, lawyers receive educational training in basic economics (both
macro and micro) whereas economists are taught basic private and public law
in turn. Moreover, civil servants, who seek achievement to higher posts, must
take supplementary courses in economics as well as distinct fields of law at the
federal academy of administration, irrespective of their university degree.
4. Prejudices and Ignorance
One reason for the weak reception of the economic approach to law seems to
be a general lack of knowledge about the state of the art. More specifically, the
entire approach is generally associated with the Chicago school, which is held
to be primarily efficiency-orientated, taking the Pareto-efficient allocations of
competitive markets as a reference standard. It is generally agreed that
therefore issues of (social) justice do not receive the attention they deserve in
legal reasoning. These conjectures are supported by the fact that the
predominant references which can be found in the literature are to criticise
Richard Posner, as, for example, in the writings of the most influential authors,
Bydlinsky (1988) and Mayer-Maly (1991).
Consequently it is generally ignored that many outstanding scholars of law
and economics have taken a much broader view than that of the Chicago school
for a long time. It is disturbing to see that their basic ideas have hardly yet
entered university classrooms. Fortunately, there is one exception: the closely
related property rights - public choice approach, as it has been termed by
Goldberg (1980, p. 402) is actually being promoted now in the economic
departments of the universities of Linz, Innsbruck, and Vienna and also in the
department of sociology of the University of Graz. From here, it would only be
a short step to adopt law and economics more generally.With the exception of
the University of Vienna, where regular lectures and seminars are held, this
step has not be taken.
Unfortunately, responses to the questionaire mentioned earlier show that the
situation with respect to teaching is even worse in law schools. There, the ideas
underlying the economic analysis of law are taught only occasionally in the
course of classes held on topics which are traditionally in the domain of law
and economics, such as corporate law, environmental law and criminal law.
0305 Law and Economics in Austria 121
5. Challenges by Legal and Economic Practice
Contrary to the weak overall interest in modern law and economics, the
Austrian economy would offer itself as an ideal playground for scholary work
in that field. It is still highly regulated, with regulations applying to
competition, barriers to entry and administered prices, to name but a few issues.
There is also growing concern about environmental standards accompanied by
an ever-increasing number of legal measures.
More recently predominant policy issues such as privatization of public
utilities and deregulation, as well as the harmonization of the Austrian legal
framework with that of the European Union, create new challenges for both
economists and lawyers. The problems associated with these newly emerging
issues would call for appropriate tools of analysis and advice. Therefore, time
may prepare the ground for a larger perception of the fruitfulness of the
economic approach to law.
6. A Necessarily Brief History
In adressing the history of economic thought in the field of modern law and
economics, one must be aware that it is both rooted in and therefore closely
related to a variety of other fields of research. These are nowadays frequently
summarized under the label of New Institutional Economics, and they comprise
many very important contributions, for example on the evolution of social order
and the economic theory of democracy. The most prominent authors associated
with these contributions are Hayek and Schumpeter respectively. Unfortunately
it is beyond the scope of this article to take full account of their work.
Moreover, although they are Austrians by birth and from origin, these authors
- like several others - received adequate acknowledgement for their
pathbreaking contributions abroad only after their emigration from Austria.
Therefore, their pioneering work should be attributed to Austria only with
reservations.
But even with respect to law and economics in a narrow sense, despite its
generally weak reception, Austria may be looked at as an important post of
forerunners: as far back as 1897, Herrmann published a book on Theorie der
Versicherung (Theory of Insurance), in which he introduced ideas which are
quite close to those which a century later became known as the Coase theorem.
Another pioneering work was Rechte und Verhltnisse vom Standpunkt der
Volkswirthschaftslehre (Rights and Relations from the Point of View of
Economics) by Eugen Bhm-Bawerk in 1881. In this small book,
Bhm-Bawerk acknowledges rights and entitlements to be valuable assets. The
title of Victor Matajas book Das Recht des Schadenersatzes vom Standpunkt
der Nationalkonomie (The Law of Damages from an Economic Perspective),
122 Law and Economics in Austria 0305
published in 1888, ought to sound familiar to present day scholars. Finally, the
work of K.G. Wurzel deserves attention here. Writing at the time of World War
One, Wurzel strongly advocated interdisciplinary reasoning for lawyers (see
also Weissel, 1991).
After World War Two, questions of property and wealth were discussed in
the course of both the adoption of ORDO-liberalism and a newly emerging
general interest in the catholic doctrine on social justice and the distribution of
private property (see for example Streissler, 1973). These writings can be seen
as loosely linked to the subject at hand.
During the 1980s, the first writings were published which explicitly
contained reference to the economic analysis of law. A landmark for Austria,
unfortunately with weak impact on the interest in general, however, was the 7th
annual conference of the European Association for law and economics, held in
Vienna in 1989, arranged by the author. It was not until the early 1990s,
though, that the economic analysis of law was explicitly taught for the first time
in classes in the economics department of Vienna university. Occasionally
interdisciplinary seminars were held, and in the Technical University of
Vienna, a group of scientists who had assumed Neoinstitutionalism started a
critical dispute about the relevance of the modern property-rights doctrine.
In Vienna as well as Graz, books by Hafner (1987), Huber (1995) and
Gimpel-Hinteregger (1994) were published, which were basically revised
versions of Habiltation theses and contained reflections on law and
economics.
A research program on Dynamic Models of Optimal Law Enforcement
was established at the Institute for Econometrics, Operation Research and
Systems Theory, University of Technology, which is devoted to the application
of game theory and operations research to the economics of crime, more
specifically corruption and illicit drugs.
Also, more recently, the first doctoral theses have been written explicitly
adressing the approach: Grabenwarter (1994) and Freyer (1994).
Law and economics was finally accepted as complementary course for the
study of both law and economics in 1994. Approximately 20 to 25 scientists are
now working in this field.
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0305 Law and Economics in Austria 123
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0310
LAW AND ECONOMICS IN BELGIUM
Gerrit De Geest
Professor at the University of Ghent
Researcher at the Economic Institute/CIAV Utrecht University
Copyright 1999 Gerrit De Geest
Abstract
This chapter concentrates on the state of law and economics (narrowly
defined) in Belgium. As in most European countries, traditional law
professors - who believe in the idea of law as an autonomous science - were
initially rather critical towards this new approach. This early scepticism
seems to have disappeared in more recent years.
Optional courses are now taught at most Belgian universities, and law
and economics articles have been published in traditional law reviews. There
is one specialized book series on law and economics. Several national
workshops and international conferences have been organized at the
Universities of Antwerp, Gent and Leuven.
JEL classification: K00
Keywords: Law and Economics, Belgium, Research, Education, Conferences
1. Introduction. Reception of Law and Economics in Belgium
Law and economics (narrowly defined) was introduced in Belgium by Cousy
(1976), when he applied the brand new economic theory on product liability
to Belgian law. Cousy had been confronted with this new approach during a
stay in the USA. The true start was given by Bouckaert (1984a) who devoted
his inaugural lecture to law and economics, and by Faure and Van den
Bergh who organized the first of a series of Flemish workshops in 1986.
As in most European countries, traditional law professors were initially
rather critical towards this new approach. A lively debate between the legal
doctrinist Kruithof (1986, 1987) and the legal economists Van den Bergh
and Heremans (1987a, 1987b) took place. Kruithof criticized law and
economics mainly for its unrealistic assumptions and for the inferiority of
economic values to moral values.
This early scepticism seems to have disappeared in more recent years.
Optional courses are now taught at most Belgian universities, and law and
economics papers have been accepted by traditional law reviews. In 1995,
the University of Ghent awarded an honorary doctorate to Richard Posner.
128
0310 Law and Economics in Belgium 129
Yet the average law professor is still not very familiar with the approach.
In the first introductory lectures of their courses, Belgian law professors
traditionally refer to historical and sometimes philosophical literature. In
rare cases only, a Belgian law professor will briefly introduce the students to
the economics of the legal rules. Belgium is of course not unique in this
respect. As in most continental countries, legal science is generally seen as
an autonomous science. In Belgium and France, the Exegetic School,
although officially dead, still has some influence. According to this view,
judges and legal scientists had to follow the legislation as faithfully as
possible and had to leave improvements of the law (de lege ferenda) entirely
to the legislator.
The following sections will survey the current state of law and economics
with respect to education, research and organized conferences and
workshops. Law and economics will be narrowly defined. There is, of
course, much more law and economics in Belgium, if the term includes, for
instance, regulation of industries and industrial organization. In other
words, this survey will pay more attention to new law and economics than
to old law and economics.
2. Education
At no Belgian university is law and economics a mandatory course,
although, it is offered as an optional course at most universities. At the
University of Ghent such an optional course for law students has existed
since the early 1980s (first under a different name, Algemene en Kritische
Rechtstheorie - General and Critical Legal Theory). At the university of
Antwerp, there is an optional course for law students. In Leuven, there is a
similar introductory course, taught in English (also offered in the LL M
programme). Robert Cooter has taught a law and economics course at
Louvain-la-neuve on various occasions. At the economics faculty of Namur
there is a course as well.
The University of Ghent is a partner in the Erasmus Programme on Law
and Economics and offers five specialized courses. The Catholic University
of Brusssels and the Facults Saint-Louis offer a joint Masters programme
on legal theory, which introduces the students to nearly all branches of legal
theory, including law and economics.
There has been a (part-time) professor on law and economics and legal
theory at the University of Ghent since 1997 (De Geest). In addition, some
other professors (Van den Bergh, Bouckaert, Van Cayseele, Heremans,
Vereecke and others) are devoting at least part of their research time to law
and economics.
130 Law and Economics in Belgium 0310
3. Research
The first introductory (little) monograph on law and economics was
Bouckaerts inaugural lecture (1984a). Faure and Van den Bergh (1989, on
tort law and insurance) was the first longer monograph in Belgium. The first
PhD based on law and economics research broadly defined was De Clercq
(1983). De Geest (1994a) was the first PhD on new law and economics. In
the PhDs of Byttebier (1993), Peeters (1989) and Strowel (1987) some
chapters were devoted to law and economics literature.
There is one book series on law and economics at Maklu publishers, first
edited by Heremans and Van den Bergh, and since 1997 by Heremans and
Bouckaert. In this series, books were published on federalism (Vanderveeren
et al., 1987), tort law and compulsory insurance (Faure and Van den Bergh
1989), contract law (De Geest, 1994a), and competition law (Van Cayseele,
1994).
There is no specialized Belgian journal on law and economics. Law and
economics papers have been published in traditional law reviews (for
example Faure and Van den Bergh, 1987; Van den Bergh, 1992; Bouckaert,
1993), traditional economics reviews (for example Van den Bergh, 1980), in
journals devoted to legal theory and legal philosophy (Bouckaert, 1986; Van
den Bergh, 1988; De Geest, 1990a), and a sociology of law journal
(Bouckaert, 1994; De Geest, 1994b; Raes, 1994; Strowel, 1994). A special
issue of the Vlaamse Jurist Vandaag (the journal of the Flemish lawyers
association) was devoted to law and economics (1987).
Research has focused on tort law and insurance (for example Faure and
Van den Bergh, 1989), property law (for example Bouckaert, 1990b; De
Geest, 1994b), contract law (De Geest, 1994a), consumer protection (for
example Van den Bergh, 1980), and competition law (for example Van
Cayseele, 1994; Van den Bergh, 1993). Quite some energy has gone into
methodological discussions (for example Bouckaert, 1984b; Kruithof 1986,
1987; Van den Bergh and Heremans, 1987a, 1987b; Strowel, 1987; De
Geest, 1994a; Raes, 1994).
4. Conferences and Workshops
Workshops on law and economics have been held in Antwerp (1986, 1987,
organized by Faure and Van den Bergh), in Ghent (1989, 1994, 1996, 1998
organized by Bouckaert and De Geest), Leuven (1991, organized by
Heremans and Van Cayseele). While the first three were meant to introduce
law and economics to Belgian lawyers, the later workshops were set up for a
more specialized and international audience.
0310 Law and Economics in Belgium 131
The annual conference of the European Association of Law and
Economics took place in Antwerp in 1988 (organized by Faure and Van den
Bergh) and in Leuven in 1994 (organized by Cousy and Heremans). In 1995
a conference on law and economics versus sociology of law was held in
Ghent (Bouckaert and De Geest). The annual conference of Belgian
economists in 1986 at Brussels was devoted to the economics of regulation.
Acknowledgements
The author would like to thank Roger Van den Bergh for having organized
the anonymous refereeing procedure.
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134 Law and Economics in Belgium 0310
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0315
LAW AND ECONOMICS IN DENMARK
Henrik Lando
Associate Professor of Law and Economics at Copenhagen Business School
Copyright 1999 Henrik Lando
Abstract
Law and economics is a small but growing area of research and teaching in
Denmark.
Economic reasoning applied especially to tort law has a long precedent in
Denmark, but often meets with opposition. At the universities, only little
research in law and economics is done within the law faculties and there is no
chair in law and economics. At the business schools the interest among legal
scholars seems greater, as is manifested by the establishment of a law and
economics programme at some of the major business schools. Economists show
an increasing interest in law, and this is largely due to developments within the
theory of industrial organization, mechanism design/contract theory, and
institutional economics.
JEL classification: K00
Keywords: Law and Economics, Research, Teaching
1. Ussings Early Contribution
Around 1900, there was a wave of interest in law and economics reasoning
among Scandinavian tort scholars. The inspiration was a book by
lawyer-economist Victor Mataja (a student of Menger) who advocated strict
liability on the basis of the principle of internalization. The wave may be said
to have culminated in the doctoral dissertation of the Danish jurist Henry
Ussing in 1914. He analyzed the question of strict liability vs. negligence in tort
law against the background of neoclassical economic principles. Ussing
advocated strict liability for extraordinary acts which involve unusual danger.
Much of his reasoning was couched in todays modern terms of prevention,
risk-allocation and administration costs. His arguments are modern. For
example, with respect to prevention he mentioned as an argument for strict
liability the problem of non-observability (though he does not use this term),
that is the difficulty for the judge of knowing the particulars of a case, which
means that not all truly sensible precautions will be made under the
negligence rule. He also mentioned that strict liability may induce more
innovation in safety. Ussings main argument for restricting the scope of
139
140 Law and Economics in Denmark 0315
limited liability to extraordinary acts concerned the administrative costs of
insurance, including not only the expense of enforcing claims but also of
administration expenses in the widest sense. In conclusion, Ussings analysis
is an early example of the application of economic principles to tort law.
However, Ussings (and Matajas) analysis was met with scepticism by most
Danish jurists. Even today, most leading Danish tort scholars seem sceptical of
the law and economics approach. For example, in the leading textbook on tort
law (Von Eyben et al., 1995, p. 35) one reads: this theory - like all other
prevention theories - in the end rest on a speculative foundation.
2. More Recent Contributions
Since Ussings doctoral dissertation in 1914, three doctoral law theses (to be
distinguished from PhD dissertations, the doctorate thesis is usually larger than
a PhD) and one PhD thesis have combined law and economics.
Bo Von Eyben, in Kompensation for personskade (Compensation for
Personal Injury) (1983) discussed the economic approach to tort law at some
length, including references to the works of Ussing, Calabresi and Posner. As
in the textbook mentioned above, the author was sceptical of the value of the
economic approach.
Jens Fejs dissertation (1985) in English translation (1990) was entitled
Monopoly Law and the Market - studies of EC competition law with US
American Antitrust Law as a frame of reference and supported by basic market
economics. He compared American competition policy with that of the
European Common Market (in particular with respect to the use of per se
prohibitions versus the rule of reason) and made extensive reference to
economic theory in his attempt to derive prescriptions.
Jan Schans Christensens doctoral dissertation from 1991, Contested
Take-overs in Danish Law - A Comparative Analysis based on a Law and
Economic Approach discussed the need for legal reform in Denmark to
facilitate contested take-overs.
Thomas Riiss PhD thesis Ophavsret og Retskonomi (Intellectual
Property and Law and Economics) (1996) deals, within an economic model,
with the optimal law of copyrights. His thesis is the first to be written by a
cand.merc.jur which combines law and economics.
The history of Danish economists contributions to law and economics is
difficult to write. Naturally, many economists have been active in designing
laws and regulations, as members for example of expert committees. However,
we will refrain from delving into how economic thought on law has developed
in practice, so to speak. Basic economic research in law seems a recent
phenomenon in Denmark.
0315 Law and Economics in Denmark 141
3. Present Research
As in other countries, both law scholars and economists show an increased
interest in law and economics. Law scholars are doing work on the law and
economics of intellectual property, contract law, company law and competition
law. Among economists, work is done in competition law, property rights, tort
law, tax law, environmental law and company law. However, the total number
of researchers in these fields amounts to a handful of law scholars and perhaps
a few more economists. There is at present no research in such areas as the
economics of litigation, criminal law, or family law. Law faculties of
universities have no chair in law and economics and it is not part of their
research agenda.
Two positive developments are worth mentioning. First, an increasing
number of economists work on subjects which have a clear connection to law.
Industrial organization, the theory of contracts and the theory of mechanism
design (institutional design) have, as in other countries, become new major
fields of study. This has already spilled over into law and economics research.
A few economists with a background in industrial organization and contract
theory are at present applying formal economic modelling to competition law,
tort law and environmental law. This is a new development. Second, it is
widely recognized that more research needs to be done in this area. At present,
there are good incentives for going into this area of research both, it seems, in
terms of future faculty positions and in terms of the funding available from
different sources.
On the negative side, development of the field seems hampered by
misconceptions and misunderstandings between jurists and economists.
Communication difficulties certainly exist between the two paradigms, as in
other countries.
4. Courses in Law and Economics
The teaching of law and economics has mainly expanded at the Business
School of Copenhagen, the Business School of Aarhus and at lborg
University. In the middle of the 1980s, the three institutions began a law and
economics programme, consisting of a 3-year undergraduate study and 2
years of graduate studies. This is perhaps the main positive development within
law and economics and it is hence worth giving some details about the study.
At the Copenhagen Business School, 588 students are at present enrolled
as law and economics students (373 undergraduate and 215 graduate students),
in rhus the number is 251 (177 undergraduate and 74 graduate students), and
in lborg University the number is approximately 250. At the Copenhagen
Business School the total number of students who have finished their graduate
142 Law and Economics in Denmark 0315
studies from the beginning to the present is 163, in rhus it is 124 and in
lborg it is approximately 160.
Some of the graduate courses are taught jointly by a law scholar and an
economist, for example Tort and Insurance Law and Competition Law, at the
Copenhagen Business School. The programme enjoys a good reputation and
candidates have in general had no problems finding jobs in the private or public
sector. However, it is fair to say that the students are given more training in law
and legal method than in economics. In particular, economic modelling is
given very little attention.
Outside the business schools little is happening in terms of incorporating
law and economics into education, though there are signs of an increasing
interest. At the law faculty of Copenhagen University, a course in law and
economics was established last year, but so far with only a low attendance. In
Aarhus (the second largest city), a similar course was begun some years ago but
it has been abandoned since.
Students of economics are rarely taught law, with the exception of a course
in business law at the undergraduate level at the business schools. Economic
students may, however, obtain credit during their graduate studies for following
courses at the law faculty. In general, however, economists knowledge of law
is very limited at the time they finish their education. Formerly, law was a
first-year mandatory course, but this is no longer so.
Law students are generally taught a first-year course of elementary
economics (although it looks like this course may be cancelled soon at Aarhus
University).
5. The PhDs
It is worth paying attention to the number of PhD students which the subject
attracts, since this number (and the quality of the students in combination with
the quality of the PhD education) is likely to be important for the future of law
and economics in Denmark, even though it must be remembered that some of
the best students study abroad. One can hope, and it seems likely, that the latter
will be of importance in importing law and economics into Denmark.
The number of PhDs working in the field of law and economics is
expanding. As a result of the establishment of the law and economics line of
education mentioned above, this is particularly the case in the business schools.
A handful of graduates with a law and economics degree are presently writing
PhDs, most of them at business schools. Only a couple of these PhDs, however,
combine law and economics in their research, while the rest have mainly
specialized in law. At the law faculties of universities, there is at present only
one PhD student in the field of law and economics (at Copenhagen University,
in contract law).
0315 Law and Economics in Denmark 143
6. Conclusion
Law and economics, that is, the application of economic theory to the field of
law, is a growing area of research and teaching in Denmark. However, the area
is at present small, even in relation to the size of the country.
The following features stand out: economic reasoning applied to law has a
long history in Denmark, but has often met with opposition. At the universities,
only little research in law and economics is done within the law faculties. At
the business schools, the interest among legal scholars seems greater, as is
manifested by the establishment of a law and economics programme at some
of the major business schools.
Bibliography on Law and Economics in Denmark (0315)
Albk, Svend, Molgaard, H. Peter and Baltzer Overgaard, Per (1995), Dansk Konkurrenceret og
Vertikal Kontrol (Danish Competition Law and Vertical Control), 133 Nationaltokonomisk
Tidsskrift, 268-283.
Andersen, Peder, Jensen, Vibeke and Birk Mortensen, Jrgen (eds) (1993), Governance by Legal and
Economic Measures, Copenhagen, Gad.
Blegvad, Britt-Mari and Collin, Finn (eds) (1987), Virksomheden mellem konomi og jura (The Firm
between Law and Economics), in Samfundslitteratur 1987.
Christensen, J.S. (1991), Contested Take-overs in Danish Law - A Comparative Analysis based on a
Law and Economic Approach doctoral dissertation discussing the need for legal reform in
Denmark to facilitate contested take-overs, Gad, Kbenham.
Collin, Finn (1987), Integration af Juridiske og konomiske Beslutningsmodeller (Integration of Legal
and Economic Decision models), in Blegvad, Britt-Mari and Collin, Finn (eds), Virksomheden
mellem konomi og jura.
Daintith, Terence C. (1987), Oprettelse og anvendelse af langfristede kontrakter (The Creation and
Use of Longterm Contracts), in Blegvad, Britt-Mari and Collin, Finn (eds), Virksomheden mellem
konomi og jura.
Davis, Jerome, Breinholt Larsen, Finn and Pagh Nielsen, Karen Marie (1984), Offentlig Styring af
Olie-gas Aktiviteter i Grnland (Public Regulation of Oil and Gas Activities in Greenland),
Aarhus University Press.
Davis, Lee N. (1989), Skydd for Innovationer (Protecting Innovations), in Bjurggren, Per-Olof and
Skogh, Gran, Foretaget - et Kontraksekonomisk Analys, Stockholm, SNS forlag, 151-158.
Davis, Lee N. (1991), Patenter og innovationer: Mod et Strategisk Perspektiv. (Patents and
Innovations: Aiming for a Strategic Perspective).
Fej, Jens (1985), Monopol-ret og Marked (Monopoly Law and Market), Kbenhavn, HHK.
Jeppesen, Tim (1995), Miljpolitiske Muligheder i EF (Framing Environmental Policy in the EC),
Nordisk Administrativt Tidsskrift.
Krenchel, Jens Valdemar (1996), Okonomisk ret - om den Retskonomiske Analyse (Analysis of Law
and Economics), 4 Justitia.
144 Law and Economics in Denmark 0315
Lando, Henrik (1996), Hvornr br Objektivt ansvar Glde? Det Retskonomiske bud p et st af
Kriterier for Objketivt Ansvar (When Should Strict Liability Apply? The Law and Economics
Answer), Under Review with Tidsskrift for Retsvidenskab.
Lando, Henrik (1996), Tre Essays om Principper i Rrstatningsretten: Objektivt Ansvar, Culpa-ansvar
og det Offentliges Erstatningsansvar (Three Essays on Tort Law: Strict Liability, Negligence and
Liability of the Public Sector), Working Paper, Institute of Finance.
Larsen, Anders and Olsen, Ole Jess (1995), Konkurrence i Energisektoren og Statslig Regulering
(Competition in the Energy Sector and State Regulation), AKF rapport.
Molgaard, H. Peter, Baltzer Overgaard, Per and Ohlenschlger Madsen, Ole (1996), Den Danske
Konkurrencelov i Moderne Industrikonomisk Belysning (The Danish Law of Competition
analysed in the Perspective of Modern Industrial Economics), Aarhus University Press.
Moller, Michael (1996), Inskydergarantifonden og Redning af Konkurstruede Pengeinstitutter
(Devising a System to Rescue Failing Banks), 5 Finans/Invest.
Moller, Michael and Nielsen, Niels Chr. (1993), En konomisk Analyse af Kbenhavns Kommunes
Hjemfaldspolitik (An Economic Analysis of Repurchase Declarations of the Copenhagen
Community), 2 Nationalokonomisk Tidsskrift.
Moller, Michael and Nielsen, Niels Chr. (1994), Okonomers og Juristers Syn p arv (Economists and
Lawyers View of Inheritance), in Lynge Andersen, Lennart and Mogelvang-Hansen, Peter (eds),
G.E.C. Gad.
Mortensen, Jorgen Birk and Olsen, Ole Jess (1991), Privatisering og Deregulering (Privatisation and
Deregulation), Jurist- og konomforbundets Forlag, 1993.
Nielsen, Niels Chr. (1987), Okonomi, jura og Markedsmekanismer (Law, Economics and the Market
Mechanism), in Blegvad, Britt-Mari and Collin, Finn (eds), Virksomheden mellem konomi og
jura.
Nielsen, Niels Chr. (1993), Minoritetsaktionrbeskyttelse - eller et Velfungerende Marked for
Virksomhedskontrol (Minority Protection or a Well-functioning Market for Corporate Control),
Revision og Regnskabsvsen.
Nielsen, Niels Chr. and Ebbesen, Jan (1993), Stemmelofter - En konomisk Analyse af den Retlige
Analyse (Restrictions on Voting Rights, an Economic Analysis of the Legal Analysis), 6 Juristen,
251-264.
Olsen, Ole Jess (1993), Regulering af Offentlige Forsyningsvirksomheder i Danmark (The Regulation
of Public Utilities in Denmark), Jurist- og konomforbundets Forlag.
Raaschou-Nielsen, Agnete (1988), (Institutional Change and Economic Theory), Kbenhavn, PhD
thesis, Det Statsvidenskablige Fagrd.
Riis, Thomas (1994), Ophavsret og Kulturkonomi i EF (Copyright and the Economics of Culture in
EC), NIR.
Riis, Thomas (1996), Ophavsret og Retskonomi (Intellectual Property and Law and Economics),
PhD thesis.
Riis, Thomas (1996), Copyright and Law and Economics, Gadjura, PhD thesis.
Schledermann, Helmut (1987), Retskonomi for Jurister (Law and Economics for Jurists), Aarhus
University Press.
Svendsen, Gert Tinggaard (1993), Fordele ved et Marked for CO2 -kvoter (Advantages in CO2
Emissions Trading), 7 Samfundskonomen, 5-9.
Svendsen, Gert Tinggaard (1994), Globalt CO2 -marked, 1 Fremtidsorientering, 35-36.
0315 Law and Economics in Denmark 145
Svendsen, Gert Tinggaard (1994), Kvoter og Syreregn (Quotas and Acid Rain), 3 Okonomi & Politik,
33-39.
Svendsen, Gert Tinggaard (1995), Den Stationre Bandit - og Lobbyisme (The Stationary Bandit and
Lobbyism), 3 Okonomi & Politik, 24-31.
Von Eyben et al. (1995), Laerebog i Erstatningsret (Textbook in Tort Law), Jurist s konomabindets
Forlag, p. 35.
Wegener, Morten (1996), Franchising i EU-Konkurrenceretten (Franchising in Perspective of the
EU-Law of Competiton), Forthcoming report winter.
0320
LAW AND ECONOMICS IN FINLAND
Risto Nuolimaa and Pekka Timonen
University of Tampere
Copyright 1999 Risto Nuolimaa and Pekka Timonen
Abstract
This chapter gives an overview of law and economics in Finland and seeks an
explanation for why law and economics arrived late in Finland and then spread
only slowly. In Finland as in the other Nordic countries, legal formalism was
superseded by Scandinavian realism and by the analytical legal research
influenced by this realist school as long ago as the 1940s and 1950s.
In addition, scholars who in a country as small as Finland are few in
number, have had to devote all their efforts to Finnish issues and changes in the
Finnish legal system. European economic integration, however, has been the
main reason for the awakening of interest in law and economics in Finland.
JEL classification: K00
Keywords: Law and Economics, Finland, Legal Realism
1. Background
Until the middle of the 1990s legal research in the field of law and economics
was sporadic in Finland. In economics the situation has been better, though it
has been a field in which only a few scholars have been interested. Since 1994,
however, the gradually increasing volume of research has been produced
mainly by legal scholars and it is this body of work on which this essay will
concentrate. It is based largely on the study by Timonen (1998).
There are several interlinked reasons why law and economics arrived late
in Finland and then spread only slowly.
(1) Jurisprudence in Finland has traditionally been influenced by
developments in the other Nordic countries and in Germany. Thus awareness
of law and economics, yet alone active interest in it, did not spread very
quickly.
(2) Law and economics is intimately connected with the Anglo-American
common law system and so this way of thinking as well as its application seem
somewhat alien in a statute-based legal system. In the Finnish tradition the
written law and travaux prparatoires carry much greater weight than case law
and so research has focussed on the interpretation of current statutory law. This
being the case, it has been possible only to a very limited extent to evaluate the
146
0320 Law and Economics in Finland 147
central question in the common law system: what would be the best (most
efficient) way on a general level to form legal rules.
(3) In the USA law and economics is seen as part of a continuum covering
various trends critical of legal doctrinalism. This is a point emphasized in
particular by Mercuro and Medema (1997). In Finland, as in the other Nordic
countries, legal formalism was superseded by Scandinavian realism and by the
analytical legal research influenced by this realist school as long ago as the
1940s and 1950s (see Stray Ryssdal, 1995, pp. 29-57). A very considerable part
of the pressures for change that Posner (1987) has shown lay behind law and
economics, were dealt with then.
(4) Throughout the 1990s Finnish researchers have been wrestling with the
new legislation and the new questions arising from the EEA agreement and full
EU membership. At the same time the exceptionally severe depression in the
domestic Finnish market and the problems that it caused have given rise to a
debate about reforming or dismantling the Nordic welfare state and this debate
has inevitably raised important legal issues. In other words, scholars, who in
any case in a country as small as Finland are few in number, have had to devote
all their efforts to Finnish issues and changes in the Finnish legal system. They
simply have not had the time and energy to take up new ideas such as law and
economics until they had got a grip on the changes taking place in the Finnish
legal environment and understood their significance. European economic
integration, however, has forced Finnish scholars to seek out a new analytical
apparatus. As Timonen (1997) stresses, this has been the main reason for the
awakening of interest in law and economics in Finland.
2. Law and Economics research in Finland
The law and economics approach was first presented in Finland in an article
published in 1980 (see Oker-Blom, 1980). It did not, however, arouse much
interest and the whole theme was forgotten in Finland for nearly a decade and
a half, although Timo Rapakko did publish the doctoral thesis he had done in
the USA (Stanford) in Finland (Rapakko, 1987). It might be helpful to point
out here that in Finland doctoral theses have been relatively rare and highly
appreciated. In many subjects they have been written not by young academics
embarking on a career, but by mature scholars in mid-career. Almost without
exception doctoral theses are published. Considerable efforts are now being
made to increase the number of PhDs and to reduce the number of years spent
on doctoral research.
Law and economics research can be said to have got under way in Finland
in 1994. The first economics-based doctoral theses in the field were published
in 1994 and 1995 (see Hgholm, 1994 and Sundgren, 1995). The first law-
148 Law and Economics in Finland 0320
based doctoral theses were published in 1997 (see Timonen, 1997 and Mtt,
1997). So far interdisciplinary discussion and research cooperation has been
meagre.
Otherwise, presentations of the subject for Finnish readers and reports on
research in progress can be found in scholarly articles. In 1995 and 1996
several works were published that presented the approach, see especially
Kanniainen, Mtt and Heimonen (1995). Mostly they describe the
mainstream of law and economics research and explain the basic economic
terminology. The first Finnish textbook on law and economics, Kanniainen and
Mtt (1996) is also a collection of articles, in which each writer treats the
subject from his or her own perspective, the team of writers including experts
in economics as well as law.
From a comparative perspective it is interesting that work on the law and
economics approach in legal studies has begun by using two modes of analysis
that lie outside the mainstream. In Timonen (1997) the questions posed belong
to the branches of law dealing with market behaviour (company, securities and
competition law). The writer questions the suitability of Chicago law and
economics thinking, rooted as it is in neoclassical economics, as a point of
departure for the study of statute-based law and proposes in its place an
approach based on neo-institutional economics. Making use of this, the work
gives a general evaluation of the relationship between markets and regulation
and of the significance of the efficiency argument in legal analysis. Mtt
(1997) applies regulation theory to evaluate environmental taxes and their
efficiency and to examine the development of environmental politics. Of the
trends current within law and economics he has relied most on public choice
thinking.
The first studies that clearly emphasize efficiency arguments and thus best
represent the law and economics approach have yet to see the light of day in
Finland and it is not yet possible to present any overall evaluation. The
approach is, however, spreading rapidly and it can be expected that it will
establish its place as a rightful recognised part of law studies in Finland before
the end of the century.
Bibliography on Law and Economics in Finland (0320)
Hgholm, Kenneth (1994), Essays in the Market for Corporate Control, Helsinki, Swedish School of
Economics and Business Administration.
Kanniainen, Vesa and Mtt, Kalle (eds) (1996), Nkkulmia oikeustaloustieteeseen (Perspectives
on Law and Economics), Helsinki, Gaudeamus.
Kanniainen, Vesa, Mtt, Kalle and Heimonen, Matti (1995), Oikeustaloustiede - law and economics
(Law and Economics), Oikeus, 107-124.
Mtt, Kalle (1997), Environmental Taxes. From an Economic Idea to a Legal Institution, Helsinki,
Finnish Lawyers Publishing.
0320 Law and Economics in Finland 149
Oker-Blom, Max (1980), Jurionomi eller rtten i ekonomiskt perspektiv (Law and Economics or Law
from the Economic Percpective), Tidskrift utgiven av Juridiska Freningen i Finland, 245-265.
Rapakko, Timo (1987), Corporate Control and Parent Firms Liability for their Controlled
Subsidiaries: A Study on the Regulation of Corporate Conduct, Helsinki, Helsinki School of
Economics.
Sundgren, Stefan (1995), Bankruptcy Costs and Bankruptcy Code, Helsinki, Swedish School of
Economics and Business Administration.
Timonen, Pekka (1997), Mrysvalta, hinta ja markkinavoima - Julkisesti noteeratun yrityksen
mrysvallan siirtymisen oikeudellinen sntely (Control, Price and Market Power - The
judicial regulation of transfers of control in quoted companies), Helsinki, Finnish Lawyers
Publishing.
Timonen, Pekka (1998), Oikeustaloustiede - mit se on? (Law and Economics - What is it About?),
Lakimies, 100-114.
Other References
Mercuro, Nicholas and Medema, Steven G. (1997), Economics and the Law. From Posner to
Post-Modernism, Princeton, Princeton University Press.
Posner, Richard (1987), The Decline of Law as an Autonomous Discipline: 1962-1987, 100 Harvard
Law Review, 761-780.
Stray Ryssdal, A.C. (1995), Legal Realism and Economics as Behaviour. A Scandinavian Look at
Economic Analysis of Law, Oslo, Juridisk Forlag.
0325
LAW AND ECONOMICS IN FRANCE
Lionel Montagn
Assistant in Civil Law
Universit de Montpellier - Faculty of Law
Copyright 1999 Lionel Montagn
Abstract
Even if economic reasoning applied to law is sometimes used by economists,
the majority of jurists in France have some difficulties in accepting this tool as
a complement to legal thought. So, there is no chair in law and economics in
our French University of law, even though an effort seems to be made by the
University of law in Montpellier, which includes some lectures in law and
economics in its training for postgraduates students in law. But, in spite of that,
prejudices and a lack of knowledge of law and economics, among jurists have
slowed down the process of development of this matter.
JEL classification: A12, K00
Keywords: France, Research, Education.
1. Introduction
Even if the economic analysis of law has been developed well in most common
law countries, as well in countries such as Germany or Sweden on the
European continent, it must be noted that in France this tool is still
underestimated by lawyers. Initially put forward by economists (A) the
economic approach to law did not have the hoped-for success. As the matter of
fact, we just have to look at the number of works published in this field, to see
that the challenge has been ignored by the legal community (B).
A. Economic Analysis of Law: A Challenge for the French Jurist
The economic analysis of law aims at a better understanding of the logic of
legal rules and judicial decisions. It is supposed to enlighten the jurist,
whatever his or her discipline, as to the construction and the finality of the law.
However, in France this tool was developed by economists and not by jurists
(section 2), and the legal community did not examine the assets of such an
instrument until some time later. In studying questions traditionally dealt with
by lawyers, economists raised a real challenge that has been taken up only in
150
0325 Law and Economics in France 151
the last few years by certain authors from Montpellier and Aix-en-Provence
(section 3). Despite those efforts, the majority of the legal profession today
seems to remain insensible to this tool.
2. The Economist and the Law
Economics is defined by Lionel Robbins as the science which studies human
behavior in terms of the relationships between ends and means. Therefore, it
is evident that the rules of law, in so far as they organize the means in a world
of scarcity and uncertainty, will sooner or later also become the object of study
by economists in France. As elsewhere, this is precisely what happened, and in
that process important notions, such as the notion of transaction costs, were
established that shed light on legal doctrines. Different fields, until now the
private domain of jurists, have come under the scrutiny of the economic
community. Hence the development of an economic approach to property rights
(Lepage, 1984), contract law or matrimonial law (Lemennicier, 1991).
Nonetheless, this was not enough to stimulate the curiosity of the French legal
community, at least not until 1986 when a symposium was organized on the
economic analysis of law at Aix-en-Provence. For the first time, a degree of
enthusiasm for applying economic reasoning to law became apparent.
Indeed, Professor Savatier in his lesson on the theory of liabilities in
economic private law (Savatier, 1974) had already underlined the utility and
the efficiency of economic tools in the development of legal reasoning.
Professor Mouly, too, was convinced, especially after the 1986 conference, that
a reflection on the mutual contributions of economy and law was both necessary
and beneficial (Mouly, 1987, p. 413). But, in spite of this, and contrary to what
was happening in other European countries, law and economics was still not
taken up in France. If economists show a continued interest in this subject, very
few legal authors refer directly to this instrument, even if incontestably they
sometimes use a Posnerian approach to law in their writings (see Mousseron,
1987). Among the few exceptions, mention should be made of authors such as
Mouly (1995, p. 377), Atias (1987, p. 477) or Chrot (1987a, p. 443), who
occasionally use this tool. But, to this day, no work has been written by a jurist
in this domain. The only existing work remains that of Lemennicier (1991),
Professor of Economics.
3. The Jurist and the Economy
In the early 1990s one began to see an implicit recognition by various legal
authors of the utility of the economic analysis of the law as a complement to
legal thought, on the same level as sociology or morality. Hence, in the last
edition of his civil law treaty, Ghestin (1994, pp. 84-85) dedicated some pages
152 Law and Economics in France 0325
to law and economics in order to better situate the position of civil law among
the legal disciplines. Fabre-magnan, in her thesis (1990, pp. 50-117) on the
obligation of information in contracts, suggests an economic analysis of this
obligation after having explained the basics of the economic analysis of law.
Also , Cabrillac (1995, p. 23) in his general introduction of law, summarizes
in a few lines the three functions (normative, predictive, critical) of an
economic analysis of law. Finally, on the initiative of economists in
Aix-en-Provence, Le Journal des Economistes et des Etudes humaines was
founded, including, and this is noteworthy, some professors of law in its
scientific committee.
In 1994 an important event occurred that led us to believe that the challenge
set to the legal community more than thirty years ago had finally been accepted.
Indeed, while the economic analysis of law was not taught in any of the French
universities of law (except, perhaps, the DEA Analyse conomique des
institutions which, however, depends on the University of Economics and is
intended for students in economics), Professor C. Mouly started to introduce his
postgraduate students to the utilization of economic tools in legal reasoning,
and at the same time took part in the third-term university Erasmus (now called
Socrates) Program in law and economics. The department of economic theory
of law at the university of law in Montpellier, of which he was the creator and
the director, became the privileged meeting place for economists and jurists
whose common research on the economic approach to contract law and
property rights, augured a much awaited success. Unfortunately, two years
later, Professor Moulys tragic and premature demise was to slow down the
process of development of law and economics in the French legal culture.
B. The Economic Analysis of Law: a Challenge Ignored by the French
Jurist
The study of legal questions often requires the use of different elements taken
from sociology, history or logical analysis. The jurist uses these for the same
reason that he/she refers to legal linguistics or philosophy of law. But curiously
enough, the utilization of the economic approach to law is neglected. Some
authors assign this marginalization to the absence of publications in French
(see Mackaay 1987a), but this imbalance, we believe, is also, and firstly, due
to a bias jurists have against economics (section 4) and the specific choice of
economic instruments made by the advocate of an economic analysis of law
(section 5).
4. The Subjective Obstacles to the Development of an Economic Analysis
of Law
The intuitive perception of what is economics, acquired through the multitude
of economic acts that they accomplish every day, leads most jurists to believe
that they have enough knowledge of economics to fulfill their task. For others,
0325 Law and Economics in France 153
the economic analysis of law is too narrow in its approach, and so must be
excluded from legal discussions.
Such attitudes are easily explained. A first reason is the separation of the
legal and economic disciplines in our academic system; jurists have little
knowledge of economic analytical tools. Today, a law student does not receive
the basic economic training that he had in the past. Also, the internal division
within the legal discipline increases the effect of a separation between law and
economics. Thus, the only jurists who use economics are those who follow a
training in patrimonial law or in antitrust law.
Secondly, the jurist dislikes in modern economics what he perceives as a
utilitarian approach. Convinced that economists are motivated only by the study
of efficiency, he quickly turns away from their works. This belief is also
reinforced by the use of mathematical or rationalistic language in economics,
and tools that from the point of view of most jurists are incompatible with
social studies. Not having completely mastered the tools of law and economics,
legal authors therefore prefer to ignore this challenge.
Finally, due to insufficient knowledge of the field and his a priori judgment,
the jurist was not in a position to appreciate the latest evolutions in economics.
Hence, he was unable to notice the new conceptions, such as the Austrian
School, according to which, for example, the criteria of efficiency used in law
and economics must not be static but should be dynamic (Centi, 1987). So,
according to this new view, one cannot appreciate the quality of legal rules only
through its capacity to organize the efficient management of the scarcity. One
must also verify whether our legal system adjusts itself appropriately to change
in our environment. Through its recent development the economic analysis of
law could thus oblige the jurist to question the foundations of institutions,
instead of dogmatically affirming solutions directly translated from Latin
adages which are sometimes obsolete.
5. The Objective Obstacles to the Development of an Economic Analysis of
Law
The idea of a commercial activity whose object would be the persons
themselves provokes a strong hostility from classical jurists. There are border
lines which should not be crossed, and a law regarding persons cannot be
analysed in the same way as law to be applied to ordinary assets. However, even
if, for example, the prohibition to sell civil clienteles and ministerial offices is
constantly affirmed, the jurisprudence did not hesitate to allow their indirect
commercialization. Does not the patronymic name, which in France is
imprescriptible and not transferable (inalienable), become itself the object of
transactions which sanction this commercialization ? In view of this fact some
economists proposed to submit the law of persons and the law of assets to the
economic approach, without discrimination, with the risk of violating this
summa divisio to which every French jurist is so attached. The American origin
154 Law and Economics in France 0325
of the movement, as well as its slight respect for legal assumptions was,
therefore, the object of diatribes from the legal community. The economic
approach was blamed for being an imperialistic tool like sociology under the
influence of Durkheim. But if we look at todays economic analysis of law, this
argument is no longer true; Posner himself has moderated his positions (see
Posner 1992, p. 25) and other movements have been born admitting that the
economic analysis of the law is just a means among others to appreciate the
quality of certain legal rules.
However, the neoclassic foundations on which the movement is founded
further add to the reasons to ignore the economic analysis of the law. The
rationality of the economic agent who is perfectly aware of prices, and operates
calculated choices in order to maximize his pleasure at the least cost, is a
disconcerting model for one who searches solutions in equity and not in utility.
Homo economicus would not be the model of jurists who think the law and
economics to be incompatible, and presume the collaboration between jurists
and economists to be impossible through lack of a common language.
As Mackaay 1987a has written, the language represents a further obstacle
to this collaboration. Indeed, depending on the disciplines, words have different
meanings. The exchange, for example, represents for economists the general
act by which a person gives up a good against another good, whereas for the
jurist it defines a very particular contract. Inversely, some equivalent notions
are expressed using different words: depending on whether the contract allows
one to get rid of uncertainties or not, the economist will use the terms
complete or incomplete contract where the jurist will use the terms perfect
or imperfect contract. Finally, the legal vocabulary finds its origins in Roman
law whereas the economist uses a more recent terminology adapted to a present
and evolutionary world.
C. Conclusion
The lack of communication and the existence of prejudices are regrettable
stumbling blocks to the development of law and economics in France. In spite
of the efforts of economists to propose a fruitful collaboration in the
development of the field, only some jurists have responded. Others still prefer
to ignore this tool and the situation will remain thus so long as the French Law
Universities do not make an effort to demonstrate an interest in the use of this
tool of analysis, a natural complement to the conventional training of a lawyer.
Acknowledgements
Special thanks to Prof. Pierre Garello for his help and patience.
0325 Law and Economics in France 155
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0330
LAW AND ECONOMICS IN GERMANY
Roland Kirstein
Center for the Study of Law and Economics
University of Saarland
Copyright 1999 Roland Kirstein
Abstract
Law and economics in Germany was dominated by regulation, competition, and
German Ordnungspolitik until the early 1970s. Since then, German scholars
have published a broad body of work in German and in the English language,
covering fields like contract law, environmental law, labor law, public law,
bankruptcy law, constitutional economics and legal procedure. Also in the
1970s, teaching activities were started at German universities. In addition to
this, several (bi)annual conferences on law and economics were launched. The
foundation of some research centers gave a further impetus to the German law
and economics movement.
JEL classification: K00, A20
Keywords: German Literature, Teaching Activities, Conferences, Research
Institutes on Law and economics
1. Introduction
Until 25 years ago, research in the field of law and economics in Germany
mainly focussed on competition and regulation. Discussions on the relation
between jurisprudence and economics took place only occasionally, see for
example Sttzel (1966) and Jahr (1966). Since the late 1970s however, the first
German books on other law and economics topics were published, such as Kunz
(1976a) on the economics of individual and collective crime, Behrens (1986)
on Political Economics, and Adams (1981) on procedural law. A collection of
seminal law and economics papers, translated into German, was published by
Assman, Kirchner and Schanze (1978).
Since then, publications by German scholars have covered all fields of law
and economics. Teaching programs were installed and new research
institutions were founded. A lot of these publications were published in
English, although the bibliography attached to this chapter is limited to
contributions in German. Of course, the discussion as well as the bibliography
can only give a brief overview, which does not claim to be complete.
160
0330 Law and Economics in Germany 161
2. German Ordnungspolitik
German research on competition policy traditionally focussed on
Ordnungspolitik, a term that can roughly be translated as Institutional
Policy or as Constitutional Political Economics. The term refers to the legal
and organizational means governments can use to influence the institutional
framework of the economy. Within this framework, the economic actors are
free to pursue their own goals. W. Eucken, E. Hoppmann, C. Watrin and H.
Willgerodt are among the early contributors to this traditional approach. Since
1949, the ORDO. Jahrbuch fuer die Ordnung von Wirtschaft und Gesellschaft
annually publishes papers on ordnungspolitik.
Not only economists but also lawyers contributed to this field of research,
see for example Boehm (1980), Mestmaecker (1978) and Mschel (1988), who
wrote many papers on German and European competition law with a clear
economic focus. Law scholars as well as economists serve in several federal
commissions, which turned out to be an important interface for the
interdisciplinary transmission of research results. Ingo Schmidt developed an
early expertise in the comparison of US and German competition law, see for
example Schmidt (1973a).
The 10th volume of the Jahrbuch fuer Neue Politische Oekonomie provides
an overview of newer ideas on ordnungspolitik, see Boettcher, et al. (1991).
In 1979, the first Symposion on New Political Economics als Ordnungstheorie
took place. These papers were published in 1980.
3. New Law and Economics in Germany
3.. Basic Concepts
German law scholars sometimes criticize the law and economics movement for
focussing on efficiency, and argue against its usage as a legal principle for the
judicature, such as Fezer (1986). Ott and Schfer (1988) and Weise (1991)
dicussed Fezers article. Eidenmueller (1995a) has written a comprehensive
book on this important debate, with a detailed review by Schmidtchen (1997).
Kunz (1985a) was one of the first books in German on the evolution of norms
and orders, followed by Hutter (1989). Witt (1988) und Kerber (1992) examine
the impact that institutions have on competition and innovation. The evolution
of judge-made law was analyzed by Wangenheim (1995).
3.2 Contract Law and Externalities
An important field for German law and economic scholars is environmental
economics, see for example Lehmann (1992b) on Environmental Liability Law.
Endres (1993) has analyzed instruments of Environmental Policy in a project
162 Law And Economics In Germany 0330
on International Environmental Contracts. He also does research into Tort and
Liability Law (see Endres, 1991b). A game theoretic approach to this subject
was chosen by Jost (1997a).
Lawyers as well as economists broadly covered the field of workers
participation and labor law (see Nagel, 1988b or Eger (1995b) analyzed
long-term contracts. Workers participation as a mean to protect quasi-rents
from sunk investments was analyzed by Schmidtchen (1987a). Adomeit (1996)
covers labor regulation.
Weck-Hannemann (1996) wrote about female employment and family
taxation. Walwei (1993) provides an analysis of the regulation of private
employment agencies.
Druckarzcyk started to do research into insolvency law and reorganization
in 1980 (see for example Druckarczyk, 1987c). An early contribution to the
economic analysis of insolvency law was made by R. Schmidt, see also Schmidt
(1981b). On the regulation of finance and loans, see Herrmann (1994) or
Terberger (1987). Intellectual Property Rights are discussed by Koboldt and
Schmidtchen (1991) and Tietzel (1994). The economics of international trade
and the territoriality of law is the subject of Schmidt-Trenz (1990a), who tried
to explain the role of international trade firms from an institutional economics
viewpoint. Ktz (1986) analyzes international private law harmonization.
3.3 Public Law and Procedural Law
Besides the work on ordnungspolitik, German scholars also contributed to the
economic analysis of constitutions, see for example Vanberg (1982b). The
relevance of constitutional economics for economic policy is discussed by Voigt
(1996). Leschke (1993) relates economic theory of constitutions to the concept
of democracy. Schmidt-Trenz (1996) points out the two basic dilemmas
institutions have to solve simultaneously: the contribution and the delegation
problem. The Jahrbuch fuer Neue Politische Oekonomie vol. 15 collects articles
that were presented during a symposium on New Forms of Cooperation
Between State and Citizens (see Schenk, Schmidtchen and Streit, 1996).
An application of constitutional economics to drug policy was provided by
Erlei (1992) and Koboldt (1995c). Adams (1994) wrote on the costs and
benefits of drug liberalization, whereas Frank (1995) analyzed smoking bans.
Contributions to the economic analysis of the welfare and health care system
were provided by Schulenburg (1993) and Seidl (1988a). Schffski (1995)
writes about the regulation of German pharmacies.
Civil and criminal procedure seem to be less attractive as subjects of
economic research than substantive law. After some contributions by Adams
that were published in the early 1980s, only a few papers on this topic followed,
such as Schfer and Ktz (1992). Schfer (1995) points out the productive
function of jurisdiction for the creation of cooperation rents. Only recently, had
0330 Law and Economics in Germany 163
this field gained more attention (see for example Ott and Schfer (1996) on
plea bargaining, or Schmidtchen and Kirstein (1997), who analyze the
motivational impact of procedural rules on potential litigants.
4. Teaching Activities, Research Centers and Conferences
One of the oldest institutions in Germany working in the field of law and
economics is the Institut fuer Genossenschaftswesen in Mnster, which was
founded in 1947. Nowadays, it is concerned with analyzing different forms of
cooperation, such as franchise contracts, or Genossenschaften (buyer or seller
cooperatives), making use of the framework of New Institutional Economics,
see Bonus (1981b). Also in Mnster, Grossekettler edits the Schriften zur
wirtschaftswissenschaftlichen Analyse des Rechts.
Teaching activities in law and economics started in the early 1970s. Some
interdisciplinary courses have been organized, such as seminars on competition
and cartel law in Stuttgart or in Tbingen. The annual workshop in law and
economics in Maastricht (the Netherlands) was launched by the German
scholar Jrgen Backhaus in 1987. Since 1984, Backhaus has co-edited the
European Journal of Law and Economics.
In Hamburg, Ott and Schfer installed an Erasmus program for
postgraduate students from 18 European countries, and integrated law and
economics into the Law Faculty. Their textbook (Ott and Schfer, 1996) was
recently published in the 4th edition. Since 1988, Ott and Schfer have
organized a biannual conference on law and economics in Travemuende.
Together with R. van den Bergh, they founded an Institute of law and
economics at the University of Hamburg. The same university also hosts a
Center for Research in Law and Innovation, founded by W. Hoffmann-Riem.
Also in Hamburg, P. Behrens, M. Holler, C. Ott, H.-B. Schfer, and W. Walz
edit a law and economics publication series, called Schriftenreihe zur
oekonomischen Analyse des Rechts.
The first annual meeting on New Political Economics took place in 1981.
Nowadays it is organized by K.-E. Schenk, D. Schmidtchen and M. Streit. The
papers of this conference are published in the Jahrbuecher fuer Neue Politische
Oekonomie. D. Schmidtchen has founded the Forschungsstelle fuer die
oekonomische Analyse des Rechts (Center for the Study of Law and
Economics) at the University of Saarbruecken. The recently founded
Max-Planck Institute for Research into Economic Systems in Jena is mainly
concerned with transition economics. Its starting point in the attempt to explain
the change of economic systems is the idea that economic development mainly
depends on the institutional framework (see for example Streit, 1996). The
Walter-Eucken Institut in Freiburg publishes lectures and papers on economic
policy.
164 Law And Economics In Germany 0330
In 1994, B. Nagel, P. Weise and T. Eger founded an Institut fuer Recht und
Oekonomis (Institut for Law and Economics) at the University in Kassel. I.
Schmidt has founded a center for research into competition policy and cartel
law at the university of Stuttgart. In Trier, the Institut fuer Arbeitsrecht und
Arbeitsbeziehungen in der Europischen Gemeinschaft (Institute for Labor Law
and Labor Relations in the EU) uses institutional economics to perform
empirical comparisions of the labor law of different European countries (see
Sadowski and Kurth, 1991).
R. Richter is the founder of the Wallerfangen summer school (nowadays
organized by U. Schweizer), and started the annual Wallerfangen conference,
which in part covers law and economics subjects. The papers presented in this
conference are published in the Journal of Theoretical and Institutional
Economics (JITE), which is now edited by E. Schlicht.
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0330 Law and Economics in Germany 207
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282 ff.
208 Law And Economics In Germany 0330
Schmidt, Ingo (1981b), Wettbewerbspolitik in den USA (Competition Policy in the US), in Cox, Jens
and Markert (eds), Handbuch des Wettbewerbs, Mnchen, 533-556.
Schmidt, Ingo (1981c), Preiskontrolle in Deutschland (Price Control in Germany), 50 Annalen der
Gemeinwirtschaft, 491 ff.
Schmidt, Ingo (1981d), Obsoleszenz als Mibrauch wirtschaftlicher Macht (Obsolescence as an Abuse
of Economic Power), 21 Wirtschaft und Wettbewerb, 868 ff.
Schmidt, Ingo (1986), Ist Gre an sich gefhrlich (Is Bigness Dangerous Per Se?), 36 Wirtschaft und
Wettbewerb, 193 ff.
Schmidt, Ingo (1990a), Wettbewerbspolitik und Kartellrecht: Eine Einfhrung, (3rd edn)
(Competition Policy and Antitrust Law: An Introduction), Stuttgart, Gustav Fischer, 330 p.
Schmidt, Ingo (1990b), Die Europische Fusionskontroll-Verordnung (The European Merger Control
Law), 70 Zeitschrift fr Wirtschaftspolitik, 90 ff.
Schmidt, Ingo (1992a), EG-Integration, Industrie- versus Wettbewerbspolitik (European Integration,
Industrial Policy vs. Competition Policy), 72 Zeitschrift fr Wirtschaftspolitik, 628 ff.
Schmidt, Ingo (1992b), Die Wettbewerbsordnung (The Competition Restraint), in Adams, W.P. et
al. (eds), Lnderbericht USA I, Geographie, Geschichte, Politische Kultur, Politisches System,
Wirtschaft, Schriftenreihe vol. 293/I der Bundeszentrale fr politische Bildung, 2nd ed., Bonn,
606 ff.
Schmidt, Ingo (1995), Europische Industriepolitik - ein Widerspruch zur Wettbewerbsordnung?
(European Industrial Policy - Contradiction to the Competition Law System?), 45 Wirtschaft und
Wettbewerb, 971 ff.
Schmidt, Ingo (1996a), Pro und Contra Konzentrationsprivileg, Die unterschiedlichen Wirkungen von
Kartellen und Fusionen auf Wettbewerb und Effizienz (Pro and Contra Privileged Concentration,
The Different Impacts of Cartels and Mergers on Competition and Efficiency), in Kruse, Jrn and
Mayer, Otto G. (eds), Aktuelle Probleme der Wettbewerbs- und Wirtschaftspolitik, Erhard
Kantzenbach zum 65. Geburtstag, Baden-Baden, 119 ff.
Schmidt, Ingo (1996b), Wettbewerbspolitik versus Industriepolitik in der EG, Korreferat zu Erhard
Kantzenbach (Industrial Policy vs. Competition Policy, Comment), 44 Applied Economics
Quarterly, 59 ff.
Schmidt, Ingo and Binder, Steffen (1996), Wettbewerbspolitik im internationalen Vergleich, Die
Erfassung wettbewerbsbeschrnkender Strategien in Deutschland, England, Frankreich, den
USA und der EG (An International Comparision of Competition Policy), Heidelberg.
Schmidt, Ingo and Eler, Stefan (1990), Innovationsoptimale Unternehmensgren und
Marktstrukturen (Innovation Optimal Firm Sizes and Market Structures), 19 WiSt, 556 ff.
Schmidt, Ingo and Eler, Stefan (1992), Die Rolle des Markenartikels im marktwirtschaftlichen
System (The Role of Brands in the Market Economy), in Dichtl, Erwin and Eggers, Walter (eds),
Marke und Markenartikel als Instrumente des Wettbewerbs, Mnchen, 47 ff.
Schmidt, Ingo and Engelke, Heinz (1989), Marktzutrittsschranken und Potentieller Wettbewerb
(Market Entry Barriers and Potential Competition), 18 WiSt, 399 ff.
Schmidt, Ingo and Kirschner, Ulrich (1985), Darstellung und wettbewerbspolitische Wrdigung der
U.S. Vertical Restraints Guidelines (Critical Evaluation of the US Vertical Restraint Guidelines),
35 Wirtschaft und Wettbewerb, 781 ff.
0330 Law and Economics in Germany 209
Schmidt, Ingo and Kirschner, Ulrich (1987), Capture Theory, Ein Erklrungsansatz fr die mangelnde
Effizienz der Regulierung (Capture Theory as an Approach to Explain the Lack of Efficiency of
Regulation), 16 WiSt, 293 ff.
Schmidt, Ingo and Richard, Sabine (1989), Unternehmensgre, Ausdruck von Macht oder Effizienz?
(Size of Firms as an Indicator for Efficiency or Power?), gdi impuls, 26 ff.
Schmidt, Ingo and Richard, Sabine (1991), Zum Verhltnis von Dumpingrecht und Kartellrecht in der
EG (On the Relation of Anti-Dumping Law and Antitrust Law), 41 Wirtschaft und Wettbewerb,
665 ff.
Schmidt, Ingo and Ries, W. (1983), Der Hirschman-Herfindahl-Index (HHI) als
wettbewerbspolitisches Instrument in den US-Fusionsrichtlinien 1982 (The Hirschmann-Herfindah
Index as an Instrument of Competition Policy in the US Merger Guidelines), 33 Wirtschaft und
Wettbewerb, 525 ff.
Schmidt, Ingo and Rittaler, Jan B., Das wettbewerbstheoretische und -politische Credo der sog.
Chicago School (The Guidelines of the So-alled Chicago School on Competition Theory and
Competition Policy), Diskussionsbeitrge aus dem Institut fr VWL No. 23/85.
Schmidt, Ingo and Rittaler, Jan B. (1986a), Die Chicago School of Antitrust Analysis: Wett (The
Chicago School of Antitrust Analysis: Competition Theoretical and Political Analysis of a Credo),
Baden-Baden, Nomos, 119 p.
Schmidt, Ingo and Rittaler, Jan B. (1986b), Chicago School of Antitrust Law, konomische Analyse
des Wettbewerbsrechts (Chicago School of Antitrust Law, Economic Analysis of Competition
Law), 15 WiSt, 283 ff.
Schmidt, Ingo and Rittaler, Jan B. (1987), Marktphasen und Wettbewerb (Market phases and
Competition), 16 WiSt, 597 ff.
Schmidt, Ingo and Rhrich, Martina (1992), Kompetitive Marktstrukturen und externes
Unternehmenwachstum (Competitive Market structures and External Firm Growth),29 WiSt, 179
ff.
Schmidt, Ingo and Schmidt, Andr (1996), X-Ineffizienz, Lean Production und Wettbewerbsfhigkeit
(X-Inefficiency, Lean Production, and Ability to Compete), 25 WiSt, 65 ff.
Schmidt, Reinhard H. (1981a), Kreditsicherung und Konkursrecht (Credit Security and Insolvency
Law), in Gppl, Hermann and Henn, Rudolf (eds), Geld, Banken und Versicherungen,
Knigstein/Ts. 1981, Geld, Banken und Versicherungen, Knigstein/Ts., 569-573.
Schmidt, Reinhard H. (1981b), konomische Analyse des Insolvenzrechts (Economic Analysis of
Insolvency Law), Wiesbaden, Gabler, 155 p.
Schmidt, Reinhard H. (1981c), Die konomische Grundstruktur des Insolvenzrechts (The Economic
Struckture of the Insolvency Law), 26 Die Aktiengesellschaft, 35-44.
Schmidt, Reinhardt H. (1981d), Die konomische Grundstruktur der Insolvenz Recht (The Economic
Basic Structure of Bankruptcy Law), Die Aktiengesellschaft, 35-44.
Schmidt, Reinhard H. (1984), Asymmetrische Information und Glubigerverfgungsrechte in der
Insolvenz (Asymmetric Information and Creditors Rights during Insolvency), 54 Zeitschrift fr
Betriebswirtschaft, 717-742.
Schmidt, Reinhard H. (1996), Betriebswirtschaftslehre und Rechtspolitik (Business Administration and
Legal Policy), 41 Die Aktiengesellschaft, 250-260.
Schmidt, Reinhard H. and Koch, Hans-Dieter (1981), Ziele und Instrumente des Anlegerschutzes
(Goals and Means of Investor Protection), 33(3) Betriebswirtschaftliche Forschung und Praxis,
29-48.
210 Law And Economics In Germany 0330
Schmidt, Reinhard H. and Kbler, Friedrich (1988), Gesellschaftsrecht und Konzentration (Company
Law and Concentration), Berlin, Duncker and Humblot, 225 p.
Schmidt, Reinhard H., Ballwieser, W., Bcking, H.-J. and Drukarczyk, Jochen (1994), Bilanzrecht
und Kapitalmarkt, Festschrift zum 65. Geburtstag von Adolf Moxter (Accounting Law and
Capital Markets), Dsseldorf.
Schmidtchen, Dieter (1973a), Politische konomie staatlicher Preisinterventionen. Dargestellt am
Beispiel der politischen Preise im Nachrichtenverkehr (Political Prices in the News Business as
an Example for the Politcal Economics of Public Price Interventions), .
Schmidtchen, Dieter (1973b), Fr eine konsequente Wettbewerbspolitik und ber die Wege dorthin,
Bemerkungen zum Wettbewerbsverstndnis des Sachverstndigenrates (For a Consistent
Competition Policy and How to Achieve It), 129 Zeitschrift fr die Gesamte Staatswissenschaft,
102 ff.
Schmidtchen, Dieter (1974a), Der politische Preis (The Political Price), 1
Wirtschaftswissenschaftliches Studium, 17 ff.
Schmidtchen, Dieter (1974b), Politische konomie (Political Economics), 24 Jahrbuch fr die
Ordnung von Wirtschaft und Gesellschaft, 233 ff.
Schmidtchen, Dieter (1978), Wettbewerbspolitik als Aufgabe: Methodologisch (Competition Policy
as Task: Methodological and System Theoretical Foundations for a Reorientatation), Baden-Baden,
Nomos.
Schmidtchen, Dieter (1979), Ausbeutung aufgrund einer Wettbewerbsbeschrnkung durch Zustand?
Kritische Analyse der theoretischen Grundlagen einer freiheitsgefhrdenden Wettbewerbspolitik
(Expropriation through a Competition Restraint by State? A Critical Analysis of the Theoretical
Foundations of a Competition Policy that Threatens Freedom), 30 Ordo: Jahrbuch fr die
Ordnung von Wirtschaft und Gesellschaft, 273 ff.
Schmidtchen, Dieter (1981), Leitungspartizipation, Wettbewerb und Funktionsfhigkeit des
Marktsystems (Management Participation), in Issing, D. (ed.), Zukunftsprobleme der sozialen
Marktwirtschaft, Schriften des Vereins fr Socialpolitik, N.F. Bd. 116, Berlin, 191 ff.
Schmidtchen, Dieter (1982a), Property Rights, Freiheitsschutz und die Logik staatlicher
Preisinterventionen: Kritische Analyse der theoretischen Grundlagen einer freiheits gefhrdenden
Wettbewerbspolitik (Property Rights, Protection of Liberty and the Logic of Governmental Price),
in Die Mi Brauchsaufsicht Vor Dem Hintergrund Der En (ed.), Schriften des Vereins fr
Socialpolitik, Vol. 124.
Schmidtchen, Dieter (1982b), Theorie des politischen Preises (Theory of Political Prices), in Bcker,
F. (ed.), Preistheorie und Preisverhalten, Mnchen, 279 ff.
Schmidtchen, Dieter (1985), Monopol und Institutional Choice (Monopoly and Institutional Choice),
in Schenk, K.-E. (ed.), Wirtschaftsordnung, Industrieorganisation und Koordination - Theorie
und Lndervergleiche, Stuttgart, 180-211.
Schmidtchen, Dieter (1987a), Sunk Costs, Quasirenten und Mitbestimmung (Sunk Costs, Quasirents,
and Worker Participation), 6 Jahrbuch fr Neue Politische konomie, 139 ff.
Schmidtchen, Dieter (1987b), Unsichtbare-Hand-Erklrung und die Theorie der komparativen
Kosten (Invisible-Hand Explanations and the Theory of Comparative Costs), in Borchert, M.,
Fehl, U. und Oberender, P. (ed.), Markt und Wettbewerb, Festschrift fr Ernst Heu Bern,
Stuttgart, 287 ff.
0330 Law and Economics in Germany 211
Schmidtchen, Dieter (1987c), Gebhrenpolitik der DBP und Ordnungspolitik (Pricing Policy of the
Deutsche Bundespost and Constitutional Policy), in Diederich, H., Hamm, W. and Zohlnhfer,
W. (eds), Die deutsche Bundespost im Spannungsfeld der Wirtschaftspolitik, Heidelberg,
221-281.
Schmidtchen, Dieter (1988), Fehlurteile ber das Konzept der Wettbewerbsfreiheit (Wrong
Conclusions on the Concept of Competitive Freedom), 39 Ordo: Jahrbuch fr die Ordnung von
Wirtschaft und Gesellschaft, 111-135.
Schmidtchen, Dieter (1989), Evolutorische Ordnungstheorie oder: die Transaktionskosten und das
Unternehmertum (The Theory of Evolutionary Order, or: Transaction Costs and
Entrepreneurship), Ordo: Jahrbuch fr die Ordnung von Wirtschaft und Gesellschaft, 161-182.
Schmidtchen, Dieter (1990), Die Produktion von Recht. Ein Literaturaufsatz (The Production of Law.
An Overview), 146(4) Journal for Institutional and Theoretical Economics, 749-757.
Schmidtchen, Dieter (1991), Jenseits von Maximierung, Gleichgewicht und Effizienz: Neuland fr die
konomische Analyse des Rechts? (Beyond Maximization, Balance and Efficiency: New L), in
Ott, Claus and Schfer, Hans-Bernd (eds), konomische Probleme des Zivilrechts, Berlin,
Springer, 316-343.
Schmidtchen, Dieter (1993), Neue Institutionenkonomik internationaler Transaktionen (New
Institutional Economics of International Transactions), in Schlieper, Ulrich and Schmidtchen,
Dieter (eds), Makro, Geld and Institutionen, Tbingen, 57-84.
Schmidtchen, Dieter (1994a), Vom nichtmarginalen Charakter der Steuermoral (On the Non-marginal
Character of Tax Morals), in Chr. Smekal and Theurl, E. (eds), Stand und Entwicklung der
Finanzpsychologie, Baden-Baden, 185-211.
Schmidtchen, Dieter (1994b), konomik des Vertrauens (Economics of Trust), in Hof, H. (ed.), Recht
und Verhalten, Verhaltensgrundlagen des Rechts - zum Beispiel Vertrauen. Interdisziplinre
Studien zu Recht und Staat, Bd. 1, Baden-Baden, 129-163.
Schmidtchen, Dieter (1994c), Antitrust zwischen Marktmachtphobie und Effizienzeuphorie, Alte
Themen - neue Anstze (Antitrust between Fear of Market Power and Euphoria about Efficiency),
in Mschel, W., Streit M. and Witt, U. (eds), Marktwirtschaft und Rechtsordnung, Festschrift fr
Erich Hoppmann, Baden-Baden, 143-166.
Schmidtchen, Dieter (1995a), Territorialitt des Rechts, Internationales Privatrecht und die
privatautonome Regelung internationaler Sachverhalte. Grundlagen eines interdisziplinren
Forschungsprogramms (Territoriality of Law, International Private Law, and Private Autonomous
Order of International Relations),59(1) Rabels Zeitschrift fr auslndisches und internationales
Privatrecht, 56-112.
Schmidtchen, Dieter (1995b), Die Zwillingsideen der Evolution und der spontanen Bildung einer
Ordnung (The Twin Ideas of Evolution and Spontaneous Order), in Francke, H.-H. (ed.),
konomischer Individualismus und freiheitliche Verfassung, Freiburg, 239-271.
Schmidtchen, Dieter (1997), Effizienz als Rechtsprinzip. Bemerkungen zu dem gleichnamigen Buch
von Horst Eidenmller (Center for the Study of Law and Economics), Discussion paper 9708,
1997. Jahrbcher fr Nationalkonomie und Statistik
Schmidtchen, Dieter and Fehl, E.U. (1986), Wettbewerbstheoretische Aspekte der Mibrauchsaufsicht
ber Autobahntankstellen (Competition Theoretical Approach of the Abuse Control Concerning
Highway Gas Stations), Wirtschaft und Wettbewerb, 572 ff.
212 Law And Economics In Germany 0330
Schmidtchen, Dieter and Kirstein, Roland (1997), Abkoppelung der Prozekosten vom Streitwert?
Eine konomische Analyse von Reformvorschlgen (Separation of Litigation Costs and the Value
of the Case? An Economic Analysis of Reform Proposals), in Prtting, H. and Rssmann, H. (eds),
Verfahrensrecht am Ausgang des 20. Jahrhunderts. Festschrift fr Gerhard Lke zum 70.
Geburtstag, Mnchen 1997, Mnchen, 741-766.
Schmidtchen, Dieter and Koboldt, Christian (1991), Copyrights - A und O in Literatur und Musik?
(Copyrights in Literature and Music), 42 Ordo: Jahrbuch fr die Ordnung von Wirtschaft und
Gesellschaft.
Schmidtchen, Dieter, Koboldt, Christian and Kirstein, Roland (1997), Rechtsvereinheitlichung beim
droit de suite? konomische Analyse des Richtlinienentwurfs der Europischen Kommission
Center for the Study of Law and Economics (Harmonization of a Droit de Suite? An Economic
Analysis of a Proposal of the European Commission), .
Schmidtchen, Dieter, Schmidt Trenz, Hans Jorg and Utzig, S. (1988), Zwang oder nicht Zwang - das
ist hier die Frage. Der Verein fr Socialpolitik und seine Mitgliederzeitschrift (Coercion or not -
thats the Question. On the Member Journal of the Verein fr Socialpolitik), 204 Jahrbuch fr
Nationalkonomie und Statistik, 423-436.
Schmidt-Trenz, Hans-Joerg (1987), Der state of nature im Schatten von Erwartungen ber die
Bildung und Verteilung von Eigentumsrechten. Ergebnisse einer spieltheoretischen Analyse der
Vertragstheorie von J. M. Buchanan (The State of Nature in the Shadow of Expectations on
Creation and Distribution of Property Rights), Diskussionsbeitrge Fachbereich
Wirtschaftswissenschaft der Universitt des Saarlandes.
Schmidt-Trenz, Hans-Joerg (1990a), Auenhandel und Territorialitt des Rechts. Grundlegung einer
Neuen Institutionenkonomik des Auenhandels (Trade and Territoriality of Law), Baden-Baden,
Nomos.
Schmidt-Trenz, Hans-Joerg (1990b), Kammern und Verbnde als spontane Hilfssheriffs, (Anstze
zu einer Neuen Institutionenkonomik von Kammern und Verbnden, Teil I) (Chambers and
Non-profit Organizations as spontaneous Deputy Sheriffs), 15 Verbandsmanagement, 21-28.
Schmidt-Trenz, Hans-Joerg (1990c), Kammern und Verbnde als Organisatoren von
Whlerinteressen, (Anstze zu einer Neuen Institutionenkonomik von Kammern und Verbnden,
Teil II) (Chambers and Non-profit Organizations to Organize Voters Interests), 15/3
Verbandsmanagement, 52-59.
Schmidt-Trenz, Hans-Joerg (1991), Kammern und Verbnde als Nicht-Marktliche Institutionen
(Hierarchien), (Anstze zu einer Neuen Institutionenkonomik von Kammern und Verbnden, Teil
III) (Chambers and Non-profit Organizations as Non-market Institutions), 16
Verbandsmanagement, 19-24.
Schmidt-Trenz, Hans-Joerg (1992a), Systemwandel und vertrauensbildende Manahmen. Der
Transformationsproze der DDR-Wirtschaft im Lichte einer Neuen Institutionenkonomik von
Kammern und Verbnden (System Transition and Trustbuilding Means), 11 Jahrbuch fr Neue
Politische konomie, 145-163.
Schmidt-Trenz, Hans-Joerg (1992b), Systemwandel und vertrauensbildende Manahmen. Der
Transformationsproze der DDR-Wirtschaft im Lichte einer Neuen Institutionenkonomik von
Kammern und Verbnden (System Transition and Trustbuilding Means), Diskussionsbeitrge
Fachbereich Wirtschaftswissenschaft der Universitt des Saarlandes A 9203, Saarbrcken, No. A
9203.
0330 Law and Economics in Germany 213
Schmidt-Trenz, Hans-Joerg (1995), konomische Analyse der Reform des Rechts der privaten
Schiedsgerichtsbarkeit. Was nutzt die Straffung des Vollstreckbarerklrungsverfahrens?
(Economic Analysis of the Reform of Private Arbitration Law), Diskussionsbeitrge der
Forschungsstelle zur konomischen Analyse des Rechts der Universitt des Saarlandes 9505,
Saarbrcken, 1995.
Schmidt-Trenz, Hans-Joerg (1996), Die Logik kollektiven Handelns bei Delegation. Das
Organisationsdilemma der Verbnde am Beispiel des Beitragszwangs bei den Industrie- und
Handelskammern (The Logic of Collective Action with Delegation), Tbingen, Mohr/Siebeck.
Schmidt-Trenz, Hans-Joerg and Schmidtchen, Dieter (1994), Theorie optimaler Rechtsrume. Die
Regulierung sozialer Beziehungen durch die Kontrolle von Territorium (Theory of Optimum Legal
Areas), 13 Jahrbuch fr Neue Politische konomie, 7-29.
Schmitz-Herscheidt, Friedhelm, Anstze zu einer konomischen Theorie des Gesellschaftsrecht (Initial
Stages to an Economic Theory of Company Law), in Boettcher, Erik, Herder-Dorneich, Philipp
and Schenk, Karl-Ernst (eds), Jahrbuch fr Neue Politische konomie, Tbingen, Mohr.
Schneider, Jens-Peter (1996), Kooperative und Konsensuale Formen Administrativer
Entscheidungsprozesse (Cooperative and Consensual Forms of Administrative Decision Making),
15 Jahrbuch fr Neue Politische konomie, 82-102.
Schneider, Jens-Peter (1997), Das Neue Steuerungsmodell als Innovationsimpuls fr
Verwaltungsorganisation und Verwaltungsrecht (New Public Management as an Innovative
Impulse for Administrative Organisation and Adminstrative Law), in Eberhard Schmidt-Amann
and Wolfgang Hoffmann-Riem (eds), Organisationsrecht als Steuerungsressource (Band 5 der
Schriften zur Reform des Verwaltungsrechts), Baden-Baden, Nomos.
Schneider, Jens-Peter and Hoffmann-Riem, Wolfganf (1995), Wettbewerbs- und umweltorientierte
Re-Regulierung im Grohandels-Strommarkt (Re-Regulation of wholesale electricity markets
towards competition and environmental protection), in Hoffmann-Riem/Schneider (eds),
Umweltpolitische Steuerung in einem liberalisierten Strommarkt, Baden-Baden, Nomos, 13-94.
Schch, Heinz (1985), Empirische Grundlagen der Generalprvention (Empirical Foundations of
General Prevention), in Vogler, T. (ed.), Festschrift fr Hans- Heinrich Jescheck zum 70. Ge,
Berlin, Duncker and Humblot, vol. II, 1081-1105.
Schffski, Oliver, Gedanken zur Deregulierung des deutschen Apothekenwesens (Ideas for the
Deregulation of the German Pharmacy System),45(2) Zeitschrift fr Wirtschaftspolitik, 216-248.
Schffski, Oliver (1995), Die Regulierung des deutschen Apothekenwesens. Eine konomische
Analyse (Regulation of German Pharmacies. An Economic Analysis), Baden-Baden, Nomos.
Schffski, Oliver and Zhang, J. (1992), berlegungen zur Einfhrung einer Krankenversicherung in
der Volksrepublik China (Reflections about the Introduction of Health Insurance in the Peoples
Republic of China), 81 Versicherungswissenschaft, 249-260.
Schrder, Michael (1997), Betriebliche Vollzugskosten der Arbeits- und Sozialgesetzgebung. Ein
internationaler und intertemporaler Vergleich (Execution Costs of Labor and Social Laws),
Frankfurt, Campus.
Schrder, Roland (1996), Sind kleine Bundeslnder zu teuer? (Federal States in Germany, Are the
Small ones too Expensive?), Diskussionspapiere fr liberale Politik Nr. 1, 1996.
214 Law And Economics In Germany 0330
Schulenburg, J. Matthias Graf Von Der, Demographischer Wandel und Umverteilung via Gesetzliche
Krankenversicherung (Demographic Change and Redistribution via Statutory Health Insurance),
in Gfgen, G. and Oberender, P. (eds), Verteilungsziele und Verteilungswirkungen im
Gesundheitswesen, Gesundheitskonomische Beitrge Band 6, Baden-Baden, Nomos.
Schulenburg, J. Matthias Graf Von Der (1982), Health Maintenance Organizations - Eine interessante
Alternative zur traditionellen Krankenversicherung? (Health Maintenance Organizations - An
Alternative for Traditional Health Insurance), 71 Zeitschrift fr die gesamte
Versicherungswissenschaft, 27-648.
Schulenburg, J. Matthias Graf Von Der (1984), Wettbewerb und Regulierung im Gesundheitswesen
- Property Rights als Ziel und Restriktion rztlicher Honorarpolitik (Competition and Regulation
in the Health Care Sector), in Neumann, M. (ed.),Ansprache, Eigentums- und Verfgungsrechte,
Berlin, Duncker and Humblot, 435-456.
Schulenburg, J. Matthias Graf Von Der (1985), Pro-Competitive-Strategy im Gesundheitswesen,
Eine kritische Stellungnahme aus deutscher Sicht (Pro-Competitive-Strategy in the Health Care
Sector, A Critical Statement from the German Point of View), in Hamm, W. and0 Neubauer, G.
(eds), Wettbewerb im Gesundheitswesen, Bd. 7 der Beitrge zur Gesundheitskonomie,
Gerlingen, Bleicher, 325-353.
Schulenburg, J. Matthias Graf Von Der (1987), Marktstruktur und Wettbewerb in der ambulanten
Versorgung, Die rzteschwemme und ihre Auswirkungen auf die ambulante Versorgung (Market
Structure and Competition in Out-Patient Care, The Glut of Physicians and and Effects on
Ambulatory Care), in Brennecke, R. and Schach, E. (eds), Ambulante Versorgung, Nachfrage
und Steuerung, Berlin, Springer, 125-172.
Schulenburg, J. Matthias Graf Von Der (1988), Mehr Markt im Gesundheitswesen (More Market in
the Health Care Sector), 144 Zeitschrift fr die Gesamte Staatswissenschaft, 396-402.
Schulenburg, J. Matthias Graf Von Der (1989), Probleme der Gesundheitspolitik in Frankreich und
Deutschland (Problems of Health Politics in France and Germany), Frankfurt, Campus.
Schulenburg, J. Matthias Graf Von Der (1990), Demographischer Wandel, intergenerationale
Gerechtigkeit und Stabilitt des Generationenvertrages (Demographic Change, Intergenerational
Justice and Stability of the Contact Between Generations), in Gahlen, B., Hesse, H. and Ramser
H.J. (eds), Theorie und Politik der Sozialversicherung, Schriftenreihe des
Wirtschaftswissenschaftlichen Seminars Ottobeuren Bd. 19, Tbingen, Mohr/Siebeck, 269-300.
Schulenburg, J. Matthias Graf Von Der (1992), Wie souvern darf der Konsument auf
Versicherungmrkten sein? Nachfragerverhalten und Regulierung auf Versicherungsmrkten (How
Sovereign is a Consumer on Insurance Markets Allowed to be? Behaviour of Consumers and
Regulation on Insurance Markets), in Jacob, H., Adam, D., Hansmann, K.-H., Hilke, W., Mller,
W., Premar, D.B. and Scheer, A.-W. (eds), Schriften zur Unternehmensfhrung, Band 45,
Wiesbaden, Gabler, 3-18.
Schulenburg, J. Matthias Graf Von Der (1993), Kann der moderne Wohlfahrtsstaat die Konflikte
zwischen medizinischen Mglichkeiten, sozialer Verantwortung und wirtschaftlicher Machbarkeit
lsen? (Is the Modern Welfare State Able to Solve the Conflicts Between Medical Possibilities,
Social Responsibility and Economic Possibilities?), 2 Staatwissenschaften und Staatspraxis,
256-269.
0330 Law and Economics in Germany 215
Schulenburg, J. Matthias Graf Von Der and Breyer, F. (1989), Umlagefinanzierte Rentenversicherung
bei abnehmender Bevlkerung unter den Bedingungen eines demokratischen Wahlmechanismus
(Pension Insurance Financed by Contributions in Times of Decreasing Population Under the
Conditions of a Democratic Election Mechanism), in Boettcher, Erik, Herder-Dorneich, Philipp
and Schenk, Karl-Ernst (eds), Jahrbuch fr Neue Politische konomie, Tbingen, Mohr,
126-139.
Schulenburg, J. Matthias Graf Von Der and Finsinger, Jorg (1989), Der Sonntagsverkauf (Selling on
Sunday), 109 Zeitschrift fr Wirtschafts- und Sozialwissenschaften, 119-228.
Schulenburg, J. Matthias Graf Von Der and Hauser, Heinz (1988), Health Maintenance Organizations
- Eine Reformkonzeption fr die Gesetzliche Krankenversicherung in der Bundesrepublik
Deutschland (Health Maintenance Organizations - A New Concept for the Statutory Health
Insurance in Germany), 19 der von der Robert Bosch Stiftung herausgegebenen Beitrge zur
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0335
LAW AND ECONOMICS IN GREECE
Aristides N. Hatzis
University of Chicago Law School
Copyright 1999 Aristides N. Hatzis
Abstract
In Greece there is no established discipline of law and economics yet, if by this
we mean a coherent body of work and a group of scholars dedicated to its
promotion. There are only some recent and hesitant attempts by some scholars
to introduce law and economics to Greek legal bibliography and a number of
dispersed studies. However, the substantial body of work of an eminent social
scientist and the first samples of writing by young scholars, combined with the
first informal courses at a graduate level and the first references to law and
economics in textbooks, bear promise of a brighter future.
JEL classification: A11, A23, K00, K10
Keywords: Greek Legal Scholarship, Economic Law, Law and Economics:
Teaching and Scholarship, Graduate Studies.
1. Introduction
Economic analysis of law (EAL) is at a nascent level in Greece. It is virtually
unknown to the great majority of lawyers and economists (including
academics), who think of it as something as exotic and elusive as sociology of
law (which is established as a course in the three public law schools of Athens,
Thessaloniki and Komotini). For some lawyers, economic analysis of law (the
term law and economics is not employed) is similar to economic law, an
all-encompassing term for the sum of commercial, banking, company, and so
on, laws. For economists, EAL is equally vague, perhaps something they hear
about in a conference, although most of them are familiar with the Coase
theorem and theories of regulation. There is definitely no Greek EAL, if by this
we mean a coherent body of work and a relevant group of scholars dedicated
to its promotion.
However, there is a small number of scholars who have, over the last few
years, begun to publish articles (mainly introductory ones) presenting the new
theory to Greek lawyers and economists. Most of them have studied law in the
United States and have become familiar with the movement-turned-discipline
there. A great number of Greek legal scholars have conducted their doctoral
research in Germany and even those who have written their theses in Greece
228
0335 Law and Economics in Greece 229
have used mostly German bibliography. This is largely the result of the heavy
influence of German law on Greek law (especially civil law). As a result, the
Greek scholars with a doctorate from a common law country (especially from
the United States) are very few in number. This is the basic reason for the
embryonic status of law and economics in Greece.
2. Research in Law and Economics
Many papers have been published from 1960 to the early 1980s studying the
relationship between law and economics and emphasizing the need for a
broader collaboration. These papers were often overly theoretical, without
potential application to actual legal problems and with no discussion of the
developments in the Anglo-Saxon legal world. The discussion revolved around
the work of Weber, Stammler and Marx, with some references to the
socialization of the economy after World War II (particularly the excellent
papers by Mantzoufas, 1960; Karakantas, 1973; Rokas, 1980, all three
professors of civil law in economic departments, Loukopoulos, 1962, as well
as Liakopoulos, 1982, for a typical Marxist, critical-legal approach). Another
extensively discussed problem was state intervention in the economy and the
ensuing constitutional issues from the antinomies created in a mixed economic
system (see Manitakis, 1975; Stathopoulos, 1981; Gemtos, 1990b). Finally,
a number of legal scholars have treated purely economic problems with the
intention of informing their colleagues of parallel developments in another
social science (see in particular the brief discussion of the Laffer curve by
Rodios, 1986, and the excellent survey by Gavrielidou,1990, of the economic
literature on taxation and the work of four scholars: Milton Friedman, Nicholas
Kaldor, Firmin Oules and Maurice Allais).
The scholar who first introduced EAL to the Greek legal world is the former
Rector of the University of Athens, Prof. Petros Gemtos. Gemtos (a specialist
in the philosophy and methodology of science and a holder of two doctorates,
one in law and another in economics from the University of Tbingen) is also
the central figure of Greek EAL. Prof. Gemtos was not only the first Greek
EAL scholar, but made original contributions, presented almost simultaneously
with the expansion of EAL in the USA in the early 1970s.
In his first and seminal EAL paper (Gemtos, 1976) on the legal problems
created by hyperinflation (in constitutional, tax and contract law), he not only
studied a legal problem using the tools of economics, but he extensively
discussed the usefulness of positive economics to the analysis and solution of
legal problems (see p. 833 for some insightful remarks and also pp. 836-846).
This paper was an exemplary application of his research program (formulated
and expounded as early as 1974, see Gemtos, 1974) for the association of legal
science with positive social science. In a second endeavor to treat legal
230 Law and Economics in Greece 0335
problems under an economic prism, Gemtos (1990b) dealt with consumer
protection legislation as a necessary restraint of economic freedom. He also
briefly criticized the proliferation of products liability legislation as leading to
inefficient results that can harm consumers.
In a series of publications (see Gemtos, 1988, 1990a, 1991, 1998 and
Gemtos, 1995 for a definitive treatment of the issues discussed in the previous
articles), he elaborated extensively on the relations between law and economics,
and especially between legal reasoning and economic methodology, not only
critically presenting the literature see especially Gemtos (1998), but also
offering considerable original insights.
Gemtoss theoretical and methodological views on the interdisciplinary
cooperation between law and economics are applied to his major contribution
to EAL. In an article on the property rights theory he critically introduces the
older institutional theories of economics and the new institutional theory of
property rights (in his view, the most successful attempt to incorporate
institutional analysis in economics). By supplying neoclassical economics with
the necessary concept of transaction costs that replaces the unrealistic
assumption of perfect information, new institutional economics lend a more
realistic nature to economic analysis and facilitate its use by lawyers and other
social scientists who have to work with complex actual situations.
Gemtos identifies himself clearly with the neo-institutional school, but with
some reservations rooted in the relevant discourse taking place in Germany. He
places the theory of property rights at the central stage of his EAL, giving
property rights a broader meaning than the one they have in both economics
and law. He uses the word praxeological rights to include the right to
damage someone or something (which of course might produce the obligation
for restitution), the opposite right to defend oneself from the damage, and so
on. Every good is accompanied by a bundle of praxeological rights, not
restricted to the well-known rights recognized by property law (Gemtos, 1988,
pp. 1201-1202).
Prof. Gemtos remains the leader in the field, not only because of his
writings, but also because of his active support for the institutionalization of
EAL at the University of Athens. In 1995 he published the first textbook on law
and economics in Greek. It consists of two volumes (the second one is
forthcoming) and its purpose is twofold: to introduce basic economic concepts
(including macroeconomics) to lawyers and law-students and to present EAL
(and the contemporary economic analysis of institutions in the broad sense) to
the Greek legal world see also Gemtos (1998).
Besides Gemtos, and at the same time with him, a number of scholars
specializing in economic or commercial law and with graduate studies mainly
in the USA, published introductory EAL articles. The first of these articles was
a general treatment of the relation between law and economics by a commercial
0335 Law and Economics in Greece 231
law scholar, Ioannis Rokas (1980), who completed his graduate studies in
Germany (Berlin) and now teaches at the Athens University of Economics and
Business. Rokas, like Gemtos, draws heavily upon German bibliography for the
relations between economy and law and briefly discusses the new field of
EAL. Although his intention was not to present EAL as a separate discipline
or school, his target was the lack of communication between law and
economics. These two disciplines are related internally to such an unusual
degree that it creates problems to both lawyers and economists who deal mainly
with the same object. Rokas calls for a standing interdisciplinary contact,
citing a number of examples where the convergence of law and economics is
inevitable. Rokas defends the old law and economics with clarity and zeal.
This lack of communication between lawyers and economists is bridged
temporarily by the first and only attempt in Greek legal scholarship (after
Gemtos, 1976, but also see Delivanes, 1954, for an early treatment of a legal
issue by an economist) of Phanes Christophorou (1986), a lawyer with the
European Commission (LL.M. from Harvard), to use economic analysis in
treating a legal issue, that is antitrust law (what else!). His interpretation of
Greek antitrust law is informed by an extensive critical discussion of the
economic literature (ibid., pp. 898-909) with the purpose of influencing the
implementation of the law (pp. 900, 906-907) (Similarly, see the brief
discussion of the economics of crime by Calliope Spinellis, 1992, a criminal
law professor with a doctorate from the University of Chicago).
Michalis Tsibris (1989) was the first to present an up-to-date introduction
to EAL. His paper consists of a fair presentation and discussion of the leading
theories and basic concepts and discusses various examples from torts and
property law (with an extensive reference to the Coase theorem). Tsibris has
many reservations concerning the use of efficiency as a criterion and the
compatibility of the two discourses, and although he is outright negative to the
normative EAL, he is decisively positive toward the use of economic analysis
by lawyers. Tsibris (a commercial law scholar) holds an LL.M. degree from
Harvard, where the influence of Frank Michelman on his thinking has proven
greater than that of Steven Shavell, as this article reveals.
A similar introductory paper has been written by another
American-educated scholar, Thanos Papaioannou (LL.M. and doctorate on
labor law from the University of Pennsylvania). This article is the most typical
of the attitude of Greek legal scholars (especially the ones specializing in
economic law), who are receptive to the use of economics by lawyers, but at
the same time quite suspicious of both the unintended and the intended effects
of the application of economic theories to what they perceive as the coherent
logical construct of Greek law. The title of the article is telling and, starting
from the first introductory paragraph, Papaioannou (1991) informs the reader
that EAL is a movement parallel and congenial to the wave of the reappraisal
232 Law and Economics in Greece 0335
of free-market ideas by economists and the dominance of New Right ideas in
the USA, personified by President Reagan and the judges he appointed to the
federal courts. However, Papaioannou is generally favorable to EAL, especially
when applied to contract law, commercial law or torts. Notwithstanding, he is
critical of the economics of crime and especially of any attempt to attack
individual rights on economic grounds.
In the same vein with the three aforementioned articles, we should consider
the work of Prof. Phaedon Kozyris (1991). Kozyris, then professor at Ohio
State University School of Law (with graduate studies at Chicago and Cornell
and a doctorate from Pennsylvania) is now Professor of International Law at the
University of Thessaloniki. This article is a critical evaluation of the prevalent
schools of legal philosophy in the United States, including a presentation of
EAL of the free-market Chicago School, as he mentions several times in the
text. He emphasizes the political elements in the law and economics discourse,
discussing very briefly (and with a faultfinding mind) some EAL proposals. In
spite of his hesitation, he acknowledges the usefulness of economic analysis as
a tool and method for the revision of the law. In a more recent paper, Kozyris
(1996) takes a more positive stand towards EAL (pp. 58-68, and especially pp.
73-74), characterizing it as innovative and fruitful.
The last and most recently published article is also the most friendly
towards EAL, not surprisingly, since the author, Nicholas Georgakopoulos (a
Professor at the University of Connecticut Law School with graduate studies
and a doctorate from Harvard) is a well-known legal scholar in the USA with
significant work on EAL. Georgakopoulos wrote his article because of the
minimal impact of EAL in Greece. He deplores the reception of critical legal
theory by Greek constitutional scholars and holds that, if it is generalized, it
can destroy Greek legal scholarship as long as it is not offset by a parallel
dissemination of EAL that will reinforce the scientific character of legal
science. Georgakopoulos emphasizes the success of EAL in the USA and its
pragmatic character, urging for the incorporation of EAL in law school
curricula.
Georgakopoulos is also the translator of Richard Posners Cardozo: A Study
in Reputation, in Greek (Posner, 1997). Given the scarcity of translations of
foreign legal works in Greek (particularly from the Anglo-Saxon world), this
translation is important not only for the introduction of the Greek legal world
to the mechanisms of common law by two famous American judges, but also
for the introduction to EAL and Richard Posners recent work. Georgakopoulos
(1997a, 1997b) in two extensive notes accompanying the lively translation,
extensively discusses relevant philosophical and doctrinal issues but also the
development of Posners legal theory in the direction of a singular liberal
pragmatism.
The original contributions to EAL are analogous to its influence on Greek
legal scholarship. With the exception of the work by Gemtos (see above), the
original work is meager. There are only two young scholars specializing in
0335 Law and Economics in Greece 233
EAL: Panagiotis Evangelopoulos, an economist (holding a doctorate degree
from the University of Athens, under the supervision of Prof. Gemtos) who is
working in the field of property rights theory; and Aristides Hatzis, a lawyer,
who is studying the economics of contract law at the University of Chicago,
under the supervision of Judge Richard Posner. However, their approaches are
disparate.
Evangelopoulos is an economist with an interest in political philosophy. His
principal work (1997) is in no way an application of property rights theory
towards the study of Greek property law (or any particular property law for that
matter), but rather a philosophical examination of the institution of property.
Evangelopoulos constructs a theory of property rights that is more in tune with
neoclassical theory and influenced by the libertarian theories of justice (Nozick
and Buchanan) and free-market economics (Austrian but Chicago school as
well) to a greater degree than the majority of works in this tradition.
This becomes clear in a piece that is a statement of his philosophical
position and his methodological stance (Evangelopoulos, 1996) as well as in an
insightful recent article, where he develops the argument that all kinds of rights
(even basic human rights) are subsumed under the hyper-set of property rights.
Property rights are mainly allocated by majority rule via state intervention and
by independent individuals via market mechanism. If the former is dominant,
then the political process has the upper hand; if the latter is dominant, then a
spontaneous order emerges. Property rights must be determined mainly by the
market and away from state intervention, since the former combines rationality
and liberty, while the latter inefficiency and coercion (Evangelopoulos, 1998).
On the other hand, Hatzis (the author of this survey) is, perhaps, the only
adherent of EAL in the narrow sense. The basic goal of his thesis (1998b) is the
construction of an economic theory of Greek contract law, which will help in
evaluating the existing legal rules in terms of efficiency, in creating legal rules
that are more consistent with the objectives of contract law and consequently
in solving a number of allegedly unresolved problems of Greek contract law
theory. The comparative study (in Greek and American contract law) of
contract formation, unconscionability, commercial impracticability and
liquidated damages under the prism of EAL leads to some useful conclusions,
not only towards the efficient solution of the aforementioned much-discussed
problems, but also towards the problem of the existence of an inherent
economic logic in civil law, similar to that of common law (see Hatzis, 1997,
for a summary of his thesis and also Hatzis ,1997c, on the comparative
efficiency of civil and common law).
Hatzis contribution to Greek bibliography is of a more introductory nature.
In an article published in 1991, he presents the life and work of Ronald Coase,
with a detailed critical presentation of the Coase theorem. He did the same in
Hatzis (1998a) for the work of Mancur Olson. In a lengthy paper, Hatzis (1996)
introduces the rational choice revolution and the new schools that use
234 Law and Economics in Greece 0335
neoclassical microeconomic methodological tools for the study of political
science, sociology and legal theory. He examines the various consequentialist
libertarian philosophical approaches to society and institutions, and explores
the relation that each of them maintains to the particular elements of rational
choice theory (see also Hatzis 1993, 1999a and 1999b for similar introductory
papers and surveys in English).
Another young scholar whose work is relevant is Aspasia Tsaoussis-Hatzis
(1999a), a sociologist of law whose work on the economic consequences of
divorce draws heavily on the theories of Nobel laureate Prof. Gary Becker (who
is also the supervisor of her thesis (1999b) at the University of Chicago Law
School) on the economics of the family.
3. Education
The discussion thus far has shown that Greek EAL is a newly-emergent field,
still taking hesitant infantile steps. There is a small number of scholars who
work in the field (or who at least have an interest in the field), largely due to
the nature of technical doctrinalism that characterizes Greek legal theory and
the absence of institutionalization. It is extremely difficult to expect a change
of attitude on the part of the great majority of Greek lawyers (even scholars)
who are both formalists and positivists. Nevertheless, some recent
developments, such as the founding of the School of Judges in Thessaloniki
(that emphasizes the study of social science), as well as the increasing
specialization and the tendency for the continuation of legal studies at the
graduate level displayed by Greek lawyers, are promising signs for the future.
Starting from the academic year 1995-1996, Nikolaos Intzessiloglou
(Professor of Sociology of Law at the University of Thessaloniki and the Greek
coordinator of the Erasmus Programme in Law and Economics) has dedicated
the second year of the graduate course of Sociology of Law to EAL. In
collaboration with Aristides Hatzis, he introduced the basic concepts of EAL
with a parallel discussion of philosophical, epistemological and methodological
issues. The readings consisted mainly of Cento Veljanovskis The Economics
of Law: An Introductory Text (London, IEA, 1990) and also included a number
of introductory articles in English, French and Greek, and notes prepared by
Hatzis (1997a). The first courses of EAL in Greece were very successful,
mainly because they were addressed to graduate students (all of them being
lawyers or judges) with a manifested interest in jurisprudence (most of them
had sociology of law as their major). After the completion of the course, many
graduate students showed a particular interest in continuing their studies in
EAL.
Prof. Intzessiloglou, as the founder and editor of Aissymnetes (an
interdisciplinary law journal) has promoted the discussion on EAL, dedicating
0335 Law and Economics in Greece 235
the sixth volume of the journal to this discussion (see Evangelopoulos, 1996;
Hatzis, 1996; Reynolds, 1996). This symposium includes an article by the
Professor of the University of Macedonia Vaios Lazos (1996) on the economics
of crime. Lazos, an economist who is not at all influenced by EAL or the work
of Gary Becker, comes to essentially similar conclusions.
4. Prospects
The prospects for EAL in Greece are more than favorable. In the following
years, the first special chairs for EAL are expected to be established by the
Universities of Athens and Thessaloniki. There is already a number of graduate
students with a great interest in the field and the number of publications is
steadily growing.
But the most significant development is the use of economic analysis by
mainstream legal scholars. In 1991, Prof. Panagiotis Papanikolaou, a contract
law scholar at the University of Athens, published a remarkable monograph on
freedom of contracts, using the findings of EAL in his discussion (Magoulas
and Jost, 1985, preceded him but they are professors in Germany). His book
(together with all the aforementioned work) managed to familiarize the Greek
legal world with EAL. As a result, in recent textbooks by some of the most
prominent civil and commercial law professors at the University of Athens,
there were many references to EAL (see for example Michales Stathopoulos,
General Law of Obligations, 2nd edn, Athens-Komotini, Ant. N. Sakkoulas,
1993, pp. 11-13, Leonidas Georgakopoulos, Handbook of Commercial Law,
vol. 1.1, 2nd edn, Athens, P. Sakkoulas, 1995 and Apostolos Georgiades,
General Principles of Civil Law, Athens-Komotini, Ant. N. Sakkoulas, 2nd
edn, 1997, pp. 67-68, all in Greek). This is more important than it appears.
Greek legal scholars are hostile to almost any interdisciplinary or philosophical
treatment of private law. These scholars present (particularly in textbooks, not
treatises) EAL, and EAL alone, as a very interesting (but also dangerous if
misused) theory of adjudication and interpretation.
The much-needed next step for economic analysis of law in Greece is its full
institutionalization and its extensive use for the analysis of legal problems.
However, such a prospect seems quite remote today.
Acknowledgments
I would like to express my appreciation to Gerrit De Geest, Panos
Evangelopoulos, Petros Gemtos, Nicholas Georgakopoulos, Nikolaos
236 Law and Economics in Greece 0335
Intzessiloglou, Aspasia Tsaoussis-Hatzis and an anonymous referee, whose
comments on the first draft of this paper were very helpful.
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0340
LAW AND ECONOMICS IN HUNGARY
Andrs Saj and Kinga Ptervri
Central European University (Budapest) - Legal Studies
Copyright 1999 Andrs Saj and Kinga Ptervri
Abstract
This chapter describes the state of law and economics in Hungary in 1996.
Its main conclusion is that little work has been done in this field. Earlier it
was the socialist economic system which hindered the introduction of this
sort of analysis. But - contrary to our expectations expressed in the 1992
precursor of this article - the creation of a market economy did not lead to
the establishment of law and economics in Hungary as a side-effect. The
main factors which prevented this were the nature of the Hungarian legal
system and legal thinking and the rigid divisions within the academic
system.
JEL classification: K00
Keywords: Hungarian Legal System, Research, Teaching, Hungarian
Academic System
1. Introduction
As you will see below the numbers of items in the bibliography of this
chapter is smaller than that of the 1992 list. The main reason for this is that
we have decided to change the principle upon which the selection is based.
When compiling the 1992 bibliography we construed law and economics in
a very broad sense, which now seems to be far too broad. The reason why
this broad construction seemed justified to us back then had to do with some
promising starts at the ELTE Law School, for example the extra-curriculum
seminars on law and economics in 1987 held by Andrs Saj, which are no
longer available.
2. Past and Present Situation
In the 1970s and very early 1980s the non-conceptual, case-by-case oriented
command market system was often referred to. This term implies a softened
planned economy, in which state enterprises have some degree of legally
guaranteed autonomy in executing the central plans, as opposed to the strict
command economy characteristic of the 1950s and early 1960s, in which the
240
0340 Law and Economics in Hungary 241
state exercises discretionary and direct control. However mild the system
had gradually become, it was still in control of the economic regulations,
thus leaving no room for considerations of efficiency analysis. Even though
students of law had to study economics, the kind of economics they were
exposed to was Marxist economic theory, the spirit of which is quite alien to
that of law and economics.
After the fall of the communist regime, economic legislation got from the
ground and an enormous number of new laws were introduced (for example
the Company Act of 1988, the Income Tax Act, the VAT Act, and so on in
1989, and so on). This frenzy of economic legislation has of course given
rise to serious theoretical reflections and the 1992 bibliography is the record
of that. Certainly, some of that literature does not belong to law and
economics proper, but it dealt with related topics and had the promise of
developing into law and economics in a narrow sense. To put it briefly, it
seemed to us then that the economic analysis-related legal literature of the
late 1980s and early 1990s constituted the rudiments of a session study of
law and economics. This expectation proved to be wrong.
The more recent literature, voluminous as it still is, shows little signs of
the assimilation of the theoretical principles, explanatory models,
argumentative strategies, methodological approaches, and so on
characteristic of law and economics in its narrow sense. The most significant
common feature of the Hungarian articles, comments and textbooks is that
they focus on the mere interpretation of the new laws, the explanation of
new legal institutions and the description of enforcing specific provisions.
Because of that, new legal periodicals have been established in the past few
years (for example Gazdasg s Jog, Economy and Law), which despite their
inspiring titles show no inclination to apply the method of analysis of law
and economics. We might have continued to construe law and economics
broadly and put together a bibliography as long as (or even longer than) that
of 1992, but this would have been thoroughly misleading.
3. Explanations for Lack of Success
Clearly, the application of the same principles of selection, which may have
been charitable in 1992, would now be straightforwardly deceptive. At this
juncture one may naturally inquire into the reasons of why the
economics-related legal literature has failed to develop into an economic
analysis of law. It seems that the main factors include the following:
(a) The predominance of traditional German legal thought in Hungarian
legal thinking. It must be emphasised that this involves traditional German
242 Law and Economics in Hungary 0340
legal thought. Recent developments in German legal thinking incorporating
law and economics approach are little known.
(b) Not only Hungarian legal thinking as such but the whole Hungarian
legal system follows traditional German legal thought (even though it is just
as heavily influenced by Roman law). Whereas the exact nature of the
connection between law and economics and the Anglo-American legal
system is still a question of dispute, it seems clear that it is difficult to adopt
a mode of analysis when the circumstances are quite different from those
under which it has usually been applied. So the differences between the
Anglo-American and the Hungarian legal systems constitute a barrier, even
if it is not an insurmountable one
(c) For historical reasons, Hungarian higher education has not provided
people with a sufficient background in both law and economics to be able to
conduct this sort of analysis. The university system, modelled after the
Russian one, preferred relatively small, specialised units of higher education.
As it happens, economics and law have ended up in different institutions.
Since all other scholarly institutions have been organised along the same
disciplinary boundaries as higher education, the institutional separation of
law and economics has spread over the whole of Hungarian intellectual life.
Therefore the interdisciplinary approach of law and economics not only has
little scholarly support, it was virtually defined out of existence by the
rigidity of the academic system.
Furthermore, lawyers have increasing difficulties with the increasingly
mathematicised economic analysis of law. As a corollary, the lack of
significant legal research in the field contributes to a great extent to the poor
publication list in law.
4. Prospects
Even so it does not seem justified to conclude from all this that the chances
of law and economics are meagre. Integration into the international
community of legal scholars has increased and the Hungarian students of
law are aware of the issues which have the focus of attention of the
international community. A good example to that may be that there are more
articles in English on law and economics now than in Hungarian. So,
whereas five years ago the great majority of Hungarian scholars had not yet
heard of law and economics, this is not the case any longer. The community
of Hungarian legal scholars has a fairly good basic understanding of the
basic issues and approaches associated with law and economics, which
seems to provide a strong enough basis for the future development of law
and economics research.
0340 Law and Economics in Hungary 243
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0345
LAW AND ECONOMICS IN ITALY
Roberto Pardolesi
University of Roma (Luiss)
Giuseppe Bellantuono
University of Trento
Copyright 1999 Roberto Pardolesi and Guiseppe Bellantuono
Abstract
Law and economics in Italy is still an underdeveloped subject. Despite the early
contributions of the 1960s and 1970s, most Italian lawyers and economists have
displayed a marked indifference towards the economic approach to law. After
reviewing some initiatives which promise to foster the spread of law &
economics, we show that the hindrances encountered by the economic analysis
of law stem from a misconception of both the economic and the comparative
method.
JEL classification: K0
Keywords: Law and economics, Italy, Comparative Law, Interdisciplinary
Education.
1. Introduction
The origins and subsequent development of law and economics in Italy can be
described as a history with some lights and many shadows. In the following
sections we shall see that since the 1960s the economic approach to law has
attracted increasing attention, but it has not succeeded becoming a prominent
part of Italian legal doctrine. The second section briefly reviews the earliest
Italian contributions to EAL and summarizes the debate on its transplantation
to a civil law country. Sections 3 and 4 discuss the reasons why large sectors
of the legal and economic profession have chosen not to follow the path that
has proved so fruitful in the United States.
2. Italian Law and Economics Between the Past and the Future
At the same time as Ronald Coase and Guido Calabresi were working on their
seminal articles, an Italian scholar, Pietro Trimarchi, published a pathbreaking
244
0345 Law and Economics in Italy 245
book on strict liability (Trimarchi, 1961) entirely based on concepts such as the
allocation of risks to the least cost insurer or recourse to strict liability to induce
potential wrongdoers to adopt optimal precautions. A later article, also
translated into German, applied the tools already employed in the field of tort
law to breach of contract cases ( Trimarchi, 1970).
These contributions marked the first appearance of EAL in Italy. However,
they did not prompt an immediate reaction. It was not until the late 1970s that
systematic EAL research and teaching began in Italy. Even at this late stage,
moreover, the economic approach to law was largely confined to the margins
of the legal profession.
Some years ago the spread of the economic approach to law in Italy was the
subject of a detailed analysis by Ugo Mattei and Roberto Pardolesi (1991). The
authors remarked that the hindrances encountered by the economic analysis of
law stemmed, above all, from a misconception of both the economic and the
comparative method.
With regard to the former, Mattei and Pardolesi stressed that Italian
economists had devoted their energies mostly to the study of post-Keynesian
economics. Yet, it is well known that the law and economics movement sprang
from the development and revision of the neoclassical paradigm during the
decades following the end of the Second World War. The choice of a different
line of research was probably one of the factors that most seriously hampered
the dialogue between lawyers and economists.
As far as the comparative method is concerned, Mattei and Pardolesi
dismissed the claim that EAL is useless in civil law systems because of its
American origin. To be sure, the great dichotomy between civil law and
common law is still a distinctive feature of the Western legal tradition. Today,
however, few scholars (if any) would be willing to reject the doctrines
developed on the other side of the Atlantic because of fundamental differences
in the American legal system. The phenomenon of legal transplants, which
modern comparative studies have emphasised and explored (see for example,
Watson, 1974; Sacco, 1991; Ewald, 1995) is the best evidence that each
tradition borrows from the other when confronted with the same problems.
If common and civil lawyers are able to communicate in many fields,
explanation is still required as to why, in the late 1990s, the economic analysis
of law has still not gained widespread acceptance in Italian legal culture. In the
following two sections we shall see that the answer probably differs between
lawyers and economists. Both groups of social scientists may have been heavily
influenced by EAL, but each chose not to cultivate the interaction between
algebra and pandects. The reasons why lawyers and economists have been deaf
to the lessons of Coase et al. shed light on the evolution of these two branches
in Italy.
246 Law and Economics in Italy 0345
3. Why Italian Lawyers do not Listen
Lest we give a distorted portrayal of the Italian situation, we must immediately
specify that recent years have witnessed a growing interest in the economic
approach to law. As the Italian Bibliography makes clear, the number of
authors applying the microeconomics categories to the study of legal problems
is now much greater than it was in the recent past. Even more importantly, the
subjects dealt with by these writings are highly diversified, ranging from
classical antitrust themes to environmental issues to the market for works of art.
Other initiatives have been planned to foster the spread of EAL. Il Mulino,
a prominent Italian publisher, is about to issue a journal entirely devoted to law
and economics. This undertaking will be backed by a textbook on law and
economics, presently being compiled, which should link with the Italian
translation/adaptation of the second edition of the famous textbook by Cooter
and Ulen. The purpose of the Italian version is to enable Italian students to
grasp the main features of the economic approach to law through their
application to the Italian legal system. However, the courses in comparative law
and private law offered by the Law Faculties of Rome and Trento are already
being taught with an eye to the concepts arising from law and economics. As
further evidence of interest in this subject we may cite the law and economics
meetings held in Siena in 1992 (see the papers collected by Mattei and Pulitini
1994) and 1996, attended by more than one hundred Italian lawyers and
economists, and the conference organized in Milan in October 1995 with the
joint participation of American and Italian lawyer-economists (see the papers
by Monateri, 1995; Gambaro, 1996; Pardolesi, 1996).
Although these projects confirm the impression of lively debate, explanation
is still required for the indifference displayed by most of the Italian legal
doctrine (not to mention the courts). A host of reasons apparently hamper
complete acceptance of the economic approach to law. None of them, however,
is compelling.
To begin with, lawyer-economists must still contend with the perennial
claim that the notion of efficiency is politically biased. The choice of efficiency
as the reference point or crucial paradigm of a value judgment is regarded with
suspicion by those who believe that the law cannot neglect distributive concerns
(see, for example, Zaccaria, 1995). Suffice it to say that the traditional
distinction between positive and normative economics is now in crisis and the
notion of efficiency is no longer regarded as neutral (see Blaug, 1992;
Hovenkamp, 1990). It is worth noting, moreover, that even an influential
scholar clearly extraneous to the law and economics movement acknowledges
the possibility of a reconciliation between cost-benefit analysis and the
principles of egalitarianism (Dworkin, 1986, p. 276ff.). Hence, in economics
as well as in law, the usefulness of the concept of efficiency should be judged
0345 Law and Economics in Italy 247
according to the problem at hand.
However, rejection of the ideologically oriented approach believed to be
prevalent in Chicago-style law and economics hampers thorough understanding
of other currents of thought which shape the economic analysis of law. In other
words, it is a mistake to identify EAL with Posner and his followers. The
success of law and economics is largely due to the variety of research programs
on which it is able to draw. The neoclassical paradigm of the Chicago school,
for example, is now - at least, from a certain point of view - far less interesting
than the comparative institutional analysis conducted by Oliver Williamson and
other scholars in the area of new institutional economics (for discussion of the
relationship between new institutional economics and law and economics see
Williamson, 1993). It is worth mentioning that many Italian economists are
now deeply involved in this research program (see, for references, the survey
by Rizzello, 1996).
There are those who already suggest the existence of post-Chicago law and
economics (see Symposium, 1989; Rubin, 1996). We prefer to speak of
numerous competing lines of inquiry which sometimes yield conflicting results.
A prominent role is now played by game theory, whose first applications to
legal problems date back to the early 1970s. The analysis of strategic
interactions among individuals, the main concern of game theory, has
progressively undermined traditional beliefs about the role of the market and
governmental regulation (see, for example, Ayres, 1990; Hovenkamp, 1995; for
an updated list of game theory applications to legal problems see Huang, 1995).
In the light of these developments, nothing could today be further from the
truth than the monolithic vision of EAL often displayed by Italian scholars.
These remarks take us to another debated aspect of the reception of EAL in
Italy. In many quarters the economic approach to law is regarded as simply
irrelevant to better understanding of legal problems. Why study economics, the
argument goes, if the solutions it provides are more or less coincident with the
ones reached by means of the familiar legal methods? Statements of this kind
reveal a patent misconception of the purposes that EAL seeks to accomplish.
The prestige which surrounds economics - often regarded as the leading social
science - may have prompted the belief that the economic approach to law is
able to provide a definitive answer to any doubtful matter. By contrast, it is
more realistic to recognize that law and economics provides useful tools with
which to check the arguments that lawyers employ by shedding light on the
economic contest in which a legal dispute arises. Therefore, the main
contribution of law and economics is the enhanced understanding of the
interests at stake it supplies.
A brief survey of the Italian literature lends support to this view. In nuisance
cases, for example, the notion of externality explains why Italian courts grant
a sum of money to the injured party even when the wrongdoer is allowed to
248 Law and Economics in Italy 0345
pollute (Pardolesi, 1977 and, more recently, Mattei 1995; Gambaro, 1995). In
tort law the age-old debate on the content of fault gains a new and stimulating
meaning when analysed through the lens of economics (Cafaggi, 1996).
Needless to say, the new Italian antitrust law of October 1990 would be
impossible to understand without the support of an economic apparatus (see
Pardolesi, 1993).
Although its results are hardly original law and economics exerts a powerful
influence on the style of legal reasoning. The new rhetoric of EAL is best seen
as a device which shows the lawyers which elements of a legal controversy are
relevant and which are not (see Ackerman, 1984; McCloskey, 1988). This
feature, however, can be regarded as a primary reason for its appeal as well as
for its uneasy reception in Italy. Indeed, the economic argument compels
lawyers to look at legal disputes from an unprecedented point of view, one
almost at odds with the supposedly orthodox attitude. Instead of talking about
rights and entitlements, lawyers are forced to assess the consequences of each
rule on the allocation of resources. Apart from the complexity of the analysis,
it is clear how far it diverges from the traditional reasoning of the Western
legal tradition. The clash between the Western legal tradition and the Posnerian
version of law and economics has recently been highlighted by Monateri
(1995). By contrast, the usefulness of instrumental reasoning in the Italian legal
system has been reaffirmed by the constitutional judge Mengoni (1994).
In short, Italian legal culture finds itself caught in a paradox. Law and
economics promises valuable insights into legal problems, but at the same time
it requires in-depth understanding of its techniques. Lawyers can take
advantage of the economic approach to law only if they choose to invest in this
field. Unfortunately, though, they lack the data with which to gauge the benefits
available until that investment is made. This paradox is largely due to the scant
attention paid to economics in lawyers training. The Italian law faculties
normally include only one course of economics on their programs, which is
clearly inadequate to tackle the complexity of modern mathematical economics.
Of course, Italian lawyers have occasionally displayed deep understanding
of the economic issues underlying legal matters. For their part, many Italian
economists have been keenly aware of the interaction between law and
economics (for references to the works of nineteenth-century Italian lawyers
and economists see Cosentino, 1990). It is clear, however, that this tradition
has been unable to lay the basis for more systematic study. It may be that one
of the reasons for this lack of communication has been the role played by social
scientists in Italian society and culture, but we believe that the present situation
can be explained mainly by the shortcomings of academic training.
In short, the lack of a formal training is a problem that cannot be postponed
any longer. It is at this point that Italian economists should enter the scene.
Unfortunately, they have listened no more than Italian lawyers have done.
0345 Law and Economics in Italy 249
4. Why Italian Economists do not Listen
About two decades ago Ronald Coase suggested that the expansion of
economics into contiguous fields would come to an end when social scientists
in those fields were able to master its techniques. The number of American
lawyers who now have a PhD in economics seems to confirm his forecast
(Coase, 1978, 1996). Nevertheless, it is clear that law and economics in the
United States would have had less impact if economists had not involved
themselves in the enterprise. It is hardly an exaggeration to state that the
cooperation between lawyers and economists has been a fundamental factor in
the development of the economic approach to law (for information on the
involvement of economists in law and economics see Ellickson, 1989; Landes
and Posner, 1993; Stigler, 1992).
What about Italy? The indifference of economists towards legal institutions
is so manifest that it is not worth dwelling upon. Suffice it to say that a recent
introduction to a collection of papers by Ronald Coase does not include the
slightest reference to his influence on the economic analysis of law or to Italian
contributions in that field (Grillo, 1995, pp. 7ff.). Judging from these writings,
it seems that economics and law in Italy do not communicate at all.
This situation is even more surprising if we look at the training provided by
Italian schools of economics. Their programs include a wide range of law
courses, and economics students have ample opportunity to become fully
conversant in both disciplines. Why this does not happen is not clear. One
might suggest that the jobs market is highly specialized and young graduates
with hybrid skills do not find employment easily. Whatever the case may be, on
the eve of the twenty-first century the Italian Bibliography of Law and
Economics lists only a few contributions by Italian economists.
It is difficult to say whether the present situation will to change in the near
future. Since the last century, political debate on the reform of administrative
agencies and governmental regulation has been the main concern of economic
thinkers in Italy (see, for example, the essays on market and democracy
collected in Bocciarelli and Ciocca, 1994). In accordance with this tradition,
current analysis appears to be dominated by macroeconomics issues (for a
recent survey of the Italian situation by a French economist see Bartoli, 1996).
This is not to say, however, that hopeful signs of a renewed interest in legal
institutions are entirely lacking. The presence of economists in the law faculties
has recently begun to yield fruitful interdisciplinary studies. Some courses in
economics, for example, have applied insights from law and economics to
Italian laws and institutions (see Chiancone and Porrini, 1996; Galeotti 1995),
and there are encouraging signals from the already mentioned Italian
economists working in the field of the New Institutional Economics. Even more
importantly, modern economics textbooks are now devoting more space to such
250 Law and Economics in Italy 0345
subjects as transaction costs, asymmetric information, strategic interactions and
institutional constraints (see, for example, Del Bono and Zamagni, 1996).
Since the 1980s, moreover, there has been a growing interest in game
theory. The activities of the Interuniversitary Centre for Game Theory and
Applications, established in 1990 in Florence, range from the development of
research programs to the spread of game theory in the scientific community.
Unfortunately, Italian economists at work in this field are unaware of the
applications of game theory to legal problems. For example, a recent
introductory textbook notes that game theory has been applied outside
economics in such areas as political science, philosophy, computer science,
engineering and evolutionary biology (Costa and Mori, 1994, pp. 10f.). Law,
of course, is not even mentioned.
Italian scholars are equipping themselves with the theoretical instruments
employed in the economic analysis of the American legal system. In the short
period the institutional dimension - be it the theory of the firm or the structure
of administrative agencies and public utilities - will probably attract more
attention than private law topics like contract, tort and property. Needless to
say, even this development would be a giant step towards the interdisciplinary
study of law and economics.
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0345 Law and Economics in Italy 255
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0350
LAW AND ECONOMICS IN MEXICO
Andrs Roemer and Jos Diego Valads
Copyright 1999 Andrs Roemer and Jos Diego Valads
Abstract
Despite its almost exponential growth, particularly since 1983, economic
analysis of law is still an area of minor importance in Mexico. Economic
analysis of law is still not an integral part of legal education. Legal
scholarship is formalistic in general, and is concerned more with definitions
that with the purposes of legal provisions.
This disciplines main achievement in the academic community has been
its contribution to forming a different juridical mentality, whether of
research, policy or analysis.
Since its establishment on April 6, 1995, the Mexican Academy of Law
and Economics has carried out several academic, teaching and research
activities.
JEL classification: K00.
Keywords: Research, Teaching, Mexican Academy of Law and Economics.
1. Introduction
Despite its almost exponential growth, particularly since 1983, economic
analysis of law is still an area of minor importance in Mexico. However, its
growth rate and the weakness of its adversaries are indications that
economic analysis of law will soon become an important trend in legal
research and in public policy matters.
There are approximately 40 people working in this field. Some are
full-time academicians and most of them work for the federal government.
Their writings are concerned mainly with the problems of the Mexican
regulation system and are almost always written in Spanish. Because of their
small number and their relatively high demand, research tends to cover a
considerable diversity of topics instead of concentrating on particular areas.
Among others, we can mention the following topics that have been the
object of analysis in this field: regulation, law and economics, education, the
economics of water, contracts, ownership, institutions, public services, labor
legislation and domestic trade.
It should be mentioned that legal knowledge in Mexico is formalistic in
general, and Mexican legal scholars have a greater relationship with
262
0350 Law and Economics in Mexico 263
scholars of continental Europe, particularly with Spanish, Italian and French
academicians, than with Americans, the ones who substantially inspired this
discipline. On the other hand, the participation by legal scholars in the
political process is remarkable. This influence is characterized by different
routes, significantly through members of courts, the executive branch, the
Congress, and the high-level bureaucracy.
Based on the foregoing, in Mexico a large part of the evolution of
economic analysis of law has grown significantly from public sector
parameters. Lawyers and economists, particularly specialists in
microeconomics theory, keep in mind the usefulness of economic analyses of
law in the field of public policy. An important example in this respect is the
new agrarian legislation that, without ignoring the principles of justice, was
clearly revised using standards of economic efficiency.
2. Law and Economics at Mexican Universities
In the academic community there are few Mexican universities that show
any interest in economic analysis of law. Among them we can mention the
Autonomous Technological Institute of Mexico (ITAM), Center for
Economic Research and Teaching (CIDE). Likewise, a certain interest has
been detected in the Law School of the National Autonomous University of
Mexico (UNAM) (since the new curriculum of 1993, there exists a course
related to economic matters in each of the 10 semesters), the National
Institute of Public Administration (INAP), and the University of the
Americas in Puebla (UDLA).
This disciplines main achievement in the academic community has been
its contribution to forming a different juridical mentality, whether of
research, policy or analysis. Students often see the emphasis on the real or
potential effects of law and economics through the incentives it produces and
the importance of the costs of the legal system as the main contribution of
the economic approach to law.
In law schools, most teaching related to economics is given in courses
that concern economic theory, history of economic thought and economic
law (part of Mexican social law). These courses are part of the law schools
curriculum (first, second and seventh semesters respectively). This teaching
lasts approximately four months per term.
3. The Mexican Academy of Law and Economics
As regards economic analysis as a movement, the Mexican Association of
Law and Economics (called Mexican Academy of Law and Economics since
264 Law and Economics in Mexico 0350
May of 1997) (AMDE) was founded on April 6, 1995 with the important
support of professors Robert Cooter and Albert Fishlow, as well as of the
former President of Mexico, Miguel de la Madrid Hurtado, the former
Federal Attorney of Mexico, Pedro Ojeda Paullada, the President of the
ITAM, Dr Arturo Fernndez, and Andrs Roemer. Being part of the Latin
American and Caribbean Association of Law and Economics, the AMDE
has more than 30 founding members, 27 numerary members (who have
presented academic papers and are current with their fees), as well as 25
supernumerary members (who are current with payments but have not
presented any related academic paper) and another 400 people interested in
the Academy (who attend congresses and seminars).
Since its establishment on April 6, 1995, the Mexican Academy of Law
and Economics has carried out academic, teaching and research activities
among which the following should be mentioned:
To date more than 137 research papers have been compiled that address
Economic Analysis of Sexual Commingling and Regulation,
Microeconomics of Civil Liability and the Marriage Contract, to Analysis
of the Free Trade Agreement.
- A data base in the subject has been formed with 9000 academic
essays from more than fourteen countries, indexed by place, topic
and author.
- Two National Congresses have been held with more than 200
participants in each one.
- Economic Analysis of Law courses have been implemented in the
Autonomous Technological Institute of Mexico (ITAM), in the
Center for Economic Research and Teaching (CIDE) and in the
Autonomous Metropolitan University (UAM), as well as seminars in
the National Institute of Public Administration (INAP), the
University of the Americas, Puebla Campus and in the Law School
of the National Autonomous University of Mexico (UNAM).
- The Annual National Law and Economy award was established for
the best research paper in the area, as well as the Robert Cooter
Award for the best academic paper in Law and Economics from the
ITAM.
- The respective Academies were likewise formed in the States of
Puebla, Coahuila, Chiapas, Jalisco, Oaxaca and Veracruz.
0350 Law and Economics in Mexico 265
4. Perspectives
As regards publishing services, no single journal has been created dedicated
specifically to the economic analysis of laws. Lawyers are critical of
economic analysis of law. One of the reasons could be that Mexican
academic lawyers lack an understanding of quantitative methods; another
reason is that there has been scant contribution by Mexican economists to
law, although some economists have taught in the law schools and, more
significantly, a number of legal scholars question the essential deontological
bases and the fundamental validity of economic analysis in general.
As can be seen, economic analysis of law is still not an integral part of
legal education. Mexican juridical training and some other institutional
circumstance can explain the reason why. Juridical formalism in Mexico is
concerned more with definitions that with the purposes of legal provisions.
On the other hand, the economic approach to law would seem instrumental
and deals mainly with how certain aims can be achieved by giving the
member or members of a society incentives. However, we should not be
pessimistic as to the future of economic analysis of law in Mexico. The
positive factors must not be overlooked. In the first place, as mentioned
previously, academic lawyers and economists have an interest in applying
economics to law. In the second place, in some law schools there seems to be
a dissatisfaction with the traditional teaching of law as an autonomous
discipline. Thirdly, a considerable number of young academicians are
interested in the international perspectives, and consequently in the new
juridical perspectives. Lastly, as was shown, the application of economic
analysis of the legislation in force in Mexico has produced fruits and is
being practiced profusely. This will probably be reflected in legal education
in the medium and long terms.
Thus, the presence and influence of economic analysis of law will
continue to grow, both from the legal and from the social point of view. The
future of law and economics in Mexico depends crucially on the ability of
this discipline to show in a simple way, not just the potential but the real
value of this approach. It must also show its own limitations and
reciprocities with the science of law: the what and the how of legal
knowledge can contribute to the development of law and of economics. This
kind of cooperation is necessary for an interdisciplinary approach such as
law and economics. Meanwhile, public policies will continue to be the main
source of demand (and inspiration) for economic analysis of law in this
country.
266 Law and Economics in Mexico 0350
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0350 Law and Economics in Mexico 273
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0355
LAW AND ECONOMICS IN THE NETHERLANDS
Rudi W. Holzhauer
Erasmus University of Rotterdam
Rob Teijl
Dutch Ministry of Justice
Copyright 1999 Rudi W. Holzhauer en Rob Teijl
Abstract
The rise of law and economics in the Netherlands has been a mixed lawyers
and economists effort. Budget cuts during recent years put pressure on
economics departments in law faculties to focus more on the law and hence
law and economics became an interesting issue for these departments.
Adoption by the regular law professors is fairly slow and fairly reluctant.
The cautious positioning of law and economics by its early (and later)
proponents avoided any major confrontative philosophical or political
debates.
JEL classification: K00.
Keywords: Research, Education, Teaching.
1. Introduction - Overview
The proper activities in new law and economics started in the Netherlands in
1987. Leiden University (Franken, Hol) then organised a nationwide
meeting, with the aims to make an inventory of all law and economics
activities in the Netherlands, and to see what options were open to cooperate
with and coordinate research and teaching. Approximately 40 academics
attended that meeting.
One of the results was the plan to cooperate in writing a student text
book. Representatives of three faculties (Franken and Hol from Leiden,
Backhaus from Maastricht and Holzhauer and Teijl from Rotterdam) agreed
to write a text that was embedded in Dutch law and that used examples from
the Dutch legal system. A first student textbook by Holzhauer and Teijl was
published in June 1989; a second edition appeared in 1995. Other textbooks
followed: Theeuwes et al. (1989), Hondius (1991), Nentjes (1993b) and Van
Velthoven and Van Wijck (1997).
274
0355 Law and Economics in the Netherlands 275
The Dutch judiciary has a centre for permanent education. In 1992 a first
two day seminar was organised, which basically is repeated bi-annually.
There is some - be it limited - interest (15 to 20 participants).
The major general Dutch law review (Nederlands Juristen Blad) has had
a special editor for law and economics since the 1980s (Ejan Mackaay). The
main student law journal (Ars Aequi) has had a one page column twice a
year since 1992 (Holzhauer, Teijl). The major general Dutch economists
journal (Economisch Statistische Berichten) intends to accommodate a
regular column from 1998 onwards.
So far the Society for Civil Law (Van den Bergh and Faure, 1990) and
the Society for Procedural Law (Holzhauer, 1993) have explicitly put the law
and economics approach at the centre of an annual meeting.
2. Research - General
The first PhD thesis in the field of law and economics in the Netherlands is
Mackaay (1982). Mackaay has also published several overview articles of
(1985, 1988, 1989, 1991). Kaufmann wrote his PhD thesis in 1985 on
Passing off and misappropriation in the law of unfair competition (thesis
Utrecht); Kneppers-Heynert in 1988 on An economic and legal analysis of
franchising (thesis Groningen); Kerkmeester in 1989 on Law and game
theory: an economic model for the emergence of state organization and law
(thesis Rotterdam); Hol on Law in balance (1993; thesis Leiden) and Teijl
and Holzhauer in 1997 on Changing Perspectives in Law and Economics
(thesis Rotterdam). By now several law and economics oriented research
projects have been started.
In 1988 it was decided to found the Centre for Law and Economics. Its
goal is to promote research and teaching in law and economics. Its
information adress is Erasmus University Rotterdam - law faculty, PO box
1738, 3000 DR Rotterdam, Netherlands.
In 1988 the first workshop on law and economics was held in Maastricht
(Backhaus). The workshop had five lectures. And Gordon Tullock was as a
guest-speaker invited. His keynote lecture was on Economic analysis of
legal procedure. By now there is a firm tradition: in April 1998 the eleventh
Workshop was held in Maastricht.
All law faculties now regularly focus on the economic implications of
(changes in) legal rules.
In 1991 a Dutch language law and economics series was started by
Franken, Holzhauer and Teijl (Series Rechtseconomische Verkenningen,
published by Gouda Quint, Arnhem). The purpose is to offer a forum for
publishing contributions of 75-150 pages. On average one volume a year has
276 Law and Economics in the Netherlands 0355
been published: Teijl and Holzhauer (1991b), Richters (1991), Kerkmeester
(1993a), Van den Bergh (1993, 1994, 1997c), Gaakeer and Kerkmeester
(1997).
3. Research - Topics
Property Law
Limited attention is paid to institutional property arrangements. Bouckaert
(1990) gives a summary outline. Meijs and Jansen (1989) relate ownership
to politics and economics. De Geest (1994) discusses private versus common
ownership. Economic ownership and legal ownership are confronted by
Slagter (1968), Colijn et al. (1981) and Huijgen (1995). For a more
sociological setting see von Benda-Beckman (1992).
Hol (1993) touches nuisance issues. Environmental topics are discussed
by Faure (1990b, 1993, 1994). Wiersma (1989) and Peeters (1992) focus on
tradeable (pollution) permits. Ownership of the company is analysed by
Moerland (1995c) and Timmerman (1996). See Company Law below.
Teijl and Holzhauer (1991b) provide an overview of the economic
analysis of intellectual property. An economic perspective on intellectual
property can also be found in Koopmans (1983, 1994) and Strowel (1994).
Van Dijk (1994) concentrates on the economics of patent protection, and
Kaufmann (1986) on the economics of trademarks. For an economic
approach on copyright on the Internet see Richard (1996).
Contracts
There is no literature on the economics of contracts in general. Du Perron
(1990) and Theeuwes (1996) are summary attempts. Franchising is dealt
with in depth by Kneppers-Heynert (1988). Aelen (1990) examines the EC
block exemption for franchise agreements. Castermans and Notermans
(1985) look at disclosure rules in contract formation.
Tort
Basic outlines are Mackaay (1990) and Van Schilfgaarde (1990). Hol (1993)
offers a fairly thorough economic analysis of general tort principles,
including a philosophical perspective. Van Dam (1989) touches on law and
economics. Causation issues are discussed in Faure (1993), Ietswaart (1995)
and Kerkmeester (1993b, 1994b). Law professor and Supreme Court Judge
Nieuwenhuis (1991) has always been rather sceptical. More opposition can
be found in Hol (1991) and Bloembergen (1996). Raes (1988b) criticizes the
economic approach to personal harm on humanistic/philosophical grounds.
Traffic liability is the topic in two early reports by the Justice Department
Ministerie van Justitie (1978, 1980). Nentjes and Dijkstra (1993) and Van
0355 Law and Economics in the Netherlands 277
den Bergh (1997a) relate the neoclassical economic model of liability to a
proposed change in traffic liability law, as do Visscher (1998), Visscher and
Van den Bergh (1998). Liability and insurance is the theme in Van den
Bergh and Faure (1990).
Company Law
By way of introduction read De Kluiver (1994, 1996). The ownership of
the firm and the relationship between shareholders, management and
supervisors are discussed in Boot (1995), Brink (1994), Rietkerk (1992),
Slagter (1988, 1989, 1993), Van der Grinten (1994), Wildenberg and
Zwetsloot (1994).
Different systems of remuneration are analysed by Eigenhuizen et al.
(1987) and Bruining et al. (1989).
In 1995 and 1996 there was a fairly extensive discussion of Corporate
Governance issues: see Boot (1994), Crist (1995), Frentrop (1995), Frijns et
al. (1995), Mendel (1995), Moerland (1995b and 1995e), Slagter (1994),
Tabaksblatt (1995), Wallage (1995), Wiggers (1995), Commissie Corporate
Governance (1996) and Raaijmakers et al. (1996). This discussion is likely
to continue. Moerland (1995a) analyses alternative disciplinary mechanisms
in different corporate systems.
Insider dealing is discussed in Doorenbos and Roording (1990). More
law than economics (on insider dealing) are Beckman and Herst (1988),
Corstens (1989), Doorenbos (1989), Dreese (1984), Groenhuijsen (1995),
Slagter (1996) and Vote (1989).
Economic analyses of takeovers can be found in Rietkerk (1988) and
Moerland (1988), facts on the Netherlands in Vogelzang and Dotsch (1988).
See Braakman (1988) for the role of European competition law. Bruining
(1992) shows the effects of takeovers on share prices. De Jong (1988) relates
protective measures to takeovers.
Theoretical and empirical concentration issues in De Jong (1992),
Dorsman (1992) and Langendijk (1992).
Tax Law
Contributions on the economics of tax law are Caanen and Essers (1990),
Hessing and Elffers (1994) and Zwemmer (1995).
Competition Law/Anti Trust
The divide in writings on competition law is the New Dutch Competition
Act, that came into force on 1 January 1998. It marked a period where the
Netherlands were said to be a cartel-paradise. Since that date there is an
anti-trust authority, and hence more explicit attention for breaking down all
sorts of anti-competitive situations.
278 Law and Economics in the Netherlands 0355
A general law and economics overview on competition law is Van den
Bergh (1997c). More specific on the new act are Van den Bergh (1997b) and
De Vreugd (1993). See also Biesheuvel et al. (1996), Bos (1996), De Jong
(1997), Van der Ploeg (1996) and Schenk (1997).
Criminal Law
Basic analyses in line with Gary Beckers approach: Meester and Wesemann
(1976), Franken (1983, 1991) and Nentjes (1988).
The economic and non-economic factors of crime are analysed in
Theeuwes and Van Velthoven (1994a). Their conclusion is that economic
determinants like unemployment, probability of apprehension and
punishment significantly explain the decrease in criminality, but that social
norm variables at the same time have a relatively more substantial effect. An
economic model of the criminal law system is developed by Van Tulder
(1994). In a non-model way see Steenhuis (1984). Of special interest is Van
Tulders finding that extra expenditures later on in the system (for example
on prisons) are more effective. Kleemans (1996) focusses on the possibilities
to describe urban crime patterns using choice behaviour of those who
commit the specific crime. Economic offences are discussed in Van Altena
et al. (1990).
Critique on the rational choice model with respect to criminal law can be
found in Franken (1983), Wladimiroff (1991), Baerveldt (1993), Bruinsma
and Van de Bunt (1993), Van Dijk (1993), Hesseling (1993), Kleemans
(1993) and Moerland (1993). The latter six references are in a special issue
of the Tijdschrift voor Criminologie (Journal of Criminology 1993/2)
rational choice and criminal behaviour.
Administrative/Constitutional Law
An economic model for the emergence of state organization and law in a
game theoretical approach is offered by Kerkmeester (1989). The same
author presents an introduction into constitutional economics in
Kerkmeester (1993a). For an economic analysis of constitutional law see
also Backhaus (1991) and Ten Berge (1991). Van Ommeren (1990) looks at
administrative compensation and financial capacity from a law and
economics angle. Jansen (1996) discusses administrative fines in the new
Dutch Competition Act.
Regulation
Early notes on deregulation are De Kraan (1982a, 1982b) (general), Mok
(1983), Slot (1983) and Bolkestein (1985) (competition law). Deregulation
in working conditions legislation is discussed in Faure (1995a). In 1994 the
Minister of Economic Affairs initiated a research project on the functioning
of the market in the Netherlands. It has boosted the writings on regulation in
0355 Law and Economics in the Netherlands 279
general and furthermore resulted in some reports on the possible impact of
deregulation and privatization in some economic sectors. See on this (de-)
regulation debate: Bernardt and Canoy (1997), Bos (1995), Van Damme
(1996, 1997), Geelhoed (1993), Gestel et al. (1996), Jacobs (1996), Koedijk
(1994), Mol and Verbon (1997), Peeters (1994), Van der Ploeg (1994), Van
Waarden and Unger (1992), Verhaegen and Volkers (1996).
Public Choice
The economic theory of political decisionmaking is presented by
Groenewegen et al. (1988), De Geest (1990), Van Winden (1990) and
Schreuders (1990).
Environmental Law
In a very general way Nentjes (1993a) discusses who owns the environment.
The efficiency of an environmental policy in accordance with market
principles is discussed in Wiersma (1989).
Faure (1990b) takes up the Shavell model for the choice of protecting the
environment through liability law or through regulation. The first use rule is
analysed in Faure (1994), and reflections on probabilistic causal evidence for
environmental health damage are made in Faure (1993). Nieuwenhuis
(1991) offers three ways of balancing interests in environmental law,
including a critique on the economic approach (see also Nieuwenhuis,
1997).
A comparative study regarding the transferability of pollution rights is to
be found in Peeters (1992). Nentjes (1996) compares tradeable permits to
covenants.
Legal Procedure
Van Velthoven and Van Wijck (1996, 1997) apply the Shavell model on
suits and settlements. Authors that should be mentioned here in a more
general way are Van Tulder, Van Koppen, Ten Kate and Malsch. All their
work is more or less on efficiency and effectiveness in the area of
adjudication. Their empirical approach partly stems from a sociological
background. More purely sociological in nature are the contributions of
Blankenburg (1984, 1990). Klijn (1988, 1996) are somewhere in between.
Contributions from lawyers are Van Dijk (1987) and Snijders (1987).
4. Teaching
In a number of law faculties attention is paid to law and economics.
Sometimes this is done in a (compulsory) course on economics, sometimes
in another form. Mention can be made of the faculties in Groningen, Leiden,
280 Law and Economics in the Netherlands 0355
Maastricht, Rotterdam and Utrecht. There is a tendency for economics in
law faculties to increasingly focus on law/legal topics. In this way at Leiden
university law faculty law and economics material was developed for the
second year (compulsory) course in economics. Those materials are now in
the book by Van Velthoven, Van Wijck et al. (1997). In Groningen and
Rotterdam we see a similar move. In Maastricht law and economics is
offered in a much more limited way later on in the curriculum.
In the early 1990s several joint study weekends were held at an
undergraduate level, with law and economics students from Ghent, Antwerp
and Rotterdam.
Together with the Ghent Law Faculty (Bouckaert, De Geest) the
Rotterdam Law Faculty (Holzhauer, Teijl) founded the one-year English
taught Erasmus Programme in Law and Economics in 1990. The network of
participating faculties expanded throughout Europe and is at present (1998)
some 20. The coordination of the Programme shifted to Hamburg (Ott,
Schfer) in 1995. In this Programme Rotterdam teaches two terms; Leiden
one term. Utrecht created a separate one-year English taught postgraduate
LL.M. Programme in (European) Law and Economics in 1997 and founded
the first part-time chair in law and economics (held by Roger Van den
Bergh). The Rotterdam law faculty will have the first chair in law and
economics in 1998.
5. Prospects for Law and Economics in the Netherlands
The rise of law and economics in the Netherlands has been a mixed effort by
lawyers and economists. Most law faculties (there are eight in the
Netherlands) have their own chair in economics (as well as in sociology and
- often - psychology). Budget cuts during recent years put pressure on
economics departments in law faculties to focus more on the law and hence
law and economics became an interesting issue for these departments.
Adoption by the regular law professors is - as one could expect - fairly slow
and fairly reluctant. The cautious positioning of law and economics by its
early (and later) proponents avoided any major confrontative philosophical
or political debates.
So far, faculties of economics hardly seem to take an interest in law and
economics. Most contributions came and come from (economists and
lawyers in) law faculties.
For a moment, in the mid 1990s, the already mentioned budget cuts
threatened the existence of economics (and all other non-law disciplines) in
those faculties. However, there are now (1997/98) signs for a renewed
interest in interdisciplinary research and teaching. Thus, we may see regular
economics chairs being transformed into law and economics. On the whole
0355 Law and Economics in the Netherlands 281
we nevertheless seriously doubt whether law and economics will ever
establish itself acedemically in the American way, for example appear in
many/most/all students and practitioners law books.
The Department of Justice takes some interest in law and economics
issues. There are several private consultants that practice law and
economics, usually under the heading of policy analysis. The
firms/foundations Research en Beleid in Leiden; Stichting voor
Economisch Onderzoek (SEO) in Amsterdam and the Nederlands
Economisch Instituut (NEI) in Rotterdam all regularly produce economic
analyses of legal issues on demand.
Bibliography on Law and Economics in the Netherlands (0355)
This list consists of contributions to law and economics in Dutch
publications. Occasionally an article or book is in the English Language (for
example originally published in English). If in Dutch, the author may
occasionally be non-Dutch (for instance, Belgian).
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Akkermans, A. (1995), Statistisch Causaliteitsbewijs bij Toxische Schadeveroorzaking (Statistical
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Aretz, Edward M. (1993), Efficient Law, Limburg, Rijksuniversiteit, 181 p.
Baarslag, A.D. (1990), Octrooibeleid van de Onderneming (Patent Policy of the Firm), in X (ed.),
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Backhaus, Jrgen G. (1990), De Eis tot Correctie van Ondoelmatig Recht (The Need to Correct
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Backhaus, Jrgen G. (1991), Een Economische Analyse van het Constitutionele Recht (An
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Baerveldt, Chris (1993), Het Gebruik van Rationele Keuzereconstructies bij de Effect-evaluatie
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Bakker, Luit M. et al. (1996), Economie en Recht: van Confrontatie naar Integratie (Economics
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282 Law and Economics in the Netherlands 0355
Opstellen Aangeboden aan prof. dr. C. Rijnvos, Groningen, Wolters-Noordhoff, 102-111.
Bakker, Luit M. and Holzhauer, Rudi W. (1998), Parallel Import, Rechtseconomische
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Bakker, Luit M. and Ridder, Ronald K. De (1990), Het EG- Mededingingsbeleid en de
Samenwerking en Concentratie Binnen het Europese Bankwezen (EC Competition Policy and
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Barents, R. (1986), Enige Recente Ontwikkelingen in het Europese Mededingingsbeleid
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Beckman, H. and Herst, H.C.C. (1988), Handel met Voorwetenschap (Insider Dealing), 66(2) De
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Bekkers, V.J.J.M. (1996), De Schutkleuren van het Dereguleringsbeleid (The Camouflage of
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Bernardt, Y. and Canoy, M. (1997), Hordenlopen van Monopolie naar Markt (The Hurdle-Race
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Biesheuvel, M.B.W. et al. (1996), Van Ordening naar Marktwerking: Kanttekeningen bij het
Ontwerp-Mededingingswet (From a Regulatory to a Market Approach: Notes on the
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Blankenburg, E. (1984), Bevorderen Rechtshelpers de Groeiende Neiging tot Procederen of
Remmen zij deze Juist af? (Does Legal Aid Promote or Curb the Increasing Tendency to go to
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rechtspraktijk, Zwolle, Tjeenk Willink, 110-123.
Blankenburg, E. (1990), Naar een Planeconomie voor de Rechtshulp (Towards a Planned
Economy for Legal Aid), Nederlands Juristen Blad, 879-882.
Blankenburg, E. and Verwoerd, J.R.A. (1987), Vermijden en Benutten van Civielrechtelijke
Procedures in Nederland en Omringende Landen (The Use and Avoidance of Private Law
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Bleeker, K.A.M. (1989), De Geheimhoudingsplicht volgens art. 42 WEM in het Licht van het
EEG-Verdrag (The Secrecy Duty According to s. 42 WEM in the Light of the EC Treaty), 37
Sociaal-Economische Wetgeving: Tijdschrift voor Europees en Economisch Recht, 714-722.
Bloembergen (1972), Duizend Botsingen: Een Kwantitatieve Analyse van Civiele
Rechtbankvonnissen in Verkeerszaken (Thousand Accidents: A Quantitative Analysis of Civil
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Bloembergen, A.R. (1996), Wolfsbergen en de Rechtseconomie (Wolfsbergen and Law and
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Bloembergen, A.R. and Van Wersch, P.J.M. (1973), Verkeersslachtoffers en hun Schade (Victims
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0355 Law and Economics in the Netherlands 283
Booij, J.T. (1993), De Economische Betekenis van het Auteursrecht in 1989: Rapportage 1993
(The Economic Role of Copyright Law in 1989: Report 1993), Amsterdam, Stichting voor
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130 p.
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Bovens, M.A.P. and Witteveen, W.J. (1987), Bruce Ackerman over Sociale Rechtvaardigheid, de
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Supervisory Boards Act), 72 De Naamloze Vennootschap, 240-246.
Brinkhof, Jan J. (1990), Over Octrooirecht en Economie (On Patent Law and the Economy),
39(10) Ars Aequi, 794-802.
284 Law and Economics in the Netherlands 0355
Bruin, A.C.N. (1995), Fusietoezicht: Derde Pijler van het Mededingingsbeleid (Merger Control:
Third Leg of Competition Policy), 80 Economisch-Statistische Berichten, 489-492.
Bruining, J. (1992), De Effecten van Overnames op Aandelenrendementen in Fusies en Overnames
(The Effects of Take-Overs on Share Prices in Mergers and Take-Overs), in X (ed.), Fusies en
Overnames: Liber Amicorum aangeboden aan Prof. dr. L.A. Ankum, Schoonhoven,
Academic Service, 35-50.
Bruining, J. et al. (1989), Prestatieverbetering na Management Buy-out in het Licht van de Agency
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Bruinsma, G.J.N. and Van de Bunt, H.G. (1993), Misdrijven uit Berekening (Calculated Crimes),
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Castermans, A.G. (1989), Schadevergoeding bij Dwaling (Damages for Misrepresentation),
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Chao-Duyvis, M.A.B. (1990), Vergelding als Schadevergoeding (Retribution as Damages),
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91-95.
Colijn, P.J. et al. (eds) (1981), Economische Eigendom (Economic Ownership), Deventer, Kluwer,
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0355 Law and Economics in the Netherlands 285
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Economic Importance of Copyright 1), Amsterdam, Stichting voor Economisch Onderzoek
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Crist, William D. (1995), The Corporate Governance Impact of US Pension Funds as Large Global
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Governance and the Role and Function of the Accountant), 73 De Naamloze Vennootschap,
274-276.
Walther, Sylvia R.B. (1991), Eigen schuld slachtoffer en schadevergoedingsmaatregel. Een
civielrechtelijke verdeelsleutel in het strafrecht (Victims Fault and Damage Orders. A Civil
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Wassenaer Van Catwijck, A.J.O. Baron Van (1977), Verkeersverzekering (Traffic Insurance),
Zwolle, Tjeenk Willink, 78 p.
308 Law and Economics in the Netherlands 0355
Wassenaer Van Catwijck, A.J.O. Baron Van (1988), Verkeersverzekering in Noord-Amerika
(Traffic Insurance in North America: No-fault in Action), Het Verzekerings-Archief, 321-377.
Wassenaer Van Catwijck, A.J.O. Baron Van (1991), Op zeker spelen. Invloeden van zekerheden in
het NBW op het financieringsbedrijf (Play it Safe. Influence of Dutch New Civil Code Se), in
Coljee, P.D., Franken, H., Heertje, A. and Kanning, W. (eds), Law and Welfare Economics,
Amsterdam, VU Amsterdam, 133-150.
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and Entrance: Aspects of Competition), Den Haag.
Weijden, Carel J. Van Der (1981), Toestaan of verbieden? Een beschouwing rond de Wet
economische mededinging (Allowing or Banning? Considerations about the Economic
Competition Act), 66 Economisch-Statistische Berichten, 1281-1284.
Weijden, Carel J. Van Der (1987), Werkzame mededinging (Workable Competition), 72
Economisch-Statistische Berichten, 1194-1199.
Wertheimer, H.W. (1983), De Europese Concentratiecontrole in De Revisie (European
Concentration Control in Revision), 31 Sociaal-Economische Wetgeving: Tijdschrift voor
Europees en Economisch Recht, 66-84.
Wichers Hoeth, L. (1984), Mini-monopolies: Een Reactie (Mini-monopolies: A Response),
Rechtsgeleerd Magazijn Themis, 356-357.
Wiersma, D. (1989), De Efficintie van een Marktconform Milieubeleid (The Efficiency of an
Environmental Policy in Accordance with Market Principles), Dissertatie Groningen.
Wiggers, Willem J.H. (1995), Corporate Governance, Rechtsvergelijkende Beschouwingen over
Kwaliteit van Bestuur en Toezicht in de Onderneming (Corporate Governance, Comparitive
Considerations on Quality of Management and Supervision in the Firm), Working Paper
Juridische Faculteit.
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Nederlandse Vennootschap (Towards a New Division of Power in the Dutch Company),
Deventer, Kluwer, 69 p.
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Economics and Criminal Law: Some Critical Remarks), in Hondius, E.H., Schippers, J.J. and
Siegers, J.J. (eds), Rechtseconomie en Recht, Zwolle, Tjeenk Willink, 181-186.
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X (1990), Special Issue on Law and Economics, Ars Aequi, 603-804.
Zijlstra, Jelle and Goudzwaard, Bob (1966), Economische politiek en concurrentieproblematiek
in de EEG en de lidstaten (Economic Policy and Competition Problems in the EC and the
Member States), Serie Concurrentie, Brussel.
Zwemmer, J.W. (1995), Belastingrecht op het Grensvlak van Economie en Recht (Tax Law on the
Borderline of Economics and Law), in X (ed.), Ondernemen tussen Macht en Ordening:
Opstellen op het Grensvlak van Economie en Recht, Amsterdam, Thesis Publishers, 37-45.
0360
LAW AND ECONOMICS IN NORWAY
Erling Eide
Professor of Economics, Faculty of Law, University of Oslo
Copyright 1999 Erling Eide
Abstract
The growing interest in law and economics among academic lawyers is
demonstrated by the fact that the subject now has become compulsory for law
students at the Faculty of Law in Oslo. A number of PhD theses at the same
faculty are wholly or partially of a law and economics character. Economists
have contributed on various issues within economics of crime, product liability,
constitutional law, environmental law, and industrial organization.
JEL classification: K00
Keywords: Product Liability, Economics of Crime, Litigation, Constitutional
Law, Environmental Law
1. Research
Although economic analysis occasionally has appeared in the traditional
Norwegian law literature, it was not until Trine-Lise Wilhelmsens study on
Egenrisiko i skadeforsikring (Retained Risk in Casualty Insurance) in 1989
that such analysis became part of a major work by an academic lawyer. Since
then, Anders C. Stray Ryssdal (1995a, 1996b) has written a two volume
dissertation, one on Legal Realism and Economics as Behaviour: A
Scandinavian Look at Economic Analysis of Law, and the other on Economic
Analysis of Civil Suits and Appeals. Another major contribution is Avtalelovens
36 og konomisk effektivitet (Section 36 of the Nordic Contract Acts and
Economic Efficiency) by Trine-Lise Wilhelmsen (1995). Economic theory also
plays an important role in three PhD dissertations that are about to be
completed at the University of Oslo, one on antitrust law and two on
environmental law.
Apart from the questions of monopolies, competition and so on analysed
in the old law and economics literature, economists have only recently entered
the more modern field of law and economics. Prevalent topics studied are
regulation, product liability, crime, environmental law and industrial
organization. Alf E. Risa has in several papers analyzed health and safety, in
particular product liability, Risa (1994). Constitutional issues are analysed by
Hylland (1984). A number of contributions to the economics of crime literature
started with Allingham and Sandmo (1972) and Sandmo (1981) on tax evasion,
309
310 Law and Economics in Norway 0360
followed by Isachsen and Strm (1980) on the underground economy, Andvig
and Moene (1990) on corruption, Andvig (1995) on organized crime and Eide
(1994a) on criminal behavior in general. An eleven-year program (1991-2001)
on economic crime by the Research Council of Norway had by the end of 1997
produced 42 reports, mostly on tax evasion, bankruptcy and economic crime in
financial markets. Some of these reports, in particular Knivsfl (1993) and
Langli (1994), are more of a law and economics type than most of the others.
A manifestation of the growing interest in law and economics was the
invitation to a group of academic lawyers and economists to spend a year at the
Centre for Advanced Study at The Norwegian Academy of Science and Letters
in 1994-95. Five scholars spent most of the year in Oslo, whereas several others
were invited for shorter periods, some attending a conference on the Law and
Economics of the Environment. A conference volume edited by Van den Bergh
and Eide was published.
2. Education
In connection with a major reorganization of the study of law at the University
of Oslo law and economics has been substituted for the traditional introductory
course in micro and macro economics. A compulsory course in law and
economics for public law must be taken in the second year, and the students
may also choose to take a more extensive course (one quarter of a years work)
at the end of the study. At other institutions no courses in law and economics
are offered, except courses for economists where industrial organization and
regulation are main topics.
Two textbooks have been published by Erling Eide. One on
Kriminalkonomi (Economics of Crime) has been written for a course in
economics, whereas one on Rettskonomi for offentlig rett (Law and Economics
for Public Law) has been written for a compulsory course at the Faculty of Law
in Oslo.
Bibliography on Law and Economics in Norway (0360)
Allingham, M. and A. Sandmo (1972), Income Tax Evasion: A Theoretical Analysis, 1 Journal of
Public Economics, 323-338.
Andvig, Jens C. (1989), Korrupsjon i Utviklingsland (Corruption in Developing Countries), 23
Nordisk Tidsskrift for Politisk Ekonomi, 51-70.
Andvig, Jens C. (1995), Corruption in the North Sea Oil Industry: Issues and Assessment, 23 Crime,
Law and Social Change, 289-313.
Andvig, Jens C. and Karl Ove Moene (1990), How Corruption may Corrupt, 13 Journal of Economic
Behavior and Organization, 63-76.
0360 Law and Economics in Norway 311
Eide, Erling (1981a), Kritikk av noen forutsetninger i Kriminalmeldingen (Critique of Some
Assumptions in the Report on Crime), Lov og Rett, 312-323.
Eide, Erling (1981b), Book Review of Lars Werin,1979, Ekonomi och Rettssystem, 94 Tidsskrift for
Rettsvitenskap, 752-754.
Eide, Erling (1981c), Heineke, J.M. (Ed.), Economic Models of Criminal Behaviour (Book Review),
Economic Journal, 584-585.
Eide, Erling (1983), Realbeskatning og Nominalismen i Norsk Rett (Real Tax Rates and Nominalism
in Norwegian Law), 37 Sosialkonomen, 5-10.
Eide, Erling (1984a), Book Review of Gran Skogh, 1982, Marknadens Villkor, 95 Tidsskrift for
Rettsvitenskap, 318-319.
Eide, Erling (1984b), Renter og Verdisikring av Pengekrav (Interest Rates and Security against
Inflation in Monetary Claims), 97 Tidsskrift for Rettsvitenskap, 477-533.
Eide, Erling (1986), Book Review of Nils Nygaard, 1985, Skatt og Skade, 96 Tidsskrift for
Rettsvitenskap, 708-712.
Eide, Erling (1987), Ekspropriasjonserstatning i en Inflasjonstid: Valg av Kapitaliseringsrente
(Compensation for Expropriation in Times of Inflation), Lov og Rett, 165-177.
Eide, Erling (1992), Rettskonomi - en Introduksjon (Law and Economics - an Introduction),
Jussens Venner, 193-224.
Eide, Erling (1994a), Kriminalkonomi (Economics of Crime), Stavanger, Rogaland Mediesenter.
Eide, Erling (1994b), Economics of Crime: Deterrence and the Rational Offender, Amsterdam,
North-Holland.
Eide, Erling (1995a), Valg av Investeringsobjekt for Erstatningsbelp (Choice of Type of Investment
for Compensatory Damages), Lov og Rett, 58-64.
Eide, Erling (1995b), Kapitaliseringsrenten - ny Episode (The Discount Rate - New Episode), Lov
og Rett, 351-358.
Eide, Erling (1997, 2. utg.), Rettskonomi for offentlig rett, Bergen, Grafisk Hus.
Heyerdahl, H. Cristopher (1991), En konomisk Analyse av de Ulovfestede Ansvarsreglene i
Erstatningsretten, for Risikonytrale Aktrer (An Economic Analysis of Common Law Liability
Rules in Tort Law for Risk-Neutral Agents).
Hylland, Aanund (1984), Br politikerne binde sin egen handlefrihet? - Om grunnlovfestet
budsjettbalanse, oljefond og politisk hestehandel (Should Politicians Restrict Their Freedom of
Action?), Bergen Bank Kvartalsskrift, 87-101.
Isachsen, Jon Arne and Steinar Strm (1980), The Hidden Economy: The Labour Market and Tax
Evasion, 82 Scandinavian Journal of Economics, 305-311.
Isachsen, Arne Jon and Strm, Steinar (1981), Skattefritt. Svart Sektor i Vekst (Taxfree. The Growth
of the Black Sector), Oslo, Universitetsforlaget.
Knivsfl, Kjell Henry (1993), Illegal Insider Trading and the Stock Market Reaction, 10 The
Research Council of Norway, Research on Economic Crime.
Langli, Christian (1994), Konkurskriminalitet: En Empirisk Analyse av Aksjeselskaper som har Gtt
Konkurs (Bankruptcy Crime: An Empirical Analysis of Corporations that Have Gone Bankrupt),
17 The Research Council of Norway, Research on Economic Crime.
Risa, Alf Erling (1994), Preference Revelation in Strict Liability Product Safety Markets, 14
International Review of Law and Economics, 41-52.
312 Law and Economics in Norway 0360
Ryssdal, Stray A.C. (1993), Antitrust Enforcement - An Inquiry into Policy Analysis of Competition
Law, Working Paper, 89 Centre for Research in Economics & Business Administration, Bergen.
Ryssdal, Anders C. Stray (1995a), Legal Realism and Economics as Behaviour: A Scandinavian
Look at Economic Analysis of Law, Oslo, Juridisk Forlag.
Ryssdal, Anders C. Stray (1995b), An Economic Analysis of Civil Suits and Appeals, Oslo, Juridisk
Forlag.
Ryssdal, Stray A.C. (1996), Towards a Nordic Competition Law?, 109 Tidsskrift for Rettsvitenskap,
332-357.
Sandmo, Agnar (1981), Income Tax Evasion. Labour Supply, and the Equity-efficiency Tradeoff,
16 Journal of Public Economics.
Stavang, Endre (1992), Verdiskapningshensyn og juridisk argumentasjon: Srlig om kompensasjon
for lokale miljskader (The Relation between Efficiency Analysis and Legal Reasoning, with
Special Reference to Local Pollution Damage), Stensilserie Nr. 139, Institutt for privatrett,
Universitetet i Oslo.
Stavang, Endre (1996), Legal Economics: How Cautious Should Lawyers Be?, Working Paper, 3
Law and Economics, Institutt for privatrett, Universitetet i Oslo.
Stavang, Endre (1997), Tolerance Limits and Temporal Priority in Environmental Civil Liability,
Working Paper, 4 Law and Economics, Institutt for privatrett, Universitetet i Oslo.
Van den Bergh, Roger and Erling, Eide (1994), Law and Economics of the Environment, Oslo,
Juridisk Forlag.
Wilhelmsen, Trine-Lise (1989), Egenrisiko i Skadeforsikring (Retained Risk in Casualty Insurance),
Sjrettsfondet, Grafisk Hus, Bergen.
Wilhelmsen, Trine-Lise (1995), Avtalelovens 36 og konomisk effektivitet (Section 36 of the Nordic
Contract Acts and Economic Efficieny), 108 Tidsskrift for Rettsvitenskap, 1-246.
0365
LAW AND ECONOMICS IN PORTUGAL
Miguel Moura e Silva
Assistente, Faculdade de Direito da Universidade de Lisboa
Copyright 1999 Miguel Moura e Silva
Abstract
This short chapter presents an overview of the current state of law and
economics in Portugal. Whereas no specific courses are taught on this subject,
researchers in the field have been relatively active. An account is given of some
of the research done so far in Portugal.
JEL classification: K00
Keywords: Portugal, Law and Economics, Teaching, Research
1. Introduction
At present, law and economics seems to remain the province of a few scholars,
mainly teaching at the University of Coimbra and University of Lisbon Law
Schools and the Economics departments of the University of Coimbra,
Universidade Nova and Universidade Catlica, as well as the ISEG -
Economics and Business School. With a few exceptions, such as a special issue
by a law review, Sub Iudice, dedicated to Law and Economics, published in
1992, there seems to be a lack of institutionalized communication channels
between scholars, particularly between lawyers and economists.
2. Law and Economics Courses
No specialized courses on law and economics exist in the current curricula at
undergraduate level in either Economics or Law degrees. In Portugal, Law is
taught as a five year degree following high school. The Economics degree has
the same structure (although it may be completed in four years in some
universities). The legal curriculum is mandatory during the first three years and
there is no possibilitity of undergraduate interdisciplinary studies in other
university departments. The economic training of law students consists, in most
law schools, in a first-year, two semesters, course on Political Economy and a
second-year, one semester, course on International Economic Relations. These
courses tend to focus more on institutional and historical aspects rather than on
313
314 Law and Economics in Portugal 0365
applied economic theory even at an elementary level. No formal economic
theory is normally taught and only a few law schools adopt elementary
textbooks such as Nordhaus/Samuelson. This is hardly surprising as lecturers
and assistants of economic subjects are usually lawyers with no specific
economic background.
On the other hand, economics students are typically taught two law courses
of one semester each. The first course consists of an introduction to law, a
simplified version of a similar subject taught to first-year law students. The
second is an upper-class course, normally dealing with basic corporate and
trade regulation law.
At graduate level, to my knowledge the only experiment so far has been in
the Masters degree at the University of Lisbon Law School where a research
seminar was held two years ago on basic game theory concepts by Emeritus
Prof. Soares Martinez.
Despite this bleak outlook, law and economics basic concepts are fairly well
known among legal scholars and they are reflected in their academic work.
The introduction of a specialized Law and Economics course in
undergraduate curricula at law schools seems to be a remote prospect. A
traditional approach to legal education tends to keep curricula unchanged for
many years and there is at present no proposal for change in existing law
schools. This may yet change as the Universidade Nova in Lisbon is in the
process of setting up a new law school opening in 1997. Since this university
has a well reputed economics department one may expect a greater inclination
to innovate legal education by incorporating law and economics. At the time
of writing the curricula was not yet available for comment.
As to the use of law and economics as a tool in specific subjects taught at
law schools, this is greatly undermined by law students general lack of any
serious undergraduate economics background.
3. Research
3.1 Methodology and Fundamental Concepts
Professor Jorge Sinde Monteiro of the University of Coimbra Law School is one
of the pioneers of law and economics in Portugal. In an article published in
1981 (Sinde Monteiro, 1981) he considers several methodological questions
regarding the place of economic analysis of law in the context of the science
of law (jurisprudence). The author considers the role of values, and concludes
that justice as defined by law and economics scholars such as Guido Calabresi
is not the same as lawyers justice. For the latter justice is what the author
terms a constitutive and regulative principle and not a merely empirical fact.
His conclusion is that the economic analysis of law may usefully constitute an
auxiliary science of law, but not science of law itself.
0365 Law and Economics in Portugal 315
Professor Sousa Franco, of the University of Lisbon Law School and the
Portuguese Catholic University Law School, emphasizes the role of economic
analysis of law in overcoming legal positivism by providing a framework for
the analysis of the content and purpose of legal rules (Sousa Franco, 1992).
Nevertheless, he cautions against an excessive enthusiasm for economic
analysis of law due to what he terms its materialistic and individualistic bias.
The preservation of the particular values established by the legal system is
necessary to prevent an instrumentalization of law and the replacement of
non-economic or supra-economic values. Despite these methodological issues,
the author argues cogently for the role of economic analysis in overcoming a
certain narrow-mindedness of legal studies and in bringing together law and
its practice.
3.2 Civil Procedure
In the field of civil procedure, Justice Ribeiro Mendes of the Portuguese
Constitutional Court has written one of the most interesting pieces of economic
analysis of Portuguese law (Ribeiro Mendes, 1992). Setting out from Richard
Posners analysis of civil procedure, Justice Ribeiro Mendes examines some of
the economic effects of the Portuguese rules regarding debt collection
(executive procedure). The division between declarative procedure (mandatory
for creditors that do not have an executive title) and the increased costs of this
two-tier procedure create incentives to look for alternative ways of securing
debt, such as guaranty cheques, hidden property guarantees, negative
guarantees and withholding of title. Another significant problem examined by
Justice Ribeiro Mendes is that of the sale of debtors assets. In Portugal this sale
is made by order of the courts and the tender takes place before a judge.
According to the author, this system has developed into a collusive market,
where bid-rigging is rampant, thus defrauding creditors and the State.The
author envisages central sales agencies, managed by the State or by
specially-regulated firms.
3.3 Antitrust
Moura e Silva (1993) attempts to show the tension and the interplay between
intellectual property law with its concern for the protection of incentives to
innovate and antitrust with its goal of maintaining competitive markets. The
1991 EC software directive incorporated this concern in the form of a
decompilation exception which allows access to the elements of a computer
program which are necessary to achieve interoperability. However, this delicate
balance may be upset by the use of EC competition law in order to prevent the
exercise of such intellectual property rights as a mean to foreclose competitors,
as evidenced by the Magill case. Using the tools of economic analysis of
intellectual property, he argues for moderation in the use of antitrust when
316 Law and Economics in Portugal 0365
competitive concerns have already been reflected in the mechanism design of
intellectual property laws, as is the case of EC software protection.
Moura e Silva (1994) analyses the application of the EC merger regulation
until 1993, under the light of current industrial economics and compares the
Commissions approach to that used by US antitrust enforcement agencies
under the 1992 Merger Guidelines. An argument is made for greater use of
economic analysis, especially regarding market definition, and for an explicit
efficiencies defence.
3.4 Consumer Protection
Teixeira (1994) sets out from MacNeils relational contract theory to study the
structure of contracts involving different legal orders from the perspective of
the choice of law and consumer protection. The impact of consumer protection
goals in the context of rules on conflict of laws on the contractual balance
between the parties is then analysed. The author argues, from a conflict of laws
point of view, that the concept of market plays a pivotal role in defining the
applicable law in the case of international consumer contracts within the
European Union, particularly in light of the regime of the Rome and Brussels
conventions, as this market construct is not merely economic but also has a
social content protecting the legitimate expectations of consumers regardless
of their nationality or country of origin.
4. Conclusion
In conclusion, law and economics is well disseminated among academia,
particularly in those fields with greater contact with economic science, such as
tax law or public finance. A growing number of private law scholars use
economic analysis of law in their research work as evidenced in some of the
research reviewed above. However, at academic level, law and economics in
Portugal seems to suffer from two communication problems. One is the lack of
a workshop tradition in legal academia which could contribute to bring
together the different scholars working in the field. The other is the divide
between lawyers and economists in academia. Furthermore, the growing
interest of academia in law and economics has yet to translate into a more
common use of law and economics as a teaching method at both undergraduate
and graduate levels.
0365 Law and Economics in Portugal 317
Bibliography on Law and Economics in Portugal (0365)
Confraria, Joo (1989), Aspectos de Abordagem Econmica do Comportamento Criminal (Aspects
of the Economic Analysis of Criminal Behaviour), Scientia Juridica, 171-182.
Martins, Manuel Victor (1992), Ronald Coase: Na Fronteira de Economia e do Direito, 2 Sub Judice,
29-30.
Moura e Silva, Miguel (1993), Proteco de Programas de Computador na Comunidade Europeia,
7 Revista Direito e Justia, 253-310.
Moura e Silva, Miguel (1994), Controlo de Concentraas na Comunidade Europeia, 8 Revista
Direito e Justia, 133-139.
Ramos De Sousa, Joo (1992a), Ejan Mackaay, La Rgle Juridique Observe par le Prisme de
LEconomiste - Book Review, 2 Sub Judice, 44-46.
Ramos De Sousa, Joo (1992b), Frank Easterbrook, Criminal Procedure as a Market System - Book
Review, 2 Sub Judice, 47-49.
Ramos De Sousa, Joo (1992c), James Buchanan, Politics without Romance - Book Review, 2 Sub
Judice, 50-52.
Ribeiro Mendes, Armindo (1992), Processo Executivo e a Economia, 2 Sub Judice, 51-62.
Sinde Monteiro, Jorge (1981), Analise econmica do direito (Economic Analysis of Law), 57 Boletim
da Faculdade de Direito de Universidade de Coimbra, 247-251.
Sousa Franco, Antnio (1992), Richard A. Posner, Economic Analysis of Law - Book Review, 2 Sub
Judice, 39-43.
Sousa Franco, Antnio (1992), Anlise Econmica do Direito: Exerccio Intelectual ou Fonte de
Ensinamento?, 2 Sub Judice, 63-70.
Teixeira, Pedro Gustavo (1994), A Questo da Proteco dos Consumidores nos Contratos
Plurilocalizados (Consumer Protection in International Contracts), 54 Revista da Ordem dos
Advogados, 181-343.
0370
LAW AND ECONOMICS IN QUEBEC
Frdrick Charette
Research Fellow
University of California, Berkeley
Copyright 1999 Frdrick Charette
Abstract
Although law and economics has had a definitive impact on legal studies in the
United States and English-speaking Canada, and continues to make inroads
in Europe, the Province of Quebec remains insulated. Not only is institutional
recognition of the discipline absent, its practitioners are also few and isolated.
In this short chapter, I try to offer an up-to-date picture of the field within
Quebecs law schools as well as some hypotheses that could explain the current
state of affairs.
JEL classification: K00
Keywords: Canada, Quebec, Research, Education, Teaching, French
1. Introduction
Writing on the status of law and economics in Quebec has proven to be a
worthy challenge. Although the movement has had a definitive impact on legal
studies in the United States and English-speaking Canada, and continues to
make inroads in Europe, the Province of Quebec remains insulated. Not only
is institutional recognition of the discipline absent, its practitioners are also few
and isolated. In this short review, I will try to offer an up-to-date picture of the
field within Quebecs law schools as well as some hypotheses that could explain
the current state of affairs. We will see that language alone cannot fully account
for the lack of interest in the field. Finally, I will try and provide some hope for
the future by pointing to the possibility of a wider recognition of the field and
to the uniqueness of Quebecs legal system as a potentially rich source for
comparative studies.
2. Law and Economics Education and Research in Law Schools and
Economics Departments
In the introduction to the second edition of their Law and Economics, Cooter
and Ulen (1996, p. 2) list ten criteria by which one can measure the impact of
318
0370 Law and Economics in Quebec 319
economics on law. None of the six Quebec law schools (Laval, McGill,
Montreal, Sherbrooke, UQAM, to which I add the civil law section of the
University of Ottawa) pass all these tests. There are no Economics PhD
programmes in the faculty of any law school. There is no joint degree program
(PhD econ./LL.B.). There are evidently no journals devoted to the field and
Quebec law journals only exceptionally publish law and economics articles. The
few articles that were published, are cited only rarely by other Quebec legal
scholars, despite their quality. Not only is the field often ignored, but only four
law schools out of six have an Economic Analysis of Law course on their
curriculum (McGill and UQAM being the exceptions), and only two of them
(Montreal and Laval) have been offering the course on a yearly basis since it
was added to the curriculum. Finally, there is no professional organization in
Quebec equivalent to the Canadian Law and Economics Association (CLEA),
in spite of the fact that in most fields there are French-speaking organizations
in Quebec duplicating the corresponding Canadian organizations.
Contrary to lawyers, Quebec economists fully consider themselves to be part
of an international profession. Economics has developed into a truly
international field, with a common language and a shared hierarchy of schools
and departments. Quebec economists are not, contrary to civil lawyers,
insulated from foreign influences: they study abroad, candidates for teaching
positions come from all over the world and faculty members engage actively in
economic research whose quality they expect to be measured by world
standards. Hence, economics departments should provide more opportunities
for studies in law and economics. However, the fact remains that, as is the case
with legal scholars, most economists do not seem to have expressed any special
interest in studying Quebec law, except perhaps with regard to some special
legislation such as the introduction of the provincial no-fault automobile
insurance bill.
Two notable exceptions must be mentioned here. Reuven Brenner, who
holds the Repap Chair at McGills Faculty of Management, and Jean-Luc
Migu of the Ecole Nationale dAdministration Publique (ENAP) are two
scholars of international stature whose involvement in law and economics must
be pointed out. Although not strictly associated with the law and economics
movement, Prof. Brenner has made a distinctive use of law and economics tools
throughout his oeuvre to explain why people innovate or gamble on new ideas.
Prof. Migus involvement with law and economics has been more explicit and
more accessible, as he has written in both French and English. His most
important contribution must be his studies on the economics of language and
the economics of federalism.
Reasons as to why so few scholars have made distinctive contributions to the
field are not readily forthcoming. As is the case with Prof. Brenner, it might be
that the economic papers discussing legal issues are not written in French but
in English, and that they could be found in the appropriate section of the
320 Law and Economics in Quebec 0370
encyclopedia. Even with that caveat in mind, one would be hard pressed to find
more than twenty articles published by Quebec scholars in economics reviews.
So there is a real puzzle with regard to the lack of involvement in law and
economics by Quebec scholars, be they legal scholars or economists.
Common prejudiced views advanced as explanations for this puzzle simply
do not resist a comparative perspective. For example, the language differential
or the presence of a civil code cannot be part of the explanation: most Quebec
economists publish in English, and the language barrier has not prevented
German and Dutch jurists from applying the economic model to their own civil
code.
A more plausible hypothesis would focus on the lack of competition between
Quebec universities. Not only is the system completely public with no private
university in operation, but studies are heavily subsidized, with the lowest
tuition fees in all of North America, and teachers fully unionized. Because civil
law schools are so few in number, and because full employment security is
provided after a five year probation period, there is very little movement
between the faculties and hence an utter lack of competition. Professors
appointment fees are exclusively based on experience rather than on
performance and there is consequently a relative uniformity of treatment among
faculty members. Chairs are exceedingly rare. Incentives to innovate by
researching new fields of study are mostly indirect.
As in any other field, publications remain paramount for prestige and
promotions. However, in law schools, the criteria of international publications
is not retained, perhaps because of the civil character of the profession. The
pressure to perform at the international level remains low. As long as this will
be the case, incentives to innovate and excel will be likely to be lower in
Quebec than elsewhere. Because competition leads to a discovery process, its
absence often explains a lack of entrepreneurship. For the moment, the few
steps on the academic ladder can be easily climbed by producing commentaries
on case law or legislative notes affecting ones field; there is nothing to gain
from ventures in new studies far from the comforts of ones home turf.
3. Future Prospects
Nevertheless, there may be some hope. The expansion of law and economics
into public law and international law, and especially the economics of
federalism, is bound to influence Quebec jurists working in those fields.
Contrary to private law, and despite the language barrier, public law in Quebec
is traversed by Canadian and American influences. Moreover, funding cuts,
declining admission prospects and a relatively high unemployment rate have
forced law schools to require a doctoral degree as a condition of employment.
Aspiring professors are now more likely to have received training in the US and
0370 Law and Economics in Quebec 321
hence to have been exposed to law and economics. Finally, since there will be
growing uncertainty regarding employment security, it is likely that those new
and highly mobile professors will have to distinguish themselves in order to
keep a high profile; the law and economics field continues to offer enormous
possibilities in this regard.
Much as law and economics might catch on and attract new practitioners
in Quebec, this is still a far cry from becoming a standard part of the
curriculum in law schools. One essential step in that direction is the first
general introduction to law and economics in French (in addition to the brief
survey of core private law subjects by Bertrand Lemennicier in his conomie
du Droit, Paris, Cujas, 1991), currently being written by Prof. Ejan Mackaay
and the undersigned. Prof. Mackaay, who teaches at the Facult de Droit de
lUniversit de Montral, must be considered as one of the pioneers of the field
and the leading figure of law and economics in Quebec. His writings in
French, English and Dutch can all be praised for their clarity and soundness.
The book is aimed at the civilian legal community, both in Quebec and
elsewhere in the French-speaking world. The publication of this book should
help to establish law and economics as an integral part of the legal curriculum
in those countries. Beyond this upcoming introductory work, however, the
prospects for the development of French language literature on the subject are
dim. Economists already publish in English, and new professors at law schools
are more likely than their seniors to write in English, not only because they
have often been trained in that language, but especially because they want to
keep their job options open beyond provincial and national boundaries.
This does not mean that there is no hope for the study of Quebec private law
institutions. The recent growth of a distinct comparative law and economics
field could spur interest in the unique civil law system of Quebec, and with
good reason. First of all, there is an official English version of all legislative
texts, as well as of some court decisions and textbooks. Moreover, and contrary
to the French system, Quebecs private law has borrowed its civil procedure
styles of judicial reasoning from British common law and has developed a large
body of case law. Finally, Quebec having been more influenced by the
European model of the welfare state than by the American one, it provides a
stark contrast to the latter, a useful beginning for any comparative study.
4. Conclusion
All is not gloomy about the state of the field in Quebec. As the following
bibliography will show, there are scholars of great quality in Quebec, and the
new generation of professors will be better trained and more outward looking
than their predecessors. The development of a body of convincing comparative
322 Law and Economics in Quebec 0370
and constitutional law and economics studies may be just what is needed to
help Quebec jurists overcome their initial reservations about the field. We may
yet be heading for a new quiet revolution.
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0370 Law and Economics in Quebec 323
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Lemieux, Pierre (1993), Le Droit de Porter des Armes (The Right to Bear Arms), Paris, Belles Lettres.
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Gouvernements du Qubec de 1944 1985 (Power Relations in Laws - Comparison Between
Quebec Governments from 1944 to 1985), Sainte-Foy, Presses de lUniversit Laval.
Mackaay, Ejan (1979), Les Notions Floues ou lconomie de lmprcision (Fuzzy Concepts or the
Economics of Imprecision), 12 Langages, 33-50.
Mackaay, Ejan (1980), Le Droit Relatif aux Accidents - une Interprtation conomique (The Law of
Accidents - An Economic Approach), 15 Revue Juridique Themis, 383-415.
Mackaay, Ejan (1986a), Les Biens Informationnels ou le Droit de Suite dans les Ides (Information
Goods or the Sequel Right in Ideas), 12 Informatica e Diritto, 45-65.
Mackaay, Ejan (1986b), La Rgle Juridique Observe par le Prisme de lconomiste - une Histoire
Stylise du Mouvement dAnalyse conomique du Droit (The Legal Rule Viewed from the
Perspective of the Economist - A Stylized History of the Law and Economics Movement), 1 Revue
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0370 Law and Economics in Quebec 325
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the Economic Analysis of Law), 1987 Revue de la Recherche Juridique Droit Perspectif, 637
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Mackaay, Ejan (1987c), Le Paradoxe des Droits Acquis. De lAncienne la Nouvelle conomie -
Essais lOccasion de la Dixime Universit dt de la Nouvelle conomie, Aix-en-Provence
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Mackaay, Ejan (1987d), Le Juriste a-t-il le Droit dIgnorer lEconomiste? (May Lawyers Ignore
Economists?), Revue de la Recherche Juridique, 419-427.
Mackaay, Ejan (1988), Lordre Spontan comme Fondement du Droit - un Survol des Modles de
lmergence des Rgles dans une Socit Civile (Spontaneous Order as Foundation of Law - A
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lmergence des Rgles dans la Socit Civile (Spontaneous Order as the Foundation of Law - A
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0375
LAW AND ECONOMICS IN TAIWAN
Steven S. Kan
Professor at the Department of Economics
National Tsing Hua University, Hsin Chu, Taiwan
Copyright 1999 Steven S. Kan
Abstract
The purpose of this chapter is to show how law and economics has taken roots
in Taiwan, which authors have played primary roles in teaching and research,
and what have been the recent research topics. The chapter first presents a brief
description of Taiwans economic-social-political background. This is then
followed by an introduction to Taiwans education and research in law and
economics.
JEL classification: K00
Keywords: Economics, Law, Taiwan
1. Economic-Social-Political Background
Taiwan has changed from a traditional Chinese agricultural economy to an
industrialized economy in the last 50 years. Though geographically remote
from Western industrialized economies, the small island succeeded in the late
1970s being their trading partner in textiles, electronics, machine tools, and so
on. Today, it is catching on in the information age and has fast-growing
industries in computer peripherals and semi-conductors. Because of its
economic success many of the citizens have been able to go abroad for business,
education and vocation. They return home with aspirations for greater
individual freedom and a pluralistic society. Social relationships have thus been
transformed in many ways and a life under an authoritarian regime is no longer
acceptable. As a result, Taiwan has undertaken a series of constitutional
reforms since 1992 and is now moving towards a more democratic society. It
is in this dynamic economic-social-political setting that Taiwans study of law
and economics has taken roots.
2. Education
Economics professors in Taiwan are primarily returnees with an American
doctoral degree. In contrast, law professors hold law degrees in almost even
328
0375 Law and Economics in Taiwan 329
proportions from the US, Germany and Japan. In the past, economics students
were required to take an introductory law course, but law students were not
required to take any economics courses. Laws and regulations enacted since the
early 1980s have helped to bring about a change. They were promulgated to
meet new economic and social problems in employment, fair trade, finance,
environmental protection, and so on. Responding to the development, law
departments soon initiated specialized programs in financial and economic law.
To prepare students to deal with such legal matters, these programs require
first-year students to take four credit hours in economics principles, which are
taught by the economics faculty. For the same reason, more economics students
would like to start taking elective law courses to help their career development.
Both the economics and the law students know that there are substantial
differences not only between economics and law but also between the
English-American and Continental systems of law. However, not until recently
were they able to find a connection between economics and law, because few
scholars were familiar with Ronald H. Coases insights in the firm, the market,
and the law.
It was only ten years ago that the modern law and economics field became
known in Taiwan. Yu-Min Tang (1987) deserves special credit for translating
the first edition of Posners Economic Analysis of Law. The translated work
was well-received and reprinted after two years. Another special credit should
go to Steven Cheung (1987). His popular writings on private property rights
and contracts were published when privatization and economic liberalization
were hot issues in Taiwan. They soon became best-sellers and they helped
popularize the names of Coase, Alchian and Demsetz with Taiwans college
students.
Taiwans first undergraduate law and economics course was offered in
September 1987 to juniors by the economics department of National Tsing Hua
University. A graduate sequel, the economic analysis of law, debuted in 1990.
Coases winning of the Nobel Prize in 1991 further boosted students interests.
A course on economic organization along Oliver E. Williamsons line was
started up as a response to graduate students requests in 1992. However, the
demands of freshmen and sophomores could not be met because of a lack of
adequate teaching materials and teachers. Hwang and Kan (1994) published a
principles textbook emphasizing new institutional economics in the summer of
1994. With the arrival of a new faculty member, the department started to offer
courses on new economic history and new institutional economics. In addition
to fulfilling these teaching responsibilities, Liu (1994, 1995) translated
Douglass C. Norths two major books. Finally, with Chen and Li (1995)
translation of Coases book, there are now basic Chinese materials for students
of all departments that can open the door to law and economics.
In the meantime several scholars have also contributed to promoting the
central message of law and economics. Bing-Yuang Hsiung of National Taiwan
330 Law and Economics in Taiwan 0375
University and George S. Wang of National Chengchi University have included
Coases ideas in their public economics course. Huei-Lin Wu of Chung-Hua
Institute of Economic Research has written introductory essays in magazines
and newspapers for lay readers. Tze-Chien Wang, who is now a grand justice,
arranged a seminar and invited me to introduce law and economics to his
colleagues at the law department of National Taiwan University. These
educational and promotional efforts are now taking effect. For example,
Soochow Universitys law department, which specializes in common law, has
started an undergraduate law and economics course in its night program. The
law department of National Taiwan University is now offering a graduate
course in tort law along Posner, Landes and Shavells line. The department is
also planning to have undergraduate law and economics courses in the near
future.
3. Research: Activities and Scope
A few institutions and foundations have in recent years sponsored the visits of
distinguished foreign scholars to promote academic research in economics. For
example, the visitors included Gary Becker, James Buchanan, Issac Ehrlich,
Douglass North and Gordon Tullock. Their visits have helped stimulate
research in law and economics. A special day was marked on January 19, 1991
when Cyrus C. Chu successfully organized Taiwans first academic conference
on the economic analysis of law. The conference not only brought together
various researchers in law and economics but also opened up a dialogue
between legal scholars and economists. The effect of these activities is clear in
that legal scholars and professional lawyers are now invited to help with an
economics students thesis. Likewise, economists are invited to be members of
a law students thesis committee. As a result, there is more vigorous research
in law and economics and more research results are appearing in professional
journals.
The law and economics research community in Taiwan is small. There are
two types of research related to law and economics. The first type deals with
financial and economic laws and is mainly conducted by legal scholars. It is
related to law and economics because more of the substance is involved but less
of the methodology is used. The second type of research involves rigorous
economic analysis and belongs to the narrowly defined field of law and
economics. It is conducted by economists and several areas of law have been
taken up. To illustrate Taiwans recent interest in law and economics a select
bibliography is appended at the end of this overview. The bibliography shows
that recent research topics can be classified into four groups: financial and
economic law, criminal law, environmental law and others. While the volume
cannot warrant a full survey, I will try in the following to give a brief guide and
0375 Law and Economics in Taiwan 331
show that Taiwanese scholars can actively contribute to law and economics
research.
4. Research: Some Recent Research Topics
In the area of financial and economic law, research topics are concerned with
current economic conflicts. Li and Chen (1995), Hwang (1995, 1996) and Chen
(1997) focus on antitrust issues of intra-industry alliance in product designs,
intra-industry mutual holdings of stocks, vertical mergers, and collusive
pricing. The issues of foreign competition and financial disclosure have been
investigated by Juang (1997) and Tseng (1996). Fong (1997) and Tan (1991)
discuss issues related to intellectual property rights such as the corporate name,
the trademark, and counterfeits. Aoki and Hu (1997) have also investigated the
effect of a legal system on incentives to innovate. They are mostly written in
Chinese and some of their research results have wider implications that are not
limited to Taiwanese cases. However, no law and economics research related
to employment laws is being published, perhaps reflecting the fact that Taiwan
has been able to maintain full employment.
The most active law and economics research is on criminal law and purely
conducted by economists. The results of this line of research are especially
interesting and some of them have been published in international journals.
They are interesting because the researchers have utilized Chinese cases to shed
light on some less attended topics in Western literature. For examples, two
articles by Chu (1990a, 1990b) explicitly consider venal tax officials and plea
bargaining with respect to the problem of tax evasion. As law enforcement
efforts in Taiwan have been oscillatory, Chu (1991) makes a case that
oscillatory enforcement is optimal under some conditions. On the proposition
that fines are more efficient than imprisonment, Chu and Jiang (1993) present
an opposite case by considering wealth. Imprisonment serves the dual functions
of deterrence and incapacitation; yet little work has been done to address the
latter function. For criminal offenses involving bodily parts that cannot be
deterred, Kan (1996) finds that imprisonment is less efficient than corporal
punishment because it incapacitates other productive parts as well. As a life
sentence involves a permanent incapacitation of the whole body, he also finds
that its abolition would hinge on whether a society accepts temporary
incapacitation as a substitute punishment. Chu (1991), Chu et. al. (1997), Chen
et al. (1997), Koo (1991) and Shea and Wu (1994) have embarked on other
important topics such as criminal proceedings, litigation procedure, repeat
offenses, the allocation of legal costs and anti-monitoring activities. There are
also empirical studies written in Chinese. Adopting a Bayesian approach, Yang
and Chen (1996) find that a life sentence had no deterrence effect.
332 Law and Economics in Taiwan 0375
An unfortunate aspect of Taiwans economic development is that it was
achieved at the expense of its environment. Despite the environmental
regulations that are now in place, much remains to be done. There are
significant law and economics papers on the problems related to environmental
law. Taking hints from Taiwans poor enforcement of environmental
regulations, Huang (1996a, 1996b) has explicitly considered incomplete
enforcement, a firms avoidance behavior and hierarchical governments in his
studies. He sheds new light on the effectiveness of environmental regulations
and the complex relationships among legislators, regulators and firms. Yeh
(1992) used a special Taiwanese case, in which the central government set up
a compensation fund for the victims nearby a petroleum cracking plant, to
discuss the problems associated with the de facto sales of pollution rights. Shaw
(1992) compared Pigovian taxation and strict liability as methods to control
externalities in Taiwan. Fu et. al. (1993), on the other hand, adopted the
property rights and contractual approach to discuss sustainable development.
Shaw (1995) has also translated Anderson and Leals Free Market
Environmentalism.
While other research topics in law and economics are important as well,
they have so far only received limited attention from Taiwanese researchers.
For example, Chu and Qian (1995) and Hsieh (1991) seem to be the only two
discussing vicarious liability and medical malpractice in the area of tort law.
Research in other areas is the same. Koo and Sung (1993) is the only study on
the public funding aspect of Taiwans election and recall law. Wu and Huang
(1994) presents the only theoretical work on norms and cultures. Kan and
Hwang (1991a, 1991b, 1995) are also alone in considering ancient Chinese
economic and legal thoughts in a modern light.
Most of the research works we have introduced so far, however, do not
touch on property rights and transaction costs. The fact indicates that Coase,
Cheung and Williamsons insights are yet to make a strong impact on Taiwans
research, as Chien (1997) has indicated in his recent book review. Despite
being few in numbers, the research results are quite significant. There were two
papers on transaction costs and Coase theorem. Kan (1993) elucidates the
subjective nature of transaction cost and emphasizes the much neglected
entrepreneurship in exchanges. With an effort to reconcile Buchanans
criticism on the celebrated the Coase theorem, Hsiung (1993) was able to
clarify several issues of the debate. On property rights, Su (1991) used law and
economics argument to discuss the conditions for or against the principle of
numerus clausus. Other works are involved with the application of transaction
cost analysis to Taiwanese cases. The empirical test of Kan and Hsiao (1996)
shows that peasants choices of irrigation contracts in the Tsing Dynasty were
consistent with transaction cost economics. The paper also echoes Coases view
that public works need not require government intervention. Chien (1995)
0375 Law and Economics in Taiwan 333
relates the common use and abuse of a condominiums top space to transaction
costs and property rights.
Finally, Taiwans ongoing democratization process has spurred Hwang and
Kans (1995) and Kan and Hwangs (1996, 1997) significant contributions to
constitutional law. They adopt a super-firm approach to focus on the
organization of a democratic government. As there are transaction costs
between representatives and officials and between them and the people, they
think that checks and balances are mechanisms to prevent the collusion of
officials and representatives. However, the costs associated with checks and
balances have been neglected. Applying Fama and Jensens distinction of
decision control and decision management powers in the firm, they elucidate
that different concerns over the two types of transaction costs can lead to
various forms of presidential, parliamentary and hybrid governments. A
testable implication of their transaction cost analysis is that the number of
check-and-balance mechanisms decreases with the development of competitive
mass media and the technological advances in transportation as well as
telecommunication. The research not only breaks away from current models in
political science, but also shows that transaction cost economics can shed
significant insights into the organization of a democratic government.
Acknowledgments
The author would like to thank Sheng C. Hu, Ruey-Hua Liu and Daigee Shaw
for their comments and suggestions.
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Anti-Trust Law (in Chinese), 5(1) Fair Trade Quarterly, 65-96.
Chen, K.M. and Li, H.H. (1995), Chinese Translation of Ronald H. Coases The Firm, the Market, and
the Law, Taipei, Yuan-Liou Publishing Company, Ltd.
Chen, Kong-pin, Chien Hung-ken and Chu, Cyrus C.Y. (1997), Sequential versus Unitary Trials with
Asymmetric Information, 26(1) Journal of Legal Studies, 239-258.
Cheung, Steven N.S. (1987), The Words of An Orange Seller (in Chinese) Taipei, Yuan-Liou
Publishing Company, Ltd.
Chien, Tze-shiou (1995), A Study on the Property Right of a Condominiums Top Space (in Chinese),
41(10) Military Law Journal, 8-15.
Chien, Tze-shiou (1997), Coases The Market, the Firm, and the Law: A Legal Perspective (in
Chinese), 26(2) National Taiwan University Law Journal, 229-246.
334 Law and Economics in Taiwan 0375
Chu, Cyrus C.Y. (1990a), A Model of Income Tax Evasion with Venal Tax Officials: The Case of
Taiwan, 45(3) Public Finance, 392-408.
Chu, Cyrus C.Y. (1990b), Plea Bargaining with the IRS, 41(3) Journal of Public Economics,
1319-1333.
Chu, Cyrus C.Y. (1991), An Economic Analysis of the Criminal Proceedings in Civil Law Countries,
11(1) International Review of Law and Economics, 111-116.
Chu, Cyrus C.Y. (1993), Oscillatory vs. Stationary Enforcement of Law, 13(3) International Review
of Law and Economics, 303-315.
Chu, Cyrus C.Y. and Jiang, Neville (1993), Are Fines More efficient Than Imprisonment?, 51
Journal of Public Economics, 391-413.
Chu, Cyrus C.Y. and Qian, Yingyi (1995), Vicarious Liability under a Negligence Rule, 15(3)
International Review of Law and Economics, 305-322.
Chu, Cyrus C.Y., Sheng-Cheng Hu and Ting-Yuan Huang (1997), Punishing Repeat Offenders More
Severely!, IEAS Working paper No. 9703, Academia Sinica.
Fong, Jerry G. (1997), Corporate Name, Trade Name, Trade Mark, and Domain Name (in Chinese),
5(2) Fair Trade Quarterly, 65-96.
Fu, Tsu-tan, Shaw, Daigee and Yu, B.T. (1993), A Property Rights and Contractual Approach to
Sustainable Development, Discussion Paper No. 9334, The Institute of Economics, Academia
Sinica.
Hsieh, Chee-Ruey (1991), Medical Liability, Dispute, and Litigation: Theory and Evidence of Taiwan
(in Chinese), 19(1) Taiwan Economic Review, 87-114.
Hsiung, Bing Yuang (1993), The Scale of the Market and the Scale of the Heart: Reconciling Coase
and Buchanan on the Coase Theorem (in Chinese), 21(2) Academia Economic Papers, 331-356.
Huang, Chung-Huang (1996a), Hierarchical Government, Environmental Regulations, Transfer
Payments, and Incomplete Enforcement, in Mendelsohn, Robert and Shaw, Daigee (eds), The
Economics of Pollution Control in the Asia Pacific, 253-272. Vermont, Edward Elgar Publishing
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Huang, Chung-Huang (1996b), Effectiveness of Environmental Regulations under Incomplete
Enforcement and the Firms Avoidance Behavior, 8 Environmental and Resource Economics,
182-204.
Hwang, Chun-Sin and Kan, Steven S. (1994), Principles of Economics-Cooperating for Mutual
Prosperity and Progress, Vol. 1 (in Chinese), published by the authors and distributed by Shin
Lu Bookstore, Taipei.
Hwang, Chun-Sin and Kan, Steven S. (1995), Democracy and the Principle for the Division of Labor
in Government Organization (in Chinese), in Chien, Sechin Y.S. and Tai, Terence H. (eds),
Philosophy and Public Norms, Book Series 34, Sun Yat-sen Institute for Social Sciences and
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Discussion on Fair Trade Law (in Chinese), 4(2) Fair Trade Quarterly, 1-14.
Hwang, L.T. (1995), The Paradoxical Regulation of Fair Trade Law on Vertical Merger: An
Economic Analysis (in Chinese), 3(3) Fair Trade Quarterly, 19-31.
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5(1) Fair Trade Quarterly, 1-47.
Kan, Steven S. (1993), Entrepreneurship, Transaction Costs, and Subjectivist Economics, 1(2)
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0375 Law and Economics in Taiwan 335
Kan, Steven S. (1996), Corporal Punishments and Optimal Incapacitation, 25(1) Journal of Legal
Studies, 121-130.
Kan, Steven S. and Hsiao, Ding-Way (1996), Contracts in Tsing Dynasty to Build Irrigation System
at Lan-Yang Plain: A Transaction Cost Analysis (in Chinese), 59 Journal of Agricultural
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0380
LAW AND ECONOMICS IN SERBIA
Zeljko Sevic
Senior Lecturer
Business School - University of Greenwich
Copyright 1999 Zeljko Sevic
Abstract
This chapter aims to present an overview of the development of law and
economics as a scientific and academic discipline in Serbia from its very
beginnings. It starts with an historical introduction describing the beginning
of legal education in Serbia in the mid-nineteenth century, and the early
development of legal and economic sciences and teaching in Serbia, until the
fall of the socialist self-management system. The most prominent works in law
and economics are discussed briefly by giving the prospective reader a broad
idea of the state-of-the-art literature in the field published in Serbian
(Serbo-Croatian) in the last few decades. All of this supports the final
conclusion that law and economics in Serbia may be a very fast growing field
of economic and legal literature in the years to come.
JEL classification: K00, B2, B3, K1
Keywords: Serbia, Law and Economics, Belgrade Law School, Legal Transition
1. Introduction
From the early 1990s onwards Yugoslav scholars have increasingly begun to
recognise the importance of the economic analysis of legal institutions and
practice.
In the former Republic of Yugoslavia, the development of legal and social
science disciplines was strictly influenced and monitored by political bodies,
but probably less so than in other socialist countries; hence the need to analyze
this legal and economic development within the political and cultural
frameworks of these countries. Given the traditional influence of universities
on social life in Serbia, the teaching of these disciplines will be analyzed as
well.
First, a brief chronicle of the developments in law and economics against
the background of the changes in social and political structures in Serbia will
be given. Second, the major works in law and economics in Serbia will be
presented, and finally a conclusion will be provided (Section 4).
337
338 Law and Economics in Serbia 0380
2. Historical Developments
Legal sciences have been taught in Serbia since the establishment of the Faculty
of Law in 1841 (more correctly it concerned the legal division of the Great
School). A number of economic subjects also were taught in courses from the
mid-1850s onwards, to provide students with the broad educational background
necessary for future employment, mainly in the civil service. With the
reorganisation of higher education and the establishment of the University of
Belgrade in 1905, a separate Department of National Economy and Finance
was established within the Faculty of Law. The Faculty of Law educated
aspiring lawyers, some of whom were specialising in economics and finance.
Until 1937, the Faculty of Law was the only institution offering training in
economics, but only as a supplementary subject. The main degree (which was)
granted to successful students was a classical LLB degree. A number of the best
performing students continued their studies abroad, at the faculties of
economics, and gained doctoral degrees in economics (political economy). In
1937, the Higher Economics and Commerce School (analogous to a
polytechnic) was established. Although after World War II this school became
the University of Belgrades Faculty of Economics, the Faculty of Law retained
its economics department.
After the socialist revolution during World War II, both institutions suffered
great changes in their educational programmes and lost a number of
unsuitable staff (that is, despite their academic merit, a number of academics
were arrested or expelled from the university). The syllabi were changed to be
in line with mainstream socialist doctrine. Immediately after World War II the
Soviet textbooks were simply translated and used for teaching. Even after the
break with the Soviet Union in 1948, a few authors were still largely influenced
by Stuchka-Pashukanis legal, and Kondratyevs economic doctrine.
With the introduction of market reforms in 1965, changes in the
universities educational programmes were introduced. Some Western theories
were slowly integrated into both legal and economic theory, and scholars
gradually reestablished links with research institutions in Western countries.
This resulted in a huge increase in the number of publications. Although these
reforms lasted a year or so, it did not improve the openness of the research
institutions. However, some academics, particularly lawyers, passed the
Rubicon of socially allowed political dissidence determined by the political
censors, with their strong criticism of a final draft of the Federal constitution
drawn up in 1973. Some of the scholars, for the first time, began to analyze the
welfare effects of proposed legal acts from the point of view of comparative
constitutional law, the legal system, social logic, social justice, and so on. But,
it turned out that Titos regime did not support academic freedom fully, and
some academics were either imprisoned or isolated from the academic
0380 Law and Economics in Serbia 339
community. Others simply fled the country. Fifteen years later the predictions
of these academics proved to be correct, when the constitutional crisis caused
the former Republic of Yugoslavia to disintegrate. The introduction of a
concept of self-management, in connection with the institutions of associated
labour and social ownership without owners (non-ownership concept of
social property) severely affected the universities educational programmes.
3. Current Situation
The fall of the communist regimes in Eastern Europe has shown that the
Yugoslav concept of socialism with a human face was not socially
sustainable either. The transition requires change, new proposals and social
solutions. This implies both the return to the positive pre-socialist traditions
and a critical adoption of advanced Western theory. In this respect, the 1990s
marked the birth of law and economics literature in Serbia. A number of
authors adopted a more or less economically-based approach to legal and
economic phenomena. Generally, these works were devoted to the problems of
property rights and their (social) efficiency. Some of the authors apply
simultaneously both law and economics and the public choice approaches
(Sevic).
Professor Vodinelic of Belgrade Universitys Faculty of Law first mentioned
law and economics in his textbook Civil Law - Introductory Themes, in 1991.
With simple and generalistic explanations of law and economics concepts, he
introduced them to the first-year law students. The second and more significant
move was made by Professor Labus, also from Belgrades Faculty of Law, in his
recent textbook: Foundation Economics: Contemporary Theory and
Application, published in 1995. This book was aimed at second-year law
students, and presented in an exhaustive fashion the Coase theorem and its
possible application in legal practice with reference to the Yugoslav legal order.
It also stressed, as had been done many times before, that the judge is more
constrained by law in a continental legal system than in the Anglo-Saxon
(Common Law) system. The author provided his students with many splendid
examples referring to Yugoslav positive law and practice, especially in the field
of torts. Until this work the economic aspects of damage had not been
considered from the point of view of the classic restitution rules. Currently, law
students are informed about the basics of the economic analysis of law (in
Professor Labus words: Legal School in Economics). In contrast, at the
Faculty of Economics there is no mention of law and economics. Even the
course in Contemporary Economic Thought does not consider this discipline,
and only one page is devoted to public choice. Economics students are taught
positive commercial (or international commercial) law but they do not have an
opportunity to learn about law and economics.
340 Law and Economics in Serbia 0380
Professor Vracars book: Reexamination of the Legal Methodology:
Indications of State-Legal Integralism published in 1994 as a textbook for
masters and doctoral students in law is a very interesting publication worth
mentioning as well. This book is, in fact, a collection of Professor Vracars
previously published and unpublished papers, written between the early 1960s
and mid-1990s. The renowned Yugoslav legal philosopher, legal theoretician
and methodologist did not try to solve all the existing controversies in law and
its related disciplines, but simply to share his thoughts with colleagues. One of
the most famous critics of the draft for the Federal Constitution in the 1970s,
and a victim of state terror, he returned to his theoretical roots and to his
favourite legal thinker Professor Hans Kelsen. In addition to the promotion of
a socio-politically (and economically) efficient concept of legal system and legal
order, the book revealed that Professor Vracar had been a proponent of the use
of game theory in law and political science as early as 1962. It is a real
discovery to find out that he tried to introduce game theory (which he called
theory of competition) as a method of legal research at that time. The paper
on advanced mathematics might, at first sight, seem descriptive today, but in
fact it is very analytical and rather overwhelming in its complex legal logic
applications.
A recent work which should, certainly be mentioned is the textbook Tax
Science and Tax Law by Professor Dejan Popovic (1997), former Dean of
Belgrade Faculty of Law. In a delightful manner he introduces basic and more
advanced topics on taxation, utilising both legal and economic methodologies.
However, the majority of recently published books using law and economics
methodology are concerned property right problems in the light of the
transition in Yugoslavia. The voluminous work by Professor Madzar, entitled
Property and Reform, published in 1995, is certainly one of them. He
examines the role of property in socialism and its shortcomings, arguing for the
overall reform of property and privatisation, stressing the importance of
property rights for the final outcome of the transition process in Yugoslavia.
Recently, in 1998, a number of books were published under the auspices of the
project Constituting Serbia as a Legal State, generously funded by the Serbian
Ministry of Science and Technology. The book by Dr Hiber on Property in
Transition (1998) is one of those which may enrich the literature on property
rights issues in Serbia. The author analyses the different aspects of property and
modes of privatisation. However, he could not omit an analysis of the socialist
and self-management property concepts as a point of departure in property
reform in Serbia. The work is predominantly practice-oriented, focusing on the
criticism of some positive legal provisions. Another important work is the book
entitled Introduction to the Economic Analysis of Law by Dr Jovanovic
(1998). Written in a textbook manner, the monograph slowly introduces the
reader to some basic concepts of law and economics within the Yugoslav
context. It may be that the book lacks proper academic rigour, but it certainly
0380 Law and Economics in Serbia 341
fills a gap in Serbian/Yugoslav legal and economic literature. As the first book
of its kind, it really reaches its aims, and provides a basis to build upon. The
main objection beside its over-simplicity may be the lack of use of up-to-date
literature, and support of only some streams in modern law and economics,
equalising Law and Economics with New Institutional Economics, which the
author refers to as Economics of Property Rights.
The application of principles of law and economics is still not accepted in
court procedures, even though an improvement in the field may be expected.
At present a number of economists are sworn court experts (appointed by the
Minister of Justice). They are supposed to formulate opinions on different
economic, financial and accountancy issues, but in most cases they just estimate
the losses. The sworn experts opinion is not obligatory but (optional
demonstrative) as the final decision is always in the hands of the court council,
usually consisting of the presiding professional judge and two so-called jury
judges. Although experts only apply a classical utilitarian cost-benefit analysis,
the judges usually base their sentence on the experts opinion. Practice is not
a formal source of law in Serbia, but lower courts take into account previous
acknowledged decisions in order to avoid cancellation of the sentence in the
appeal procedure later on. Although it is widely believed that judges in
continental legal systems firmly stick to the legal norms stipulated in the law
(Statute, Act), practice has recently shown a wide variety in sentencing, at least
in Serbia.
What are the possible reasons for the present state of law and economics in
Serbia? Besides the previously noted influence of a dominant socialist model
in the past, a divergence of academic lawyers and economists can be observed.
Both professions seem to try to keep their respective disciplines clearly
separated from one another. For a while, there was open reluctance towards
authors who tried to connect the two disciplines in their research. Historically,
there has also been rivalry between the Faculty of Law and Faculty of
Economics. The Faculty of Law kept its own department of economics, which
is usually staffed very well. Even a well-known American property rights
economist, Professor Svetozar (Steve) Pejovich, graduated from Belgrades
Faculty of Law in 1955.
4. Conclusion
It seems that Serbian law and economics is on its way to developing its own
distinctive identity, rather than merely following the dominant American path.
It is more European, and as a result more conservative with respect to certain
typically Anglo-Saxon applications. The introduction of efficiency in the
analysis of law, which comprises all three analyses (predictive, explanatory
342 Law and Economics in Serbia 0380
and normative) can undoubtedly influence the further development not only of
legislative activities, but also of legal and economic thought as a whole in the
country. However, it is not clear whether legislators in Serbia understand that
law enforcement is not free and whether they know how to deal with the
existence of externalities. At present, it seems that the Serbian/Yugoslav
legislators strongly believe that the implementation of law and law enforcement
does not bring about any costs. This can, consequently, influence the path of
administrative and legal reforms. More particularly, the size of the state
apparatus may be more important for the legislator than its actual efficiency
level. However, some authors have recently pointed out this problem, and the
legislation policy stance will hopefully change in the future.
The mid-1990s appeared to be a turning point in the development of law
and economics in Serbia. Up to this moment the main subjects of interest in
terms of research have been property rights and privatisation, given that these
issues are crucial for the transition process. Papers dealing with the efficiency
of (commercial) law and its influence on the dynamics of economic change can
be found as well. Authors who started to show an interest in law and economics
at the beginning of the 1990s are currently very research-productive. They have
also obtained senior positions in academia, and it can be expected that law and
economics as an academic discipline will have a prominent future in Serbia in
the years to come.
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0380 Law and Economics in Serbia 343
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344 Law and Economics in Serbia 0380
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0380 Law and Economics in Serbia 345
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0385
LAW AND ECONOMICS IN SPAIN
Santos Pastor
Universidad Complutense de Madrid y Centro de Investigaciones en
Derecho, Economi y Administracin de Empresas
Jess Pintos
Instituto de la Rioja et Instituto de Derecho y Economi
Copyright 1999 Santos Pastor and Jess Pintos
Abstract
This chapter addresses the evolution and current situation of law and
economics in Spain along four major dimensions: teaching, academic research,
legal policy and judicial practice. A glance at trends and likely extensions is
also included. Furthermore, an accompanying Spanish bibliography in law and
economics provides detailed information on a wide variety of research fields
and authors, following the guidelines provided by the editors.
JEL classification: K00, H0, L5
Keywords: Law and Economics in Spain, Public Choice, Economics of
Regulation, Public Economics.
1. Introduction
Although, as usual, one can trace the roots further back, in Spain what can be
narrowly defined as new Law and Economics started in the 1980s. At that time,
some academics started to introduce basic ideas of the movement as they were
evolving (mainly in the United States), and tried to apply them to Spanish legal
institutions. As time went by, the emphasis tended to be placed more on the
applications and less on the review or importing of existing developments from
abroad. At the present time, one may well conclude that at least one third of
legal scholars have heard about this business, and at least one tenth are well
acquainted with the approach. On the other hand, about half of the academic
economists know the approach well and more than 10 percent are familiar with
it and use it on a more regular basis.
This short report concerns law and economics in a broader sense, that is, it
reflects not only (although mainly) works pertaining to what has been named
new Law and Economics, but also publications related to Public Choice and
Constitutional Economics, Economic Regulation and (only a few) General
346
0385 Law and Economics in Spain 347
Public Economics. Such a broad scope is a consequence of the wide table of
contents suggested by the editors.
As a framework for this report, we will take into account as a starting point
the article that one of us wrote in 1991 on the situation and future of law and
economics. According to the prediction made then on the likely evolution of
this movement, there would be a fast growing progress from the economics side
of law and economics, in sharp contrast with a slower evolution on the law side
(see Pastor, 1991). As expected, one of the apparent features of the current
situation turned out to be the confirmation of that prediction. Of course, the
legal literature, both explicitly and implicitly, has also grown at a relatively fast
pace.
The number of scholars now doing research in law and economics has
become big enough and the fields covered so wide that, unlike in that 1991
article, we do not personally know quite a number of the individuals listed
below. An increasing number of fields of law have been addressed by the
economic approach. In order to figure out where law and economics is
practiced and the extent to which this is being done, the affiliation institutions
of the scholars listed below may serve as a good clue. By the way, it is
remarkable that the 1997 Annual Conference of the European Association of
Law and Economics was held at Barcelona (Univ. Pompeu Fabra).
Despite the abovementioned progress, the economic approach to law is still
practiced by a minority within the academic world. The encouraging increase
comes, on the one hand, from the fact that more scholars (specially younger
ones) master foreign languages (English in particular) which enables them to
follow progress made abroad, and on the other hand, from the strength of the
approach.
The consistency of the approach should be shown in practice. Unfortunately
this is often not the case as fireworks and paraphernalia have taken the place
of actual substantial contributions.
2. Teaching Law and Economics
Undergraduate Studies in Law
Recent changes in the law curriculum have caused a reduction in the length of
a compulsory course on principles of economics (it lasts now one semester
instead of two) at the expense of the introduction of several non-compulsory
courses, law and economics being one of them (the governmental regulation of
the curriculum explicitly mentioned law and economics as one of the fields to
cover in the one semester course in principles of economics. Although the
actual coverage greatly depends on the lecturers knowledge and on time
constraints it has been of some help in establishing the presence and expansion
of this discipline in the law schools). To our knowledge, such a course is
348 Law and Economics in Spain 0385
already being taught in the law schools at the University Carlos III and
Universidad Autnoma, both in Madrid. It is also contemplated at the
University of Santiago de Compostela (including public choice), at the
University of Extremadura, and may soon be adopted as part of the curriculum
at the Universidad Complutense in Madrid.
In addition, law and economics topics are being taught as part of the
course on principles of economics in several universities: for instance, at the
University of La Corua, and Complutense (Madrid). Topics in Public Choice
and Constitutional Economics are also taugth at the Universities of Valladolid,
Valencia and Santiago de Compostela Law Schools.
Undergraduate Studies in Economics and Business Administration
Although topics in law and economics are definitely part of a number of courses
in Public Economics, Industrial Organization, and Microeconomics, the only
formal courses in Law and Economics in a curriculum in Economics are taught
at the University Carlos III de Madrid, as an elective course for the last year
students, and at the University Pompeu Fabra in Barcelona, as an elective for
second-year students of the Graduate Program in Economics and Management.
Similarly, some topics of law and economics are covered in the Business
Administration curriculum as part of the courses in Business Organization
(University Pblica de Navarra, Zaragoza, and Pompeu Fabra).
Graduate Studies in Law
Public Universities Complutense, Autnoma and Carlos III, all of them in
Madrid, offer graduate courses in Law and Economics, some of them as part of
European programmes.
Graduate Studies in Economics
The theory of contracts, property rights, and economic regulation are part of
most PhD programmes. Optional courses on topics in Law and Economics are
offered at the University Carlos III (which includes a course in Insurance Law
and Economics) and at the University Pompeu Fabra.
3. Scholarly Work
In addition to the attached list, other substantial legal scholarship applies
elements of law and economics. Actually, we suspect that this part of the
literature (which only slightly appears in our list) shall be of great relevance in
the future. To mention just one area, most conventional works in bankruptcy
law involve substantial economic reasoning and, to a lesser extent, that could
0385 Law and Economics in Spain 349
also be applied to a great deal of commercial law, torts and contract law. We
can expect this direction to be further developed most rapidly in the next years.
The setting up of the specialized Center of Law and Economics, Instituto
de Derecho y Economa at the University Carlos III and the newest Centro de
Investigaciones en Derecho, Economi y Administracin de Empresas (Cinde)
at University Complutense, may be an important achievement for the scholarly
work as well as for the policy implementation of this approach.
4. Law and Economics and Legal Policy
To some extent, economic reasoning is present in important parts of legal
reform. Procedural Law, Bankruptcy Law, Tort Law and Court Administration
are some of the areas covered, although one can seldom see explicit mention of
Law and Economics.
5. Law and Economics, Law Practice and Judge Decisions
Although some efforts have been made, there is no substantial achievement in
the appropriation of this approach by legal practitioners. Two hypotheses can
explain such a failure. One is the academic nature of the predominant output
produced so far. The other may have to do with the continental European, that
is civil law, tradition and the way the role of judges is perceived in this
tradition. We believe that difficult cases deserve economic attention because in
those cases the law is open to different interpretations, and the economic one
could then be most competitive.
6. Final Remarks
Language barriers are dropping, and this will open up the market for ideas. It
is also an advantage that the law and economics practitioners, at least in
Europe, are nowadays more realistic and practice-oriented than before.
We still believe that the expansion of the approach greatly depends on its
involvement and application to specific areas (sometimes called disciplines) of
law. Economics will be more fruitful as Economics of Corporate Law, Criminal
Law, Contract Law and the like. When some sound economics is placed in the
hands of a good legal scholar, the productivity is more that duplicated in any
respect, that is, for the law itself, for the law and economics approach and
sometimes even for economics as well. We need to know more about the legal
350 Law and Economics in Spain 0385
industry to be able to produce something sound. And for that, co-authorship
could be a good strategy.
Although the achievements so far are worth the effort, the emphasis in
training and joint legal and economics efforts sound to us as something
worthwhile to be seriously taken into account. In that respect, joint support and
supervision of PhD theses by a legal scholar and an economics scholar may be
a good policy both for purposes of training candidates and for the research
itself. Some of our preliminary results confirm the mutual gains of such a
proposal.
7. Note on the Bibliography
To elaborate the Spanish Bibliography we asked the scholars we knew were
working in this field to inform us of any other scholar using the law and
economics approach. We may have been unable to reach every contributor, and
for that we apologize. Subsequent updates may restore our unconscious
omissions.
On the other hand, we refrain from including in the list translations of
books and articles, mainly from English, but also some from German. The
books by Calabresi on accidents, the introduction to law and economics by
Polinsky, the textbook on private law by Ott and Shaffer, are some of those
which come to our minds. A number of articles written in non-Spanish
languages have also been published. (A number of them are collected in Santos
Pastor (ed.), Lecturas de Anlisis Econmico del Derecho, (Reading Materials
in Law and Economics), Instituto de Derecho y Economa, Universidad Carlos
III de Madrid, Documento de Trabajo, 2/97, 1997).
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Competition Policy), 687 Informacin Comercial Espaola, 51-66.
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Disposiciones Generales (Standard Form Contracts: Why Are They Binding?), chapter 1, Madrid,
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Alfaro Aguila-Real, Jess (1993), Autonoma Privada y Derechos Fundamentales (Freedom of
Contract and Fundamental Rights), 46(2) Anuario de Derecho Civil, 57-122.
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(Consumer Protection and Contract Law), 47(2) Anuario de Dericho Civil, 305-323.
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0385 Law and Economics in Spain 351
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352 Law and Economics in Spain 0385
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0390
LAW AND ECONOMICS IN SWEDEN
Gran Skogh
Professor of Economics, Department of Managment and Economics,
Linkping University
Copyright 1999 Gran Skogh
Abstract
The European law and economics movement started early in Sweden. However,
the dialogue between economists and lawyers has developed slowly, if at all.
The reluctance toward economics in the law schools can be explained by the
strong influence emanating from legal realism and positivism. Moreover,
scholars with a law degree have most limited training in social sciences.
Although law and economics has only exerted a marginal impact on legal
education, it has nonetheless influenced the Swedish political debate.
JEL classification: K00
Keywords: Law and Economics, Scandinavian Realism, Education, Research.
1. Introduction
During 1974-77, a Law and Economics seminar took place at the Department
of Economics and at the Faculty of Law at the University of Lund. The first
international conference in Law and Economics in northern Europe was held
in 1977, and a conference volume ensued, Acta Societatis Juridicae Lundensis
(1977). Thus, the European law and economics movement started early in
Sweden.
The first doctoral dissertation in law and economics in Sweden was
defended at the University of Lund (see Skogh, 1973). Thereafter, several
dissertations have been presented by economists, for example Soeria-Atmadja
(1983), Bjuggren (1985), Schuller (1986), Fahlbeck (1996), Bolin (1996),
Berggren (1997), Hgg (1998) and by lawyers, for example Samuelsson (1991),
Runesson (1996) and Domeij (1998).
Nevertheless, the dialogue between academic economists and lawyers has
developed slowly, if at all. Nowadays, there are no regular law and economics
seminars at any Swedish university. Nonetheless, there are three fully
accredited law schools in Sweden: at the universities of Lund, Stockholm and
Uppsala. Other universities and colleges offer partial programs in law. There
is one chair in Economics (shared with the economics department) at the
Faculty of Law at the University of Stockholm. There used to be a similar chair
370
0390 Law and Economics in Sweden 371
in Economics at the law faculties of the Universities of Lund and Uppsala, but
the chairs have been withdrawn.
Law students traditionally take an obligatory introductory course in
economics. This course was reduced in the 1970s from around ten weeks to four
weeks of full-time study. Swedish textbooks in economics for law students are
Skogh (1977), Werin (1982, 1997), Hglund (1984), Bjuggren and Skogh
(1990), Skogh and Lane (1993), and Bergstrm and Samuelsson (1997). Also
international textbooks are used. Law students are, thus, to some extent
acquainted with the economics of property rights, risk-sharing, and so on. The
normal period of study for a law degree is four-and-a-half years. Swedish law
students have no previous university training (such as the bachelors degree in
the USA). Hence, the Swedish lawyer gains very little training in the social
sciences.
2. Scandinavian Realism
The reluctance to include more than rudimentary courses in economics in the
law schools can be explained by the strong influence emanating from the legal
realist school in Sweden. Scandinavian legal realism is sometimes called the
Uppsala School. Its founding father was Axel Hgerstrm, a philosopher at
the University of Uppsala during the first decades of the century. Hgerstrms
attention was directed to law and ethics as sources of metaphysics, which he
found meaningless and unscientific. Important members of the Uppsala School
were Alf Ross (1968, 1971) and Karl Olivecrona (1939). For an overview of
Scandinavian realism, including selected translations into English, see Lloyd
(1972, pp. 497-560), and Ryssdal (1995).
According to Olivecrona, the scientific study of the law should be a study
of empirical facts. He dismissed notions such as the existence of (natural)
individual rights or property rights as fantasies of the mind. Scandinavian
realists were extreme positivists in that they tried to eliminate all metaphysical,
ideological and normative elements in the study of the legal order.
Scandinavian legal realism has influenced legal thinking and legal
education for most of the twentieth century. Lawyers and legal philosophers
who wanted to protect natural, traditional, or moral rights were regarded as
conservative, backward, or sometimes even misled by legal or moral
metaphysics. Teaching at the law faculties was largely the positive study of
actual law de lege lata, while the study of the philosophy of law and the social
function of law de lege ferenda was limited. Courses in jurisprudence were
short and were dominated by legal realism, at least until the mid 1970s. The
possibility of using scientific principles to study general (natural) principles of
law was ruled out in elementary textbooks (see Malmstrm, 1986). Thus, the
372 Law and Economics in Sweden 0390
academic lawyer was trained as a technician, a specialist in knowledge of the
actual legal documents and in interpretation of the aims of legislators. The
study of law in society was left to sciences and arts outside the law faculties,
such as Philosophy, History, Sociology, Political Science and Economics. This
does not say that the Scandinavian realists did not take part in the legal policy
debate. Indeed, from the 1920s to the 1960s, several of the most influential
realists were members of Parliament and/or ministers in several Social
Democratic governments.
3. The Legal and Economic Profession
As noted above, the study of social sciences at law schools is minimal.
Consequently, most scholars with a law degree have limited knowledge of
social sciences, mathematics, or statistics. This may appear somewhat
paradoxical, given realisms advocacy of a purely positive and empirical legal
science.
The recruitment of lawyers to the courts is made within the judicial system.
Besides legal training, other qualifications have low value, which tends to
isolate judges from other professional groups (see Ryberg, 1989). Lawyers in
high-level positions in public administration are to a large extent recruited from
the courts. Hence, there may be a similar bias in public administration. There
may also be a political bias among lawyers - all higher positions are filled
through appointment by the government. Loyalty to the general ideology on
which the welfare state is based may thus be maintained. The same tendencies
exist in law schools. Law professors are commissioned to appoint professors to
faculties of law, which may favour the preponderance of traditional,
welfare-oriented lawyers. There are no private law schools.
The separation of the study of economics from law is mainly a post-war
phenomenon. Earlier, research in economics, and especially in public finance,
took place at law faculties. For instance, Knut Wicksell (1958), who made
seminal contributions to the economics of constitutional and tax law, was
professor of Economics at the Faculty of Law in Lund in the beginning of the
twentieth century. The presence of economics at law faculties might have
helped to spread the law and economics movement in Sweden. However, just
the opposite has occurred. The common pool of knowledge between lawyers
and economists diminished as economics became more and more influenced by
mathematics and statistics. For a long time now, the two disciplines have
isolated themselves from each other, even though they once coexisted within
the same faculty. Economics research has adapted Anglo-American scientific
values, with results normally published in international journals. Most law
professors, on the other hand, do not publish in English. Their writing is
generally limited to legal investigations and to textbooks written in Swedish
(see Sthl, 1989). Because of this difference, some economists occasionally
question the competence of lawyers. Lawyers, on the other hand, are critical of
0390 Law and Economics in Sweden 373
economic analysis of law. Exceptions, however, are Hellner (1988) and Roos
(1981, 1990) that notes the relevance of economic analysis of law. One reason
for the reluctance may be that Swedish academic lawyers lack understanding
of economic methods, and another may be that the contributions Swedish
economists have made to law have been limited.
The mutual distrust has to some extent been transmitted to law and
economics research. Economic analysis of law is not regarded as mainstream
economics. Nevertheless, there is an interest in institutional economics, and as
long as the analysis of institutions is based on generally accepted methods,
economic analysis of law is accepted within the profession.
Applied economics, in cooperation with lawyers or adapted for them, has
little professional status among academic economists. Similarly, cooperation
with economists is of low professional value in the legal profession.
Nevertheless, a number of scholars are working on law and economics
problems at various institutions. In addition to what has been mentioned above,
work by Holmn (1993), Eklund (1995) and Bjuggren (1992, 1995) should be
noted. Moreover, the Stockholm School of Economics has an Economics
Department and a Law Department interested in the field. Some smaller
business schools and universities have also shown an interest in law and
economics, especially Linkping University and Jnkping International
Business School. Finally, the private Center for Business and Policy Studies
(SNS) has conducted a number of law and economics projects: see, for
instance, Bergstrm and Rydqvist (1992) and Macey (1994).
4. The Impact of Law and Economic Thinking
The Political Debate
Although law and economics has only exerted a marginal impact on legal
education, it has nonetheless influenced Swedish society in a number of ways.
Legal rule-making is based mainly on legislation, prepared by public
administrators and adopted by Parliament. Politics, lobbying and public opinion
are important determinants of the outcome of this process. Here, economics
plays an important role. The impact of lawyers on legal rules is mainly indirect,
occurring through administration and through the wording and interpretation
of statutes. To the extent that lawyers participate in the general political debate,
they do so either as specialists in a defined field of law or as contributors to the
general political debate.
For a long time the main issue in Swedish politics has been the public
sector. The Social Democrats in power have expanded the public sector, while
the conservative (non-Socialist) parties generally argue in favour of a smaller
public sector, decentralisation and increased reliance on markets. The
374 Law and Economics in Sweden 0390
opposition also favours protecting private property and constraining the
government through constitutional reforms. Economists have been influential
in this debate. Arguments resting on public choice, the economics of regulation,
the theory of property rights and law and economics have frequently been used
to attack the Social Democrats. A few years ago, when the bourgeoisie parties
came into power, they included the protection of property rights in the
constitution. This has contributed to giving law and economics an image of
being right-wing.
Criminal Law
Economic reasoning has also influenced specific legal fields. Until the early
1970s, the criminological debate was dominated by sociological and medical
schools, which held that the purpose of sanctions was to treat the individual and
to make the criminal less inclined to commit crimes. Punishment did not
appear to deter, and general deterrence was not analysed in detail. In the mid
1970s, the classical school experienced a renaissance: punishment was to be
proportional to the harm of the crime and not only related to the criminals
need for treatment. General deterrence was again regarded as important (see
Brottsfrebyggande Rdet, 1975), and the criminal code was adjusted,
accordingly.
Although it is not possible to identify clearly the connection between
changes in criminal policy and the economics of crimes, it can be argued that
the connection existed. The first publications in law and economics in Swedish
were on the economics of crime (see Skogh, 1973; Skogh and Stuart, 1982a,
1982b). Swedish criminologists and criminal lawyers in the Ministry of Justice
were familiar with Gary Beckers (1968) work and the subsequent empirical
literature on deterrence. The Swedish debate was also influenced indirectly
through international changes in favour of the classical schools belief that
punishment should parallel harm.
National factors also had an impact on the rapid change in Swedish
attitudes toward general prevention. One such factor was that criminals formed
an association, KRUM, which claimed to represent prisoners. KRUM rejected
the idea that criminals were mentally ill or incapable of rational decisions. It
wanted prisoners to be regarded as rational and argued in favour of
time-limited sentences instead of time-unlimited treatment. In the 1970s, there
was also an increased interest in white-collar crimes, drug-related crimes, tax
evasion, and other calculated crimes. For such crimes, deterrence may be the
most obvious reason for punishment.
Tort law
One of the major goals of the Social Democratic party has been to build up an
extensive public insurance system. Health insurance, disability insurance,
unemployment insurance, and pension schemes today cover most personal
economic losses. Such insurance is mainly financed through taxes and is
0390 Law and Economics in Sweden 375
independent of negligence.
Opponents have argued that damages are an important tool for preventing
accidents. The counter-argument from Social Democratic politicians and some
influential lawyers has been that the tort system is slow, unsophisticated, and
expensive. It has also been argued that the preventive effect of damages is
unproved, (see Hellner, 1985).
Economic analysis of accident law was introduced in Sweden two decades
ago, (see Skogh, 1977, 1998a, 1998b). In general, there has been a political
reluctance to change the public system of undifferentiated, no-fault insurance
schemes. However, attitudes have changed among lawyers, (see Roos, 1990).
One reason for the change in political attitudes is that costs of compensating
people for losses of earnings due to sickness have increased sharply. A reform
instituting deductibles for employees and employers has been introduced and
extended. An immediate effect was a significant reduction in the absence at the
workplace. The traffic and disability insurance systems are now under debate
(see Bladini, 1994).
5. Concluding Remarks
Although law and economics came to Sweden more than two decades ago, it
has not yet become an integral part of legal research. The Scandinavian
doctrine of legal realism, together with various institutional obstacles, may
explain why. There is no reason, however, to be overly pessimistic about the
future of law and economics in Sweden. Several positive factors ought not be
overlooked. First, especially young academic lawyers are interested in applying
economics to law. In the law schools, there appears to be dissatisfaction with
traditional legal realism and formalistic positivism. Second, membership in the
EU and the presence of international common law trends influence the legal
scholars. Third, the application of economic analysis to ongoing legislation is
fruitful, which is likely to have an impact on legal education and research in
the long run.
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0390 Law and Economics in Sweden 379
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0395
LAW AND ECONOMICS IN SWITZERLAND
Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest
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0395 Law and Economics in Switzerland 381
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0400
METHODOLOGY: GENERAL
Heico Kerkmeester
Associate Professor
Erasmus University of Rotterdam
Copyright 1999 Heico Kerkmeester
Abstract
Most disputes on the methodology of law and economics have been initiated
by critical scholars from disciplines outside the field itself, such as
practitioners of law and literature and critical legal studies. This chapter
reviews the literature on the methododology of law and economics.
It discusses, among others, the following issues: the object of law and
economics, the measuring rod (money versus utility), positive and normative
law and economics, and the scientific value of law and economics
JEL classification: K00.
Keywords: Positive and Normative Law and Economics, Scientific Value,
Method and Object.
1. Law and Economics: Method and Object
Law and economics does not differ from other fields of study in the respect
that over time different schools of thought have come into existence. Such
schools include Chicago Law and Economics, Public Choice Theory,
Institutional Law and Economics and Neoinstitutional Law and Economics
(Mercuro and Medema, 1997). It has been argued, however, that most legal
economists follow a pragmatic, eclectic, approach and that with a few
exceptions, it is hard to fit them in a particular school of which they
faithfully follow the rules. The economic approach to law is based on a
limited number of assumptions that themselves may be amended if an
alternative set of assumptions would fit the particular object of study better
(De Geest, 1994). Therefore, a review of the methodology of law and
economics must concentrate on the ideas that are shared by the vast majority
of the people working in this field, although attention will be paid to the
cases in which alternative viewpoints have been defended by major scholars.
Remarkably, most disputes on the methodology of law and economics have
been initiated by critical scholars from disciplines outside the field itself,
such as practitioners of law and literature and critical legal studies.
383
384 Methodology: General 0400
Disputes on the proper definition of object and method of law and
economics are not completely absent, but there seems to be a consensus
among most of its practitioners. The fundament of this consensus is Gary
Beckers (1976) argument that economics should be defined according to its
method, rather than to its object of study. According to Becker, this method
is the rational choice approach. Students of law and economics sometimes
summarize this approach in just four words - people maximize, markets
clear (Baird, 1997) - but besides maximizing behavior and market
equilibrium, the economic rational choice approach also comprises the
assumption of stable preferences.
The rational choice approach can be and is applied to almost any object
of study where choices are made, including for example criminal activities,
sexual behavior and animal behavior. The notion of market clearance or
market equilibrium refers to the fact that because demand rises if prices go
down, supply rises if prices go up, and vice versa, the market will tend
towards a situation where supply equals demand at a particular equilibrium
price.
Equilibria will not only result on explicit markets such like the stock
exchange, but also on implicit markets such as the market for criminal
activities or the marriage market, which in law and economics are more than
just metaphors. If the price of criminal activities goes up, due to for example
a stricter criminal law, demand will go down, and similarly the demand for
marriages will go down if the price rises (Becker, 1991).
Law and economics can be defined as the economic analysis of law, and
therefore as the application of the rational choice approach to law. In
accordance with the textbook definitions, the term law here refers to statutes,
judge-made law, treaties and customary law. However, not only the law itself
is studied, but also the way it came into existence and, in particular, its
effects.
Law and economics is closely related to neo-institutional economics, but
as Ronald Coase (1994) has shown, it is possible to distinguish both. Coase
argues that while law and economics demonstrates how economics is
important for the study of the law, neo-institutional economics focuses on
the importance of institutions - mainly the firm, the market, and of course
the law - that are important for the understanding of the economic system.
Coase predicts that over time the fields will diverge from each other and
increasingly will become the domain of specialists. Initially, a lot of insight
in the law is gained by the understanding that people make choices and,
therefore, economists are able to contribute to the understanding of the law.
Once lawyers get familiar with the basic concepts of economics, however,
their superior understanding of the object of study will enable them to
surpass economists working in the same field. Lawyers will be able to refine
0400 Methodology: General 385
the method and thereby improve on the study of the particular object. Over
time this will be required in order to advance law and economics.
The people who are assumed to maximize are individual people. This is
to say that the individual action is the basic unit of analysis, so that the
action of collective actors like firms or states should be analyzed in
individual terms. This principle, known as methodological individualism, is
just an analytical tool and in itself does not have ethical implications in the
sense that the interests of individuals ought to be maximized.
Moreover, methodological individualism does not require that
individuals are nontuistic in the sense that they only take their own
wellbeing into account when they make decisions. It is true that in most
economic analysis of law the assumption of rationality implies nontuism, but
this is clearly an example of an assumption that may be amended without
violating the essence of an economic analysis. In the context of family law,
for example, it is usually assumed that parents are altruistic towards their
children (Becker, 1991). Neither does methodological individualism imply
that individuals are assumed to make their decisions in isolation from
others. The idea that individuals choose in the context of social interactions
is made explicit when game theory is used as a method of economic analysis,
as nowadays is often the case (Kerkmeester, 1995).
It has been argued that human rationality is bounded in the sense that it
is limited by a lack of information or of abilities to process information. An
alleged consequence is that people do not maximize but are satisfied with
reaching a certain aspiration level of utility. However, in mainstream law
and economics issues of information may be taken into account by
acknowledging that acquiring and processing information is costly and that,
therefore, a rational individual deliberately will limit the collection of
information (Posner, 1993a).
Recent developments in law and economics extend its realm beyond the
context of markets by analyzing the consequences of social norms. The
existence of social norms can be the basis for an explanation of human
behavior, alternative to the rational choice approach. In some cases the best
predictions may be yielded by the assumption that individuals choose
certain acts because it is the norm to do so, rather than that they would base
their actions on an outcome-oriented evaluation of costs and benefits (Elster,
1989). Within law and economics, social norms have particularly attracted
attention since Ellickson (1991) showed that, different from what the Coase
theorem predicts, individuals do not bargain towards an efficient solution on
the basis of clearly defined rights that function as starting point for
negotiations. Rather they simply follow social norms that often, although not
always, help to obtain efficient outcomes.
386 Methodology: General 0400
Many attempts have been made to show that social norms themselves
may be the results of rational choices (Becker, 1996; Cooter, 1998).
2. The Measuring Rod: Money Versus Utility
If people maximize, what do they maximize? Two measuring rods are
widely used in law and economics.
The first is utility, a term referring to the preferences of individuals: the
more a particular item is preferred, the higher is by definition the utility that
it yields to the individual. Everything can be measured in terms of utility,
including for example leisure, love, altruistic feelings, the adherence to
norms, and so on. It is even conceivable that someone derives utility from
losing his money. What individuals prefer and to which extent they do so, is
a matter of personal taste in which economics does not interfere: de gestibus
non est disputandum (Becker, 1996).
The most important arguments for the use of utility rather than money
are derived from the axiom of diminishing marginal utility, that says that
the utility gained from successive units of a commodity diminishes. The
same can be argued with regard to money, in the sense that an additional
euro will yield less utility than the last one. If the axiom holds, this has
consequences for the attitude of individuals toward risk. If twice the amount
of money does not yield twice the amount of utility, an individual will prefer
the certainty of a particular amount of money above a gamble with a 50
percent chance of getting the double amount and a 50 percent chance of
receiving nothing. However, the axiom does not always hold and, moreover,
in some contexts individuals may not be risk-avoiders but be neutral towards
risk, or even risk-seekers in the sense that they prefer a gamble with a
certain expected value over the certainty of this value.
An important drawback of utility is that it is hard to make interpersonal
comparisons if such a subjective measuring rod for utility is used. This is
why the use of the Pareto criterion is defended. The definition that a change
will result in a Pareto improvement if at least one person will be better off
and no person will be worse off than before avoids the need for making
interpersonal comparisons. A solution is Pareto optimal if no further Pareto
improvements can be made. The Pareto criterion is to be distinguished from
the Kaldor-Hicks criterion that states that a change results in a wealth
improvement if the winners gain more than enough to compensate the
losers, whereby however such a compensation need not take place in fact.
While as a logical statement the assumption that an individual is
engaged in the maximization of utility is true by definition and therefore a
truism, the same assumption clearly is unrealistic as an empirical statement.
0400 Methodology: General 387
Ronald Coase (1994) compares the use of the term utility in economic
models with the use of the term aether in classical physics. It is not
observable, but only called in because it is required to make the traditional
model work.
The fact that all behaviors can be explained in terms of utility is an
advantage, but at the same time another drawback of its use. The only way to
determine someones utility function is to observe his behavior. If, however,
the utility function thus derived will be used to predict the behavior of the
same individual, circularities are bound to occur. No matter how unusual
ones behavior, it always can be explained by assuming that it maximizes
utility. This helps to understand the importance of rational choice theorys
assumption that preferences are stable during the period under
consideration.
The most obvious alternative for the use of utility is money, as is
preferred by both Coase and Posner, and this use has clearly some
advantages. In the first place the assumption that, other things being
constant, people prefer more money over less and always like to have more,
is among the most realistic assumptions that can be made. Because,
however, some individuals may form an exception to this rule, the circularity
inherent in the statement that individuals maximize utility is avoided.
Interpersonal comparisons are easier to make with money than with utility.
Although a dollar may not mean the same to person A as to person B, at
least it is the same dollar. This possibility is particularly important in
normative law and economics. In order to avoid the restrictions of the Pareto
criterion that as was noted above, only allows for a change if nobody is
worse off as a result, Richard Posner (1992) defends the use of the principle
of wealth maximization. The measure is the willingness to pay: if goods and
other resources are in the hands of the persons who were willing and able to
pay the highest amount for this, wealth is maximized. Willingness to pay is
not a pure expression of the preferences that an individual has towards a
particular item. It may be the case that although A has more intense
preferences with regard to an item than B has, still B may be willing to pay
more for it, for the simple reason that he has more money available. There is
a speculative element in it since the offering prices one needs to know to
determine willingness to pay are not always observable.
Alternatives
There has not been much attention for the use of alternatives to money or
utility in law and economics. This neglect contrasts with the extensive
discussions in economics and in ethical discourses. A source of alternatives
for money is fed by some authors argument against welfarism, that is the
idea that the social ordering of different situations should depend on the
utility that individuals derive in those different states of the world (Roemer,
1996). An important problem is that individuals may have perverse
388 Methodology: General 0400
preferences, for example deriving utility from torturing someone else, or
expensive tastes. For positive purposes this is not a point, but it causes
difficulties as soon as utility maximization is regarded as something that
should be promoted (Posner, 1979).
The alternatives presented not only counter welfarism, but also provide
better opportunities for interpersonal comparisons. Examples are John
Rawls well-known concept of primary goods and Amartya Sens
functionings. Functionings refer to what goods can do for people, which is
not only yielding individual utility, but also escaping death, being nurtured,
getting self-respect, participating in community life, and so on. The point is
not that those functionings could be measured in terms of utility, because of
course they can, but that they themselves can be measured more objectively
than is possible with utility. However, for most economic analyses of law, it
is doubtful whether the advantages just mentioned outweigh the costs of a
more complicated approach.
Criticisms
The economic assumptions regarding utility or wealth maximization have
been the main objects of attacks by critics of law and economics. The
criticisms have focused on the positive as well as the normative use of the
assumptions.
The mainstream ideas about maximizing behavior are based on the
assumption that desires and opportunities are independently given
(Kerkmeester, 1992). It may, however, be the case that desires are
influenced by opportunities. Dworkin (1980) points at the possibility that
because of the familiar grass is greener phenomenon, social wealth may be
increased by a transfer from A to B, but because of the resulting change in
preferences then again may be increased by transferring the item back from
B to A. Even more common is the situation in which on the contrary
someone will ask more for something he owns than he would pay to acquire
it. This has become known as the endowment effect and as such it has
received its place in the economic analysis of law (Sunstein 1997a).
Particularly vexing for economists is the sour grapes effect, named after
the fable of the fox who, when he discovered that he could not reach certain
grapes, did not want them because they were sour anyway (Elster, 1979).
The effect is important for a judgement of the assumption of wealth
maximization but it conflicts with the equally important assumption that
preferences are stable.
Some authors have argued that the unidimensionality of measuring in
terms of utility or money fails to take the complexity of human motivation
into account. Martha Nussbaum (1997) argues that in law and economics too
much attention is paid to variables that are measurable, at the expense of
0400 Methodology: General 389
other factors that may play no lesser role in determining human action.
According to Robin West (1988) legal economists fail to reckon with the
warmth and empathy that characterizes human relations. The use of
Kaldor-Hicks efficiency in law and economics, however, implies the
assumption that it is possible to obtain sufficient insight in the preferences of
others to determine what one needs to get in order to be compensated for a
loss (De Geest 1994). Therefore, it is doubtful whether Wests criticism
holds against mainstream law and economics.
All the previous remarks are based on the idea that the assumptions
regarding utility or wealth maximization do not provide for a realistic
description of the complexities of human behavior in the real world. One
response from law and economics could be that its assumptions can be - and
often are - made to be more in accordance with reality. In particular, Gary
Beckers (1996) recent work on tastes shows willingness to incorporate the
possibility of changes in preferences into the economic model. A different
response, however, could be that unrealism of assumptions is not necessarily
a bad thing. The latter point will be returned to in Section 4.
Most reactions have been provoked by Richard Posners principle of
wealth maximization. The most influential of these reactions is Ronald
Dworkins (1980) comment.
In the first place Dworkin notes that willingness to pay for an item is not
only determined by preferences for the item, but also by ability to pay.
Therefore, a scarce item may end up in the hands of a rich man who barely
needs it, rather than with a poor soul who desperately needs it, but simply
cannot afford to pay the same amount. This situation is in accordance with
the principle of wealth maximization, while total utility is not maximized.
In the second place, wealth maximization may lead to outcomes that can
be regarded as unfair. This is the case in the example mentioned above, but
outcomes can also be unfair in cases in which total utility is maximized but
unequally divided.
In the third place, Dworkin argues that the principle of wealth
maximization interferes with individual autonomy as would be guaranteed
by individual rights. He mentions a case in which A attaches a higher value
to an item than owner B does. A benevolent dictator then would maximize
wealth by taking the item from B and giving it to A.
The allegation that law and economics does not recognize rights that is
implicit in the last remark is clearly unjustified, and Dworkin himself
mitigated his criticism in this respect. As the importance of the notion of
property rights within law and economics shows, rights do play an important
role. Dworkins remarks certainly have their merits, but it should be noted
that a normative law and economics does not stand or fall with Posners
390 Methodology: General 0400
wealth maximization. Posner (1980) himself insisted that the principle of
wealth maximization is in accordance with individual autonomy.
3. Positive and Normative Law and Economics
Due to the discussion above it has become obvious that it is important to try
to distinguish between positive and normative law and economics. This issue
is particularly important for an evaluation of the position of law and
economics as a scientific discipline. In other words: it should be clear
whether law and economics regards statements about how the law and its
effects are, or about how they ought to be.
A possible point of view is that both are possible (Friedman, 1987). A
positive analysis explains the law, predicts its effects and thereby indicates
which legal rule as a matter of fact will be efficient. These results of a
positive analysis can then be used for normative purposes, such as the
prescription of the efficient rule.
The approach leading to normative statements has been aptly
characterized by James Buchanans (1990) words the ought is derived from
the presumed is. A legal economists starts with assumptions about human
behavior. Correct predictions of human behavior and the way it is influenced
by the law are required for decisions on how the law should be. Therefore,
the discussion about the realism of assumptions that will follow in the next
paragraph will be relevant for both positive and normative law and
economics.
However, not everyone is satisfied with the idea of a co-existence of
positive and normative law and economics. Some argue that only a positive
economic analysis of law is possible (De Geest 1994). The efficiency of a
legal rule is regarded to be a factual issue, and that it thus can be determined
objectively. To argue that therefore this rule is desirable is to add a value
judgement that is not a part of an economic analysis.
A point of view that is even more radical is that economics is a strictly
positive science, while law is a strictly normative undertaking, and that
therefore law and economics cannot go together (Couwenberg et al. 1980).
The opinions just cited lose ground, however, as soon as it is
acknowledged that a science is not necessarily positive and that this is
particularly true for the economic science. Coase gives the example of an
economist predicting that a certain measure, namely collectivization of
agriculture, will lead to mass starvation. In Coases opinion it is absurd to
state that the economist is not able to make a statement about whether this
particular measure is desirable or not. The idea that the making of value
judgements is better left to others is rejected by Coase (1994), since he
0400 Methodology: General 391
believes that economists and others share many values and economists thus
are able to make acceptable value judgements on their own.
Coases opinion is supported by the fact that nowadays many economists
are no longer reluctant to acknowledge that they are engaged in a normative
undertaking. In particular, the relation between economics and ethical issues
as the just distribution of welfare has been the subject of study (Roemer,
1996). It could well be argued that if economics could be normative
anywhere it is in the context of the economic analysis of law.
Several authors (for example Raes 1990) even argue that an economic
analysis always is normative, at least implicitly. Their argument is that if
legal economists focus so much on efficiency, this shows that they believe
laws should be efficient or that at least efficiency is an important and
desirable characteristic. An even more critical approach to the allegedly
normative contents of law and economics is put forward from critical legal
studies and law and literature. Both are currents in American legal theory
that have been particularly aimed at unmasking law and economics as a
biased - inherently conservative, right-wing - movement (Kelman, 1987;
Duxbury, 1995; Mercuro and Medema, 1997).
4. The Scientific Value of Law and Economics
Inductive versus Deductive Approaches
In the previous paragraph it was argued that the relation between theory and
the empirical world is not only important in positive law and economics, but
also if a normative point of view is taken. According to the famous words of
Oliver Wendell Holmes, which are often quoted in law and economics:
experience not logic is the life of the law.
Two extreme viewpoints are possible as to the relation mentioned above.
The most common is the application of the deductive method, of which the
rational choice approach is an example. Deduction implies that the focus is
from theory to reality, that is starting with making assumptions, deriving
hypotheses from them, and testing these hypotheses by confronting them
with the results of empirical observations.
The alternative is an inductive approach, that is to say focusing from
reality to theory. One starts with making empirical observations, making
generalizations in order to develop a theory. In his criticisms on the use of
assumptions in law and economics, which use is inherent to the deductive
approach, Ronald Coase defends the inductive alternative that he has been
practicing himself. Coase accuses the followers of the deductive approach of
practicing blackboard economics, that is having the conviction that a
model that is drawn on the blackboard obviously has meaning for the real
392 Methodology: General 0400
world. An example is given by the provision of lighthouses, which according
to economic models are classical examples of public goods for which the
government should provide. Coase (1988) showed that empirical, inductive,
research led to the conclusion that in fact in England for centuries there
been a profitable private provision of lighthouses.
The predominance of deductive approaches in law and economics has
also resulted in criticisms from law and literature (Gaakeer and
Kerkmeester, 1997). By focusing on generalizations rather than on
individual cases, law and economics allegedly overlooks aspects that make
every case unique (White, 1987).
Given the dominance of the deductive approach in law and economics,
the debate on the position of assumptions in law and economics deserves
closer scrutiny. The usual point of view is that for several reasons the
realism of assumptions is irrelevant. In the first place an economic theory of
law that captures its full complexity would not be a theory, but a description
(Posner, 1992).
The most principled as well as influential counterargument is based on
Milton Friedmans (1953) ideas about the role of assumptions in positive
economics that have become part of the dominant methodology in law and
economics. Friedman argues that the realism of a model should not be tested
on the level of the assumptions underlying it, but on the level of the
hypotheses derived from the model. Therefore, what counts is whether a
model predicts well, in other words whether the predictions derived from the
model (the hypotheses) are in accordance with empirical observations.
A frequent comment on the rationality assumption, namely that real
people are not rational in the sense that they make deliberate calculations,
calculating with lightning speed can be countered by pointing at Friedmans
argument. It is not relevant whether people really calculate, but whether
their behavior can be predicted correctly on the basis of a model that is made
as if those calculations are made and decisions are based upon them.
An extreme viewpoint of Friedman that has become known as the
F-twist, is that assumptions even should be unrealistic, because that is
what makes them general enough to yield fruitful predictions.
Friedmans methodological paper has evoked a large amount of
comments. An argument against the use of Friedmans methodology is the
assertion that - at least in a number of contexts - unrealistic assumptions fail
to yield correct predictions about the empirical world, and thus the F-twist
certainly does not hold. The most important defender of this view is Cass
Sunstein, who pleas for a behavioral law and economics.
Based on empirical research that found anomalies in rational choice
theory, Sunstein (1997b) develops a catalogue of complications that law and
economics should take into account, in particular if it comes to estimation of
0400 Methodology: General 393
probabilities, changes of preferences, and addiction. This is not to say that
behavior is unpredictable. On the contrary, deviations from the predictions
of rational choice theory often happen in a systematic way and inductive
research of these deviations can help to build economic models that yield
better predictions.
Another point to be mentioned is that in Friedmans view correct
predictions are useful because they help confirm to a theory. However, the
logical-positivist idea that the confirmation of theories is relevant has come
under attack from the philosophy of science known as critical realism, with
Karl Popper as its founder. Popper argued that confirmations never are able
to prove that a theory is correct. One should therefore strive for the
falsification of his theory, looking for empirical observations that are not in
accordance with the predictions of the model. If a model is falsified in a
confrontation with reality, the assumptions of the model can be adjusted and
attempts at falsification can start anew. Ideally, deduction and induction will
follow each other in an empirical cycle.
The methodological prescriptions of critical rationalism have found wide
support (Teijl and Holzhauer, 1997). Critics of this viewpoint, however,
have argued that although the falsification principle is adhered to in theory,
it is not followed in practice. Usually, scholars look for confirmations of
their theory and in case a discrepancy between reality and the predictions of
the theory is found, this is blamed on anomalies that require further study
(Coase, 1994).
Alternatives to Critical Rationalism
Observing the failure of critical rationalism to describe the practice of law
and economics as a scientific discipline, alternative models have been
sought. Thomas Kuhn presented an alternative in his The Structure of
Scientific Revolutions (Coase, 1994). Kuhn noted that indeed isolated
discrepancies do not lead to the abandonment of a generally accepted
paradigm. Whether a new paradigm will replace the old will not only be
determined on the basis of empirical results. Of no less importance is the
ability of the adherents of the new paradigm to gain key posts at universities
and at the boards of important journals. Legal economists choose between
competing theories and empirical research plays a role in showing the
attractiveness or unattractiveness of a theory.
The fact that Kuhn stresses an institutional perspective implies that the
success of law and economics to a large extent depends on the ability of
lawyer-economists to obtain positions at law schools and to get their articles
accepted in prestigious legal journals. A complicating point hereby is,
however, that the amount of success will depend on the attractiveness of law
and economics as a normative theory. Of old, the legal academia has been
394 Methodology: General 0400
less interested in positive studies than in normative arguments that state how
a case should be decided or how a law should be written.
Another alternative that attracted attention in law and economics is
Lakatoss Methodology of Scientific Research Programmes (De Geest 1994;
Teijl and Holzhauer 1997). According to Lakatos, theories have a hard core
that is maintained, even if some elements have been falsified. A layer of
additional hypotheses, ceteris paribus clauses and empirical observations
protects this hard core. In practice, several research programs compete with
each other. A research program is regarded as progressive if it yields new
and correct predictions. A theory is only regarded to be falsified when it is
replaced by a new and better theory.
De Geest (1994) has developed a theory that does not stress the
importance of the truth of a theory but its plausibility, defined as the
probability that its statements about the reality are true. For the plausibility
of a theory not only empirical confirmations are relevant, but also the
accordance of its statements with self-observation and life experience of the
specialists that give a judgement of the theory. The latter is important for
law and economics because empirical confirmations in the form of
observable data are still limited in number. The same line of reasoning is
followed by Coase (1994) in his effort to reconcile the main works of Adam
Smith, namely The Theory of Moral Sentiments and The Wealth of Nations.
If the complicated theory of motivation as developed in The Theory of Moral
Sentiments is used as the starting point of an economic analysis the
conclusions from The Wealth of Nations still hold, but are made more
plausible. In this respect the problem with the use of unrealistic assumptions
as defended by Friedman is that they do not contribute to the plausibility of a
theory.
Ronald Coase (1994) further argues that even if predictions on the basis
of unrealistic assumptions are correct, a theory based upon them may fail in
providing insight in the working of the economic (or legal) system. An
important factor in judging the importance of realism of assumptions is the
goal one is aiming for. If it is only prediction and control, the use of
unrealistic assumptions is fine, as long as they indeed predict well. If,
however, the goal is explanation, an approach based on unrealistic
assumptions is not really helpful in providing insight in what really moves a
person and in how legal rules really have effects. There is an additional need
for a mechanism that shows how something could have happened. Not
only the predictions, but also the beauty, elegance and internal consistency
of an economic model determine its value for the analysis of law. Therefore,
the life of law and economics is not just experience; it is logic as well.
0400 Methodology: General 395
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0500
SCHOOLS: GENERAL
Ejan Mackaay
Professor of Law
University of Montreal
Copyright 1999 Ejan Mackaay
Abstract
The concept of schools is used to summarise the ideas of thinkers who share
common premises on how and what to research, and to contrast them with
those of other schools. It is an expositional convenience and should be used
only when the differences touch fundamental matters of the field of research.
The differences between schools focus attention on questions to be resolved by
further research.
Within the current law and economics movement, besides the mainstream,
the institutionalists, the neoinstitutionalists and the Austrians constitute distinct
schools. Whether the New Haven School constitutes a distinct school is
debatable.
JEL classification: K00
Keywords: Law and Economics in General, Schools
1. Introduction: Schools in General
1.1 Schools
A school of thought in scientific endeavour is a group of thinkers who adopt a
common approach, including shared theoretical premises, on how and what to
research in a particular field. The term is also used as shorthand for the ideas
those thinkers defend.
Originally the term school may have designated a major thinker, founder
of the school, and his or her disciples. In current usage the link to a common
intellectual leader is no longer essential. The members of a school of thought
may, but need not, themselves claim allegiance to the school. Members of a
school may consider that the adherence to a set of common precepts allows
them to build on each others work and so to attain economies of scale in
research not available if they worked in isolation.
402
0500 Schools: General 403
When should we distinguish schools? To speak of schools, one must see
groups of scholars defending contrasting, even incompatible, views about
fundamental aspects of a field of research and these views must have a certain
complexity and logical coherence (De Geest, 1995, p. 458). Classifying such
views into schools facilitates exposition (Teijl and Holzhauer, 1990, p. 622;
Teijl and Holzhauer, 1997, p. 8). We understand through contrasts.
Presentation of schools focuses attention on their differences, which further
research, theoretical as well as empirical, should aim at resolving.
The convenience of summarising the thinking within a school through the
common ideas should not lead one to disregard the differences amongst the
thinkers belonging to that school. Menger, Mises and Hayek, all belonging to
the Austrian school of economics, share ideas of spontaneous order and a
reluctance towards government intervention designed to correct its
imperfections. But they differ in that, for instance, Mises is clearly more
aprioristic and deductive in his reasoning than is Hayek and sees no room for
empirical testing of his ideas, something Hayek admitted (Teijl and Holzhauer,
1997, pp. 121-128). Whether the Austrian school itself should be distinguished
from the neoclassical mainstream is sometimes questioned within economics
proper: With all the respect due to Austrian economics, its latter-day
insistence to differentiate itself from the neoclassical mainstream seems more
important to a small band of its practitioners than to the bystander. What
matters is that Menger and Wieser argued within the same rational choice
paradigm as Marshall and Edgeworth (de Jasay, 1992, p. 337).
Legal theory shows many instances of schools. The legal realists in the
United States, associated with the names of Holmes, Frank, Llewellyn and
others, were united in their reaction against what they presented as the excesses
of positivism in American law schools of the late nineteenth and early twentieth
century. During the same period in France, the cole de la libre recherche
scientifique (Free scientific research school) of Gny and Saleilles was a
comparable reaction against the earlier cole de lexgse (exegetic school),
to whom they attributed the view that law was strictly to be found in the Code
and statutes. The historical school of Savigny and others in Germany, followed
by Maine, Maitland and others in the UK, reacted against what was considered
excessive reliance on logic and aprioristic reasoning in German legal thinking
at the time. In their view law was to be seen as something which evolved from
the instinctive sense of right of the community and developed in and by reason
of particular social, economic, and other contexts (Walker, 1980, p. 1106).
1.2 Movements
It is useful to consider a few related terms. Movement is a broader term than
school of thought. It designates a large grouping of people loosely sharing
404 Schools: General 0500
scientific or practical and, in particular, political aims. One could speak of the
law and economics movement, but scarcely of the law and economics school.
1.3 Paradigms
Since the 1960s, two new terms, paradigm and research programme, are used
to describe aspects of the evolution of scientific thinking (De Geest, 1995, p.
389 f.). Paradigm in normal usage is a very clear or typical example of
something. With respect to the evolution of the sciences, it acquired a different
meaning as a result of Thomas Kuhns book (Kuhn, 1970). The term research
programme is due to Lakatos, writing in reaction to Kuhn (Lakatos, 1970).
The puzzle Kuhn sought to explain is how science grows. The collapse of
the best-corroborated scientific theory of all times, Newtons mechanics and
gravitation theory, in favour of Einsteins ideas, had scattered the view of
scientific growth by accumulation of eternal truths (Lakatos, 1970, p. 92).
Popper had used this and like episodes to argue that the best way forward in
science is not so much by seeking confirmation of ones ideas through
observation, but by seeking ruthlessly to disprove them. The force of scientific
theories lies in the attempted refutations they have so far withstood.
Do scientists effectively proceed in this manner? Kuhns reading of the
history of science leads him to argue that they do not. During periods of what
Kuhn terms normal science, the practitioners of a scientific discipline let
themselves be guided by a shared fundamental theory and view of methods,
problem-field, and standard of solution (Kuhn, 1970, p. 103). These shared
ideas Kuhn termed the paradigm (Kuhn, 1970, p. 10). To attract a following
amongst scientists, the paradigm must account for observations and regularities
considered certain within the discipline, and for some new ones; it must also
be open-ended enough to set a range of new puzzles to be solved. During this
period of normal science, scientists are engaged in puzzle-solving and the
discipline advances without the paradigm being questioned (Kuhn, 1970, p.
10).
As research proceeds and empirical results accumulate, one finds
observations tending to support the theory, but also some which tend to
disconfirm it. If the latter concern puzzles at the periphery of the theory, one
attempts to refine it to yield predictions that better accord with observation. But
the contrary evidence may also concern more fundamental aspects of the theory.
Such observations do not immediately lead one to consider the current theory
refuted. Rather such instances are provisionally set aside as anomalies.
As the number of known anomalies grows, there comes a point when some
practitioners of the discipline no longer consider the current paradigm tenable
and start looking for a modified or improved one. As this sentiment spreads,
the discipline enters into a crisis: practitioners are no longer convinced that
their theory and associated research procedures are well-founded. An outsider
0500 Schools: General 405
may have the impression that research stagnates and that there are interminable
discussions about foundations and methodology.
As the crisis deepens the stage is set for a new paradigm to be proposed.
The acceptance of the new paradigm bring about what Kuhn calls a scientific
revolution. The fundamental advances in science are in his view the result of
such revolutions.
1.4 Research Programmes
In Lakatoss eyes scientific advances do not all come by way of revolutions and
Kuhns view suffers furthermore from the difficulty that the transition from one
paradigm to another appears to be based on the psychology of researchers
rather than on reason. Lakatos sees within any discipline or sub-discipline
several competing research programmes which specify at their hard core a
set of unquestioned premises about the discipline (Lakatos, 1970, p. 133) and
at their periphery a protective belt of matters for which the theory may be
further elaborated and which may be subjected to empirical testing. At the
periphery, one accepts negative test results without considering the theory
refuted. They invite further refinement of the theory.
On this view, scientists adhere to a research programme because of its
plausibility and the research agenda it implies. Progressive research
programmes, offering a wide open research agenda, attract many practitioners,
degenerating or declining research programmes are progressively abandoned.
Growth of scientific knowledge in this view is more like the competitive
process with which economists are familiar rather than like a religious
conversion (Lakatos, 1970, p. 93) or a bandwagon effect (Lakatos, 1970, p.
178).
1.5 Paradigms and Research Programmes in Law and Economics?
Do the concepts of paradigms and research programmes apply to law and
economics? Kuhn himself is doubtful about the application of his ideas to the
social sciences generally, which he consider pre-scientific. He concedes that
any group of scientists may adopt common beliefs and practices to guide their
endeavours (even a phlogiston theory), but stresses the difference between such
a paradigm and the one guiding the activity of the practitioners of a mature
science.
About the the transition from the pre- to the post-paradigm period in the
development of a scientific field he writes: Before it occurs, a number of
schools compete for the domination of a given field. Afterward, in the wake of
some notable scientific achievement, the number of schools is greatly reduced,
ordinarily to one, and a more efficient mode of science practice begins. The
latter is generally esoteric and oriented to puzzle-solving, as the work of a
group can be only when its members take the foundations of their field for
granted (Kuhn, 1970, p. 178) and he continues [w]hat changes with the
406 Schools: General 0500
transition to maturity is not the presence of a paradigm but rather its nature.
Only after the change is normal puzzle-solving research possible. Many of the
attributes of a developed science which I have above associated with the
acquisition of a paradigm I would therefore now discuss as consequences of the
acquisition of the sort of paradigm that identifies challenging puzzles, supplies
clues to their solution, and guarantees that the truly clever practitioner will
succeed. (Kuhn, 1970, p. 179).
Blaug (1980) considers paradigms and research programmes for economics
at large. He concludes that a presentation in terms of competing and partly
overlapping research programmes is apposite and to be preferred to one in
terms of revolutions. He speaks nonetheless of the marginalist revolution in the
latter part of the nineteenth century and of the Keynesian Revolution in the
1930s. Wolin (1980) applies Kuhns ideas to political science, but adopts as the
criterion for the merit of a theory the extent to which it is acceptable to various
political actors. The approach allows him to demonstrate what he considers to
be a paradigm shift in his discipline. But it leaves the reader with the
uncomfortable question of what distinguishes a scientific paradigm from a
shared social or religious outlook, or even a mere fashion. Surely the distinction
must ultimately rest on the possibility to account for observations and to make
testable predictions.
Can these concepts of paradigms and research programmes be usefully
applied to law and economics? Several writers have recently considered this
question (Rubin, 1985; Veljanovski, 1985; De Geest, 1995, p. 389 f.; van den
Hauwe, 1996; Teijl and Holzhauer, 1997, p. 7 f.; Ellickson, 1998; Posner,
1998). If the answer is affirmative, further questions concern the scope of the
paradigm or research programme and the grounds for preferring one paradigm
or research programme to another.
In the piece on the History of Law and Economics (0200) the term
paradigm was loosely used in describing different periods of the latest wave
of law and economics. The 1950s, 1960s and 1970s might be described, loosely
again, as periods of normal science: the research agenda seemed clear and
researchers spent their time solving puzzles indicated by the paradigm. The
1980s brought debates about various foundational questions. Since then several
competing schools present themselves in the law and economics literature. In
Kuhns terms, that could indicate attempts to establish a first scientific
paradigm or a crisis in the existing paradigm.
To accept the latter hypothesis, one would have to be able to point to a set
of unquestionable scientific accomplishments and to anomalies giving rise to
the crisis. Ellickson (1998, p. 551) professes to see the latter in the blindness
of the classical law and economics to social norms (which, in his view,
would give an entirely different twist to the problem situations envisaged in the
Coase theorem). Posner (1998, p. 565) sees no crisis but merely new puzzles
to be solved within the existing research programme, the core of which, in his
0500 Schools: General 407
view, is the rational choice theory. A paradigm shift occurs when a theory no
longer furnishes acceptable answers to the questions that trouble current
researchers, not when it is modified or enriched to cope with new questions or
questions previously beyond the grasp of the theory (Posner, 1998, p. 564).
The question of the criteria to be used for choosing amongst competing
theories or research programmes is debated in Rubin (1985); Veljanovski
(1985); De Geest (1995, pp. 389 f.); van den Hauwe (1996); Teijl and
Holzhauer (1997, pp. 7 f.); Posner (1998). Posner (1998, p. 555) recalls
Friedmans prediction test in writing that a theory that does not generate
predictions is difficult to feel comfortable with. De Geest, after a lengthy
discussion of the issue, proposes what he terms a plausibility theory (1995, pp.
407 f.), which is criticised by van den Hauwe (1996). In De Geests view, the
mainstream approach to law and economics is sufficiently open-ended to
absorb, by way of puzzles to be solved, the ideas which are now put forward by
competing schools. This view appears close to Posners (1998).
Teijl and Holzhauer (1997) undertake a comparison of what the Chicago
school and the Austrian School have to contribute to law and economics. The
Austrian School considers that the optima on which much Chicago law and
economics relies are indeterminable. The approaches appear to be radically
incompatible and this obliges the authors squarely to face the question of the
criteria for choosing between rival approaches. The difficulty is to avoid
judging the performance of one approach in terms set by the other. Teijl and
Holzhauer opt for the framework of research programmes put forth by Lakatos
and propose to examine what each approach has to say on a range of practical
legal puzzles within the fields of contracts, tort liability and litigation. In each
case, they seek answers to three questions: what are the effects of legal rules
can be explained? To what extent do they contribute to societys welfare? How
can the emergence and contents of legal rules be explained? (Teijl and
Holzhauer, 1997, p. 35). At the end of their study, Austrian economics is
presented as perhaps more like the armchair economics than its practitioners
would like to admit. Nonetheless the authors profess, in conclusion, to be
unable to state a preference between these theories on objective grounds.
Ultimately the choice is a matter of acceptance within the scientific community
(Teijl and Holzhauer, 1997, p. 365).
Before examining the different schools within law and economics, it may
be helpful to summarise the common principles which set law and economics
approaches off against other intellectual currents such as Critical Legal Studies,
and feminism. As for the sociology of law, popular in Europe in particular as
a link between the social sciences and the law, there is debate about the extent
to which its practitioners share the premises set out below, in particular the
postulate of methodological individualism.
408 Schools: General 0500
2. Common Ground in Law and Economics
All law and economics research is aimed at gaining new insights in the law by
applying economic concepts and theories. The underlying premises are those
of economics proper.
2.1 Methodological Individualism
The first premise is the postulate of methodological individualism. According
to this postulate all analyses must ultimately be couched in terms of the
behaviour of individuals; all collective phenomena must be explained as
compositions or perverse effects of individual decisions.
By way of an example, consider the urban war in Amsterdam in the late
1970s and early 1980s opposing about 3000 squatters and their sympathisers
amongst the public at large to the police. One might be tempted to attribute this
to the climate of the times, in Amsterdam in particular, to large unemployment
amongst the young and to the housing crisis. All of these factors have some
plausibility but do not touch the heart of the matter. They do not explain how
individual participants in this development could rationally act as they did and
yet arrive at a collective disaster.
The source of the problem was the rent control policy then in force in the
Netherlands. It granted tenants fixed rents and almost unassailable occupancy
of rented premises, and placed severe restrictions on what landlords could do
with their property. This led landlords recovering possession of their premises
to leave them empty while waiting for permission to renovate. As a result there
were a lot of vacant buildings in the city. This in turn led squatters forcibly to
occupy such buildings, a practice which the courts were reluctant to stop. Once
legal ways had been found to secure eviction of squatters, there remained the
practical problem of enforcing the judgements. The police called in to enforce
were facing a determined group defending a vested interest.
This explanation accounts for the climate which developed in Amsterdam
in that period. Each step of the development is the result of transparent rational
choices made by actors in this game. The overall disaster is a perverse
composition effect which the law should seek to avoid.
2.2 Rational Choice
Individual decision makers are presumed, secondly, to be rationally maximising
their satisfactions, or their benefits over costs, as they see them (the rational
choice hypothesis). This hypothesis is essential for scientific work in that [i]f
people do not behave in predictable ways, then the idea that we can regulate
society by laws and incentives becomes untenable (Veljanovski, 1990, p. 35).
It allows one to flesh out predictions of how individuals are expected to react
to changes in their environment.
0500 Schools: General 409
The realism of the rational choice hypothesis is questioned principally on
two grounds. Psychological research tends to show that peoples decisions tend
to deviate from the rational choice model in situations involving in particular
small probabilities or great complexity. We do not appear to have the
intellectual hardware to perform the calculations that the full rationality
assumption attributes to us. Furthermore in real life individuals face decisions
fraught with risk or uncertainty. They are often imperfectly informed about the
stakes. There is debate about what rationality means in a context where
decision makers cannot assess the extent of their own ignorance. As we shall
see, these difficulties are the focus of criticism by both the institutional and
Austrian schools. The critics propose to attenuate the rationality postulate, but
not to reject it. It is one of the matters on which the survey of the history of law
and economics (0200) sees room for further research.
2.3 Stable Preferences
A third premise is that of stable preferences (Becker, 1976, p. 5). Admittedly,
preferences are not given at birth, by biological necessity, to remain fixed
during ones lifetime; they are shaped or reshaped during ones youth and may
shift more slowly during later life. Cultural influences may thus be accounted
for (Becker, 1996, p. 3; Sowell, 1998). Yet to make predictions of how
individuals will react to change, one must presume their preferences to remain
constant in the short run. Whoever submits that preferences have changed must
adduce evidence to that effect.
2.4 Equilibrium
A fourth premise concerns what happens in human interaction. Barring
disturbance, interactions are presumed to tend towards an equilibrium,
described in bare form by game theory and more elaborately by economic
theory dealing with markets, in which (implicit) price adjustments in the
process of competition tend to equalise supply and demand for a good or
service. Becker (1976, p. 5f.) considers the premise of market equilibrium to be
applicable to implicit markets in politics, marriage and other areas as much as
to markets in which transactions involving money take place.
3. Schools in Law and Economics
Within a community as large as the law and economics movement, one must
expect differences of opinion about research matters. They may concern such
questions as whether particular anomalies should count as tolerable within the
existing theoretical framework, rather than as refutations calling for rejection
or revision of the theory, or what is admissible simplification of reality within
410 Schools: General 0500
a model as opposed to unacceptable reductionism. In law and economics,
different views are expressed, for instance, on whether inconsistencies in choice
or the practice of rule following should call into question the postulate of
rational choice.
Not all differences of opinion indicate distinct schools. The term schools
ought to be reserved for situations in which several fundamental differences of
opinion coalesce to form incompatible approaches at a relatively fundamental
level.
The Encyclopedia itself distinguishes in its classification several schools
and approaches: Austrian School, Institutionalism, New Institutional
Economics, Property Rights Approach, Game Theory Applied to Law,
Comparative Law and Economics, Experimental Law and Economics, Law and
Economics and Development. Some authors profess to discern even further
schools: Law and economics and critical legal studies are richly diverse
intellectual movements involving a multitude of individual views,
methodologies, schools, and diverse theoretical traditions. There are,
however, other schools [than the Chicago school] within law and economics
that exhibit different perspectives. The New Haven school, of Yale University,
for instance, has attracted liberal practitioners who adopt the common
methodology of the Chicago school but believe that there is a larger need for
state intervention in order to cure problems involving market failure (Minda,
1989, pp. 111-112).
Let us briefly look at each of these schools, to determine whether the term
school is justified. For convenience we begin with the last item of the
classification in the Encyclopedia.
Law and Economics and Development is a field to be investigated with the
tools of law and economics, but should not be seen as a distinct school.
Comparative Law and Economics too is a field for the application of law and
economics. It is all the more promising as it exposes law and economics
methodology to the test of being applied to legal systems different from its
home base of American law and possibly being found wanting. This is not a
distinct school, but rather a focus which gives larger scope to existing
approaches. Game Theory Applied to Law and Experimental Law and
Economics are promising tools or approaches with which to broach law and
economics questions. They are not in opposition to older approaches, but
complement them.
3.1 The Property Rights Approach
The Property Rights Approach is presented in the chapter on History (0200)
as the name economists gave to their attempts at solving a puzzle in economics
proper. In neoclassical economic theory - till according to Demsetz (1997, p.
1) the central theory of economics - organizations and the behaviour of
individuals within them are puzzling. In studying decentralised socialist
0500 Schools: General 411
enterprises in the former Yugoslavia, for example, one does not get far by
examining policies adopted by the owner of the capital goods, which is to say
the State or the bureaucrats nominally in charge of the enterprise (Furubotn and
Pejovich, 1974b, p. 250; Barzel, 1989, pp. 98-113). It is more instructive to
look at the preferences and decisions of the workers, who were in charge,
through the Workers Council, of the policy decisions for their firm. Focusing
on the workers, one can readily explain why such firms were loath to let
workers go in circumstances which would make such a decision seem logical
for a comparable Western firm: the workers making such decisions would cut
the branch on which they were sitting.
More puzzling is the question why the firms did not maximise worker
salaries, but instead retained some profit as savings for future investments. Why
would workers invest in capital goods they did not own? As Furubotn and
Pejovich explain, workers would find this to be in their interest in so far as it
maximised the present value of the future income stream paid to the average
employee. Their conclusion is that the behaviour of the Yugoslav firm is
explicable in terms of rational decisions by persons who actually control the use
of the resources in the firm. The heuristic Furubotn and Pejovich draw from
this insight is that to explain the behaviour of the firm, one must look at the
property-rights structure at all levels (Furubotn and Pejovich, 1974b, p. 251).
It is clear that the term property-rights structure is not used here in its
legal sense. Property rights, in this usage, mean decision authority (Libecap,
1989, p. 1), the actual power to control the use of a good and to appropriate the
fruits. Property rights in this economic sense are a descriptive term, more
general than right of ownership (Furubotn and Pejovich, 1974a, p. 4). When
one speaks of my office, my secretary or when a gang speaks of its territory
the possessive term is used in this sense.
The term property rights used in the property rights approach has
created confusion with the legal meaning of the term. Be that as it may, the
approach no longer seems to constitute a separate school. Its insights have been
absorbed into law and economics proper as Posner first unified it.
3.2 The Austrian and Institutionalist Schools
The clearest case for distinct schools within the classification adopted in the
Encyclopedia could be made for the Austrians and for the old and the new
Institutionalist approaches, in contrast to the mainstream or Chicago approach
to law and economics. The distinctions correspond to schools in economics
proper.
Readers are referred to the chapters on these three schools (0510, 0520 and
0530) for detailed accounts of what these schools stand for and the differences
with the mainstream approach. The differences between schools and the
mainstream point to matters that are part of the agenda for future research
412 Schools: General 0500
presented in the conclusion of the piece on the History of Law and Economics
(0200): the role of institutions, historical research, the place of uncertainty,
discovery and entrepreneurship, strategic behaviour and bounded rationality.
3.3 The New Haven School
Minda sees room for the New Haven school: There are, however, other
schools within law and economics that exhibit different perspectives. The
New Haven school, of Yale University, for instance, has attracted liberal
practitioners who adopt the common methodology of the Chicago school but
believe that there is a larger need for state intervention in order to cure
problems involving market failure (Minda, 1989, pp. 111-112). The school
warrants an Aside in Mercuro and Medemas chapter on Chicago Law and
Economics (Mercuro and Medema, 1997, pp. 79-83).
The New Haven school goes back to the writings of Calabresi (see review
of History of Law and Economics - 0200), whose views are quite distinct from
the Chicago law and economics (Duxbury, 1995, p. 393). Without taking issue
with any of the postulates of the neoclassical model, Calabresi believes that
efficiency which the model stresses could never be the whole story in so far as
legal rules are concerned. Justice and distributional concerns would always
have to have their due (Duxbury, 1995, p. 393).
Susan Rose-Ackerman articulates what she sees as the central tenets of the
school following in Calabresis footsteps (Mercuro and Medema, 1997, p.
79-83; Rose-Ackerman, 1989, 1992). Distributional concerns remain central.
Market failure is held to be more prevalent than Chicago law and economics
would make it out to be and government intervention is expected to be capable
of correcting it, although it may not succeed in all circumstances. The overall
philosophy of this group is presented as less politically conservative than the
Chicago law and economics group and the public choice group.
On the whole, the differences seem to be a matter of political colour. The
theoretical premises and methods the New Haven group adopt are insufficiently
distinct from the mainstream view to constitute a separate school.
3.4 The Freiburg School
The Ordo-Liberal or Freiburg school of law and economics is now mainly of
historical interest. It was founded in the 1930s and influential in the years
immediately following the Second World War. It included well-known scholars
and politicians such as Walter Eucken, Wilhelm Roepke, Ludwig Erhard,
Franz Bhm. The school has only recently been recognised internationally as
an interesting intellectual current of law and economics, as a result of the
translation of the major works of Bhm and Eucken in particular. (Vanberg,
1998, p. 172). Several articles on the movement as a whole and on individual
0500 Schools: General 413
members have appeared recently (Backhaus, 1996; Behrens, 1984, p. 8, 1993;
Grossekettler, 1996; Lenel, 1996; Streit, 1992).
The Freiburg school focused on the proper role of government in an open
society which had evolved out of the earlier feudal structures, on preventing
factions from controlling the state and on competition policy as fostered by the
state. The paradox of the state as grantor of special privileges and at the same
time as guarantor of competition was, in their view, to be solved by
constitutional design. This focus brings them close to the agenda of the public
choice and the constitutional political economy groups.
4. Conclusion
Schools are an expositional convenience to summarise the ideas of thinkers
who share common premises on how and what to research, and to contrast
these with those of other schools. They focus attention on questions for further
research. One should not lay too much stress on the alleged differences amongst
schools (De Geest, 1995, p. 468). It may be worthwhile to see them as puzzles
to be solved within a broadly defined mainstream approach (Posner, 1998).
Within the current law and economics movement, the mainstream, the
institutionalists, the neoinstitutionalists and the Austrians may be regarded as
distinct schools, as they are in economics proper. Whether the New Haven
School constitutes a distinct school is a moot point.
The differences between the schools point to questions which should be part
of the agenda for future research: the role of institutions, historical research, the
place of uncertainty, discovery and entrepreneurship, strategic behaviour and
bounded rationality. These matters have been presented in the piece on the
History of Law and Economics (0200).
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0510
AUSTRIAN SCHOOL
Copyright 1999 Boudewijn Bouckaert and Gerrit De Geest
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0520
INSTITUTIONAL LAW AND ECONOMICS
Steven G. Medema
Associate Professor of Economics, University of Colorado at Denver
Nicholas Mercuro
College of Natural Sciences, Michigan State University
Warren J. Samuels
Professor of Economics, Michigan State University
Copyright 1999 Steven G. Medema, Nicholas Mercuro and Warren J. Samuels
Abstract
From its beginnings in the late nineteenth century, institutional economics
has been concerned with the analysis of the interrelations between legal and
economic processes. The institutional approach to law and economics
examines both the influence of economy upon law and legal reasoning and
the influence of law and legal change upon economic activity and
performance. This essay examines the central tenants of institutional law
and economics, dating from the early work of individuals such as Robert Lee
Hale and John R. Commons and through its modern manifestations. As
such, it emphasizes the evolutionary nature of law and economy, the tension
between continuity and change, the problem of order, the reciprocal nature
of legal-economic problems and the attendant dual nature of rights, the
problematic nature of efficiency, and the need for a comparative institutional
approach to the practice of law and economics. By recognizing the
multiplicity of potential solutions to legal-economic problems and the
underlying value premises attending each, the comparative institutional
approach to law and economics attempts to flesh out both what is actually
going on within the legal-economic nexus and the alternative possibilities
open to society within the legal-economic decision-making process.
JEL classification: K00
Keywords: Law and Economics, Institutional Economics, Efficiency, Rights,
Government
418
0520 Institutional Law and Economics 419
1. Introduction
From its beginnings in the late nineteenth century, institutional economics
has been concerned with the analysis of the interrelations between nominally
legal and economic processes. The earliest roots of law and economics are in
part within the institutionalist tradition of economics but, as recognized by
Warren J. Samuels (1993), go well beyond that school of economic analysis.
Early contributions to the institutional approach to law and economics
include the work of Henry Carter Adams (1897) on economics and
jurisprudence, Richard T. Ely (1914) on the relation of property and contract
to the distribution of wealth, and, especially, John R. Commons (1924,
1925) on the legal foundations of the economic system. Important elements
of the institutional approach to law and economics can also be found in the
work of Thorstein Veblen (1899, 1904), lawyer-economists Robert Lee Hale
(1952) and Walton H. Hamilton (1932), and legal scholars such as Karl
Llewellyn (1925), Jerome Frank (1930), and Roscoe Pound (1911a, 1911b,
1912). Institutional economics is essentially an American contribution to
economic thought, one that, like Legal Realism in jurisprudence, is said to
have had its heyday in the 1920s and early 1930s (Bell, 1967).
Nonetheless, it continues to have a relatively strong presence today in both
the US and Europe.
A. Institutional Economics
2. Overview
Institutional economics developed as a rather heterodox approach to the
study of economic society and has been amply reviewed by Bell (1967, pp.
539-571), Gordon (1964, pp. 123-147), Kapp (1976), Mitchell (1937),
Rutherford (1994), Spiegel (1971, pp. 628-641), Srivastava (1965, pp.
470-487), and more recently by Pribram (1983, pp. 355-62; 424-29) and
Whalen (1996). There also are extensive overviews/anthologies of
institutional economics including those by Hodgson, Samuels and Tool
(1994), Samuels (1988), and Tool (1988, 1993). As its name implies,
institutional economics places at the center of analysis the study of the
institutions of the economic system. Institutions are variously and broadly
defined within institutional economics. Commons (1934) defined an
institution as collective action in control of individual action and as
collective action in restraint, liberation, and expansion of individual action
thereby emphasizing the social bases of the individual which orthodox
economists took as given and self-subsistent. Veblen (1899) defined
institutions as widely followed habits of thought and the practices which
prevail in any given period, thereby emphasizing their problematic and
420 Institutional Law and Economics 0520
belief-oriented nature. Herbert J. Davenport essentially combined the two
definitions in his description of an institution as a working consensus of
human thought or habits - a generally-established attitude of mind and a
generally-adopted custom of action as for example, private property,
inheritance, government, taxation, competition, and credit (cited in
Srivastava, 1965, p. 470).
Institutional economics has often been described as part of a revolt
against formalism (Spiegel, 1971, p. 629), a revolt that took place in law, in
history, and in economics at about the same time. Institutional economics, as
part of that revolt, was led by a group of young American scholars who, after
World War I, engaged in a critique of the predominate, formalistic economic
doctrines of the day. In economics, formalism was taken to be the abstract
deductive reasoning of orthodox economic analysis that enthroned
universally valid reason, assumed passive, rational utility-maximizing
behavior, and demonstrated an inordinate concern over the equilibria of
comparative statics (in particular utility analysis of consumer behavior and
the marginal productivity theory of distribution).
Reflecting their belief that this methodology was inadequate for
understanding many important facets of the economic system,
institutionalists focused their attention on inductive analyses of specific
institutional aspects of the American economy. While their principal
emphasis was on using the inductive method to describe the constituent
elements of the economy, the institutionalists never employed the inductive
method to extremes and thereby were still able to make substantive
theoretical generalizations. As noted by Buckingham (1958, pp. 107-108),
the development of generalizations gave institutional economics more of a
theoretical content than the largely descriptive [German] historical school
was ever able to attain. Institutional theory is by no means as refined and
exact as orthodox theory, but is not so abstract and lacking in empirical
content either.
3. Factors Contributing to the Institutionalist School of Thought
Whalen (1996) has traced the emergence of institutional economics to three
distinct sources of influence. One was the German historical school, which
influenced such early institutionalist thinkers as Richard T. Ely. The
German historical school, founded by Wilhelm Roscher (1817-94) and later
dominated by Gustav von Schmoller (1838-1917), emerged at least in part as
a reaction against classical economic thinking in the mid-nineteenth
century. The historical school emphasized the dynamics of economic
development, the need to use empirical data (rather than abstract ideas) to
0520 Institutional Law and Economics 421
ground economic theories, and the necessity of paying particular attention to
human institutions. This emphasis on gathering facts and studying them in
relation to their historical significance rather than as isolated, objective data
in static, timeless models had a direct bearing on the methodology of
emerging institutionalist economics.
The second influence was from American pragmatic philosophy as set
forth by, among others, Charles Peirce, William James and John Dewey.
Proponents of American pragmatic philosophy recognized an uncertainty
inherent in understanding and looked for philosophical methods for
establishing the meaning of concepts and beliefs. The analysis of social
phenomena had to be conducted within systems of relationships among
individuals in their empirical settings. They largely replaced a priori
abstract reasoning with empirical studies. Contrary to the narrow, uniform
rational behavior assumption in orthodox microeconomics, choices were
pragmatically perceived - to be made in a world of ever-changing empirical
objects and emerging economic, political, and social institutions. True
ideas are those to which responsible investigators would assent after
thorough examination - that is, after considering what conceivable effects of
a practical kind a theory or object holds. Thus, only those hypotheses that
contributed to organizing data garnered through sense perceptions related to
the real world (that is, held practical significance), and did so in a
progressive and unifying manner, were taken to be legitimate. In short, an
idea was right if it had fruitful consequences. The pragmatist emphasis on
the uncertainty inherent in understanding served to provide an
epistemological foundation and a social philosophy upon which to erect the
basic tenets of institutional economic thought.
The third influence came through Thorstein Veblens turn-of-the century
writings focusing on the Darwinian, non-teleological evolutionary nature of
economic change to which one can trace many of the origins of and early
insights into institutional economic thought. After short sojourns at a variety
of universities, including Johns Hopkins, a doctorate degree in philosophy
from Yale University in 1884, and several years (1891-96) as an economics
fellow at Cornell University and the University of Chicago, Veblen was
given a teaching post at the University of Chicago in 1896, becoming an
assistant professor of economics in 1900 at the age of 43. The previous year
he published his first and most renowned book, The Theory of the Leisure
Class (Veblen 1899).
Here, as in his other writings, Veblen emerged a strong critic of orthodox
economic thinking, rejecting the mechanistic view of economic society as
reflected in static equilibrium analysis. As observed by Spiegel (1971, pp.
631-632), Veblen rejected the orthodox hedonistic conception of man as a
lightning calculator of pleasures and pain as overly narrow and outmoded.
422 Institutional Law and Economics 0520
Consequently, he characterized the conventional approach to economics as
taxonomic, overly concerned with classification and systematization that
depicted human behavior in passive, inert, hedonic terms and, at the same
time, brushed aside the disturbing factors that did not fit into the received
doctrines pursuit of truth. With respect to conventional economics pursuit
of truth, in a revealing statement in an address in 1908, Veblen asserted that
the outcome of any serious research can only be to make two questions grow
where one question grew before (Spiegel, 1971, pp. 631).
Veblen focused on what he called an evolutionary method of economic
analysis. He believed that the material environment, technology, and
propensities of human nature condition the emergence and growth of
institutions. Because he believed that social change implied changes in
habits of thought and customs as crystallized in institutions, he insisted on a
critical examination of capitalistic institutions - especially what he termed
industry and business, along with the economic power they were able to
exercise - to better comprehend economic society. Toward that end, he
emphasized that it was necessary to understand both the widespread social
habits and the institutions, and not merely how prevailing institutions
worked, but with finding out how the institutions of capitalism evolved.
In another of his books, The Theory of Business Enterprise (1904),
Veblen identifies the price system as the leading economic institution in the
so-called pecuniary economy. Many contributing factors, most of which are
inherent in the economic system including businesslike technicians, labor
organizations, technological advances, and so on, lead to economic
tensions among the interrelated forces of production and profit. These
tensions manifested themselves in a class system - (1) the productive class,
comprised of those who were socially productive, and (2) the leisure class,
comprised of those who came to depend upon acquisition. And, as described
by Bell (1967, pp. 548-549), these manifested themselves in custodians of
absentee-credit who were certain to engage in capitalistic sabotage and
further, that the struggle for economic advantage for their own vested
interests would result in both labor and business technicians engaging in a
conscious withdrawal of efficiency. Cultural lags brought on by
technological change altered the institutions and human behavior resulting
in an ever-present class conflict (Srivastava, 1965, pp. 474-475). Thus, as
Veblen described it, it is the very factors within the institution of the price
system that led business to experience fewer intervals of short-term
depressions that ultimately gave way to more chronic stagnation. For
Veblen, the pecuniary aspects of life are all-pervading and become an
integral part of the analysis of the evolution of society.
0520 Institutional Law and Economics 423
4. Modern Elements of Institutional Economics
From the writings of Thorstein Veblen and other contributors (to be
reviewed below) such as Wesley C. Mitchell, Clarence E. Ayres, Walton H.
Hamilton, Robert Lee Hale and John R. Commons, institutional economics
emerged as a rather heterodox approach to analyzing economic society. As
will become evident, many of the founders of and present contributors to
institutional economics stress the evolutionary facet of institutions and, thus,
the economy. This continuing concern with the evolutionary nature of the
economy underlies the name of the association - The Association For
Evolutionary Economics - that has maintained some intellectual continuity
and focus among this group of economists. The Association publishes its
own journal, the Journal of Economic Issues. The Review of Political
Economy regularly publishes work embodying the institutionalist perspective
(often with a somewhat more European flavor), as do the Cambridge
Journal of Economics, Economy and Society, Industrial and Corporate
Change and the Review of International Political Economy.
In its modern form institutional economics, as set forth by Gordon (1964,
pp. 124-125), is embodied in a series of propositions defining an approach
both alternative to and complementary to mainstream economic analysis.
These propositions, together with the particular and specific focus
contributed by Commons, provide the foundation upon which institutional
law and economics rests.
1. Economic behavior is strongly conditioned by the institutional
environment within which economic activity takes place and,
simultaneously, economic behavior affects the structure of the
institutional environment.
2. The mutual interaction between the institutions and the behavior of
economic actors is an evolutionary process, hence the need for an
evolutionary approach to economics.
3. In analyzing the evolutionary processes contained therein, emphasis is
directed to the role played by the conditions imposed by modern
technology and the monetary institutions of modern, mixed-market
capitalism.
4. Emphasis is centered upon conflicts within the economic sphere of
society as opposed to harmonious order inherent within the cooperative,
spontaneous, and unconscious free play of economic actors within the
market.
5. There is a clear and present need to channel the conflicts inherent in
economic relationships by structuring institutions to establish a
mechanism of social control over economic activity.
424 Institutional Law and Economics 0520
6. Institutionalism requires an interdisciplinary approach calling on
psychology, sociology, anthropology, and law to help understand the
behavior of economic actors and thereby generate more accurate
assumptions in describing their behavior.
These propositions offer a partial rejection of the mechanistic
price-theoretic approach proffered by the more orthodox neoclassical
microeconomics. The propositions are a manifestation of the institutionalist
position that the framework of orthodox economic analysis does not allow it
to get at certain fundamentally important features of economic activity.
Further, evolutionary institutional economics is proffered as being based
on more realistic behavioral assumptions derived from a broad array of
social science knowledge and a fuller appreciation for and understanding of
the institutions driving a mixed-market economy. This drive for realistic
assumptions led the early institutionalists to extensive data-collection efforts.
A pioneer in this regard, and a leading institutionalist, was Wesley C.
Mitchell, a student of Veblens at the University of Chicago. Mitchell spent
most of his academic career at Columbia University (from 1913-1944). His
book, Business Cycles (Mitchell, 1928) was his greatest research work. In it,
he maintained that all institutions were subject to forces that brought about
change in response to changing conditions and behavior. His concern was
with the behavior of institutional factors which would provide a basis for
generalizations; thus the need to produce the empirical evidence (statistical
records and quantitative verification of change) that would thereby permit
the development of more realistic theories of economic change (Bell, 1967,
p. 565). The book was a historical description of the economic organizations
of four countries (US, Germany, Great Britain and France) and of the
pecuniary aspects of their economies. In his research he compiled all of the
data necessary to recount the business cycle theories within each country.
Mitchell demonstrated that trade cycles were not accidental disruptions in
the economy but were instead systematic fluctuations brought on by the
changing economic organization of the economy together with its changing
culture. It should be noted in passing that in furtherance of this tradition
Mitchell founded the National Bureau of Economic Research, which has
become a major center for empirical work in economics. Mitchell succeeded
in helping to expand the scope of economics beyond static equilibrium
analysis thereby fulfilling his mission to explain at once the current
working and the cumulative changing of economic processes (Mitchell,
1914, p. 37).
0520 Institutional Law and Economics 425
B. Institutional Law and Economics: Origins and Development
5. Ayres and Hale
Because institutional economics has always been concerned with legal facets
of the economy (that is the relationship between the law and the
development and performance of the economy), there is no clear dividing
line or simplistic transition between institutional economics and institutional
law and economics. Thus, an understanding of the nature of the analyses
and the concerns of the major contributors to institutional economics
concomitantly provides an understanding and appreciation of the scope and
content of present-day institutional law and economics. This and the next
section are intended to help make this transition.
Certain of Thorstein Veblens ideas described above were given further
development by Clarence E. Ayres. Ayres received his PhD in philosophy
from the University of Chicago in 1917 writing on the relationship between
ethics and economics. He started his teaching career at Amherst College
assisting the legal-economist, Walton H. Hamilton in his course, Social and
Economic Institutions. After brief sojourns at the University of Wisconsin
and New York University, in 1930, his former colleague, Hamilton, was
influential in urging Ayres to move to the University of Texas at Austin
where he influenced a generation of institutionalist scholars.
Ayress perspective on the economy is found in his treatise The Theory of
Economic Progress (Ayres, 1944). As described by Breit (1973), it is a
theoretical work that attempts to explain the forces that have shaped the
economy, focusing on those factors that accelerated the economys
development as well as those that have impeded it. For Ayres, the challenge
confronting economics is to devise new organizational forms, to
pragmatically develop organizational arts to match, rather than contradict,
our science and technology (Breit, 1973, pp. 255-256).
Ayres saw human activity as reflective of two basic and ever-present
forces: technological behavior, a productive and progressive force, and
ceremonial behavior (as manifested in, for example, hierarchies, mores,
culture and ideology), which is counterproductive and inhibits change,
acting as a curb on technological progress. The central theme of this work is
that an exponentially expanding and advancing technology (defined
broadly as all human activities involving the use of tools, and thus including
both human and physical capital) is responsible for the enormous changes in
the welfare of society. The focus is not so much on the individuals, but on
technological progress as related to the advancement of the tools (that is, the
objective instruments capable of being variously combined) and the role of
technology in enhancing economic progress. Since the ceremonial
426 Institutional Law and Economics 0520
institutions resist change, he argued, progress is a function of the relative
strength of these progressive and inhibiting forces, with the variance of their
relative strengths helping to explain the differential rates of development
across societies and cultures.
Robert Lee Hale received his LLB from Harvard University in 1909 and
his PhD in economics from Columbia University in 1918. As recounted by
Dorfman (1959), Samuels (1973) and Duxbury (1990, 1995), Hale initially
held a joint appointment in the economics department and the law school at
Columbia University and then moved to the law school on a full-time basis
in 1928. His emphasis on the integration of economics and law was reflected
both in his teaching - particularly his course on Legal Factors in Economic
Society - and in his writing, much of which dealt with the regulation of
railroads and public utilities, fields in which an understanding of the
interface between economics and law has always been fundamental. Hale
wrote extensively on the legal and economic theory of rate-base valuation, as
well as on the regulation of rate structure and level. His writings were
instrumental in the adoption by the courts of the prudent investment
doctrine of valuation for public utilities (Dorfman, 1959, p. 161).
Hale is perhaps best described as a legal realist who drew upon the
emerging tradition of institutionalism (Duxbury 1995, pp. 107-108).
Consistent with the realists of the day, Hales work was very much a
challenge to and critique of the dominant tradition of laissez-faire
capitalism. And, while Richard Posner (1995, p. 3) contends that the legal
realists had little influence on the contemporary law and economics
movement, he does allow that Hale anticipated some of the discoveries ... of
law and economics as we know it today.
Like John R. Commons (whose contributions will be reviewed below),
Hale was influenced by Wesley H. Hohfelds articulation of fundamental
legal conceptions, which, in Hohfelds mind, were the lowest common
denominators of law (Cotterrell, 1989, p. 88). Hales paradigm was
comprised of the concepts of voluntary freedom, volitional freedom,
coercion, power and government. Legal and economic processes were
viewed as inseparable and the economy described as a structure of coercive
power arrangements and relationships which necessitated an understanding
of the formation and structure of the underlying distribution of economic
power. As such, the economy was seen as a system of power operating
through a system of coercion, and thus the economic freedom expressed by
the courts of the day was merely freedom to engage in economic coercion
(Samuels, 1973).
Hale did not view coercion as something to be condemned, but rather as
a basic fact of economic life. For example, he argued that if income is in fact
acquired through coercion, abetted actively or passively by government, then
it cannot be said that overt coercive redistributions of income by government
0520 Institutional Law and Economics 427
are themselves wrong (Dorfman, 1959, pp. 162-163). Hales Hohfeldian
perspective on rights led him to view nearly every statute with economic
implications as impacting negatively upon someones liberty or property.
Given this, he believed that it was essential for the courts to undertake an
intelligent balancing of the gains and losses brought about by the particular
statutes brought before them - a process which, he said, requires a realistic
understanding of the economic effect of the legislation (quoted in Dorfman,
1959, p. 163). While Hale believed that ethical judgments must ultimately be
the basis upon which the courts decisions are made, he felt that the judicial
application of economic principles was necessary in order to ascertain the
economic consequences - allocative and distributive - of the legislation
whose constitutionality the court was asked to evaluate (Hale, 1924, 1927).
Hales brand of legal economics - as reflected in both his writing and his
teaching - gradually evolved into a theory of the economy as a system of
mutual coercion and the legal basis thereof (Samuels, 1973, p. 25), with his
perspective being most fully spelled out in his classic book Freedom
Through Law (Hale, 1952).
6. John R. Commons and his Impact on the Development of
Institutional Law and Economics
John R. Commons stands as the central figure in the development of the
institutional approach to law and economics. Unlike his contemporaries,
Commons never earned a PhD degree and after a slowly developing
academic career, in 1904, at the age of 42, he was given an appointment at
the University of Wisconsin where he and his associates quickly brought the
economics department to the forefront of the discipline (Spiegel, 1971, p.
630).
Commons became associated with the progressive government of the
State of Wisconsin, engaging in what he termed investigational economics
(preparatory fact-finding reports produced by Commons and his students)
necessary for the drafting of legislation and the formulation of innovative
policies in a wide variety of areas including industrial relations, labor law
reform (including workmens compensation and unemployment insurance),
public utility regulation and price stabilization. Besides teaching and writing
at the University of Wisconsin, he was also very involved in public life
serving on an array of state and federal commissions. In his distinguished
academic career, Commons wrote several books, two of which now serve as
a benchmark for institutional law and economics: Legal Foundations of
Capitalism (Commons, 1924) and Institutional Economics: Its Place in
Political Economy (Commons, 1934).
428 Institutional Law and Economics 0520
As Spiegel (1971, pp. 628-629) has pointed out, there was a pronounced
linkage between Commons institutional economics and the German
historical school (due in part to his teacher Elys attachment to the German
school). The influence of the American pragmatic philosophers on his
thinking was much less significant, although its presence is evidenced in his
emphasis on the pragmatic importance of using inductive analysis. And
unlike Thorstein Veblen, who sought a near total rejection of orthodox
economic theory, Commons (as well as Wesley C. Mitchell) held a much
more conciliatory position seeing institutional economics as a complement
to, rather than a substitute for, neoclassical analysis.
Commons institutional economics was conceived as a broad synthesis of
law, economics and ethics; it recognized both conflicts of interest and their
mutual dependencies as well as the need for security of expectations and
order (Spiegel, 1971, p. 638). In contrast to the strict methodological
individualism and the harmony of interests paradigm that imbued orthodox
economics, Commons placed a greater emphasis on the role of collective and
corporate activities in the economy and centered his analysis on the conflicts
of interest inherent in a modern economy. Human action was seen to be
socially or culturally determined; that is, human action and cultural
determinants were seen to interact with each other. Consequently, the free
will of individuals contributes to the cultural environment and is, in turn,
molded by that environment (Buckingham, 1958, p. 104).
As characterized by Parsons (1957, p. 23), for Commons, the main task
of economics consisted of determining the reasonableness of the working
rules underlying the general economic order in an age in which citizens,
corporations, and labor unions have economic power (see also Parsons,
1985). Institutional economics for Commons was an economics of rights,
duties, liberties and exposures and he looked at the economy as a series of
intended and purposeful changes - so-called managed equilibria. He
believed that the primary economic institutions were formed on the basis of
definite patterns of socially sanctioned habits and could be reshaped. This
belief led him to probe extensively the impact of institutions, particularly the
operation of the legal system (including the judiciary, the legislature and the
regulatory commissions) in working out solutions to conflicts and the impact
of those solutions on economic structure and performance.
In Legal Foundations of Capitalism (Commons, 1924) Commonss chief
concern was with uncovering the development, evolution and workings of
the institutions that ultimately impact the performance of the economic
system. It was a theoretical work that examined the legal foundations of the
capitalist economic system. The treatise was unlike anything that had come
before and benefited from Commonss close contact with law through his
extensive aforementioned involvement with the courts, his service on
0520 Institutional Law and Economics 429
government commissions and his drafting of legislation. The emphasis of
the book is on the role of law and the courts and how they determine the
structural elements of an economic system. Like his predecessors, Commons
believed all economic institutions are subject to evolution. Whether
describing the institution of capitalism, private property, or the state itself,
each was shown to receive its sanction from the authorities - the church, the
state, the courts - through an evolutionary process.
Commons analysis showed, on the one hand, how economy influences
law as the economic system brings to bear pressures on political and legal
systems for legal change that facilitates a particular evolutionary path and,
on the other hand, how law influences the economy - that is, how legal
change facilitates the development of economic activity in a particular
direction. In order to bring out the nature and extent of this mutual
interdependence, he undertook an analysis of a wide variety of cases,
working rules and statutes to probe their impacts on the development of
modern capitalism and thereby to illuminate the interrelations between legal
and economic processes. Of particular import here is his analysis of the role
played by rights and working rules within the economic system, where he
lays out, in a systematic way, why rights (and thus law) matter within the
economic system and why the development of economic theory should
proceed with attention to the role of law and legal change in structuring
economic activity and performance.
Commons was particularly concerned in Legal Foundations to uncover
the values both underlying and ensconced in the working rules that govern
social-economic relations. He found them in the courts use of the term
reasonable value - whether reasonable value in public utility regulation, the
reasonable wage in labor law, the reasonable safety as related to workmens
compensation, or the reasonable conduct of private and public citizens. He
observed that legal history demonstrated certain well-defined tendencies on
the part of the courts to eliminate those practices of capitalistic institutions
deemed destructive, while at the same time to reaffirm the reasonable
policies that should be encouraged and followed in a competitive system.
Determinations have to be made as to whose interests are to count or, said
another way, to determine whose preferred practices would be given
protected status. Reasonable value could be used by the courts to ground
policies that would bring about compromises in arenas of economic conflict,
including labor disputes, public utility rate-making, tax policy, pricing, and
so on (Bell, 1967, pp. 556-557). As the definition of what types of activities
were considered reasonable evolved over time, so too did the legal rules
governing social-economic relations, the structure of markets and the
structure of capitalism itself, as seen in the effects of the transformation of
the legal definition of property and its impact on business and the effects of
law on the employment relation within the firm, on the market mechanism
430 Institutional Law and Economics 0520
and on the wage bargain. Thus, in the West, a movement was engendered
from a feudal and agrarian society to a capitalist system, with economic
change driving legal change, which in turn facilitated the economic
transformations. (See Samuels (1996) for a Readers Guide to the Legal
Foundations of Capitalism.)
7. Contemporary Institutional Law and Economics:
The Commons Tradition
Virtually all of contemporary institutional law and economics follows in the
tradition of Commons and much of this emanates from Michigan State
University through the work of Warren J. Samuels and A. Allan Schmid,
both trained at the University of Wisconsin by students of Commons. Others
at Michigan State University who continue to contribute to this tradition are
Harry Trebing, whose works exhibit many of the same concerns as Hale with
regard to the analysis of regulation and public utilities (Trebing, 1976, 1989;
Trebing and Estabrooks, 1993); and Robert A. Solo, much of whose work
focuses on monopoly regulation and institutional change (Solo, 1967, 1974,
1982). Former students of Samuels and Schmid who have gone on to focus
their research on the relations between legal (or governmental) and
economic processes rather than the application of microeconomic theory to
the law, include Steven G. Medema and Nicholas Mercuro writing
individually and together on topics including the Coase theorem (Medema,
1994, 1996a; Medema and Zerbe, 1997), the policy implications of Coasean
economics (Medema and Samuels, 1997), the commonalities between the
work of the Institutionalists and the work of Coase (Medema, 1996b), law,
economics and public policy (Mercuro and Ryan, 1984), the comparative
institutional approach to law and economics (Mercuro, 1989b) and on the
various schools of thought comprising law and economics, including the
institutionalist school (Mercuro, 1989a; Mercuro and Medema, 1995, 1997);
Philip Wandschneider (1984,1986) on water rights; and Josef Broder (1981,
1983) on the judicial process.
Other examples of the institutional approach to law and economics can
be found in Bromley (1989), Carter (1985), Kanal (1985), Liebhafsky
(1987), Ostrom (1986), Parsons (1974), and Seidman (1973).
Much, though not all, of the work of A. Allan Schmid and Warren J.
Samuels (see the extensive references to their respective work at the end of
0520 Institutional Law and Economics 431
this essay) can be best understood in the context of the
structure-conduct-performance paradigm:
law or legal structure v behaviour or conduct in the mixed
market economy v economic peformance
For institutional law and economics, the emphasis is on the interrelations
and mutual interaction between government and the economy, with the
effect that its perspective is described by the relation
law or legal structure ] behaviour or conduct in the mixed
market economy ] economic performance
Both Samuelss and Schmids practices of institutional law and
economics are avowedly positive. As they describe it in the introduction to
their book on institutional law and economics (Samuels and Schmid 1981, p.
1), Our principal goal is quite simply to understand what is going on - to
identify the instrumental variables and fundamental issues and processes - in
the operation of legal institutions of economic significance and to promote
the development of skills with which to analyze and predict the
performance consequences of alternative institutional designs. The focus of
their institutional approach is on delving into the workings of the
legal-economic nexus in order to understand its processes and thereby
analyze the processes and consequences of choice. Resource allocation and
the distribution of income and wealth are explained in terms of a complex
causal chain involving both allocation and distribution as functions of
market forces that depend in turn on power, rights and the use of
government (Samuels and Schmid, 1981, p. 4).
Samuels and Schmids respective approaches are best understood as two
complementary branches that differ only with respect to the relative
emphasis given to structure and conduct. The work of Schmid has tended
to concentrate on the interdependence of structure and performance, with an
emphasis on empirical work that explores the economic impact of alternative
legal structures. A concise statement of Schmids approach to institutional
law and economics is contained in his book Property, Power and Public
Choice: An Inquiry Into Law and Economics (Schmid, 1987), which
includes examples of empirical studies undertaken by Schmid (see Schmid,
1987, pp. 257-291). In his approach, he brings to the forefront the many
varieties of human interdependence, focusing both on (1) the various types
of transactions - bargained, administrative and status and grant transactions
and (2) the varied interdependencies that emerge - technological, pecuniary
and political externalities. Schmids analysis takes place under a
432 Institutional Law and Economics 0520
situation-specific structure-conduct-performance paradigm, in which
alternative institutional structures (for example, different definitions and
assignments of property rights) are identified, together with the
(dis)incentives created, their consequences for individuals, firms and
government behavior are identified and their effects on economic
performance and quality of life are assessed. As such, it reflects a total
approach to policy analysis (Schmid, 1987, pp. 257-258), one that
emphasizes the link between structure and performance. As posed by
Schmid (1987, p. 188), the institutional approach to law and economics
must ask: How do the rules of property structure human relationships and
affect participation in decisions when interests conflict or when shared
objectives are to be implemented? How do the results affect performance of
the economy?
The work of Samuels, in contrast, has tended to concentrate on
describing the interdependence between conduct/behavior of individuals and
groups and legal-economic performance. For Samuels, the organizing
concept is that of the legal-economic nexus, wherein the law is a function of
the economy and the economy (especially its structure) is a function of law
... [Law and economy] are jointly produced, not independently given and not
merely interacting Samuels (1989a, p. 1567). Through the legal-economic
nexus are worked out the structures of the law and the economic system,
where each serves as both dependent and independent variable in the
construction of legal-economic reality. Legal rules govern the terms of
access to and participation in the economy by potential economic actors and
property and other rights ... govern whose preferences will be given effect
through the market (Samuels, 1975, p. 66).
C. Central Themes of Institutional Law and Economics
8. The Evolutionary Nature of Law and Economy
As noted above, one of the factors emphasized by the institutionalists and
especially John R. Commons in his discussion of the legal foundations of the
capitalist economic system is the evolutionary nature of the economic
system. The import of the evolutionary perspective is that it broadens the
frame of analysis beyond the idea of mechanistic maximization under static
constraints (Hodgson, 1994, p. 223) to the longer-run processes (gradual or
in leaps) of economic development - structural transformations owing to
technical, legal, or other forces, knowledge acquisition, and so on. While not
eschewing static analysis or denying its value, the role of legal change in
affecting the course of this evolution makes the institutional approach to law
0520 Institutional Law and Economics 433
and economics inherently evolutionary, as exemplified in Commons
analysis and in particular in his discussion of the evolution of the law of
property.
Prior to the late nineteenth century, the US courts held to a physical
conception of property, a view that defined property as value in use rather
than value in exchange (Commons, 1924, p. 12). One of the implications of
this definition of property was that governmental deprivations of exchange
value did not require compensation under the Fifth and Fourteenth
amendments. As Commons (1924, pp. 12-14) points out, it was only in the
1870s that the idea of property as value in exchange first began to creep into
dissenting opinions of the US Supreme Court and it was not until the 1890s
that the Court finally made the transition from a definition of property as a
thing having only use value to a definition that conceived of property as the
exchange value of something. In making this transition, the Court was
saying not only that physical things are property, but that the expected
earning power of those things is property and thus [t]o deprive the owners
of the exchange value of their property is equivalent to depriving them of
their property (Commons, 1924, p. 16, emphasis in original). No longer
were physical seizures of property the only takings requiring
compensation; it now became the case that activities (including government
regulations) that reduced the exchange value of things could give rise to
claims for compensation. The concept of property was further expanded in
the Allgeyer case of 1897 to include liberty of access to markets, an
important component in the determination of exchange values (Commons,
1924, p. 17). The received definition of property as corporeal property had
been expanded to include both incorporeal property - for example, debt
instruments or promises to pay - and intangible property - anything that
enables one to obtain from others an income in the process of buying and
selling, borrowing and lending, hiring and hiring out, renting and leasing,
in any of the transactions of the modern business (Commons, 1924, p. 19).
The import of this expanded definition of property for the development
of the capitalist system is set forth by Commons in the context of farming:
The isolated, colonial or frontier farmer might produce and consume things,
attentive only to their use value, but the modern farmer lives by producing
social-use-values and buying other social-use-values produced and sold by other
business men. In this way he also produces exchange-value, that is, assets. He
farms for sale, not for use and while he has the doubtful alternative of falling back
on his own natural resources if he cannot sell his products, yet his farm and crops
are valuable because they are business assets, that is, exchange-values, while his
liabilities are his debts and his taxes, all of them measured by his expectations and
realizations on the commodity markets and money markets, in terms of
exchange-value or price. (Commons, 1924, p. 21)
434 Institutional Law and Economics 0520
That is, what in part distinguishes capitalism from the colonial and
feudal systems it replaced is the transition from production for ones own
use to production for the use of others and acquisition for the use of self
(Commons, 1924, p. 21) and it was the adoption of this more expansive
definition of property that helped to facilitate this economic transition.
Following Commons, the contemporary institutional approach to law and
economics is evolutionary, emphasizing the importance of historical process
and evolutionary change of law through time. As described by Samuels
(1989a, p. 1578), the legal-economic nexus is a continuing, explorative and
emergent process through which are worked out ongoing solutions to legal
problems. The legal-economic nexus is that sphere of decision making that
reflects the working out of whose interests are to count as rights, whose
values are to dominate and who is to make these decisions. The resolution of
these issues determines not just rights, but the allocation and distribution of
resources in society and hence power, income and wealth. The structure of
legal-economic institutions - the state (whether in the context of the
legislature, the bureaucracy, or the judiciary), the firm and the market -
channels legal-economic decision making and this structure is seen as the
outcome of an evolutionary process of legal-economic change rather than as
movement to a steady-state equilibrium (Schmid, 1989, p. 66). Legal
change, while gradual, has been continuous and has led to major
transformations of the legal system and of the pattern of rights and, thereby,
of the system of economic organization and control (Samuels and Mercuro,
1979, p. 167). The pervasiveness of legal change and the ongoing process of
legal-economic reconstruction through the nexus process thus makes
necessary an evolutionary-historical approach that accounts for the array of
factors and forces promoting both continuity and change over time.
Illustrative examples of this type of analysis are provided by Field (1979,
1981, 1984, 1991) and Bromley (1989).
Field (1979, 1984) argues that a meaningful analysis and explanation of
rules structures that organize and regulate economic activity cannot be
accomplished by incorporating the rules into an endogenous neoclassical
model. Rather, he asserts, a thorough understanding of the determinants and
consequences of institutions and rules requires a case-by-case approach that
maintains particular sensitivities to the historical, cultural and legal facets of
the particular legal-economic institution being studied, including the norms
that influence legal-economic behavior. In an analysis critical both of
Chicago law and economics and of neoinstitutionalist law and economics
(particularly the works of Posner and North and Thomas), Field (1981)
asserted that some subset of institutional structures needs to be treated as
parametric in the general equilibrium models and granted an explanatory
status analogous to that traditionally accorded tastes, technology and
0520 Institutional Law and Economics 435
endowments in the neoclassical model. More recently, Field (1991) has
urged that legal-economic scholars devote more extensive attention to the
effects of legal rules (particularly through income-expenditure effects) on
aggregate or macroeconomic variables.
Bromley (1989), too, criticizes the narrowness of the Chicago and
neoinstitutional (or new institutional) models of institutional change -
particularly their contention that institutional change is driven solely by
considerations of efficiency. Against this, he presents an analysis of
institutional change that makes such change hinge on four factors: (1) the
alteration of the economys productive efficiency, (2) the redistribution of
income, (3) the reallocation of economic opportunity and (4) the reallocation
of economic advantage - all worked out over time in the context of
individuals and collectivities pursuing their interest within a larger
social-political context.
9. Continuity versus Change
The recognition of the evolutionary nature of legal-economic relations
brings to the fore a second fundamental theme of institutional law and
economics: the ever-present tension between continuity and change in
legal-economic relations. The evolutionary path of the legal-economic
system is derivative of the legal-economic policy choices that are made over
time. Continuity and change are the outcome of the policymaking process,
more specifically, of the interaction between the groups supporting the
respective forces of continuity and change and the power that each can bring
to bear on this process (Samuels, 1966, pp. 267-273). Within this
policymaking process (be it legislative, bureaucratic, or judicial) arise and
operate forces that, through acts of commission or omission, serve to
maintain the status quo structure of legal-economic institutions and relations
- that is, continuity - while other forces promote an alteration in these
institutions and relations - that is, change. The ongoing choice process
within the legal-economic arena determines both the institutional structures
that obtain at any given point in time and whether the status quo
institutional structures, or some other, will prevail in the future, that is,
whether there will be change and if so how much.
10. Mutual Interdependence, Conflict and the Problem of Order
Institutional law and economics views the legal-economic system as a
system of mutual interdependence rather than one of atomistic
independence. The economy, says Schmid (1989, p. 59), is a universe of
human relations, not merely a universe of commodities and within this
436 Institutional Law and Economics 0520
world each individual has scarcity relationships with others. While it may be
that part of life deals with movements from positions off of contract curves
to positions on contract curves in the process of exhausting gains from trade,
the institutionalist approach places strong emphasis on (1) who gets to play,
(2) where one starts in the game and (3) the rules governing the game.
Given the importance of human interdependence and the emphasis on
who plays and what are the starting points, the focus of institutional law and
economics is on conflict rather than harmony, where [t]he role of the legal
system, including both common and constitutional law, is to provide a
framework or a process for conflict resolution and the development of legal
rights (Samuels and Mercuro, 1979, p. 166). The fundamental problem here
is that of order, which Samuels (1972a, p. 584) defines as the reconciling of
freedom and control, or autonomy and coordination including hierarchy and
equality, with continuity and change. The ultimate meaning of the legal
and economic processes says Samuels (1971, p. 449), is in terms of their
functioning toward resolving the problem(s) of order. The existence of
conflicting interests necessitates both a process (or processes) for deciding
between these competing interests and a method (or methods) for
determining how these conflicts are to be resolved.
At the micro level, the firm is seen as something more than a nexus of
contracts among isolated individual agents. It is a community designed in
part to suspend narrow, individualistic calculations of advantage and
facilitate the learning of standard objectives. This is more fully explored by
Hodgson (1988), Eisenberg (1990), Lazonick (1991) and Leibenstein (1987),
who focus not only on the social origins of individual preferences and goals
but on the complex processes by which individual utility functions are
constructed and revised and by which the meaning of profit maximization
is worked out by agents within the firm. Present within this and other
literature is a rich array of analyses of individual psychology, going beyond
the simplistic rationality assumption; of organizations, going beyond their
treatment as homogeneous, predetermined entities; of behavior in general,
going beyond the singular focus on isolated individuals to the institutional
and organizational environment in which they operate; and so on. Among
the sources of these analyses are modern Darwinian evolutionary theory,
cognitive psychology, organization theory and comparative economic
systems. Some of the analyses can appear to be either extensions of or
departures from neoclassical economic theory, while other analyses are
intended to be alternatives to mainstream economics. One result is the
showing that the unique determinate optimal equilibrium solutions of the
neoclassical research protocol are both presumptive and forced, heuristically
0520 Institutional Law and Economics 437
useful for analytical exercises but not representative of actual economic
processes in all their evolutionary complexity.
In all this, society is recognized, at least in part, as a cooperative venture
for mutual advantage where there are both identities and conflicts of
interests in ongoing human relations. Within this system of mutual
interdependence, societal institutions, including the legal system, both
enhance the scope of cooperative endeavors and channel
political-legal-economic conflict toward resolution (Mercuro, 1989b, p. 2).
The resolution of these conflicts, of whose interests government will give
effect through law and otherwise, is the resolution of the problem of order in
society - a working out of a societal structure that promotes coherence,
security and orderliness in human relations. Indeed, the manner by which a
society comes to channel conflict says much about its ultimate character.
11. Rights, Power and Government
Law is fundamentally a matter of rights creation and recreation. Consistent
with the positive, descriptive nature of their approach, institutionalists are
concerned with the rights (re)creation process and the impact of this process
on legal-economic decision making and activity. To understand the
importance of rights from the institutional perspective, it is first necessary to
understand the sphere of activities open to individuals and the
institutionalist conception of the determination of the individual choice
process.
Individual decision making is a function of ones opportunity set, which
consists of the available alternatives for action or choice, each with a
relative opportunity cost, which are open to the individual (Samuels, 1974,
p. 120). However, these opportunity sets are limited in their scope: owing to
human interdependence and scarcity, each individuals opportunity set is
constrained and shaped by the opportunity sets of others in society. Since
each individual desires to make choices from a set that is as unconstrained
as possible, individuals will wish to control the choices and hence
opportunity sets, of others who may constrain their choice. The extent of
each individuals ability to determine his or her own choices and to
influence the opportunity sets and hence choices, of others is the outcome of
a process of mutual coercion, where the ability to coerce is simply the ability
of A to impact Bs opportunity set without Bs consent. An individuals
capacity to exercise coercion is, in turn, a function of that individuals
power, defined as the means or capacity with which to exercise choice and
this power is relative to the power of others. Thus, [t]he opportunity set of
the individual, within which he attempts a constrained maximizing
438 Institutional Law and Economics 0520
equilibrium, is a function of the total structure of mutual coercion, grounded
upon relative power. Moreover, power is also a dependent variable in this
process, being a function of the choices made from opportunity sets that
exist and evolve through time (Samuels, 1972b, pp. 65-66). Opportunity
sets, then, are endogenously worked out rather than being exogenously
given.
The ongoing attempts to delineate and redefine opportunity sets, through
the machinations of power and mutual coercion in the face of conflicts, give
rise to disputes which necessitate resolution. For example, the upstream
polluting factorys choice of production technology impacts and conflicts
with the choice of activities of the downstream water user and conversely.
The upstream user cannot exercise choice without impacting the choice of
downstream users and conversely. The resolution of such conflicts comes
through the creation and assignment (or reassignment) of legal rights, which
define the scope of choices open to each individual and the degree to which
each is exposed to the choices of others. Thus, power and hence coercion
and the resulting opportunity sets and choices, are a function of rights.
The origin of rights, as well as the (re)defining and the (re)assigning of
rights through the resolution of conflicts of interest bring to the fore the
point that rights have a dual nature - the opportunity set enhancement of
those who have rights and the opportunity set restriction of those who are
exposed to them (Samuels, 1974, p. 122). Virtually every legal change
imposes both benefits and costs, the enhancement of some opportunity sets
and the simultaneous restriction of others. Externalities are thus ubiquitous
and reciprocal - any (re)definition, (re)assignment, or change in the degree
of enforcement of rights benefits some interests and harms others; the
externality remains in different form; it is merely shifted, as was made clear
by Ronald Coase in 'The Problem of Social Cost', (1960). From the
institutionalist perspective, systems of property, tort and contract law, then,
do not provide solutions to situations of externality but rather only
resolutions, as externalities and hence benefit and harm are channeled in a
particular direction through the legal delimitation of rights.
Government is seen to play a central and inevitable role within this
process, for rights are not rights because they are preexisting, but rather are
rights because they are protected by government. As Warren J. Samuels has
written, Rights are whatever interests government protects vis--vis other
interests when there is a conflict (Samuels, 1974, pp. 118-119, 127). Rights
are thus relative to and contingent upon the legal limitations inherent in
their identification and interpretation, the exercise by others of their rights
and legal and nonlegal change (Samuels, 1974, p. 118). Each of these
factors is a function of the rights-creation (and re-creation) process and
hence of the ability of individuals to secure rights (or a change therein)
through the use and control of government. Government thus becomes an
0520 Institutional Law and Economics 439
object of control for those seeking private legal-economic gain or advantage,
a mode through which relative rights and therefore relative market (income
securing) status is given effect (Samuels, 1971, pp. 441-442). The question
is not, then, one of more versus less government, but rather of whose
interests government gives effect to through law - that is, through the
process of rights creation and recreation. Contributors to institutional law
and economics thus see terms such as regulation, deregulation and
government intervention as misleading, in that government is omnipresent.
For example, it is often said that the adoption of workplace safety
regulations constitutes an intervention of government into the market, yet
such activity represents merely a change of the interests to which
government gives effect, as rights - a movement which expands the
rights/opportunity sets of workers and reduces the rights/opportunity sets of
employers. The issue as to who will have rights thus turns on whose interests
government allows to be realized and who is able to use government for
what ends. The critical matter is who is able to control and use the
legal-economic nexus in order to control legal-economic continuity or
change (Samuels, 1971, p. 440; Samuels, 1989a, p. 1578).
The central implication of the reciprocal nature of externalities is that the
decision over whose interests are protected as rights is necessarily a function
of a choice process - choice as to who will have rights and who will be
exposed to the exercise of those rights, of who will be able to inflict gains
and losses on others and to what extent (Samuels and Mercuro, 1979, pp.
172-174). This inevitable necessity of choice reveals that law is not
something that is given or to be discovered, but is instead a human artifact
marked by deliberative and nondeliberative human choice (Samuels, 1981,
p. 168). The fact that law is a human choice process means that value
judgments will necessarily be introduced in choosing between competing
interests and legal-economic outcomes are thus an expression of the values
of those who have participated and prevailed at each stage of choice in the
political-legal-economic arena - that is, those who are able to most
effectively use government to further their own ends (Mercuro, 1989b, p.
10). Justice, then, reflects not some given set of high foundational principles,
but rather a normative valuational process that determines the laws, norms
and values that are to govern living (Samuels, 1971, p. 444; Samuels and
Mercuro, 1979, pp. 160-163).
12. The Problematic Nature of Efficiency
Institutional law and economics has, on occasion, been characterized as
rejecting outright Chicago law and economics. This is not so. Indeed while
the institutional law and economics literature has been quite critical of
440 Institutional Law and Economics 0520
certain facets of the Chicago approach, Samuels (1981, pp. 148-149), for
one, has praised Posner for the usefulness of his analysis in once again
bringing to the attention of economists and legal scholars alike how
economic conditions affect the law and conversely. Nonetheless, one of the
hallmarks of the institutional approach to law and economics is the rejection
of the Chicago and general neoclassical emphasis on the determination of
the efficient resolution of legal disputes. The institutionalists do not reject
efficiency as an important variable in legal-economic analysis, but rather
maintain that efficiency alone cannot and should not, determine the
assignment of rights (Samuels, 1989a, p. 1563).
The starting point for the institutionalist critique of the efficiency
criterion is the recognition that economic activity - prices, costs, outputs,
risk, income, wealth, and so on - is not some sort of natural phenomenon,
but rather is determined by the structure of rights that exists in society, with
the levels of and changes in each of these variables being in part a function
of the legal structure and legal change over time (Samuels, 1971, p. 440,
1989a, p. 1565; and Schmid 1989, p. 67). Each particular rights structure
will give rise to a particular set of prices, costs, outputs, and so on and thus
to a particular efficient allocation of resources. Hence, there is no unique
efficient result. For the institutionalists, the purportedly positivist
Chicago-school rhetoric of atomistic industries or contestable markets
and the associated concept of price-taking behavior is exposed as nothing
more than deeply normative rights-taking behavior (Samuels and Mercuro,
1984). The institutionalists maintain that inasmuch as rights underlie
product prices and thus costs, to talk of price-takers bypasses virtually all
that is (or should be) important in Chicago law and economics and much of
public choice theory.
Because efficiency is a function of rights and not the other way around, it
is circular to maintain that efficiency alone can determine rights. Since
costs, prices, outputs, wealth and so on are derivative of a particular rights
structure, so too are cost minimization, value-of-output maximization and
wealth maximization. (For a detailed examination of the determination of
costs in this regard, see Samuels and Schmid, 1997.) Different specifications
of rights will lead to different (and economically noncomparable)
minimizing or maximizing valuations. The result is that an outcome that is
claimed to be efficient is efficient only with regard to the assumed initial
structure of rights (Schmid, 1989, pp. 68-69) the latter of which is often the
very matter at issue. Thus, as Samuels (1981, p. 154) asserts, [t]o argue that
wealth maximization [or any other efficiency criterion] can determine rights
serves only to mask a choice of which interests to protect as rights. Legal
decisions or changes can be said to be efficient only from the point of view
of the party whose interests are given effect through the identification and
assignment of rights.
0520 Institutional Law and Economics 441
Moreover, the definition of output - of what it is that one is to be
efficient about - requires an antecedent normative specification as to the
appropriate performance goal for society. Social output (the aggregate
well-being of society), consumptive output (the value of goods from the
consumer point of view) and productive output (the value of goods from the
producer point of view, that is, profits) are three examples of the alternatives
that are available. The value-laden choice of a particular definition of output
as the maximand, which in effect is the choice of a particular social welfare
function where many are possible, will drive the decision as to what
constitutes the efficient allocation (Samuels, 1978, pp. 102-104).
Further, due to the non-uniqueness of efficiency, efficiency is inevitably
bound up with distribution; as Samuels and Schmid (1981, p. 2) describe it,
the concept of efficiency as separate from distribution is false. Rights
determination is a normative activity with both efficiency and distributional
consequences, determining which efficient allocation and which distribution
of benefits and costs will carry the day. Rights determine the distribution of
income and wealth, which in turn determines the efficient solution that is
reached. But at the same time, the specification of rights and the resulting
efficient outcome, structure the future distribution of income and wealth in
society. The choice of rights, then, is ultimately a distributional issue: With
no unique optimal use of resources and opportunities independent of rights
identification and assignment, the legal system must select the
[distributional] result to be pursued: the definition of the efficient solution is
both the object and the subject of the legal system (Samuels, 1978, p. 106,
emphasis in original). In institutional law and economics [t]he distribution
problem, viz., of power, income, wealth, opportunity, exposure and sacrifice,
is critical to legal-economic research and policy (Samuels, 1975, p. 70).
Thus, as described by Schmid (1989, p. 69), the whole point is that global
welfare maximization is meaningless and [t]o recommend one right over
another, analysts must take their stand as naked normativists without the
comfort of the Pareto-better cloak or any other formalism.
The recognition of the multiplicity of efficient solutions and the
contingency of any given efficient solution on the presumed structure of
rights (the definition and assignment) and the definition of output reveals
the inherent normative element that is present in efficiency-based decision
making. Each possible legal solution points to a different efficient outcome
and [t]here is no independent test by which the laws solutions can be said
to be the efficient solution (Samuels, 1981, p. 155). The determination of a
particular efficient solution involves a normative and selective choice as to
whose interests will be accommodated, who will realize gains and who will
realize losses.
442 Institutional Law and Economics 0520
This line of reasoning leads institutionalists to reject the efficiency theory
of the common law. Any given rights structure will produce an efficient or
wealth-maximizing outcome and thus [t]he so-called efficiency of the
common law is an empirical regularity only in the sense that every
common law specification of rights can produce a unique,
wealth-maximizing outcome (Samuels, 1981, p. 162). If different interests
had been protected as rights, different efficient outcomes would have
occurred. The choice of certain rights structures reflects a normative choice
for a particular efficient pattern of law and economic development over time,
where different decisions would have led to different patterns of efficient
development. Thus, the literature purporting to explain the efficient
development of the common law explains everything and nothing Samuels
(1981, p. 162). Wealth maximization cannot ... explain the evolution of the
common law: any developmental logic concerning rights in a market
economy would have led the common law to some wealth-maximizing
result (Samuels, 1981, p. 154).
In a similar vein, proponents of institutional law and economics also
reject the standard theory of rent seeking, which defines rent-seeking
activities as resource-wasting activities of individuals in seeking transfers of
wealth through the aegis of the state (Buchanan, Tollison and Tullock,
1980, p. ix). Rent-seeking theory thereby argues that expenditures of scarce
resources by agents in an attempt to garner a privileged position (for
example, an exclusive monopoly franchise) from the state, or, the use of the
state (for example, through legislative activities or lobbying) to alter product
price and/or factor prices to enhance profits without a concomitant increase
in output, is wasteful in that resources are expended solely for the purpose of
effecting a transfer of rents from one party to another. The normative thrust
of this theory thus becomes one of promoting policies designed to avoid
wasteful, rent-seeking activities, which often involves a greater, more
exclusive reliance on markets and a scaling back of government.
The intellectual construct employed by proponents of the rent-seeking
literature is that of the competitive market economy and the legitimized
product and factor prices and thus profits that obtain therefrom. Prices and
profits that occur consequent standard marketplace phenomena - such as the
entering and exiting of firms into and from industries, adopting new
technologies, altering the scale of plant, and so on - are all legitimate.
However, when prices and profits are altered by and/or through the aegis of
the state, this is said to result in waste.
From the standpoint of institutional law and economics, this
characterization of rent seeking is an exercise in selective perception and
market legitimation (Samuels and Mercuro, 1984, pp. 55-70). As the
institutionalists have pointed out, to use todays market prices and profits as
a basis to determine rents and wastes is to give propriety to extant laws
0520 Institutional Law and Economics 443
governing the production of goods while at the same time selectively culling
out one subset of rights to make claims of wasteful, rent-seeking activity. It
is the proponents reliance on the model of competition that gives effect to
this selective perception. As is made clear in institutional law and
economics, models of the economy predicated on price-taking behavior are
in reality models of rights-taking behavior. Market prices are not absolute,
predetermined and independent of law, but, rather, are a partial function of
rights - the latter related directly to the governments ubiquitous role in
creating, defining, assigning, enforcing and altering rights. Moreover,
todays prevailing market prices of products and factors of production are all
predicated upon the past use of the state and past rent-seeking activities.
Market-generated product and factor prices that make up a firms
revenue-cost calculation are property-rights specific; as a consequence, so
too is its net revenue calculation a function of rights. The governments role
in the economy remains ubiquitous and, accordingly, a theory that purports
to identify rent-seeking behavior and the economic wastes therefrom is
question begging. There are no correct rights, prices, profits, or correct
structure of rents. Thus, rent-seeking theory is characterized as an artificial,
misguided normative theory that will mislead positive analysis and generate
artificial distinctions and thereby provide no real basis for distinguishing
between permissible and impermissible activities (Samuels and Mercuro,
1984, p. 67; see also Medema, 1991).
13. Toward a Comparative Institutional Analysis
The driving force behind institutional law and economics is the need to
come to grips with the interrelations between legal and economic processes.
Samuels (1975, p. 72) identifies three efforts that are central to this process:
(1) models of legal-political and economic interaction must be developed;
(2) objective, positive, empirical studies of government as both a dependent
and independent variable and of economic activity as both an input and an
output of political-legal processes must be undertaken; and (3) efforts must
be made to wed both theoretical and empirical analyses toward a
self-consciously objective, positive comprehension of law and economics.
Such analysis will serve the twin purposes of deepening the understanding of
legal and economic processes and their interrelations and providing a more
sound basis upon which to predict the potential consequences of
legal-economic change.
The import of this becomes clear in the institutionalist assertion that the
essential normative element in political-legal-economic decision making
means that a choice must be made between alternative
444 Institutional Law and Economics 0520
efficiency-distributional results and hence between alternative
political-legal-economic institutional structures. This, in turn, necessitates a
comparative institutional approach to legal-economic analysis. The
institutional structure cannot, in this view, merely be assumed away or taken
as given. Rather, it must be the subject of study and, more specifically, the
legal-economic decision-making process must involve a comparison of the
effects of institutional alternatives on social well-being. The need for a
comparative institutional approach to legal-economic policy and not only by
the institutionalists, has long been recognized. Other proponents of a
comparative institutional approach, coming from somewhat different
perspectives include Coase (1960, esp. pp. 42-44), Demsetz (1969), Komesar
(1981, 1994), Stewart (1987) and Shepsle and Weingast (1984) generally,
though not exclusively, working under the banner of the New Institutional
Law and Economics.
The comparative institutional approach is general rather than partial
(Samuels 1972a, pp. 582, 585) and consists of describing and analyzing the
systematic relationship between (1) the structure of political-legal-economic
institutions, focusing on the rights and rules by which they operate; (2) the
conduct or observed behavior in light of the incentives (penalties and
rewards) created by the structure of institutions; (3) the consequent
economic performance, i.e., the allocation and distribution of resources that
determine the character of economic life under these institutions (Mercuro,
1989b, p. 11, emphasis in original).
Within this structure-conduct-performance paradigm the object, then, is
to explain and compare the outcomes that will occur under real, discrete,
alternative institutional structures. A comparative institutional approach to
law and economics emphasizes the need to explain and analyze the available
alternatives and the consequences of choice at three distinct stages: (1) the
constitutional stage of choice - the social contract that binds people together,
which is subject to reinterpretation and revision; (2) the institutional stage of
choice - the structuring and restructuring of political-legal-economic
institutions; and (3) the economic impact stage of choice - describing the
economic impacts of existing or potentially revised legal-economic relations,
be they in the form of private property rights, status rights, communal
property (Mercuro, 1989b, pp. 3-6) and open-acces resources (Mercuro,
1997).
The analysis must be done at each of these levels and not solely in terms
of efficiency, but also in terms of the distribution of income and wealth,
employment rates and any other factors that may affect the quality of life or
the productive capacity of firms. As Samuels (1981, p. 165) has argued,
[f]or law to be preoccupied solely with economic maximization would rob
law of life and of much of what makes for human meaning and
significance. The goal here is not normative judgment, but description: A
0520 Institutional Law and Economics 445
viable approach to the study of the interrelations between law and economics
should be content with describing the full array of economic impacts
(including both the allocation and distribution of resources) of alternative
institutions and legal arrangements together with an articulation of whose
interests will be served and at whose expense (Mercuro, 1989b, p. 12). Such
analysis will not privilege one set of interests over others, but it will enable
those who study and participate in the processes of the legal-economic nexus
to better understand these processes and their resulting effects on law and
economy (Samuels, 1989a, p. 1578). Institutionalist-oriented case studies
include the works of Carter (1985), Schmid (1985), Seidman (1973) and
Wandschneider (1986). Carter (1985) criticizes the neoclassical
microeconomic explanation of institutional arrangements as at best partial
and at worst mystifying. Employing a Wisconsin institutionalist perspective
that recognizes both the relevance of economic power and the historical
context within which exchange occurs, Carter revisits Commonss analysis
of yellow dog labor contracts and analyzes the interlinked tenure-credit
contracts. Seidman (1973) contrasts the classical and anticlassical
perspectives on facilitative law and finds the latter, which recognizes the
asymmetric status and power of parties to a contract to be controlling, to
better describe what transpired in the colonial African economies of Kenya
and Ghana. Schmid (1985), writing on biotechnology-related property rights
issues in the agricultural sector, demonstrates that attempts to provide
exclusivity may inadvertently create added costs and affect the choice of
breeding method and agricultural technologies, was well as the division of
rents between inventors and the public. Wandschneider (1986) analyzes the
property rights institutions that allocate water in the northwest US He finds
that, as compared to the EPR (efficient property rights) model, an
institutionalist model that recognizes (1) that social norms may supersede
economic rationality and (2) that conflict over distributional issues may
block Pareto-better outcomes, is better able to explain the development of
rights to water in the US.
Of course normative judgments must be made in the process of reaching
legal decisions. Recognizing this, the institutional approach emphasizes the
need for openness and value clarification in the political-legal-economic
decision-making process, clearly a legacy of the legal realist movement
within the field of law (Samuels, 1989a, p. 1573). Economists, legal
scholars, policymakers and judges should strive to make the value premises
underlying their conclusions as explicit as possible, so that the choice
process can be effectuated carefully and overtly rather than carelessly and
446 Institutional Law and Economics 0520
covertly (Samuels, 1978, p. 113; 1989b). This call for openness is clearly
tied to the comparative institutional method:
Not only should normative premises be made explicit, but an array of studies
should be conducted on the basis of alternative normative (and factual)
assumptions. To do only one study is to give effect to only one perception and
specification of outputs, costs, benefits and rights. Alternative studies call
attention to the subtle intrusion of ideology and partisanship, emphasize the
necessary and inevitable critical choice of underlying values, highlight the
fundamental distributional consequences that depend on the political
determination of output definitions and so forth. (Samuels 1978, p. 112, emphasis
in original)
The obfuscation of values and underlying normative premises within so
much of the Chicago school of law and economics and public choice theory
is the bane of the comparative institutional approach. Relying solely on the
Pareto efficiency criterion serves to obfuscate and impede the normative
choice process that is necessarily at work in the legal-economic nexus.
Examples of scholarship that avoid much of the obfuscation brought on by
solely relying on Pareto-efficiency analysis include Bromley (1989),
Calabresi (1985, 1991), Lang (1980), Griffin (1991, 1995) and Mishan
(1972).
Calabresi (1991) demonstrates that the frequently-made distinction
between removing inefficiencies (making moves to the Pareto frontier) and
innovating (pushing the Pareto frontier outward) is a false dichotomy. He
argues that moves from the status quo are not possible without either (1)
disadvantaging at least one party (hence making distributional
considerations unavoidable), or (2) trying to shift the frontier outward (a
process that also typically entails distributional consequences). As a
consequence, Calabresi, in a combined concern for efficiency and
distribution, calls for a method of analysis that attempts to answer the
following question: Which actions are most likely, at least cost, to shift the
frontier outward and who will gain and who will lose from such moves?
Calabresi (1985) also argues that ideals, beliefs and attitudes matter in
shaping the law. Recognizing that legal entitlements alter our perception of
benefits and costs, he examines the legal response to beliefs and attitudes.
The focus on ideals, beliefs and attitudes highlights the limitations inherent
in the economic analysis of legal rules. Calabresi poses the hypothetical
question: How does or should a society contemplate improvements - be it
the automobile or any such improvement that spreads benefits and costs
across society? He asks: Is it worth the price we pay as a society? Who
should pay the price? And, given laws commitment to the concept of
0520 Institutional Law and Economics 447
reasonableness, he asks: Whos value system determines what is
reasonable? The thrust of the book is to compel society to understand and
articulate the tradeoffs being made between the values of different segments
of society as we embrace new technologies or ways of life. Consequently, the
call is for an honest and open approach to resolving issues involving
conflicting values and beliefs.
Lang (1980) critically examines several concepts of efficiency as related
to policy analysis, exposing their normative content and thereby
demonstrating the limits to efficiency-based policy analysis. He observes that
property rights issues arise from different sets of values which, if reflected in
policy, lead to different Pareto-efficient allocations of resources. He calls for
policy analysis to (1) undertake a greater use of economic analysis to
determine the incidence of benefits and costs associated with alternative
remedies, or (2) pursue an instrumental economics which places a greater
degree of emphasis on the design of policies and institutions which will
achieve a specified social and economic end. In a similar vein, Mishan
(1972) critically examines Hochman and Rodgers (1969) position that one
can resolve the distribution problem for society by promoting Pareto-efficient
redistributions. After exploring the undesirability of efficiency-derived
distributions, Mishan concludes that economists ought to concede that
welfare economics is founded on ethics and make policy recommendations
or proposals consistent with the ethics of the society for which the policy is
intended.
Griffin (1991) critiques the traditional market- and price-guided policies
for internalizing externalities offered within the context of neoclassical
theory - policies which, he argues, are insufficient for this purpose. He
contends that the major omission in neoclassical theory is a mechanism to
incorporate institutional options (and their associated transaction costs) to
resolve the problems brought on by negative externalities and he advances a
method of explicitly incorporating institutional transaction costs into welfare
diagrammatics. In a later paper, Griffin (1995) examined the differences
between the economic criteria of potential Pareto improvements and Pareto
improvements as normative foundations from which to assess public policy.
He demonstrates that potential Pareto criteria have greater disciplinary
acceptance than their normative foundations merit and that the Pareto
criterion has suffered undue criticism consequent the former.
448 Institutional Law and Economics 0520
14. Summary
In contrast to some other approaches to law and economics, the institutional
approach draws no distinction between jurisprudential, legislative,
bureaucratic, or regulatory treatments. All are seen as particular parts or
manifestations of the interrelation of government and the economy, or of
legal and economic processes. Underlying the major thrust of the
institutional approach to law and economics are two complementary modes
of analysis. Instead of concentrating on a unidirectional sequence in which
the law or legal structure governs behavior or conduct in the mixed market
economy which in turn drives economic performance, for institutional law
and economics the emphasis is on the interpenetration and interrelations
between government and the economy, so that law or legal structure and
behavior or conduct in the mixed market economy and economic
performance are dependent on each other in a process of circular and
cumulative causation.
Correlatively, whereas some of the more orthodox approaches to law and
economics seek unique, determinate optimal equilibrium solutions,
institutional law and economics finds such solutions to be question-begging
and concentrates on identifying and analyzing the processes by which the
various legal structures, the conduct and the economic performance are
worked out. Similarly, those contributing to institutionalist law and
economics do not feel obliged to identify particular legal arrangements as
optimal. They argue that putatively optimal solutions to problems of policy
only give effect to selective preconceptions and assumptions as to whose
interests are to count, for which economists have no particular basis on
which to choose, especially given that so-called optimal solutions are driven
by and specific to the choice of rights and so on which produce them -
ironically with those very rights structures which are at center stage in
virtually all schools of thought of law and economics.
Although institutionalists are interested in identifying the alternatives
open to policy and trying to say something of their consequences, they are
reluctant to substitute their preferences for those of actual legal and
economic actors engaged in the processes of working solutions out by and
for themselves. Along comparable lines, institutional law and economics
distinguishes between (1a) a market economy (typically a mixed-market
economy, often somewhat vague on the mix), (1b) a conceptual market (a
market typically characterized with a vaguely described minimalist
government in the context of pure competition) and (1c) markets in
general (typically a euphemism invoked to avoid the important factors and
details inherent in the previous two conceptions of the market) on the one
hand and (2) actual institutionalized markets on the other. Accordingly, they
question the blind reliance on the market - whether type a, b, or c to solve
0520 Institutional Law and Economics 449
problems inasmuch as institutionalized markets, in their view, are a function
of the institutions and power structures which form and operate through
them. To affirm a solution by a market together with the outcome which
obtains and is purported to be optimal, is to give effect to a particular
structure of law, rights and therefore power, and thus beg the operative
issue(s). For those who narrowly seek markets and putatively optimal
solutions to problems of policy, institutional law and economics will be
disappointing.
It may well be that since the overtly positive and even agnostic approach
of institutional law and economics is not comforting to those who would
seek refuge in determinate solutions to the questions of legal-economic
policy, then some may be inclined to dismiss it on this ground. Against this,
Schmid responds: If [institutional law and economics] has no dispositive
answer to resolve policy arguments, what is it good for? It can identify many
less than obvious sources of power in an economy so that people can know
where their welfare comes from. It can raise the level of normative debate so
that issues can be joined and people can live with tragic choices rather than
ignoring and dismissing them (Schmid, 1994, pp. 36-37). While singular
solutions to legal-economic issues reflect only one particular set of value
premises and one particular conception of the facts, benefits and costs at
issue, the comparative institutional approach, by recognizing the multiplicity
of potential solutions and underlying value premises, attempts to flesh out
both what is actually going on in the legal-economic nexus and the
alternative possibilities that are open to society in the ongoing social
construction and reconstruction of legal-economic reality.
Acknowledgments
We wish to thank the Fritz Thyssen Foundation for its generous support and
the faculty and staff of the Erasmus Program in Law and Economics at the
University for Hamburg in providing Professor Mercuro a productive
environment in the time during which this project was completed. We are
indebted to A. Allan Schmid, the editors and two anonymous referees for
their insightful comments on earlier drafts of this material. The excellent
research assistance of Mary Therese Cogeos is also gratefully acknowledged.
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Cases
Allgeyer v. Louisiana
0530
NEW INSTITUTIONAL ECONOMICS
Peter G. Klein
Department of Economics, University of Georgia
Copyright 1999 Peter G. Klein
Abstract
This chapter surveys the new institutional economics, a rapidly growing
literature combining economics, law, organization theory, political science,
sociology and anthropology to understand social, political and commercial
institutions. This literature tries to explain what institutions are, how they arise,
what purposes they serve, how they change and how they may be reformed.
Following convention, I distinguish between the institutional environment (the
background constraints, or rules of the game, that guide individuals
behavior) and institutional arrangements (specific guidelines designed by
trading partners to facilitate particular exchanges). In both cases, the discussion
here focuses on applications, evidence and policy implications.
JEL classification: D23, D72, L22, L42, O17
Keywords: Institutions, Firms, Transaction Costs, Specific Assets, Governance
Structures
1. Introduction
The new institutional economics (NIE) is an interdisciplinary enterprise
combining economics, law, organization theory, political science, sociology and
anthropology to understand the institutions of social, political and commercial
life. It borrows liberally from various social-science disciplines, but its primary
language is economics. Its goal is to explain what institutions are, how they
arise, what purposes they serve, how they change and how - if at all - they
should be reformed. This essay surveys the wide-ranging and rapidly growing
literature on the economics of institutions, with an emphasis on applications
and evidence. The survey is divided into eight sections: the institutional
environment; institutional arrangements and the theory of the firm; moral
hazard and agency; transaction cost economics; capabilities and the core
competence of the firm; evidence on contracts, organizations and institutions;
public policy implications and influence; and a brief summary.
Until recently, institutional economics usually referred to the writings of
Thorstein Veblen, John R. Commons, Wesley C. Mitchell, Clarence Ayres and
their followers. This is a diverse group, but their work reflects several common
456
0530 New Institutional Economics 457
themes, mostly criticisms of orthodox economics: (1) a focus on collective
rather than individual action; (2) a preference for an evolutionary rather than
mechanistic approach to the economy; and (3) an emphasis on empirical
observation over deductive reasoning. (For a sampling of the secondary
literature see Seckler, 1975; Gruchy, 1972; Gruchy, 1987; Rutherford, 1983;
Langlois, 1989; and Hodgson, 1998. On the German roots of American
institutionalism, see Richter, 1996.) Whatever their contributions, the older
institutionalists are little known to most contemporary economists. Coases
(1984, p. 230) dismissal is typical: Without a theory they had nothing to pass
on except a mass of descriptive material waiting for a theory, or a fire. Still,
this tradition (broadly defined) continues in such outlets as the Journal of
Economic Issues, the Cambridge Journal of Economics and the Review of
Political Economy.
The term new institutional economics was originated by Williamson
(1975). NIE, which began to develop as a self-conscious movement in the
1970s, traces its origins to Coases analysis of the firm (Coase, 1937), Hayeks
writings on knowledge (Hayek, 1937, 1945) and Chandlers history of
industrial enterprise (Chandler, 1962), along with contributions by Simon
(1947), Arrow (1963), Davis and North (1971), Williamson (1971, 1975,
1985), Alchian and Demsetz (1972), Macneil (1978), Holmstrm (1979) and
others. Its best-known representatives are Coase, Williamson and North. For
overviews and commentaries see Eggertsson (1990), Furubotn and Richter
(1991), Coase (1992), Werin and Wijkander (1992), Pejovich (1995), Drobak
and Nye (1997); and annual symposium issues of the Journal of Institutional
and Theoretical Economics.
Like its older counterpart, the new institutional economics is interested in
the social, economic and political institutions that govern everyday life.
However, the new institutional economics eschews the holism of the older
school. NIE follows strict methodological individualism, always couching its
explanations in terms of the goals, plans and actions of individuals. Of course,
NIE appreciates social phenomena like corporate culture, organizational
memory, and so on. Still, NIE takes these as explananda, not the explanans.
NIE differs from mainstream neoclassical economics, however, in insisting
that policy analysis be guided by what Coase (1964) calls comparative
institutional analysis. Orthodox welfare analysis typically compares real-world
outcomes with the hypothetical benchmark of perfectly competitive general
equilibrium. It is unsurprising, then, that actual market outcomes will come up
short. The relevant question, Coase explains, is whether a feasible alternative
can be devised:
Contemplation of an optimal system may provide techniques of analysis that would
otherwise have been missed and, in certain special cases, it may go far to providing
a solution. But in general its influence has been pernicious. It has directed
economists attention away from the main question, which is how alternative
arrangements will actually work in practice. It has led economists to derive
458 New Institutional Economics 0530
conclusions for economic policy from a study of an abstract of a market situation.
It is no accident that in the literature ... we find a category market failure but no
category government failure. Until we realize that we are choosing between social
arrangements which are all more or less failures, we are not likely to make much
headway. (Coase, 1964, p. 195)
Coases own investigation of British lighthouses (Coase, 1974) is a
well-known comparative-institutional study. Coase discovered that before the
1830s, the typical British lighthouse - the classic, textbook example of a public
good, which presumably the market cannot supply and therefore the state must
provide - was privately owned and operated. Coase pointed out that here, public
ownership does not overcome the free-rider problem any better than does
private ownership. Thus we should not be surprised to see private entrepreneurs
providing this public good - at least until it was nationalized and provided
thereafter by the state. (For other examples of public goods that were privately
provided, but later nationalized - typically to raise revenue for the sovereign -
see Benson, 1994 on police services and public highways, Benson, 1992 on
criminal law and Selgin and White, forthcoming on money.)
To organize the various strands of the NIE, it is useful to begin with Davis
and Norths (1971) distinction between the institutional environment and
institutional arrangements. The former refers to the background constraints,
or rules of the game, that guide individuals behavior. These can be both
formal, explicit rules (constitutions, laws, property rights) and informal, often
implicit rules (social conventions, norms). While these background rules are
the product of - and can be explained in terms of - the goals, beliefs and choices
of individual actors, the social result (the rule itself) is typically not known or
designed by anyone. Institutional arrangements, by contrast, are specific
guidelines - what Williamson (1985, 1996b) calls governance structures -
designed by trading partners to mediate particular economic relationships.
Business firms, long-term contracts, public bureaucracies, nonprofit
organizations and other contractual agreements are examples of institutional
arrangements.
2. The Institutional Environment
The institutional environment forms the framework in which human action
takes place. Institutions reduce uncertainty by providing a structure to
everyday life, writes North (1990, p. 3). In the jargon of the economist,
institutions define and limit the set of choices of individuals. Institutional
constraints include both what individuals are prohibited from doing and,
sometimes, under what conditions some individuals are permitted to undertake
certain activities. ... They are perfectly analogous to the rules of the game in a
competitive team sport (North, 1990, pp. 3-4). Unlike the rules in team sports,
however, these guidelines often arise spontaneously, as by-products of
0530 New Institutional Economics 459
individual choices, rather than deliberately through collective action (Hayek,
1967, 1973).
The Legal Environment and Property Rights
Of these sets of rules, the legal environment has received the most attention.
Economists have long been interested in the economic effects of laws (for
instance, the effects of a price ceiling on equilibrium price and quantity), but
only in the last few decades has economics been applied to the design of legal
rules and the legal system itself. Beginning with the early literature on the
efficiency of the common law (Rubin, 1977; Priest, 1977), economics has been
used to study not only the character and effects of law but the mechanisms by
which legal rules change. In this sense, law and economics may therefore be
considered a part of NIE, although it is customary to speak of law and
economics and NIE as separate movements. (See the exchange between Posner,
1993, and Williamson, 1993, for contrasting views on the relationship between
these two literatures. See also Williamson, 1996c, on the relationship between
NIE and legal realism.)
NIE has been particularly interested in contract law (Llewellyn, 1931;
Macneil, 1974, 1978; Langbein, 1987) and property law (Alchian, 1961;
Demsetz, 1967; Furubotn and Pejovich, 1972, 1974; De Alessi, 1980; Barzel,
1989). However, unlike the legal centralism tradition, which holds that
disputes are primarily settled by the courts as official agents of the state, NIE
often focuses on private solutions, holding that in many instances the
participants can devise more satisfactory solutions to their disputes than can
professionals constrained to apply general rules on the basis of limited
knowledge of the dispute (Galanter, 1981, p. 4). The recent studies on
decentralized law and its evolution by Benson (1990), Ellickson (1991) and
Cooter (1994), for example, are examples of this private ordering tradition.
Norms and Social Conventions
Equally important are the informal and often tacit, rules that structure social
conduct. [F]ormal rules ... make up a small ... part of the sum of constraints
that shape choices; ... the governing structure is overwhelmingly defined by
codes of conduct, norms of behavior and conventions (North, 1990, p. 36).
Such rules, once established, form constraints for individual actors. Yet how
can the rules themselves be explained in terms of purposeful individual
choices? In Mengers (1883, p. 146) words: How can it be that institutions
which serve the common welfare and are extremely significant for its
development come into being without a common will directed toward
establishing them?
One approach is to interpret social conventions as noncooperative
Nash-equilibrium solutions to a variety of repeated games (supergames) faced
by individuals in social settings. An example is the coordination game made
famous by Schelling (1960). Two friends arrange to meet one day at 5:00 p.m.
in New York City. As the time of the meeting approaches, however, neither can
460 New Institutional Economics 0530
remember where the meeting was to take place. Furthermore, the friends cannot
contact each other to verify the location of the meeting; each must guess,
independently, a likely meeting place. What can they do? Obviously, this game
has multiple Nash equilibria: any outcome in which both friends choose the
same location - say, the corner of 34th Street and 5th Avenue - is a Nash
equilibrium to the game. According to Schelling, when faced with this kind of
problem, agents rely on cultural information outside the structure of the game.
Everyone simply knows, for example, that the logical place to meet in New
York City is beneath the clock in the main terminal of Grand Central Station.
This equilibrium is what Schelling called a focal point. Over time, he argued,
behavioral regularities develop so agents can solve these kinds of coordination
problems.
Ullman-Margalit (1977) calls these equilibria norms; Sugden (1986) calls
them conventions; Schotter (1981) calls them social institutions. In
Schotters (1981, p. 11) words, a social institution is a regularity in social
behavior that is agreed to by all members of society, specifies behavior in
specific recurrent situations and is either self-policed or policed by some
external authority. These regularities are presumed to arise over time as agents
interact repeatedly. Game theory itself, however, usually says little about how
a particular convention is chosen; it only identifies combinations of strategies
that are mutual best responses. More recently, some explicitly evolutionary
models (Witt, 1989; Wrnereyd, 1990; Boyer and Orlean, 1992) have tried to
explain the dynamic process by which particular equilibria are chosen. Axelrod
(1984) has shown experimentally that strategies of repeated cooperation tend
to be established relatively quickly.
Ellickson (1991) explains that social norms, as customary law, can be
superior to administrative or judicial dispute resolution among people with
close social ties. Ellickson studied disputes between cattle ranchers and farmers
in Shasta County, California and found that these disputes were usually
resolved by appeal to generally accepted social rules, not by bargaining over
legal rights (as the Coase Theorem would predict). [M]embers of a close-knit
group develop and maintain norms whose content serves to maximize the
aggregate welfare that members obtain in their workaday affairs with one
another (Ellickson, 1991, p. 167). That is, through repeated play, agents tend
to converge on strategies of cooperation that improve joint well being. These
strategies replace traditional legal remedies. Law solves the problem of
cooperation by altering the payoff structure in each game; relationships solve
the problem by repeating the game. In Shasta County, where both solutions are
available, relationships prevail over law (Cooter, 1993, p. 423). Informal
norms, in these cases, replace law.
Norms and law are not necessarily substitutes, however. Law can shape the
outcome of private bargaining by serving as a backup mechanism for resolving
disputes that cannot be resolved privately. If the alternative to private dispute
resolution is resolution in court, then the expected outcome at trial determines
the parties threat values in bargaining. Bargaining typically takes place in
0530 New Institutional Economics 461
the shadow of the law (Cooter, Marks and Mnookin, 1982). Moreover, norms
can help shape the law, if judges look to social norms as guidelines for legal
decisions. The traditional account of the medieval law merchant illustrates this
phenomenon. During the commercial revolution merchants developed a system
of private courts to resolve disputes among themselves. The rules of these
courts became general merchant practice, enforced by the threat of ostracism.
As the English legal system developed, judges began to hear commercial
disputes once handled privately. In resolving these disputes, English
common-law judges tended to enforce the merchant customs already in place.
In this way the common law came to embody the principles that already
existed, principles developed through private interaction among merchants.
(On the law merchant see Trakman, 1983 and Benson, 1989). Today, many
commercial disputes are resolved privately, through organizations such as the
VISA Arbitration Committee (Solove, 1986; Cooter, 1994).
Economic History and Economic Growth
Attention to the institutional environment has become increasingly common in
economic history and it has deeply enriched our understanding of how
economies develop through time (North and Thomas, 1973; North, 1990;
Drobak and Nye, 1997). Economic development is no longer regarded as a
gradual, inevitable transformation from local autarky to specialization and the
division of labor. Instead, development is seen as a response to the evolution of
institutions that support social and commercial relationships. Economic growth
thus depends on the degree to which the potential hazards of trade (shirking,
opportunism and the like) can be controlled by institutions, which reduce
information costs, encourage capital formation and capital mobility, allow risks
to be priced and shared and otherwise facilitate cooperation.
In early societies, agency problems were typically solved through kinship
or other close social ties. Greif (1989), for example, has shown how
eleventh-century Jewish traders in the Mediterranean trade enforced codes of
conduct by maintaining close social relationships, using the threat of ostracism
as a disciplinary device. Later, standardized weights and measures, units of
account, media of exchange and procedures to resolve disputes (such as
merchant law courts) supported the expansion of trade by lowering information
costs. Capital markets could flourish only in societies where rulers could
credibly commit not to expropriate private wealth; North and Weingast (1989)
show how capital markets emerged in Britain after the Glorious Revolution of
1688 placed parliamentary limits on the authority of the Crown. The growth of
product and factor markets depends similarly on establishing secure property
rights. Furthermore, as an economy industrializes, more and more commercial
activity involves transacting: trade, finance, banking, insurance and
management (Wallis and North, 1986). Industrialization requires institutions
to mitigate the costs associated with these transactions.
462 New Institutional Economics 0530
Economic development, then, is institutional development. The central
issue of economic history and of economic development is to account for the
evolution of political and economic institutions that create an economic
environment that induces increasing productivity (North, 1991, p. 98).
Positive Political Theory
Political institutions have also received much attention in NIE. The
rational-choice approach to politics, as outlined in public choice (Buchanan and
Tullock, 1962; Mueller, 1979, 1989) and positive political theory (McKelvey,
1976; Riker, 1981; Enelow and Hinich, 1984), holds that political institutions
can be explained in terms of purposeful human choice. This framework has
been applied to constitutions, legislatures, executives, bureaucracies, courts and
elections. Spatial models of voting, for example, show how different voting
rules (such as which party can set the agenda) affect the outcome. Among the
better-known applications of the spatial model are studies of the committee
structure in Congress, under which committees have agenda-setting power
(Denzau and Mackay, 1983; Shepsle and Weingast, 1987). The rational-choice
perspective is also used to explain the effects of political institutions on public
policy, including macroeconomic policy, welfare policy, budgets, regulation
and technology policy (see Weingast, 1996, for an overview).
Why, however, do political institutions take one form or another? One
approach is to identify particular political institutions that are self-perpetuating,
meaning that those individuals or groups which can modify the institution have
no incentive to do so (Ordeshook, 1993; Weingast, 1995). Antebellum
American federalism is one example; it survived, arguably, because it was
supported by institutions such as the territorial balance rule established by the
Missouri Compromise of 1820 (Weingast, 1994). Another approach identifies
institutions that allow bureaucrats to make their policy choices last beyond their
own tenures (Moe, 1989).
Complexity and Cognitive Science
A few recent papers have focused on the relationship between the institutional
environment and cognitive processes in forming a framework for decision
making under uncertainty (Denzau and North, 1994; Clark, 1997). Denzau and
North (1994) argue that ideology, along with institutions, helps agents cope
with complex decisions. They define ideology as a shared set of mental models
possessed by groups of individuals. These mental models are the internal
representations that individual cognitive systems create to interpret the
environment; institutions are the external (to the mind) mechanisms
individuals create to structure and order the environment (Denzau and North,
1994, p. 4). Together, ideology and institutions form a framework for economic
activity under conditions of uncertainty. If social learning is path-dependent,
as they maintain, then economic development will be gradual and uneven. This
may explain why some economies continue to perform poorly for long periods.
0530 New Institutional Economics 463
3. Institutional Arrangements and the Theory of the Firm
These rules and customs that make up the institutional environment are
primarily economy-side phenomena. Another aspect of the new institutional
economics focuses on agreements made by specific individuals to govern their
own relationships. Such institutional arrangements - what Williamson (1996b,
p. 5) calls the institutions of governance - include contracts and organizations
and in particular, the business firm. The study of governance is more prosaic
than the study of the institutional environment. Mundane questions of whether
to make or buy a component to be used in the manufacture of an automobile or
whether to expand the hospital into outpatient and home health services are
ones that arise at the level of governance. By contrast, composite economic
growth and income distribution are more apt to be the objects of interest in an
inquiry into the institutional environment (Williamson, 1996b, p. 5). However,
the study of governance - in particular, the theory of the firm - is arguably more
developed than the study of the institutional environment.
Coase once described his 1937 paper on the firm as much cited and little
used (Coase, 1972, p. 56). Today, the theory of the firm is one of the
fastest-growing areas in applied microeconomics. For overviews of the modern
theory of the firm, see Holmstrm and Tirole (1989), Milgrom and Roberts
(1992), Radner (1992), Holmstrm and Milgrom (1994), Hart (1995) and
Buckley and Michie (1996). For critiques and alternative perspectives see
Langlois and Robertson (1995) and Foss (1997).
The Conventional Theory of The Firm
What economists usually mean by the theory of the firm is the theory of
production, not the theory of the firm as a legal entity. In economics textbooks,
the firm is a production function or production possibilities set, a black box
that transforms inputs into outputs. Given technology, input prices and a
demand schedule, the firm maximizes money profits subject to the constraint
that its production plans must be technologically feasible. The firm is modeled
as a single actor, facing a series of straightforward decisions: what level of
output to produce, how much of each factor to hire, and so on. Similarly, the
firms size and product range are usually explained in terms of production
costs: economies of scale imply larger firms, while economies of scope justify
the multiproduct firm (Spulber, 1989, pp. 113-20).
The conventional theory has proved highly useful for understanding pricing
and output decisions and how these vary with competitive conditions. It also
has the appeal of analytical tractability along with its elegant parallel to
neoclassical consumer theory (profit maximization is like utility maximization,
isoquants are indifference curves, and so on). However, the production-function
approach provides little insight into the boundaries of the firm. For example,
cost subadditivity (as reflected in economies of scale and scope) implies that
certain quantities of output can be produced more efficiently when they are
464 New Institutional Economics 0530
produced together. Yet this does not explain why the joint production must take
place in a single firm; absent transactional difficulties, two independent firms
could simply contract to share the same plant or facility and jointly produce the
efficient level of output (Teece, 1980, 1982). Whether the firms will integrate
thus depends on the cost of writing and enforcing contracts, not only on the
underlying productive technology.
The black-box model is really a theory about a plant or production process,
not a firm. Textbook treatments frequently blur the distinction between firm
and plant (for a welcome exception, see Sharkey, 1982, pp. 73-83), but the two
are quite distinct. A single firm can own and operate multiple production
processes, just as two or more firms can contract to operate jointly a single
production process (as in a research joint venture). For this reason, the
production-function approach cannot fully explain such real-world business
practices as vertical and lateral integration, acquisitions, geographic and
product-line diversification, franchising, long-term commercial contracting,
transfer pricing and joint ventures, nor is it an adequate guide for antitrust and
regulatory policy. Instead, the new institutional economics sees the firm as a set
of arrangements - as an organization - itself worthy of economic analysis.
Coase and Transaction Costs
The new institutional approach to the firm is usually traced to Coases
celebrated 1937 paper on The Nature of the Firm. Coase was the first to
explain that the boundaries of the organization depend not only on the
productive technology, but on the costs of transacting business. In the Coasian
framework, as developed and expanded by Williamson (1975, 1985, 1996b),
Klein, Crawford and Alchian (1978), Grossman and Hart (1986) and Hart and
Moore (1990), the decision to organize transactions within the firm as opposed
to on the open market - the make or buy decision - depends on the relative
costs of internal and external exchange. The market mechanism entails certain
costs: discovering the relevant prices, negotiating and enforcing contracts, and
so on. Within the firm, the entrepreneur can reduce these transaction costs by
coordinating these activities himself. However, internal organization brings
another kind of transaction costs, namely problems of information flows,
incentives, monitoring and performance evaluation. More generally, all feasible
modes of economic organization incur costs. The nature of the firm, then, is
determined by the relative costs of organizing transactions under alternative
institutional arrangements.
This transformation of economists thinking about the firm is nicely
summarized by Roe (1994, p. vii):
Economic theory once treated the firm as a collection of machinery, technology,
inventory, workers and capital. Dump these inputs into a black box, stir them up and
one got outputs of products and profits. Today, theory sees the firm as more, as a
management structure. The firm succeeds if managers can successfully coordinate
0530 New Institutional Economics 465
the firms activities; it fails if managers cannot effectively coordinate and match
people and inputs to current technologies and markets. At the very top of the firm
are the relationships among the firms shareholders, its directors and its senior
managers. If those relationships are dysfunctional, the firm is more likely to
stumble.
With this new orientation, economic theory is playing an increasingly
visible role in finance, accounting, management and other areas once thought
to be beyond the purview of economics.
4. Moral Hazard and Agency
The modern theory of the firm comprises several approaches. The moral-hazard
or agency-theoretic approach begins with Berle and Meanss (1932)
identification of the separation of ownership and control in the large firm.
The modern corporation, they claimed, is run not by owners (shareholders), but
by salaried managers, whose goals often differ from those of the owners.
Managers may use their discretion to shirk or otherwise pursue personal
objectives (firm growth, personal power, entrenchment, perquisites) at the
expense of shareholder value.
The Berle-Means account omits the possibility that competition might
impose discipline on shirking managers. Product-market competition,
competition in the internal market for managers (Fama, 1980) and competition
in the market for corporate control (Manne, 1965) all place limits on
managerial discretion. Still, their basic model of conflict between shareholders
and managers - what we would now call a principal-agent problem - remains
a powerful lens for viewing the internal organization of the firm. Agency
theory, as developed by Jensen and Meckling (1976), Fama (1980), Fama and
Jensen (1983) and Jensen (1986), has become the standard language of
corporate finance.
Agency theory studies the design of ex-ante incentive-compatible
mechanisms to reduce agency costs in the face of potential moral hazard
(malfeasance) by agents. Agency costs are defined by Jensen and Meckling
(1976, p. 308) as the sum of (1) the monitoring expenditures of the principal,
(2) the bonding expenditures by the agent and (3) the residual loss. The
residual loss represents the potential gains from trade not realized because
principals cannot provide perfect incentives for agents when the agents actions
are unobservable. In a typical agency model, a principal assigns an agent to do
some task (producing output, for instance), but has only an imperfect signal of
the agents performance (for example, effort). The agency problem resembles
the signal-extraction problem popularized in macroeconomics by Lucas (1972):
how much of the observable outcome (output) is due to the agents effort and
how much is due to factors beyond the agents control? The optimal incentive
contract balances the principals desire to give the agent incentives to increase
effort (for example, by basing compensation on the outcome) with the agents
466 New Institutional Economics 0530
desire to be insured from the fluctuations in compensation that come from these
factors beyond his control.
In the agency literature, the firm itself is not the subject of attention.
According to Alchian and Demsetz (1972) and Jensen and Meckling (1976),
the firm is simply a convenient label for the collection of contracts between
owners and managers, managers and employees and the firm and its customers
and suppliers. The firm is a nexus of a set of contracting relationships. ... The
firm is a legal fiction which serves as a focus for a complete process in which
the conflicting objectives of individuals ... are brought into equilibrium within
a framework of contractual relations (Jensen and Meckling, 1976, pp.
311-12).
The question of interest is thus the degree to which various contracts can
mitigate these conflicts; the boundary of the firm is a secondary issue.
5. Transaction Cost Economics
Transaction cost economics (TCE) represents another approach to studying
institutional arrangements. Here, the emphasis is on governing transactions.
TCE holds that all but the simplest transactions require some kind of
mechanism - what Williamson (1985) calls a governance structure - to protect
the transacting parties from various hazards associated with exchange. The
appropriate governance structure depends on the characteristics of the
transaction, so TCE implies an applied research program of comparative
contractual analysis: how do different forms of governance work in various
circumstances? For this reason, TCE (associated mainly with Williamson) is
sometimes described as the governance branch of the NIE, as opposed to the
measurement branch (associated with Alchian and Demsetz, 1972).
The governance approach is distinguished by its emphasis on incomplete
contracts. In the transaction cost framework, economic organization imposes
costs because complex contracts are usually incomplete. A complete contract
specifies a course of action, a decision, or terms of trade contingent on every
possible future state of affairs. In the textbook model of competitive general
equilibrium, all contracts are assumed to be complete. The future is not known
with certainty, but the probability distributions of all possible future events are
known (what Knight, 1921, would call risk rather than uncertainty). In an
important sense, the model is timeless: all relevant future contingencies are
considered in the ex ante contracting stage, so there are no decisions to be made
- no actions to be taken at all, really - as the future plays itself out.
TCE relaxes this assumption and holds that all complex contracts are
unavoidably incomplete. In a world of true uncertainty, the future holds
genuine surprises and this limits the available contracting options. In simple
transactions - for instance, procuring an off-the-shelf component - uncertainty
may be relatively unimportant and spot-market contracting works well. For
more complex transactions, such as the purchase and installation of specialized
0530 New Institutional Economics 467
equipment, a more sophisticated contract is needed. However, such a contract
will typically be incomplete - it will provide remedies for only some possible
future contingencies. One example is a relational contract, an agreement that
describes shared goals and a set of general principles that govern the
relationship (Goldberg, 1980). Another is an implicit contract - an agreement
that while unstated, is assumed to be understood by all sides.
Williamson attributes contractual incompleteness to cognitive limits or
bounded rationality, following Simons (1961, p. xxiv) interpretation of
human action as intendedly rational, but only limitedly so. Other NIE
economists are more agnostic, assuming only that some quantities or outcomes
are unobservable (or not verifiable to third parties, such as the courts), in which
case contracts cannot be made contingent on these variables or outcomes.
Specific Investments and the Holdup Problem
Contractual incompleteness exposes the contracting parties to certain risks.
Primarily, if circumstances change unexpectedly, the original governing
agreement may no longer be effective. The need to adapt to unforeseen
contingencies constitutes an additional cost of contracting; failure to adapt
imposes what Williamson (1991a) calls maladaptation costs. The
most-often-discussed example of maladaptation is the holdup problem
associated with relationship-specific investments. Investment in such assets
exposes agents to a potential hazard: If circumstances change, their trading
partners may try to expropriate the rents accruing to the specific assets.
Suppose an upstream supplier tailors its equipment for a particular customer.
After the equipment is in place, the customer may demand a lower price,
knowing that the salvage value of the specialized equipment is lower than the
net payment it offers. This creates an underinvestment problem: Anticipating
the customers behavior, the supplier will be unwilling to install the custom
machinery without protection for such a contingency, even if the specialized
technology would make the relationship more profitable for both sides.
One way to safeguard rents accruing to specific assets is vertical (or lateral)
integration, where a merger eliminates any adversarial interests. Less extreme
options include long-term contracts (Joskow, 1985, 1987, 1988, 1990), partial
ownership agreements (Pisano, Russo and Teece, 1988; Pisano, 1990), or
agreements for both parties to invest in offsetting relationship-specific
investments (Heide and John, 1988). Overall, several governance structures
may be employed. TCE holds that parties tend to choose the governance
structure that best controls the underinvestment problem, given the particulars
of the relationship.
The holdup problem is the best-known example of a contractual hazard.
More generally, contractual difficulties can arise from several sources: (1)
bilateral dependence; (2) weak property rights; (3) measurement difficulties
and/or oversearching; (4) intertemporal issues that can take the form of
disequilibrium contracting, real-time responsiveness, long latency and strategic
468 New Institutional Economics 0530
abuse; and (5) weaknesses in the institutional environment (Williamson,
1996b, p. 14). Each of these has the potential to impose maladaptation costs.
Foreseeing this possibility, agents seek to reduce the potential costs of
maladaptation by matching the appropriate governance structure with the
particular characteristics of the transaction.
In this way, TCE may be considered the study of alternative institutions of
governance. Its working hypothesis, as expressed by Williamson (1991c, p. 79),
is that economic organization is mainly an effort to align transactions, which
differ in their attributes, with governance structures, which differ in their costs
and competencies, in a discriminating (mainly, transaction cost economizing)
way. Simply put, TCE tries to explain how trading partners choose, from the
set of feasible institutional alternatives, the arrangement that protects their
relationship-specific investments at the least cost.
Institutions as Governance Structures
Transactions differ in several ways: the degree to which relationship-specific
assets are involved, the amount of uncertainty about the future and about other
parties actions, the complexity of the trading arrangement and the frequency
with which the transaction occurs. Each matters for the preferred institution of
governance, although the first - asset specificity - is particularly important.
Williamson (1985, p. 55) defines asset specificity as durable investments that
are undertaken in support of particular transactions, the opportunity cost of
which investments is much lower in best alternative uses or by alternative users
should the original transaction be prematurely terminated. This could describe
a variety of relationship-specific investments, including both specialized
physical and human capital, along with intangibles such as R&D and
firm-specific knowledge or capabilities.
Governance structures can be described along a spectrum, with market
and hierarchy at the poles. At one end lies the pure anonymous spot market,
which suffices for simple transactions such as basic commodity sales. Market
prices provide powerful incentives for exploiting profit opportunities and
market participants are quick to adapt to changing circumstances as
information is revealed through prices. When relationship-specific assets are
at stake, however and when product or input markets are thin, bilateral
coordination of investment decisions may be desirable and combined ownership
of these assets may be efficient. At the other end of the spectrum from the
simple, anonymous spot market thus lies the fully integrated firm, where
trading parties are under unified ownership and control. TCE posits that such
hierarchies offer greater protection for specific investments and provide
relatively efficient mechanisms for responding to change where coordinated
adaptation is necessary. Compared with decentralized structures, however,
hierarchies provide managers with weaker incentives to maximize profits and
normally incur additional bureaucratic costs. Between the two poles of market
and hierarchy are a variety of hybrid modes, such as complex contracts and
partial ownership arrangements. The movement from market to hierarchy thus
0530 New Institutional Economics 469
entails a tradeoff between the high-powered incentives and adaptive properties
of the market and the safeguards and central coordinating properties of the
firm.
The general theoretical framework of TCE is now sufficiently accepted to
have been incorporated in several textbook treatments (Kreps, 1990, pp.
744-90; Rubin, 1990; Milgrom and Roberts, 1992; Acs and Gerlowski, 1996;
and Besanko, Dranove and Shanley, 1990).
6. Capabilities and the Core Competence of the Firm
An alternative approach to explaining institutional arrangements focuses on the
core competence or capabilities of the firm. The capabilities view, which
traces its roots to Alfred Marshall and Joseph Schumpeter, was first stated
explicitly by Edith Penrose in her Theory of the Growth of the Firm (1959). It
has been developed further by Teece (1980, 1982) and by Nelson and Winter
in their Evolutionary Theory of Economic Change (1982). The capabilities
view regards the firm not as a nexus of contracts (as in Alchian and Demsetz,
1972), or as a set of residual control rights (as in Grossman and Hart, 1986),
but as a stock of knowledge. The firms capabilities depend on the tacit
knowledge it contains, as manifested in organizational memory or routines.
This knowledge is considered technologically inseparable; it is firm-specific,
not transaction-specific and thus helps determine the boundary of the firm
(Chandler, 1992). In this sense, firms exist because they are superior
institutional arrangements for accumulating specialized productive knowledge,
quite independently of considerations of opportunism, incentive alignment and
the like (Foss, 1996, p. 2).
In the field of strategic management, organizational capabilities have been
examined from within the resource-based view of the firm. In the
resource-based view, competitive advantage comes from having unique factors
of production, resources that are not easily imitable or transferable (and thus
cannot be purchased in factor markets). Excess profits or supranormal returns
are seen as rents accruing to these unique resources (Rumelt, 1984; Wernerfelt,
1984). Firm-specific resources may include organizational capabilities,
managerial skill, technological innovation and reputational capital. When firms
have excess capacity in these unique factors, they expand and diversify into
product lines whose manufacture employs similar capabilities or routines. The
resource-based view is thus concerned as much about economic change, or
evolution, as it is about the design and use of optimal contracts. For this
reason, the capabilities approach is often associated with the evolutionary
theory of the firm. (See Langlois and Robertson, 1995, for an overview.)
The capabilities perspective is intriguing and offers many useful insights
into firm organization and behavior. However, research in this area often
proceeds at a very high level of abstraction. While there have been several
applied studies (Kogut and Chang, 1991; Langlois and Robertson, 1989;
470 New Institutional Economics 0530
Langlois, 1992a, 1992b; Teece et al., 1994; Argyres, 1996) further empirical
work is needed to develop the economics of firm capabilities.
7. Evidence on Contracts, Organizations and Institutions
The same criticism has been leveled at the theory of the firm more generally.
Simon (1991, p. 27), for example, has charged the new institutional economics
and transaction cost economics in particular, with lacking sufficient empirical
support. Until the relevant empirical studies have been done, he says, the new
institutional economics and related approaches are acts of faith, or perhaps of
piety. However, much empirical work has already been carried out. (Shelanski
and Klein, 1995, provide a comprehensive survey; Masten, 1996, collects many
of the important articles.) On balance, a remarkable amount of this empirical
work is consistent with TCE - much more so, perhaps, than is the case with
most of industrial organization (Joskow, 1991, p. 81). As Williamson (1996a,
p. 55) puts it: TCE is an empirical success story.
Much of the empirical research in TCE follows the same basic model. The
efficient form of organization for a given economic relationship - and,
therefore, the likelihood of observing a particular organizational form or
governance structure - is a function of certain properties of the underlying
transaction or transactions: asset specificity, uncertainty, complexity and
frequency. Organizational form is the dependent variable, while asset
specificity, uncertainty, complexity and frequency are independent variables.
Specifically, the probability of observing a more integrated governance
structure depends positively on the amount or value of the relationship-specific
assets involved and, for significant levels of asset specificity, on the degree of
uncertainty about the future of the relationship, on the complexity of the
transaction and on the frequency of trade.
Empirical work in TCE implicitly assumes that market forces work to cause
an efficient sort between transactions and governance structures, so that
exchange relationships observed in practice can be explained in terms of
transaction cost economizing. Williamson (1988, p. 174) acknowledges this,
while recognizing that the process of transaction cost economizing is not
automatic:
The [transaction cost] argument relies in a general, background way on the efficacy
of competition to perform a sort between more and less efficient modes and to shift
resources in favor of the former. This seems plausible, especially if the relevant
outcomes are those that appear over intervals of five and ten years rather than in the
very near term. This intuition would nevertheless benefit from a more fully
developed theory of the selection process. Transaction cost arguments are thus open
to some of the same objections that evolutionary economists [for example, Nelson
and Winter] have made of orthodoxy.
0530 New Institutional Economics 471
Still, he maintains that the efficiency presumption is reasonable, offering
the argument - analogous to Friedmans famous (1953) statement on the
selection process - that inefficient governance arrangements will tend to be
discovered and undone. Concerning vertical integration, for example,
Williamson (1985, pp. 119-20) writes that backward integration that lacks a
transaction cost rationale or serves no strategic purposes will presumably be
recognized and will be undone, adding that mistakes will be corrected more
quickly if the firm is confronted with an active rivalry. Silverman, Nickerson
and Freeman (1997) have shown that transaction cost efficiency is positively
correlated with firm survival in the for-hire trucking industry, though evidence
from other industries is scant.
Despite such concerns, most empirical literature inspired by TCE takes as
given an economizing framework, assuming that we can draw inferences about
the efficiency of organizational forms by observing what organizations actually
do. Unlike earlier traditions in industrial organization, which presumed that
complex contracts and similar deviations from perfect competition are usually
attempts to gain monopoly power, TCE follows the common-law presumption
that such contracts serve affirmative economic purposes (Williamson, 1985,
p. 200). Furthermore, such contracts are objectionable only if some feasible
alternative exists (Coase, 1964).
Organizational form is often modeled as a binary variable - make or buy,
for example - though it can sometimes be represented by a continuous variable.
Of the independent variables, asset specificity is the most difficult to measure.
Williamson (1991a) distinguishes among six types of asset specificity. The first
is site specificity, in which parties are in a cheek-by-jowl relationship to
reduce transportation and inventory costs and assets are highly immobile. The
second, physical asset specificity, refers to relationship-specific equipment and
machinery. The third is human asset specificity, describing transaction-specific
knowledge or human capital, achieved through specialized training or
learning-by-doing. The fourth is brand-name capital, reflected in intangible
assets reflected in consumer perceptions. The fifth is dedicated assets,
referring to substantial, general-purpose investments that would not have been
made outside a particular transaction, the commitment of which is necessary
to serve a large customer. The sixth is temporal specificity, describing assets
which must be used in a particular sequence.
Among the common empirical proxies for asset specificity are component
complexity, qualitatively coded from survey data, as a proxy for physical asset
specificity (Masten, 1984); worker-specific knowledge, again coded from
survey data, as a proxy for human asset specificity (Monteverde and Teece,
1982); physical proximity of contracting firms, as a proxy for site specificity
(Joskow, 1985, 1987, 1988, 1990; Spiller, 1985); and R&D expenditure, as a
proxy for physical asset specificity. Other proxies, such as fixed costs or capital
intensity, have more obvious limitations and are rarely used.
472 New Institutional Economics 0530
Vertical Integration
Vertical integration, or the make-or-buy decision, was the first topic studied
extensively within the TCE framework. Traditionally, economists viewed
vertical integration as an attempt to earn monopoly rents by gaining control of
input markets or distribution channels. But in the early 1980s a few authors
began to investigate transaction-cost (that is, efficiency) rationales for vertical
integration. Monteverde and Teece (1982) made one of the first systematic
efforts to test a contractual interpretation of vertical integration. They examined
the effects of asset specificity, defined as worker-specific knowledge or
applications engineering effort, on the decision to produce components
in-house or to obtain them from outside suppliers. They found applications
engineering effort to be a statistically significant determinant of backwards
integration. The results are consistent with case-study evidence from
Globerman (1980) on firm-specific technical knowledge and integration in the
Canadian telecommunications industry. Globerman studied evidence from
public hearings and found a tendency toward common ownership of telephone
lines and equipment as the research and development demands of a carrier on
its equipment suppliers become more complex and uncertain and require more
relationship-specific investments.
Other studies of component procurement have found similar support for
transactional explanations of vertical relationships. Two studies by Walker and
Weber (1984, 1987) focus on uncertainty as a determinant of vertical
integration in the auto industry. Like Monteverde and Teece, they worked with
a list of automobile components, coded as made or bought, as the dependent
variable. They found that greater uncertainty about production volume raises
the probability that a component is made in-house, but that technological
uncertainty, measured as the frequency of changes in product specification and
the probability of technological improvements, has little effect. Their second
(1987) study included measures of market competition, testing the interactive
effects of both uncertainty in production and competition among suppliers and
added the qualification that volume uncertainty matters only when supply
markets are thin.
In a further refinement, Masten, Meehan and Snyder (1989) distinguished
among types of specific assets, comparing the relative importance of
relationship-specific human and physical capital. They also studied automobile
component production, finding that engineering effort, as a proxy for human
asset specificity, appears to affect the integration decision more than physical
or site specificity. Klein (1988), in a discussion of the G.M.-Fisher Body case,
also suggests that specific human capital in the form of technical knowledge
was a major determinant of G.M.s decision to buy out Fisher.
The relationship between G.M. and Fisher Body in the 1920s is a frequently
discussed application of TCE. Both Klein, Crawford and Alchian (1978) and
Williamson (1985, pp. 114-15) explain G.M.s buyout of Fisher in terms of the
specific physical assets that accompanied the switch from wooden- to
0530 New Institutional Economics 473
metal-bodied cars. The account in Klein (1988) is somewhat different,
emphasizing specific human capital. Langlois and Robertson (1989) also
criticize the earlier TCE account of the G.M.-Fisher relationship, arguing that
systemic uncertainty, rather than asset specificity, accounts for the failure of
long-term contracting there. Helper, MacDuffie and Sabel (1997) propose
another alternative: G.M. acquired Fisher to promote collaborative learning,
not to avoid hold-up. Obviously, this case continues to stimulate interest.
Other studies have documented a similar link between integration and
R&D, which usually involves specific human capital (Armour and Teece, 1980;
Joskow, 1985; Pisano, 1990). Site specificity, dedicated assets and the need for
specifically tailored products or production facilities have been shown to
increase vertical integration in a variety of industries, including electricity
generation (Joskow, 1985), aerospace (Masten, 1984), aluminum (Stuckey,
1983; Hennart, 1988), forestry (Globerman and Schwindt, 1986), chemicals
(Lieberman, 1991) and offshore oil gathering (Hallwood, 1991).
These papers are case studies of particular industries or production
processes. As such, they avoid the problem of inconsistent measurement across
industries, but have measurement difficulties of their own. The classification
of dichotomous variables like make-or-buy, for example, is typically based on
survey data, requiring more discretion by the researcher than economists are
comfortable with. Nonetheless, most of the empirical work in TCE on vertical
integration has been of this type. While generalizing the results is of course
difficult, the cumulative evidence from different studies and industries is quite
consistent with the basic theory. Also, there do exist some cross-sectional
studies on transactional determinants of vertical integration using
multi-industry data and most have been supportive (Levy, 1985; MacMillan,
Hambrick and Pennings, 1986).
Long-term Contracts and Hybrid Forms
Long-term contracts can be interpreted as intermediate or hybrid forms of
organization, neither market nor hierarchy. A series of papers by Joskow (1985,
1987, 1988, 1990) investigates the effects of asset specificity on contract
duration and price adjustment in agreements between coal suppliers and
coal-burning electrical plants. He examined a large sample of coal contracts
and found that contracts tended to be longer, all else equal, when
relationship-specific investments (here, site specificity and dedicated assets) are
at stake. Crocker and Masten (1988) found the same result for the natural gas
industry. More generally, they argue that efficient contract duration depends on
the costs of contracting; contract terms become shorter, for example, as
uncertainty increases. Goldberg and Erickson (1987) analysed contracts for
petroleum coke and concluded that many provisions of the contracts can best
be interpreted as efforts by the parties to protect themselves against
expropriation of specialized investments. Other relevant studies on natural gas
contracts have been done by Crocker and Masten (1991) and Hubbard and
Weiner (1991).
474 New Institutional Economics 0530
DeCanio and Frech (1993) tried to measure more precisely the efficiency
gains from long-term contracts in natural gas. Relationship-specific
investments are critical for transactions between wellhead owners and
pipelines. For that reason, take-or-pay contracts, in which the buyer must pay
for some minimum quantity even if delivery is not taken, are often used to
safeguard against buyer (pipeline) opportunism. In 1987, the Federal Energy
Regulatory Commission (FERC) outlawed take-or-pay contracts. The authors
used data from before and after the FERC order to test its effect on spot gas
prices and prices at the wellhead. They found that FERCs interference with
parties ability to craft long-term governance mechanisms raised natural gas
prices between 21 percent and 31 percent in the year following FERCs order.
The results support TCE explanations for the relative efficiency of long-term
contracts where asset specificity is required, while representing an effort to
quantify that efficiency gain. (Mulherin, 1986, and Masten and Crocker, 1985,
also examine take-or-pay contracts.)
Another hybrid form of organization is a partial ownership agreement or
equity linkage. Pisano (1990) asks why firms may rely on equity linkages
instead of contracts to support certain transactions. He argues that partial
ownership will dominate contractual governance when a relationship involves
uncertainty, transaction-specific capital and other variables. He hypothesizes
that equity linkages are more likely when R&D is to be done during
collaboration and when collaboration encompasses multiple projects and less
likely when there are more potential collaborators. His study of collaborative
arrangements in the biotechnology industry supported all these claims. Pisano,
Russo and Teece (1988) applied a similar analysis to the telecommunications
equipment business and found that the same basic framework can explain the
choice between equity linkages and other forms of cooperative ventures (joint
ventures, consortiums, or other non-equity linkages).
Allen and Lueck (1993) studied cropshare contracts between farmers and
landowners. Such contracts specify sharing rules for both inputs and outputs;
in doing so, they pool enforcement costs by making both the farmer and the
landowner residual claimants. This reduces the farmers incentive to deplete
the capital value of the soil. Allen and Lueck show that optimal sharing rules
will involve either full payment of inputs by farmers or sharing input costs in
proportion to the output-sharing rule. Nee (1992) studied hybrid governance
structures in Chinas transitional economy such as small, family-owned firms
run by peasant entrepreneurs (cadre-entrepreneurs) and collectively owned
enterprises leased to private operators (marketized firms). On hybrids see also
Gallick (1984), Masten and Snyder (1993), Lafontaine and Masten (1995) and
Menard (1996).
Informal Agreements
Like other parts of the new institutional economics, TCE pays special attention
to the importance of private solutions to resolve disputes, in contrast to the
0530 New Institutional Economics 475
older tradition of legal centralism. Several studies have investigated whether
informal trade arrangements, which are not legally enforceable, may also be
motivated by the desire to make exchange more efficient. Important work in
this area has been done by Palay (1984, 1985). In two closely related papers,
Palay studied the role of informal, legally unenforceable agreements between
rail-freight carriers and shippers. He argues that ICC regulation of the industry,
which prohibits vertical integration of carriers and shippers, was geared to
classical contracting (Macneil, 1978) but is inappropriate for transactions
requiring more complex agreements. Shipment of items like automobile parts
and chemicals, for example, requires specially designed rail cars and equipment
that cannot be easily redeployed for other uses. Palay claims that informal
agreements, substituting for combined ownership, would emerge both to
encourage and to protect these relationship-specific investments. Furthermore,
he argues that the underlying characteristics of a transaction predict whether
it will be supported by an informal agreement. Evidence from case studies of
shipper-carrier transactions reveals a pattern of informal agreements highly
consistent with TCE. Equipment tailored for particular users - custom carrier
racks for automobile parts, tank and covered hopper cars for specific volatile
chemicals, and so on - was owned by individual shippers. For more
standardized shipments, these would be owned by rail carriers. The informal
agreements also provided handling procedures for unusual circumstances
related to shipment. The transactions that did not use informal contracting all
involved non-specialized capital such as standard box cars. All of this suggests
the importance of asset specificity for complex contracting.
Two studies of New England fishing industries also examined the role of
transaction costs in determining trade agreements and market structure. Wilson
(1980) conducted an intensive study of the New England fresh-fish market. He
found that underlying the smooth functioning of the market was a system of
mutual dependence created by the particular trade arrangements there;
reputation effects provided an enforcement mechanism. Achesons (1985) study
of the Maine lobster market reached similar conclusions, finding the lobster
market to be characterized by long-term, informal relationships between
fishermen and lobster-pound operators. Fisherman and pound operators
typically crafted agreements to reduce the costs of information and the
possibility of opportunistic use of informational asymmetries. The agreements
were reinforced by reputation considerations and interdependencies arising
from sharing scarce resources, such as market information, boat fuel and bait.
Informal agreements and norms in eighteenth- and nineteenth-century whaling
have been studied similarly by Ellickson (1989) and Gifford (1993).
Finally, in an interesting application of TCE to the context of personal
relationships, Brinig (1990) employed transaction cost reasoning to explain the
sudden increase in the demand for diamond engagement rings in the
mid-1930s. The increase, she argues, can be traced to the abolition in several
states of the breach of promise to marry action around the same time. Before
476 New Institutional Economics 0530
this action was abolished, a broken engagement could trigger a lawsuit, because
a woman in this situation faced considerable loss of reputation. Once the cause
of action was eliminated, however, another arrangement was needed to ensure
the credibility of the marriage commitment. Diamond engagement rings filled
that role. In this way, rings may be seen as a governance structure: They
safeguard the future brides relationship-specific investment - her good
reputation.
Franchise Contracting
Williamsons (1976) case study of the Oakland, California Cable TV (CATV)
franchise was an early empirical study using transactional reasoning.
Responding to the Posner-Demsetz argument that competitive bidding for
monopoly franchises would result in competitive prices, Williamson claimed
that once idiosyncratic investments are in place, what was a large-numbers
bargaining situation during the bidding process is transformed into a bilateral
monopoly. Because of this change, the terms of the original contract may no
longer be suitable. Williamson outlined the difficulties faced by Oakland in the
early 1970s over its CATV franchise. The franchise was awarded to the lowest
bidder in 1970. After the franchise was awarded, however, the construction
process went more slowly than expected, fewer households signed up than
predicted and costs escalated. Consequently, the franchisee requested a
renegotiation of the contract. A complex dual-source agreement was eventually
reached, but this outcome was far different from that specified in the initial
agreement.
Two later studies of CATV have looked for similar problems, with mixed
results. Zupan (1989) examined a series of public cable franchise agreements,
comparing the terms of trade struck during the original franchise agreement
with those prevailing at the time of renewal, after relationship-specific
investments had been made; he found no significant differences in those terms.
Prager (1990), however, found that opportunistic behavior by the franchisee,
as perceived by cable customers, was higher for franchises awarded through
competitive bidding.
Of course, it is not always the franchisee who is opportunistic; the
franchiser may be as well. Grandys (1989) examination of nineteenth-century
railroad regulation in New Jersey found that the railroads in that state were
willing to make large specialized investments only when they were protected
by special corporation charters limiting state action against them. Levy and
Spillers (1994) comparative study of telecommunications regulation in
Argentina, Chile, Jamaica, the Philippines and the UK shows that private
investment is forthcoming only when regulators can commit not to pursue
arbitrary administrative actions. Furthermore, many private franchise contracts
can also be explained through TCE (Norton, 1989; Dnes, 1992).
Besides these contractual phenomena, TCE has been brought to bear on
such diverse topics as labor market contracts and regulation (Barker and
Chapman, 1989), tie-ins and block booking (Kenney and Klein, 1983),
0530 New Institutional Economics 477
international trade and the multinational corporation (Yarbrough and
Yarbrough, 1987; Gatignon and Anderson, 1988; Hennart, 1989; Klein, Frazier
and Roth, 1990), company towns and company stores (Fishback, 1986, 1992),
land tenure agreements (Roumasset and Uy, 1980; Alston and Higgs, 1982;
Alston, Datta and Nugent, 1984; Datta, OHara and Nugent, 1986) and even
indentured prostitution (Ramseyer, 1991). These and other non-standard
contracting practices, when viewed through a transaction cost lens, often turn
out to have efficiency properties, particularly in offering safeguards for specific
investments.
Is the Empirical Evidence Reliable?
The discussion here presents only a sampling of the empirical literature on
contracts, organizations and institutions (see the Appendix to Shelanski and
Klein, 1995, for a more complete list). While the vast majority of these studies
are consistent with transaction cost reasoning, some difficulties remain. Besides
the measurement difficulties discussed above, empirical research on the
institutions of governance is often hampered by confusion about the definitions
of and therefore the empirical proxies for, key variables, especially uncertainty.
Asset specificity has been more successfully treated in the empirical literature;
relationship-specific physical, site and human capital investments have all been
studied, both independently and comparatively. However, further refinement
and analysis need to be done here, particularly concerning measurement.
Proxies such as capital intensity or fixed costs are very imperfect and may not
capture whether the investment has value outside the transaction for which it
was initially made. Another concern is that asset-specificity effects may be
confused with market power. While specific investment may lead to bilateral
monopoly, a small-numbers bargaining situation is not by itself evidence of
relationship-specific investment.
Besides these difficulties of measurement and definition, empirical research
on the institutions of governance is also subject to the problem found in
empirical work generally: alternate hypotheses that could also fit the data are
rarely stated and compared. Usually, the data are found only consistent or
inconsistent with the hypothesis at hand. Undoubtedly, studies that explicitly
compare competing, observationally distinct hypotheses about contractual
relationships are needed, because rival theories commonly posit mutually
exclusive outcomes. One example is Spillers (1985) comparison of
asset-specificity and market-power explanations for vertical mergers,
explanations that have rival predictions about the size of the gains from
mergers under various competitive conditions. Another prototype for such a
project might be MacDonalds (1985) cross-sectional study of vertical
integration, which incorporated elements of both TCE and Stiglers theory of
the vertical life-cycle of the firm (though it did not attempt to distinguish
between them). Poppo and Zenger (1997) compare transaction-cost and
resource-based explanations for the make-or-buy decision, finding greater
empirical support for the former.
478 New Institutional Economics 0530
A more general concern is that most of the empirical studies discussed here
establish correlations, not causal relations, between asset specificity and
internal governance. These studies typically test a reduced-form model where
the probability of observing a more hierarchical form of governance increases
with the degree of relationship-specific investments. Plausibly, if the presence
of such investments reduces the costs of internal organization, then asset
specificity could lead to integration, independent of the holdup problem or
other maladaptation costs (Masten, 1994, p. 10). Masten, Meehan and Snyder
(1991) attempt to distinguish these two effects in the context of human capital.
They find that specific human capital investments appear to reduce internal
governance costs more than they increase market governance costs. Further
studies of this type would be valuable in assessing the implications of the
evidence for the reduced-form version of the basic theory. However, we do not
yet have a general theory of how relationship-specific assets might reduce the
costs of internal organization. By contrast, the underinvestment problem
associated with specific assets and market governance is fairly well understood.
8. Public Policy Implications and Influence
Theoretical and empirical research in the NIE has strong implications for
antitrust, regulation and other aspects of public policy. This is particularly true
for the studies of institutional arrangements discussed in the previous section.
A basic conclusion of transaction cost economics is that vertical mergers, even
when there are no obvious technological synergies, may enhance efficiency by
reducing governance costs. Hence Williamson (1985, p. 19) takes issue with
what he calls the inhospitality tradition in antitrust - namely, that firms
engaged in non-standard business practices like vertical integration, customer
and territorial restrictions, tie-ins, franchising, and so on, must be seeking
monopoly gains. In the ten years between the celebrated Schwinn (1967) and
GTE-Sylvania (1977) cases, Williamson argues, economists began to
incorporate transaction cost considerations into their understanding of vertical
restrictions. This change in the intellectual climate was reflected in the
Supreme Courts reversal in GTE-Sylvania of its earlier position that vertical
restraints are necessarily anticompetitive.
Joskow (1991, pp. 79-80) points out that this change may reflect sensitivity
to claims that vertical integration and restraints need not reduce competition,
rather than to claims that such arrangements provide contractual safeguards.
While the NIE argued that nonstandard business practices may reduce
transaction costs, Chicago-school writers like Posner, Peltzman and Bork were
maintaining that such practices do not necessarily result in reduced
competition. Of course, these arguments are largely complementary. Moreover,
the Chicago position on vertical restraints relies largely (though not explicitly)
on transaction-cost reasoning (Meese, 1997). In this sense, NIE has played an
0530 New Institutional Economics 479
important role in recent changes in antitrust enforcement, even if its
contribution has not always been recognized.
NIE and transaction cost economics in particular, also has direct
implications for many other contracting practices and regulations, though it
does not yet appear to have influenced those areas. Barker and Chapman (1989)
argue, for example, that closed-shop agreements in labor markets may serve to
protect workers job-specific training rather than to exploit a monopoly
position. They attack New Zealands blanket coverage clause, which
effectively prohibits the closed shop, supporting their claims with arguments
based on TCE. Studies of optimal contract design such as Crocker and
Reynoldss (1993) examination of Air Force procurement contracts are also
relevant as a guide to public policy toward government purchases of goods and
services. Other contracts between government agencies and private firms, such
as franchise contracts for the provision of public utilities (like cable TV), can
be evaluated using TCE reasoning. TCE also points out how the potential for
opportunism by the state affects private incentives to make specific investments
(Levy and Spiller, 1994). This is particularly important for economic and
political reform in the former communist countries, where the need to provide
incentives for private investment is paramount.
9. Summary
Speaking of Lionel Robbinss influential Nature and Significance of Economic
Science (1932), Coase (1992, p. 714) remarked that in Robbinss view, an
economist does not interest himself in the internal arrangements within
organizations but only in what happens on the market. Even Coase himself
believed, as late as 1988, that [w]hy firms exist, what determines the number
of firms, what determines what firms do ... are not questions of interest to most
economists (Coase, 1988, p. 5).
Today, this is clearly no longer the case. The preceding survey provides a
brief (and admittedly unbalanced) sketch of the new institutional economics.
The literature in NIE is expanding rapidly and gaining increasing adherents
and influence in economics, political science, law, strategy, sociology, growth
and development, history and other disciplines. It is a highly diverse field and
its many branches are rich in theoretical insight, relevant for policy and
empirically useful.
Acknowledgements
I am grateful to Nicholas Argyres, John Drobak, Richard Langlois, Jackson
Nickerson, David Robinson and Oliver Williamson for helpful suggestions and
480 New Institutional Economics 0530
clarifications. This paper draws on material in Shelanski and Klein (1995) and
Klein and Shelanski (1996).
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0550
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0560
COMPARATIVE LAW AND ECONOMICS
Ugo A. Mattei, Luisa Antoniolli and Andrea Rossato
Universit Degli Studi di Trento
Copyright 1999 Ugo A. Mattei, Luisa Antoniolli and Andrea Rossato
Abstract
This chapter aims at providing a definition of this rather new subject, which is
situated at the crossroads of two different scholarly traditions, comparative law
and economic analysis of the law. Comparative law and economics combines
the instruments and methodologies of both these two disciplines because in this
way it is possible to better understand the reasons of existing legal rules and
institutions and of their evolution. It uses a dynamic approach to law, by
focusing on the study of phenomena of legal divergence and convergence.
These phenomena may take place within a single legal system, and in this case
the analysis of legal formants (a technique created by comparative law)
provides the analytical tool for verifying the law in action, which may be
hidden behind different formal rules. Interaction may also happen among
different legal systems, and we term this latter phenomenon legal transplant,
which can take place for single rules or institutions or for entire branches of
law, and can be determined by different reasons which range from prestige to
forced imposition. Economic analysis of law provides further analytical tools
that help measure the level and entity of analogy or divergence. Beside the
traditional tools of neoclassical economics, useful insights may be gained
through the instruments of the new institutional economics, particularly
path-dependence, which, through the analysis of the relationship between
formal and informal institutions, and of these with organizations, opens new
lines of interpretation of legal change.
JEL classification: 0560
Keywords: Comparative Law, Law and Economics, Methodology
1. What is Comparative Law and Economics?
Comparative law and law and economics are well-established legal specialties.
The two disciplines may benefit from each other, both having a strong
non-state-centric approach to legal analysis. Specifically, comparative law may
gain theoretical perspective by using the kind of functional analysis employed
in economic analysis of law. Comparative law may proceed a step forward in
its target of measuring and understanding analogies and differences among
505
506 Comparative Law and Economics 0560
alternative legal patterns by using the tools of what is considered by many
scholars the most theoretically advanced social science (Cooter, 1982).
Traditional law and economics is clearly an American product. One of the
first applications of comparative law and economics is therefore the translation
of such a paradigm to different institutional settings, not only the civil law
Mattei and Pardolesi (1991) but also outside of the Western legal tradition
(Bussani and Mattei, 1997).
Several factors attest to the existence of an intellectual environment
favorable to the reception of law and economics outside the USA: the
increasing interest of civilian legal culture for the common law experience and,
particularly, for American law (Cooter and Gordley, 1991). This growing
interest is due to a multiplicity of factors, the most obvious being the
widespread diffusion of the English language which allows access to common
law sources; and the appeal of American universities to younger generations of
scholars; the introduction by means of the mass media of American cultural
models. More generally, it is globalization in the sense of a process of
Americanization of the worldwide legal culture that calls for a less parochial
approach to the economic analysis of the law.
Within such a favorable environment, law and economics not only comes
from the right place but throws in the market of legal ideas all the tremendous
prestige of economics, which many scholars regard as the leading social
science. Nevertheless, European scholars have not been able so far to develop
a European style of law and economics capable of competing in quality with the
American one. American intellectual leadership has been complete. The reason
for this shortcoming is to be detected in the lack of comparative skills. So far
in Europe, the alliance between law and economics on which the very strength
of economic analysis of law is grounded has largely failed, and the economic
approach has been used more by the lawyers than by the economists (Kirchner,
1991; Finsinger, Hoehn and Pototsching, 1991). Moreover, many lawyers using
it are remarkably unaware of the structural nature of their own institutional
setting when approached in a comparative perspective (Kirchner, 1991).
Law and economics can be used to build efficient models, which work as
uniform terms of comparison for the concrete solutions of the legal institutions
analyzed. Such models, although they may introduce unrealistic assumptions
(such as zero transaction costs) should be complex enough as not to be
simplistic, and may eventually allow the proper measurement of the distance
that separates the efficient model from each of the real-world legal system to
which it is compared. In such a way the analysis can be completely factual
(Cooter and Ulen, 1988).
Since economic models may be used to measure the real impact of a given
set of legal signals on the market actors (Prichard, 1988), comparative law and
economics, by comparing the law of alternative legal systems with the
0560 Comparative Law and Economics 507
efficient model offered by economics, conveys the possibility to measure the
core of legal system (Schlesinger, 1969), that is the actual analogy (or
difference) of the signals they convey to market actors, the assumption being
that equal signals will provide similar incentives.
On the other hand, nowadays a strong case is made for the rebirth of legal
process-style comparison of alternative legal institutions (Rubin, 1996, p.
1394; Hart and Sachs, 1994). Comparative law may offer to economic analysis
a reservoir of institutional alternatives not merely theoretical, but actually tested
by legal history (Komesar, 1994; Palmer, 1995). The contribution of
comparative law looks particularly promising to law and economics which,
until recently, has suffered from a severe American-centric provincialism.
Comparative law and economics is a positive discipline which - from the
standpoint of efficiency - deals with the transplants that have been made, why
and how they were made, and the lessons to be learned from this (Watson,
1978b, p. 318). Comparative law and economics, on the other hand, may also
be considered a practical study which - again from the efficiency point of view
- deals with the transplants which are appropriate and how they should and
can be made (Watson, 1978b, p. 319). In the language common among law
and economics scholars, there may be both a positive and a normative version
of comparative law and economics.
1.1 Static and Dynamic Comparative Research
Comparative law presupposes the existence of a plurality of legal rules and
institutions. It studies them in order to establish to what extent they are
identical or different (Sacco, 1991, p. 5).
The comparative analysis of different legal systems shows that there is a
need to distinguish between what can be called the working rule and the legal
justification given for the application of this rule. The analysis of legal
formants, that is the different formative elements of a legal rule, has the aim
to discover how the jurist concerned with the law within a single country
examines all of these elements and then eliminates the complications that arise
from their multiplicity to arrive at one working rule (Sacco, 1991, p. 22, italics
added; Monateri and Sacco, 1998).
Let us consider only two elements involved in a comparative analysis of
legal systems: the working rule, that is the rule applied in a given case
(traditionally known as law in action) and the legal justifications that are
needed in the system to ground the application of this rule. For example: if a
patient has suffered damage because of a wrong cure prescribed by a physician
we will find, for instance in the USA and in Italy, that the latter must pay to the
former a sum of money to restore his loss. But in the USA the judge will find
a breach of a duty of care, whereas in Italy a different judge will find a violation
508 Comparative Law and Economics 0560
of the constitutional right to health, granted by article 32 of the Italian
Constitution. The outcome of the case is similar, but the legal justifications for
it differ.
Comparative law can be approached within two paradigms: the static and
the dynamic analysis. The former is concerned with the comparison of a set of
legal formants in two or more legal systems at a given time: it tries to identify
differences and analogies within the realm of each legal formants and to
understand how each of them contributes in framing the working rule.
Dynamic analysis tries to give account of the mutual interactions between
legal systems in the course of history and mainly focuses on legal change.
Given the aim of this entry we will focus mainly on dynamic analysis. The
possible result of such an approach can be categorized as follows:
(1) convergence: legal systems starting from different points tend to converge
toward similar solutions;
(2) divergence: legal systems moving from similar starting points tend, in the
course of time, to reach different legal solutions.
2. Convergence and its Explanations
In comparative law jargon, convergence is defined as the phenomenon of
similar solutions reached by different legal systems from different points of
departure. Such a convergence may be explained by using both legal transplants
and economic efficiency. The general convergence of modern legal systems,
despite the large variety of institutional backgrounds, could be explained as a
movement towards efficiency. In this case there seem to be a synergy between
the efficient model and the prestigious model. Efficiency may be used to
evaluate legal transplants. The framing of legal rules may be explained as the
outcome of a competitive process. (Mattei, 1997a).
Many different inputs enter what we may call the market of legal culture.
Within this market the suppliers meet the needs of the consumers. This process
of competition would determine the survival of the most efficient legal doctrine
at zero transaction costs. Nevertheless, there are several difficult problems that
we must face in order to prevent this simple model from becoming overly
simplistic. First, we must consider that in the market of legal culture, suppliers
and consumers may be the same. Secondly, the so-called legal tradition, or
worse, legal parochialism, may unduly restrict the market and result in failures.
0560 Comparative Law and Economics 509
2.1 Legal Transplants
Comparative law has reached an important conclusion in its more recent and
sophisticated developments. In most cases, changes in a legal system are due
to legal transplants. The moving of a rule or a system of law from one country
to another has now been shown to be the most fertile source of legal
development since most changes in most systems are the result of borrowing
(Watson, 1974, p. 20). Comparative lawyers have been prolific in amassing
evidence for this somewhat paradoxical conclusion. Each single legal
transplant has its own peculiarities, which make it different from every other.
It can be more or less general; more or less confined to a superficial level of the
legal system (Watson, 1995).
The attempts to explain legal transplants from one system to another have
relied on the largely empty idea of prestige. This shortcoming is due to the
fact that comparativists who have been working on legal transplants are less
interested in a theoretical explanation of why a legal borrowing happens than
in observing its occurrence.
If a transplant happens in a competitive scenario, it is likely that the
transplanted rule or doctrine is more efficient than other possible alternatives.
Conversely, one could argue that if a doctrine enjoys wide success in the
competitive arena of international legal thinking and practice this means that
it is more efficient than its alternatives (Mattei, 1994a, 1995a).
In spite of this, the existence of divergences in different legal systems does
not mean inefficiency. Indeed, if there is a prima facie case for the efficiency
of a legal doctrine on which there is a large agreement within the competitive
market of legal theory and practice (Hirsch, 1981), this does not mean that
there is just one legal rule efficient for each legal problem. Different legal
traditions may develop alternative solutions for the same legal problem which
are neutral from the standpoint of efficiency (Rose-Ackerman, 1995).
In many areas of the law, we may find legal change and eventual
convergence due to a tendency towards efficiency, which has nothing to do with
the so-called prestige of the legal model on which convergence is eventually
reached. In the areas of the law where important efficiency concerns are at
stake, comparative law and economics can play a crucial role in legal
improvement. In its normative dimension it may work as a prestigious support
to non-prestigious legal systems which have already reached the efficient
solution without having the internal strengths to export it. In its positive
dimension it helps to detect these phenomena at work. By using the tools of the
comparativists together with those of lawyers economists we may be able to see
if an institutional arrangement, a legal doctrine, or a legal rule of one legal
system is more or less efficient than another. We may detect and explain the
phenomena of convergence. We may identify those aspects of a given legal
system that stand in the way of the reception of an efficient solution. We may
510 Comparative Law and Economics 0560
be able to foresee long-term efficiency consequences of a given legal
arrangement that are impossible to identify if we do not employ comparative
methods. By using the comparative approach we can even find a workable
answer to the question of what is efficiency. From the point of view of a given
legal system, efficient is whatever avoids waste; whatever makes the legal
system work better by lowering transaction costs; whatever is considered better
by the consumers in the legal marketplace; whatever, in other words, does not
pointlessly foreclose the development of a better organized human society;
whatever legal arrangement they have that we wish to have because by
having it they are better off.
2.2 The Competitive Relationship among Legal Formants
Another explanation of the convergence toward efficiency can be competition
among legal formants.
Competition and equilibrium among market actors may well be the key to
understanding economics (Stigler, 1987). This concept, however, is virtually
unknown to modern lawyers, who presume that the country in which they live
has a monopoly on the production of law. Comparative law strikes a hard blow
to this view by pointing out the degree to which legal issues are not restrained
by national boundaries. Law and economics scholars, who view legal rules as
a system of incentives (or implicit prices) rather than as a set of rules enforced
by the State, also challenge legal positivism. It is in the area of sources of law
that these two non-state-centered approaches seem to better complement one
another. Accordingly, a competitive model can accurately describe the
relationship between the so-called sources of law (Mattei and Pulitini, 1991).
Comparative law and economics considers the law as the product of a
competitive process whose outcome may be determined by structural (that is
institutional and cultural) constraints of decision making (Cooter and Drexl,
1994; Ulen, 1996). Of course, such constraints, and therefore the outcome of
the competition, may well vary from system to system, conferring to different
legal formants different degree of authority.
Two major legal theories have developed in Western jurisprudence, which
provide conflicting paradigms of legal scholarship: naturalism and positivism.
These paradigms, although antithetical, share a common idea, which has
remained unchallenged until quite recently. This idea, reinforced by legal
positivism, may be referred to most simply as the unitary theory of the legal
rule. This theory can be described in terms of a model of hierarchical
co-operation: the legislature drafts laws which are applied by courts to concrete
situations, possibly with the aid of books and articles written by law professors
(Sacco, 1991, 1992b). Of course there may be alternative approaches, as in
common law systems. In such an approach the legal rule may be created (or
derived) by the courts, again with the cooperation of scholars (or of other
0560 Comparative Law and Economics 511
courts precedents) and with the acquiescence of the otherwise powerful
legislature.
Lawyers, therefore, had to establish a hierarchy of sources of law to resolve
conflicts among them. The assumption was that, once ranked, sources of law
would cooperate with each other to provide coherent, unitary legal messages to
the community. The basic assumptions of the unitary theory of the law are still
shared by the majority of lawyers in both civil and common law systems and
are reflected in their terminology and in their disputes.
In recent times, some scholars have developed a theory which, taking into
account the transnational nature of law, criticizes the unitary theory of its
sources. According to this alternative theory, based on a clear distinction
between law and legislation, the legal rule is the result of the interaction of
different components, also referred to as legal formants or formative elements
(Sacco, 1991).
A legal formant is any legal proposition that affects the solution of a legal
problem. For example, rules contained in the writings of legal scholars are legal
formants, as well as rules contained in judicial decisions or statutory provisions.
Also obiter dicta, insofar as they affect the solution of legal problems, may also
be considered legal formants. So, too, can administrative regulations,
constitutional provisions and even broad definitions contained in codes. Legal
propositions that do not contain rules but only definitions or broadly stated
principles are legal formants, too. Legal formants, as sources of law, do not
have to be (as in traditional theory) mutually coherent, even within the
professional groups that elaborate them (scholars, judges, legislators) (Van
Caenegem, 1987). Scholars, judges, and legislators represent producers who
offer their products (different legal rules conceived to regulate a given
relationship) in a more or less competitive market.
Historically, legal systems develop in tremendously complex ways. There
are different sets of legal rules not only addressed to different subjects (for
example a law for merchants and a law for consumers), but also to the same
subject as a result of different transactions (for example administrative agency
in its public law v. its private law capacity). This is the product of rather
independent, and often competing, legal systems coexisting within the same
territory (suffice it to think about arbitration). Legal pluralism is the rule rather
than the exception, even after the rise of the modern State. Similar problems
of complexity are reinforced because of the multinational interaction of
different national legal systems.
Comparative law and economics goes further along this line, addressing
the relationship between different formative elements which make any legal
rule. Competition rather than hierarchy captures this relationship between
sources of authority. Competition is at play either among different legal orders,
as among members of the European Union to devise rules of European law or
512 Comparative Law and Economics 0560
to attract forum shoppers, or between different sources of the law within a given
system (Reich, 1992; Antoniolli, 1995, 1996). Of course, these two main
patterns do not exclude one another. Applied law is the outcome of a
competitive process between legal formants. More generally, law is the
synthesis both of exogenous factors, determined by culture, economic structure,
and political system, and of endogenous elements. The works of the Austrian
school, particularly Hayeks concept of competition with its emphasis on the
working of the competitive process rather than the characteristics of
competitive equilibrium, is appropriate to describe the formation of the legal
rule (Hayek, 1973). From his theory of knowledge, Hayek formulates one of his
more fundamental criticisms of perfect competition: knowledge and
information, rather than being the basis for, are the results of the competitive
process. This reverses the causal relationship assumed by traditional economic
theory.
Considering the sources of law in competition with each other despite the
official hierarchy does not lead us to assume a jurisprudence of hunches due
to the staggering variety of the possible outcomes of the competitive process
and to the impossibility to predict which legal formant will actually win.
Indeed, the result of competition is not less predictable than that of cooperation.
It is only more realistic.
Does competition lead to efficient law? It is tempting to conclude that in
the long run, within a group of cases, a legal trend may be foreseen as a result
of a spontaneous order. It would be even more tempting to say that an
invisible hand leads one efficient rule to triumph over all others.
Unfortunately, the mentioned complexity of legal systems does not allow us to
reach these conclusions (Mattei, 1994a). While in the world of zero transaction
costs such evolution towards efficiency could be expected, this is not the case
in the real world where institutional and cultural constrains introduce high
transaction costs.
2.3 Why Efficiency?
Equity and efficiency are usually perceived as antithetical concepts. An efficient
legal solution may not be equitable and an equitable one may not be efficient.
Many of the arguments used against law and economics sound like this: law
should be concerned with justice and equity; although values may not be
costless for a society, lawyers should not be concerned when their pursuit is
inefficient.
Comparative law and economics allows us rather original insights on the
matter. In using the tools of law and economics together with those of
comparative law, the notion of efficiency assumes itself a comparative meaning.
An institution, rule or state of the world is never efficient or inefficient in an
abstract or absolute way. It may only be so compared with concrete alternatives
that may fit better or worse to a given context. The alternative rules, institutions
0560 Comparative Law and Economics 513
or state of the world may be provided by history, by comparative analysis or by
scholarly creativity. Consequently, the notion of efficiency, as used in
comparative law and economics, maintains a clearly dynamic meaning, strictly
linked with the notion of legal change.
Law is not something that can be understood (as it is usually done in
traditional law and economics) as an aggregate of legal rules. It is a much more
complex phenomenon that can be understood only by considering a variety of
different levels in which a legal proposition appears.
Lawyers are part of the legal system in which they operate in whatever
professional capacity they may act in it. When they describe the law, their
interpretation is part of the law that they are describing. Law has an important
practical dimension. Since the beginning of the Western legal tradition lawyers
have been arguing whether law should be more of a theoretical doctrinal
enterprise or just a practical business. We can trace this debate to the reaction
of the humanists to the bartolists in the fifteenth century (Cannata and
Gambaro, 1989). Indeed, the role of lawyers in the Western world can be
understood in terms of the continuous interplay of these two different
approaches (Berman, 1983). The commitment to doctrine and theory has been
the major source of lawyers legitimacy: they were able to claim they had a
neutral approach to problem-solving. The practical aspect of lawyers work has
made them a powerful and influential corporation of hidden law-givers. Since
law has a practical dimension it requires an approach somewhat different from
that of a purely academic discipline (Gambaro, 1983).
In order to maintain their role in framing legal rules and institutions,
lawyers had to find some reason why their opinions about the rules that govern
society should count more than anybody elses. They had to legitimize their
work. For 900 years, whenever they could not or would not rely on a text, they
played with the philosophical concepts of equity and justice. In using these
concepts, however, they were not worried by or even aware of the many
different theoretical notions of equity and justice framed by legal philosophers.
If equity is traditionally a category of legal argument, the same cannot be
said for efficiency, which has been marketed only recently as an American
product. Seen in terms of the history of ideas, law and economics has grown to
be a powerful approach because the discipline has given some strength to the
claim that legal scholarship is a science. Indeed, the shift from equity to
efficiency brings to the analysis of the law a set of value judgments, which is
claimed to be more widely acceptable and less subjective in nature.
The change of focus proposed by law and economics goes right to the heart
of the legal discourse. Its agenda is as simple as it is revolutionary: rather than
focusing on justice, legal analysis should focus on efficiency. Efficiency should
become the key of legal interpretation (Symposium, 1980). Borrowing from the
expertise of welfare economics, the economic analysis of law puts the legal
514 Comparative Law and Economics 0560
discourse through a number of other gyrations: law should not be analyzed as
a system of coercion, but as a system of incentives or as a system of implicit
pricing. Legal interpretation should not be guided by justice; it should be
guided by efficiency (Cooter, 1989). Consequently, lawyers - as opposed to
legislators-politicians - should not be concerned with dividing the pie as much
as with making it bigger. Their role is not that of helping to cut the slices in a
more just way. Issues of distribution should stay outside of the scholarly
analysis of lawyers. They are the domain of politics.
Justice is a subjective value, while efficiency is objective. Indeed, there
are only a couple of notions of efficiency accepted by the established economic
paradigm (Pareto and Kaldor Hicks) and there are as many notions of justice
as judging individuals. Reduced to the minimum possible level of value
judgment, the efficiency criterion requires lawyers to act in a way that avoids
the waste of resources (Mattei, 1994b).
It is easy to observe that the success of law and economics lies in one
fundamental epistemological assumption that it has borrowed from economic
theory. This assumption is the difference between the world of the is and the
world of the ought, the fact and the value, the positive and the normative levels
of the scholarly discourse (Polinsky, 1989; Posner, 1992).
We should first clarify that the word positivism has a number of different
meanings (Hovenkamp, 1990). Simplifying the sense more common among
lawyers, in which we will use this notion, positivism equates the legal system
to what is positive law (that is, binding law) within a given legal order. In this
sense, it becomes a State-centric approach to the law, and both law and
economics and comparative law can well be considered non-positivistic
approaches. Another meaning - that should not be confused with the former,
although it shares with it some of the same epistemological assumptions - can
be considered fundamental to the very existence of the economic science: in this
meaning positivism refers to the paradigm of research that distinguishes
between the is and the ought.
Economics gives to lawyers, with the distinction between the world of the
is and the world of the ought, the possibility of a two steps interpretation, of a
more detached look to the legal system. The same is true, and often claimed,
of comparative law (Sacco and Gambaro, 1996).
3. Divergence: How to Compare Differences
3.1 The Theory of Property Rights: Rights and Remedies
In order to understand the divergence of legal systems we need some
instruments to compare rules and rights that are expressed in different terms
0560 Comparative Law and Economics 515
in different legal systems. The theory of property rights is usually perceived as
a very useful tool in carrying out this task.
A system of property rights is a method of assigning to particular
individuals the authority to select, for specified goods, any use from an
unprohibited class of uses (Alchian, 1965; Eggertsson, 1990, p. 33).
The literature on the subject usually indicates three categories of property
rights: (1) the right to use, transfer or destroy an asset; (2) the right to contract
over and gain from an asset; (3) the right to transfer it (Eggertsson, 1990, p.
34).
What gives effect to rights and their consequent desirability and value, are
concrete remedial devices (Levmore and Stuntz, 1990). The remedial approach
is therefore recommended by comparative law and economics as potentially
capable of introducing a degree of measurement to comparative law (Mattei,
1987). Moreover, there is now a sense within the comparativists community
that while the form of the law (in the broad sense of the style of the legal
system) is very diversified, its substance may show remarkable phenomena of
convergence, at least among systems belonging to the Western legal tradition
(LoPucki and Triantis, 1994).
Remedies give value to substantive rights. Each individual is therefore
interested in being protected by certain remedies. As only remedies may grant
the feasibility of a certain course of action, they may not be granted
contemporaneously to conflicting self-interested individuals on the same scarce
resource (Levy and Spiller, 1994). One of the two individuals must prevail, and
therefore be entitled to a stronger remedy. Accordingly, legal remedies may be
analyzed as a scarce resource whose value is a function of that of the resource
they permit someone to enjoy.
Different legal systems allocate different bundles of remedies differently
when faced with conflicts over scarce resources. The subjective desirability of
different combinations of remedies allows for a ranking of different property
rights which courts may handle in dealing with externality problems. This
degree is a function of the structure of legal remedies supplied by different legal
systems, and it is by no means constant. Remedies may be combined among
themselves in a large variety of patterns and may be given to protect varying
degrees of right-holders autonomy on the use of different resources (Calabresi
and Melamed, 1972; Kaplow and Shavell, 1996). Each legal system (or legal
tradition) chooses according to its values (and to the structure of its
decisionmakers), which rights are to be valued more and protected as such.
Other interests are valued less, and can be redistributed ex post by the courts.
In every modern legal experience property rights, in their different forms,
carry liabilities with them. Given these liabilities, property rights are not, as a
matter of principle, less socially valuable than regulation. The intellectual
challenge is to construct a theoretical model of property rights able to take into
account this complexity (Mattei, 1997a).
516 Comparative Law and Economics 0560
Injunctions (or equivalent remedies such as ostracism or criminal
sanctions) are always symptoms of the unlawfulness of the course of action
which they enjoin. When there is no injunction, the internalization of the costs
of an action is compatible both with lawfulness and with unlawfulness of the
course of action, which creates the externality. In other words, it is compatible
with any distribution of property rights. Liability rules, on the other hand, are
nothing more then an insurance for the entitled share of social welfare. They
protect an interest, not a right.
3.2 Property Rights, Liability Rules and the Theory of Transactions Costs
By discussing the historical and comparative law roots of the notion of property
rights used in the economic analysis of law (Alchian, 1987), one can examine
what may be regarded as the most important difference between comparative
law and economics and traditional economic analysis of law. While this
approach attempts to account for the different institutional alternatives
presented by real-world legal systems, law and economics elaborates its theories
on institutional backgrounds which are either abstract natural law models, or
which uncritically postulate the modern institutional background of US law
(Ajani and Mattei, 1995; Benson, 1989; Benson, 1995).
Comparative law is essentially a historical branch of scholarship which
seeks to discern both differences and similarities among alternative legal
institutions (Schlesinger, 1988). Its methodology may prove very helpful to law
and economics, since it offers a more global perspective on different legal
structures and on the evolution of these structure which may shed new light on
- and challenge at the same time - certain previously undisputed assumptions
of traditional law and economics. As a result, comparative law and economics
does not conceive the legal system as a static background for economic analysis
able to be captured by a few, never revisited, simplified assumptions. Nor does
it assume that the contingencies of the American legal process are the necessary
substratum for theories concerning the efficiency of law. The legal background
represents a dynamic variable which economic analysis of law must reflect in
both its positive and in its normative dimension.
The natural law conception of property is an intellectual category which
does not exist, and never existed, as law in action in any legal system
(Gambaro, Candian and Pozzo, 1992). Using comparative analysis, it is easy
to show that applied law only knows more complex forms of property rights
based on a mixture of property and liability rules allocated in different ways to
different individuals by different institutional agencies in different legal
systems (conjunctive property rights).
The idea of property rights which serves as the institutional background
for traditional law and economics is that of a bundle of rights that a person has
over certain resources. Included in this notion are the enjoyment and
0560 Comparative Law and Economics 517
transferability of property, and the power to exclude others from it (Demsetz,
1967; Pejovich, 1990). Comparative law and economics questions such
assumptions by showing that, due to a historical paradox, law and economics
is based on a substantive natural law conception of property rights. This
conception, developed by the civil law tradition, was never fully accepted by the
common law, and was eventually abandoned by lawyers across the entire
Western legal tradition.
Law and economics has maintained the natural law misconception of
property. How did this happen? In the cultural milieu of the United States in
the 1960s, scholarship was ripe for the merger between law and economics.
American lawyers, eager again to use broad theoretical categories, decided to
borrow them from economists. Consequently, simplified legal notions that
economists have not rediscussed since Adam Smith found their way into legal
scholarship. Rather than working within a genuine interdisciplinary effort to
develop new legal categories able to reflect the complexity of the institutional
system, law and economics borrowed a number of naturalistic legal models.
Such models are not only simplistic and unrealistic but also foreign to
American common law tradition (Mattei, 1997a)
These assumptions should not be considered necessary components of law
and economics. They are the product of accident in the evolution of a scholarly
tradition and should be analyzed as such. Comparative law shows that the
substantive structure of property rights varies from one legal system to another
and never follow the natural law model. Such unawareness may, however,
prove dangerous. Comparative law and economics develops the Coasian
paradigm by analyzing real-world legal institutions as alternative ways of
allocating unavoidable transaction costs.
The notion of property rights suggested by comparative law and economics
is at once non-naturalistic and non-positivistic. While it breaks with the former
conception, it does not go to the opposite extreme of confining itself within the
narrow and contingent boundaries of a single positivist legal system. Taking
the comparative approach means offering notions that may be used to
understand different patterns of legal organization (Ramseyer, 1989).
Since Coase (1988), we have full knowledge of two alternative models of
institutional control of externalities: the Pigouvian model, based on centralized
regulations, and the Coasian decentralized model, based on the enforcement of
property rights by the courts (Benson, 1991a). Any theory of property rights
must take into account the following central point: in the real world there
cannot exist a system that deals with externalities using a purely decentralized
approach; similarly, there cannot exist a system which deals with externalities
in a totally centralized Pigouvian way. This is the consequence of the
impossibility of the pure market, as well as of the opposite impossibility of the
absence of a market. Property rights and regulation, therefore, serve the same
purpose. Their placement in an antithetical structure, an assumption of lawyers,
economists, and the law and economics movement, is false (Williamson, 1991).
518 Comparative Law and Economics 0560
After Coase, the problem which deserves attention is the allocation of
transaction costs which are part of the real world. This allocation is the key to
understanding the problem of externalities and to elaborate a realistic
conception of property rights. From Coase onward we know that a well-defined
system of property rights will take care of externalities because individuals will
bargain to reach an efficient result. This wonderful achievement of the Coase
theorem has encouraged widespread efforts to use property rights to solve
problems of externalities in a variety of situations (Laffont, 1987). The exercise
of natural law property rights may impose external costs upon others. Restraints
upon these rights are needed to control them. Under the conjunctive conception,
obligations, which are needed to restrain external costs, are part of the very idea
of property. Consequently, controls upon externalities need not be imposed in
opposition to property rights, but may be introduced ex ante in the distribution
of property rights.
4. An Exercise in Comparative Law and Economics: the Distinction
Between Common Law and Civil Law
The lack of comparative understanding within the legal community has created
a two-fold problem for law and economics. American law and economics has
been remarkably parochial, unable to question the presumed need and
immutability of a legal process patterned after the American one. Traditionally,
law and economics contributions tend to presume a court system and, more
generally, a legal process organized on the American style.
In Europe, the same lack of comparative understanding has prevented
committed law and economics scholars from developing original insights
capable of shedding new light on the civilian legal process (Mattei and
Pardolesi, 1991). Many civilian law and economics scholars have uncritically
applied theories which only work in the American scenario to the different
background of their legal systems.
More generally, the widespread legal parochialism on both sides of the
Atlantic has precluded a distinction between institutional arrangements which
are local contingencies incapable of generalization, and deeper levels of legal
analysis that can be used in understanding the law as a general phenomenon of
social organization. The same lack of comparative understanding has,
moreover, fueled the false impression that, because of the structure of the civil
law tradition, law and economics is less useful as a tool of analysis in Europe
than in the United States. The attempt to build models which reflect the
complexities of the real world of the law is exactly what comparative law and
0560 Comparative Law and Economics 519
economics is all about.
The misconception that lawyers introduce into traditional economic
analysis of the law may be called the municipal misconception. This
misconception stems from the other leading paradigm of jurisprudence in
Western law: legal positivism. This is odd, because law and economics may be
considered per se a remarkably anti-positivistic approach. Lawyers, however,
can hardly resist focusing on the legal system they know best (that is, the legal
system in which they operate and where they received their legal education).
Certain basic institutional arrangements of the legal systems are just presumed
to be natural and are never questioned by lawyers trained in that legal system.
Legal positivism equates law with the legal production of the state.
Consequently, in its understanding, law exists only as a function of the
enforcement mechanisms behind it. This approach is rejected by comparative
lawyers who consider a legal problem the same wherever it has to be solved,
and the alternative legal systems as possible variables for its solution. It is,
however, followed more or less consciously by the majority of lawyers across
the legal traditions. Positivism is considered a reaction to natural law. From the
perspective of parochialism, however, they push in the same direction.
It is crucial for comparative law and economics to get rid of both of these
sets of mute assumptions in order to develop its scholarly paradigm. Indeed,
comparative law and economics is neither naturalistic nor positivistic, but
struggles to re-introduce a measure of experimentation into the social sciences
by comparing the different solutions of legal and social problems adopted in
different legal systems. Because of different institutional arrangements and
high transaction costs imposed on legal change by legal tradition, the
fundamental distribution of powers and the way in which institutional roles are
performed in the legal systems cannot be taken for granted either (Damaska,
1986; Shapiro, 1981).
From the comparative law and economics perspective we can see that
transaction costs are introduced not only by alternative substantive rules but by
different procedural arrangements, remedial devices, legal ideologies,
incentives to litigation, and so on; in other words, by all those characteristics,
both cultural and institutional, other than substantive rules, that comparativists
call the style of the legal system (Ramseyer, 1995). Consequently, comparing
transaction costs imposed in the real world by different legal systems introduces
the possibility of a measurement and of a more rigorous comparison than
otherwise possible. A path is hence open to compare operative rules (or as it
was once said, the law in action) rather than mere theoretical descriptions.
Possibly the most fundamental and discussed question in comparative law
is the nature of the distinction between common law and civil law. Certainly
a gap exists between common law and civil law; such a gap should neither be
exaggerated nor underestimated in nature. Comparative law and economics, by
520 Comparative Law and Economics 0560
borrowing its analytical tools from comparative law, accounts for this gap. At
the same time, it borrows from law and economics the tools necessary to bridge
it.
In approaching the question of the gap, a dynamic perspective on
comparative law is needed (Calabresi, 1982). As a result, we will assume that
the dimension of the gap is not fixed, but rather varies in both time and space.
Deep structural differences are not, of course, a differently worded statute or
regulation, or a supposedly different formalistic reasoning of the courts.
Relevant legal process differences include: the way of acquiring information in
the legislative process; the different role of public law; structural regulation of
class actions; the presence or absence of a jury in the fact-finding process; the
completely different system of incentives to sue due to different distribution of
the costs of litigation; and the different ways in which courts acquire
information (Stein, 1984).
From the timing perspective, the comparative law community agrees that
the division between common law and civil law is rooted in the early
development of centralized courts of law in England and of academic legal
training on the Continent (Baker, 1990). There is also general agreement that,
after a peak in the course of the nineteenth century, when the civilian nations
codified national systems of law, the significance of the gap has progressively
declined.
One of the major issues of law and economics concerns the role of the
judge in finding efficient outcomes for legal disputes. Great emphasis is given
to the different role of the judge in the common law vis--vis the civil law
(Eisenberg, 1988; Atiyah, 1987). Consequently, it becomes important to
scrutinize such difference to see whether it introduces a fundamental limit to
the application of law and economics in the civil law.
According to traditional comparative law doctrine, the civil law is mostly
a codified system where the role of bureaucratically recruited judges is to
interpret and apply a written body of statutes (David and Brierley, 1985; von
Mehren and Gordley, 1977). Common law, conversely, consists mostly of case
law where technocratic judges are concerned with finding the applicable rule
within the body of law made up of legal precedents. If such is the picture of the
differences between the two legal traditions, there is no doubt that law and
economics, being mainly concerned with efficient judicial decision making,
seems at odds with civil law systems where judges limit themselves to
mechanically applying the law contained in written codes. If this picture were
correct and the judges role as decision maker in common law and civil law was
so different, indeed allocating them the same decision making powers would
be very unwise from a legal process perspective. The traditional image of a civil
law bureaucratic judge, whose role is not to decide cases in terms of public
policy but of a mere interpreter of the political will contained in a statute (the
code), has been a widespread commonplace of comparative misunderstanding.
0560 Comparative Law and Economics 521
This image is opposed to that of a common law judge as the hero of a
decentralized system of decision making. This contrast is deepened by
arguments about the different value of judicial precedents in the two legal
families. Other differences which are frequently cited include a radically
different role for legal scholarship, which is allegedly much more authoritative
in civil law systems than in common law systems; and the encapsulation of civil
law in comprehensive codes (Monateri, 1986). In each of these statements there
is some truth (Dawson, 1968), of course, but this does not mean that the
consequence of such a background is a radically different legal reasoning which
would foreclose the reception of efficiency reasoning in the civil law (Zweigert
and Ktz, 1987).
In reality, although it may be true that common law judges are more
responsive than their civilian colleagues to policy problems, the aforementioned
description is dramatically misleading (Salzberger, 1993; Ramseyer, 1994b),
being based on a superficial and outdated image of the differences between the
civil law and the common law (Cooter and Ginsburg, 1996). If we consider the
role of case law, we find more convergence between modern civil law and
common law. In practice, courts in civil law countries make law just as much
as courts in common law countries (Gordley, 1994).
5. Comparative Law and Economics and Neo-Institutional Economics
A new fruitful perspective in the study of legal change and legal transplants has
been opened to comparative law and economics by recent developments of
neoinstitutional economics. Particularly, the idea of path-dependence seems to
be a very powerful analytical tool for studying and explaining the evolution of
legal systems, where all innovation, be it endogenous or the result of a
transplant, depends heavily on the existing institutional framework.
Path-dependent systems are those systems that cannot shake off the effects
of past events because small events of a random character, especially those
occurring early on the path, influence the selection of one or another among the
set of stable equilibria. For this reason ex ante predictions of outcomes may not
be possible, and consequently it is difficult to foresee future changes. In this
situation there is a marked distinction between the notion of ex ante efficiency
and ex post efficiency: the final result may not be the most efficient one in a
theoretical world, but it may well be the best achievable in the light of the
existing constraints. In other terms, lock-in phenomena, characterized by
multiple equilibrium processes and dynamic co-ordination games, may yield
Pareto inferior outcomes that tend to be stable (David, 1975). This is a typical
result for decentralized decision situations, where a large number of individual
agents are linked in a social and informational network; therefore, we may use
the term network externalities. In a network context every single decision is
522 Comparative Law and Economics 0560
taken independently, but the collective behavior is the result of interaction
among them. This is also the mechanism at work in the field of social
conventions and institutions, where the common knowledge of recurring
behavioral patterns directs the decisions of every actor, and therefore it arises
expectations on future decisions (Sugden, 1989). The behavioral norm, in its
turn, is the result of a chain of small events, and it may well be globally
inefficient, especially if the system is numerically small.
Path-dependence shows that the spontaneous evolution of social customs
and norms has a great importance in the configuration of historically existing
systems and determines their global efficiency (David, 1988). The presence of
a network of relationships creates positive feedback mechanisms, since every
agent gains by joining a generally shared rule (Arthur, 1988). This mass of a
priori beliefs and mutual expectations helps in achieving non-arbitrary
solutions in a situation characterized by co-ordination problems, since it
channels (in a probabilistic, not deterministic way) behaviors in a predefinite
path; precedent, not only in its legal dimension, is an important instrument for
decision (Heiner, 1986). In these processes, ideologies (in the sense of
commonly shared ideas and values), or mentalit play a very significant role,
and therefore any analysis that aims at explaining a social, legal or economic
model needs to delve into the dynamics of collective opinion-formation.
The environment in which decisions are taken is crucial, in the sense that
it poses constraints and incentives which determine routines of behavior. Those
routines lower transaction costs by making choices repetitive, but they also
shape reactions to new phenomena, which tend therefore to be path-dependent
(Simon, 1986). Ideologies (in the sense of subjective models and theories that
explain the world outside) are an important element of every society, since they
permit social actors to reach decisions under uncertainty conditions
(Hirshleifer, 1987); the bigger the gap between the capacity of choice and the
difficulty of picking up one among several alternatives (that is, the complexity
of the choice to be made), the greater the role of ideologies, which become key
institutions.
Institutions are the rules that govern a society, the ties that define social
relationships among people; they shape all kind of exchanges: legal, political,
social and economic. Institutions, which can be both formal and informal,
reduce uncertainty by defining the range of individual choices, and therefore
they reduce transaction costs. Organizations, on the other hand, are all kinds
of apparatus, legal, political, social, economic, through which people pursue
some kind of shared aims. Organizations work inside a given institutional
framework, but at the same time their action influences in a feedback relation
the way in which institutions evolve. (North, 1990).
The theory of institutions is based on behavior theory and on transaction
costs theory. Transactions costs (Coase, 1960) cover two kinds of costs: those
for evaluating the characteristics of the object of the exchange (information and
0560 Comparative Law and Economics 523
measurement costs) and those for monitoring and ensuring the implementation
of the agreements, that is for protecting rights (implementation costs).
Production costs, which are the key concept of microeconomic theory, are the
sum of transformation costs and transaction costs. The neoclassical model is
modified in order to take into consideration transaction costs, by posing
asymmetrical information (Akerlof, 1970) and exchanges that are not instant;
it therefore requires mechanisms for ensuring complete and correct
implementations of the agreements. Institutions are created in order to limit
those transaction costs by devising rules that dictate behaviors and by creating
incentives and sanctions that render implementation of agreements easier (as
for example the role of property law in determining rights and protecting
them). Institutions, in short, create the structure in which exchanges take place
(North, 1990); the more complex the exchanges (that is the more we move
away from the neoclassical model of perfect markets), the more sophisticated
and diversified the institutional framework that regulates them. For instance,
contracts are generally multidimensional, not instantaneous and incomplete,
with significant measurement costs and implementation costs. In a setting of
close personal relationships there will be strong incentives to stick to deals and
to perform contracts. In more complex and impersonal contexts those bonds
tend to become weaker, and different mechanisms are required to ensure
implementation, since the drive to opportunistic behaviors is stronger. In this
case, the most efficient solution will be to use a third party that controls the
correctness of the behaviors and can intervene with sanctions in case of
transgression; this new institution will decrease transaction costs for the
bargaining parties, but at the same time it will absorb resources for its own
management, thereby creating a new kind of transaction costs. All those feature
are typical of the structure of the State, which produces public goods like legal
rules and bodies for implementing them (judiciary, administrative agencies,
and so on).
Institutional change is the mechanism that explains the history of every
society, therefore in order to understand historical change we need to focus on
institutions (Braudel, 1977). Changes usually happen in an incremental way,
and they can move both in an efficient or an inefficient direction, depending on
the pre-existing institutional setting and on the kind of incentives they create;
the process, therefore, can be defined as path-dependent. The higher transaction
costs and the less complete the available information, the more the outcome of
evolution will tend to be inefficient. The incremental process of institutional
change is attained by marginal adjustments in response to the variation of
relative prices (technology, information costs, input factors, and so on) and/or
preferences, and it ensures the continuity of systems in spite of their continuous
modification. These variations can be determined both by endogenous and
exogenous factors and they may start both from the formal and informal
institutions. A change of the informal ones is a dispersed process, whereas the
524 Comparative Law and Economics 0560
modification of formal institutions requires a specific activity by organizations,
and therefore greater resources. The change of formal rules implies a sequential
adaptation of the informal ties that are related to them, and therefore in the
short run a situation of disequilibrium arises, which is then solved by a new
equilibrium. History also sometimes experiences discontinuous changes as in
the case of revolutions, conquests and calamities, but these are rare events;
however, after a strong break there follows a phase where all institutions,
especially informal ones, adapt to the new situation, thereby restoring, at least
partially, continuity with the pre-existing situation (North, 1990).
Organizations act for the attainment of ends inside an existing
institutional framework, and thereby they promote institutional change; the
institutional structure orients the process of acquiring knowledge and skills,
and this trend is the most important factor of a societys long-term
development. These activities require the capacity to build knowledge and to
transmit it, and knowledge is mutually dependent from ideology since the level
of knowledge determines the conception of the outside world, and this in its
turn influences the direction of scientific research. The firm is the type of
organization that has been most extensively studied by economists; its existence
can be explained by transaction costs: the organization reduces uncertainty in
the decision process, and thereby reduces costs (Coase, 1937). As for the firm,
the rational and maximizing behavior of all kinds of organizations influences
institutional change through the demand of investment for any kind of
knowledge, the continuing interaction between activity, knowledge and
institutional structure, and the gradual modification of informal bonds. In this
dynamic setting, efficiency is not mere allocative efficiency, but rather adaptive
efficiency (Pelikan, 1987), which emphasizes the capability to experiment new
solutions and to adapt to new conditions. In this sense, trial and error processes
performed by a large number of actors in a decentralized structure represent the
most efficient model (Hayek, 1960); once more, there is a strong parallel with
cultural evolution and evolutionary theory (Boyd and Richardson, 1985).
From a theoretical point of view, the use of a path-dependence model in
order to explain legal (economic, social) change places emphasis on causes,
rather than on results, since these latter can be explained only by referring to
the mechanisms that have shaped the dynamic evolution of the system. This
shift of paradigm is new both for lawyers and economists, who have devoted a
large part of their analytical efforts in trying to describe a static situation, more
than tracing its dynamic evolution and the factors that have determined it. In
this sense, path-dependency requires an historical approach, since an accurate
description and explanation can only be given in relation to existing systems,
with all their peculiar characteristics. Empirical research, with a strong
emphasis on timing and circumstances, becomes as important as
model-building. This new perspective has both advantages and drawbacks: it
is certainly better equipped to explain some complex social phenomena, but on
0560 Comparative Law and Economics 525
the other hand the characteristics of these systems and the kind of data that are
required by this type of analysis make it more difficult to build theoretical
models and to make predictions (Crick, 1988). Some efforts in the building of
new models and instruments have already been produced in the field of biology
and other branches that are referred to as sciences of complexity (Stein,
1989). Nevertheless, social scientists, like lawyers and economists, should be
aware that the systems that they study contain volitional agents (that is agents
whose actions reflect intentions based on expectations), and therefore they have
specific characteristics which are absent in biology or other natural phenomena.
Reality shows an enormous variety of systems, and history does not seem
to point to a general trend to evolve towards more efficient solutions. In fact,
many systems with very low returns prove to be extremely resistant, and this
fact seems to contradict the evolutionary hypothesis as applied to institutions
(Alchian, 1950). This enduring inefficiency can be explained by transaction
costs and path-dependence: once an institutional framework has been built, it
affects the possible evolutionary trends; if the kind of incentives it creates are
inefficient, it is very likely that evolution will be inefficient, too (David, 1985).
5.1 Two Examples of Path-dependancy in Law: the HIV Problem and the
Organization of the Legal Profession
The possible use of path-dependence for understanding legal change is
exemplified by the study of legal reactions in the world to the hemophiliacs
with an HIV problem (Mattei, 1997b). This problem struck all legal systems in
the same way, since it has required quick and difficult decisions involving
different areas, like politics, law, culture and technology. The solutions adopted
by several countries (Italy, France, United States, Japan) show that under a
situation of distress all legal systems react with path-dependent solutions, that
is, solutions that are determined by the institutions and organizations that are
already well established. This is also because, by happening simultaneously
everywhere and requiring quick reaction, it could not be expected that solutions
could circulate easily through transplant; in fact, a major difference in legal
transplants runs between those that take place in an incremental and slow way,
due mainly to the prestige of the exported model, and those that are the result
of single instant decisions, as happens after a revolution (for example the
export of Western legal institutions in former Socialist countries) or through
forced imposition (for example in former colonial states).
The technical solution to the hemophiliacs with the HIV problem was
quickly found by introducing heat treatment techniques in the early 1980s, but
the institutional reactions followed different paces and paths. Two sets of
elements have been crucial in shaping the outcomes. The first refers to the
interplay of formal and informal institutions: the more formal institutions are
526 Comparative Law and Economics 0560
at odds with informal ones, the less efficient are the results achieved, since
informal institutions will resist application of rules that contrast with them.
Informal bonds exist in all societies, because they are essential for guaranteeing
order in social relationships. Even if their role is clearer in simple societies, it
remains crucial also in complex developed societies, which have a strong
framework of formal institutions, in the form of moral codes, behavioral norms
and implicit conventions. Those informal rules are diffused and dispersed in
society, and they create what can be generally termed culture, which is the
means of transmission through generations of values that shape behaviors
through teaching and imitation processes. In societies without a state (Sacco
and Gambaro, 1996, pp. 26-27; Sacco, 1996) these kind of ties are very
important and stable, since they shape the relationships of a social group that
is very homogeneous and closely connected by personal bonds (Colson, 1974).
In modern developed societies a general framework of formal institutions is
required to manage complexity, but in smaller and more homogeneous sectors
within it informal rules can still be essential, as for example in the case of rules
of conduct in political parties. The relationship between formal and informal
institutions, which form a complex network, is typical of every society and
every historical epoch, and it is crucial for understanding the patterns of
change; it must be underlined, in any case, that the difference between formal
and informal institutions is a matter of degree, moving along a continuum
(North, 1990). In the short run, culture determines the choices that are made;
in the long run, informal rules may change the institutional framework, and
they may even lead to a change of formal rules. The easiness of this transition
depends on the existing transaction costs: if the costs for propounding values
and ideas are low, they will have a strong push in changing the institutions.
The other element that has influenced the institutional reaction to the HIV
problem concerns the prevailing component of every legal system; broadly
speaking, legal systems may be grouped according to the prevalence of one of
three patterns of law: traditional law, professional law and political law
(Mattei, 1997d). The prevailing pattern will determine the legal reaction in the
short run, creating a process which is path-dependent, because it is determined
by the pre-existing situations. Once more, the time dimension will be crucial,
because the lack of time will make it harder to try and transplant a foreign
solution, making it much more likely that the existing institutions will be used
to perform the new task, as happened in other fields like environmental
pollution, car accidents and illegal immigration. In fact, three out of four
examined systems reacted in a predictable way: the US with the use of tort law
through the judicial system; France and Italy with criminal sanctions and an
administrative compensation system, typical of strongly centralized and
bureaucratic systems. Only Japan reacted in an unpredictable way, by resorting
to tort litigation, instead of the traditional solution of mediation. This outcome
0560 Comparative Law and Economics 527
is due to the strong opposition of hemophiliacs, who wanted the ruling class to
take political responsibility for the HIV problem. The fact that the problem has
turned from legal to political explains a revolutionary, not path-dependent
reaction (Mattei, 1997b).
The importance of the institutional structure of every legal system can also
help to explain the changes undergone by the legal profession in Western
countries, which are not explicable on the basis of the traditional distinction
between common law and civil law (Mattei, 1997c). We may view the legal
profession as an organization that uses the institutional setting to achieve its
ends; in this process it is shaped by existing institutions and in its turn it
influences the evolution of the institutions themselves. The two existing models
of organization for the legal profession are the unitary and the divided bar. As
we have mentioned, the dividing line does not run along the civil law/common
law distinction (Abel and Lewis, 1988): the analysis of some of the worlds
paradigmatic systems (USA, England, France and Germany) shows that there
is a converging trend towards a unified profession since both England and
France, although at a different speed, are moving in that direction, while
Germany and the US have always been using this model (Mattei, 1997c). The
United States are isolated from the rest of the countries in giving strong
incentives to competition and litigation through the use of mechanisms like
aggressive advertising and contingent fees. In European countries, on the other
hand, legal professions do not push in the sense of stimulating the demand for
services, but rather on limiting the supply by rigid control of access to the
profession and on avoiding competition by neighboring professions. The effects
of endogenous pressures, like the introduction of uniform rules by the European
Community, and the push of international competition and the globalization of
markets, may well force relevant changes in the future, but the reactions in the
short run are bound to be path-dependent.
Endnote
Andrea Rossato authored section 1 to 4, Luisa Antoniolli Deflorian section 5.
Ugo Mattei supervised the work and provided most materials.
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0570
EXPERIMENTAL LAW AND ECONOMICS
Richard H. McAdams
Professor of Law, Boston University School of Law
Copyright 1999 Richard H. McAdams
Abstract
This chapter reviews experimental economics research relevant to law and
economics. The introduction includes a brief discussion of experimental
methodology and a survey of the categories of economics experiments relevant
to law and economics, with citations to other reviews and compilations. The
bulk of the chapter reviews two series of economics experiments designed to
test theoretical claims of law and economics: those relating to the Coase
theorem and those relating to pre-trial bargaining and settlement.
JEL classification: C90, C91, C92
Keywords: Experiment, Methodology, Coase, Bargaining, Settlement
A. Introduction
1. Introduction
The laboratory experiment is a time-honored tool for empirical inquiry.
Although some economists have always made use of the technique (see Roth,
1993), historically, most relied on field research. In recent years, however, the
pace of economic experimentation has greatly accelerated. From the early
1970s the number of papers has grown from two or three per year to numbers
approximating 100 per year. The number of researchers has grown from a
small handful in the early 1970s to hundreds (Plott, 1991, p. 901). Economists
use experiments, by themselves or in combination with field observation, to test
existing theories, investigate puzzling phenomena - sometimes unguided by
theory - and to evaluate policies, private or public. (See Roth, 1987b, p. 2; Roth,
1986).
Thus, when Elizabeth Hoffman and Matthew Spitzer first introduced the
idea of experimental law and economics, they did so by reviewing a substantial
portion of the extant experimental literature for its possible application to law
(see Hoffman and Spitzer, 1985b); Hoffman, 1985). Today, however, the body
of experimental economics is too vast for a short review, yet most of it remains
relevant to law and economics. Several books provide useful introductions,
including Roth (1987b), Thaler (1992), Davis and Holt (1993), Kagel and Roth
539
540 Experimental Law and Economics 0570
(1995a), and, as does a web site maintained by Roth.
This chapter reviews experimental law and economics in the following
order. Section 2 discusses experimental methodology. Section 3 reviews six
categories of experimental economics and briefly comments on their relevance
to law. The remainder of the article reviews experiments that directly test
propositions of law and economics. Section 4 describes the few law and
economics experiments concerning individual decision making under
conditions of no bargaining. Sections 5-6 discuss law and economics
experiments relevant to the Coase Theorem. Sections 7-10 discuss law and
economics experiments relevant to pre-trial bargaining and settlement. Section
11 concludes.
2. Experimental Methodology
The essence of a true experiment is random assignment: by randomly placing
subjects in groups exposed to different experimental and control conditions, the
researcher can control the effect of variables other than the ones he or she seeks
to study (see Zeisel, 1973, p. 107). By focusing only on the variables a
particular theory makes relevant, experiments have the potential for strong
internal validity and provide the most favorable setting for testing a theory. If
the theory fails to predict the relationship between variables in a pristine
laboratory environment, there are strong grounds to reject it (see Plott, 1991,
p. 905; Wilde, 1981, p. 143). Another methodological advantage to
experiments is replication. Anomalous findings in the field may be dismissed
as measurement error, but unexpected experimental findings often prompt
others to repeat the experiment. Replicated anomalies demonstrate the need
for revising existing theory.
A constant methodological concern, however, is an experiments
parallelism or external validity - the degree to which the results may be
generalized to populations and behavior outside the experiment (see Smith,
1982). The artificiality of the laboratory poses some inherent risk in this regard.
Wilde (1981, p. 142) contends, however, that, properly constructed, the
experiment creates a small-scale microeconomic environment in which real
economic agents make real economic decisions. In other words, in these
experiments, the laboratory contains a market. Since the laboratory economies
are real, the general principles and models that exist in the literature should be
expected to apply with the same force to these laboratory economies as to those
economies found in the field (Plott, 1991, p. 905). Of course, some differences
remain. Laboratory markets are often populated only by students. Moreover, the
experimenters presence and observation may affect these (or any) subjects
differently than does the presence or observation of other actors in real world
markets.
The idea of creating a market in the laboratory helps to distinguish
experimental economics from a similar experimental literature in social and
0570 Experimental Law and Economics 541
cognitive psychology. Psychological experiments are often quite relevant to
economic theory and some experiments in one discipline are inspired by
experiments in the other (see Rabin, 1998; Thaler, 1991, 1992). But besides
differences in the kind of questions each discipline finds interesting, there is a
methodological difference. Psychologists tend to ask their subjects questions.
Typically, the psychologist records the answers of subjects exposed to different
experimental conditions but rewards them all the same (including sometimes
not at all). (See Smith, 1989, pp. 162-167, 1991, pp. 878-887).
By contrast, economic experimenters employ conditions that create different
incentives for behavior and then observe how subjects react. Typically, creating
market incentives involves differential rewards of subjects, that is, letting the
subjects know the size of the payment they receive depends on the outcome of
decisions they make in the experiment. These two methods often produce
different results as verbal behavior diverges from non-verbal (sometimes called
actual) behavior. (See Smith, ibid). As Vernon Smith observes, the difference
is itself interesting and researchers should address the gap between evidence
concerning how people think about economic questions and evidence
concerning how people behave in experimental markets (Smith, 1989, p. 163).
But a concern with actual behavior (so understood) continues to characterize
economic experiments.
For further methodological discussion, see Roth (1988, 1994) and Thaler
(1991, pp. 189-195).
3. Categories of Economics Experiments Relevant to Law
The experimental economics literature intersects law and economics at many
points. Categorizing the literature is difficult because a series of experiments
is typically relevant to a number of economic topics. Combining the
comprehensive reviews in Davis and Holt (1993) and Kagel and Roth (1995),
I observe six (somewhat overlapping) primary categories of experimental
economics research relevant to legal research: (1) individual decision making;
(2) collective action (public goods) and coordination problems; (3) bargaining;
(4) auctions; (5) industrial organization; and (6) experimental asset markets
(asymmetric information).
Individual Decision Making
In one sense, all economic experiments investigate how individuals make
decisions, but most of the experiments have the individual interact with others
in a market or bargaining situation. A narrower subset of experiments focus on
individual choice in relative isolation, usually to study decision making under
conditions of risk or uncertainty. These experiments reveal various failures in
542 Experimental Law and Economics 0570
expected utility theory, cognitive errors and biases. For reviews, see Camerer
(1995), Davis and Holt (1993, pp. 435-504); Thaler and Tversky (1992).
The nature of individual decision making is obviously important to legal
analysis. Consider two examples. First, Hoffman and Spitzer (1993), survey the
extensive economic literature on the difference in willingness to pay and
willingness to accept, finding the deviation relevant to the choice between
property and liability rules (pp. 104-112). This subject is perhaps the topic of
greatest overlap with psychological experiments. For examples, see Korobkin
(1998) and Rachlinski and Jourden (1998).
Second, the quality of decision making under risk is relevant to virtually any
area of law. Hasen (1990), for example, finds one area of this research -
framing effects - relevant to the rules governing products liability and
contracts of adhesion. A separate issue is how differences in risk-preferences
might affect legal analysis. Block and Gerety (1995) report an experiment
showing that students are more risk averse than prisoners. Relative to one
another, students were deterred more by increases in the severity of
punishment, while prisoners were more sensitive to changes in the certainty.
Brinig (1995a, 1995b) reports experimental data on the link between gender
and risk aversion and considers how a gender gap in risk preference could be
relevant to divorce law.
Collective Action (Public Goods) and Coordination Problems
Economic experiments test the predictions of game theory concerning public
goods and coordination problems. The public goods experiments discover more
cooperation and less free riding than game theory predicts; the experiments
begin to identify the conditions that produce these results. For reviews, see
Davis and Holt (1993, pp. 317-80); Ledyard (1995) and Roth (1995a, pp.
26-35). The coordination experiments study adaptive learning and the
emergence of equilibria in games with multiple equilibria. For a review, see
Ochs (1995).
These results matter greatly to law because state action is often justified by
the need to subsidize public goods or to establish efficient equilibria.
Conversely, antitrust law is concerned with the conditions under which firms
will constrain free riding and cooperate on price and other matters. Similarly,
McAdams (1995, pp. 1011-1017) relies on the public goods/collective action
problem experiments in predicting the resiliency of cartel-like behavior by
racial groups.
Bargaining
Bargaining experiments test how frequently individuals will reach agreement
and how frequently the agreement will be efficient. For reviews, see Davis and
Holt (1993, pp. 241-275) and Roth (1995b). This subject is the matter at issue
in the Coase Theorem and of great relevance when choosing between liability
and property rules. See Hoffman and Spitzer (1985, pp. 1009-1013).
Bargaining experiments are also relevant to predicting settlement of litigation
0570 Experimental Law and Economics 543
and selecting default rules in contract.
Auctions.
Auction experiments isolate the conditions that facilitate and hinder
competitive pricing. For reviews, see Davis and Holt (1993, pp. 125-172,
275-305) and Kagel (1995). Competitive pricing is an obvious concern of
antitrust law. In addition, these experiments reveal incentive-compatible
means of measuring the demand for public goods - a matter relevant to efficient
regulation and taxation (see Hoffman and Spitzer, 1985, pp. 1002-1009,
1015-1020). Auction experiments are also relevant to public contract law, by
which the government seeks to structure competitive bidding to obtain
competitive prices. See, for example, Ayres and Cramton (1996); Marshall,
Meurer and Richard (1991).
Industrial Organization
Experiments in industrial organization reveal how different institutions and
industrial structures facilitate competition or collusion, central issues for
antitrust and consumer protection law. For reviews, see Davis and Holt (1993,
pp. 173-240) and Holt (1995). Experimental markets also reveal the number of
informed shoppers and the level of warranty enforcement necessary to ensure
competitive pricing, a subject of obvious import for consumer protection law,
contracts and antitrust (see Hoffman and Spitzer, 1985b, pp. 1021-1023).
Experimental Asset Markets (Asymmetric Information)
Experimental asset markets test the predictions of the rational expectations
model, including the effect that asymmetric information, suspensions in trade,
limitations on price changes and method of compensating traders have on the
formation of equilibria. For reviews, see Davis and Holt (1993, pp. 381-433)
and Sunder (1995). These matters are of obvious concern to the regulation of
securities.
4. Law and Economics Experiments: Individual Decision Making
Many law and economics scholars have begun to apply the data from economic
(and other) experiments to the economic analysis of law. The applications grow
increasingly common. For an illustrative example, see Jolls, Sunstein and
Thaler (1998). Law and economics scholars have also contributed directly to
this literature by conducting experiments themselves. Two series of law and
economics experiments deserve extended attention, which begins in the next
section: (1) experiments relating to the Coase Theorem, that is, that concern
bargaining around legal entitlements; and (2) experiments relating to pre-trial
544 Experimental Law and Economics 0570
bargaining and settlement. These bargaining experiments merit review because
they were designed to test theoretical propositions of law and economics and
because they have reached a critical mass.
One other type of law and economics experiment deserves mention because
it tests law and economics propositions but, unfortunately, has not reached a
critical mass. Lewis Kornhausers and Andrew Schotters experiments study
individual decision making (rather than bargaining) under different legal rules.
In experiments modeling one-person accidents (see Kornhauser and Schotter,
1990), the subjects decided how much to spend to affect the probability of an
accident. The subjects made this decision knowing that they would have to
compensate for the harm of any accident according to either a negligence or
strict liability standard. Kornhauser and Schotter found that the two standards
unexpectedly produced different levels of care: strict liability initially produced
overprecaution followed by underprecaution, while negligence produced a more
optimal level of care. In Kornhauser and Schotter (1992) they modeled
two-person accidents, where the care of both subjects affected the probability
of an accident, but where subjects chose their care level without bargaining
with the other. The results were largely consistent with predictions of tort
theory, except that negligence with contributory negligence achieved greater
efficiency than a simple negligence rule.
This type of experimental design is obviously important. According to
economic theory, where transaction costs prevent bargaining, legal rules will
affect individual behavior. Experiments can test whether, in these
circumstances, particular legal rules have the predicted effect. Nonetheless,
with the exception of Kornhauser and Schotter, law and economics experiments
focus exclusively on bargaining behavior, as will the remainder of this article.
B. Experiments Relating to the Coase Theorem
5. When will Bargaining around Legal Entitlements Produce the Efficient
Outcome?
5.1 Experiments Relating to the Coase Theorem: Introduction
A number of experiments purport to test the Coase Theorem. Yet even stating
the Coase Theorem is a matter of some controversy; there are various
interpretations, a few of which seem unfalsifiable. For example, see Donohue
(1989), Ellickson (1989) and Lindgren (1990). Thus, rather than discuss
whether these experiments prove or disprove the Theorem, I will simply
address how their findings relate to certain questions that are widely
acknowledged to be important for legal analysis: When will parties bargain
around legal entitlements? How often they will reach the efficient outcome by
doing so? And given such bargaining, will the allocation of legal entitlements
0570 Experimental Law and Economics 545
affect the distribution of wealth? The experiments relating to the Coase
Theorem begin to answer these questions by identifying (a) the conditions
under which bargaining achieves an efficient outcome regardless of legal
entitlement and (b) the conditions under which legal entitlements affect the
distribution of wealth. Roth (1995b, pp. 292-293) notes that
most of the evidence [generated by economists] suggests that disagreements and
costly delays are pervasive even when it is evident that there are gains to be had
from agreement. ... [E]xperimental evidence suggests that disagreements are
pervasive even in situations ... that eliminate the most obvious potential sources of
incomplete information.
Forsythe, Kennan and Sopher (1991, p. 267), for example, review
experiments resulting in a substantial range of inefficient outcomes. But most
of this evidence arises from experiments where the bargaining is anonymous;
researchers have often sought to exclude volatile social influences in order to
test certain baseline predictions of game theory see (Roth, 1995b, p. 303). For
legal analysis, however, the bargaining of interest is usually face-to-face. We
cannot assume that anonymous and public bargaining produce the same level
of efficient agreement. Indeed, Radner and Schotter (1989) and Roth (1995b,
pp. 296-298) find that face-to-face bargaining produces greater efficiency.
Against this background, law and economics scholars have sought to determine
how frequently parties will, through face-to-face bargaining, reach an efficient
outcome, even when that outcome requires one party to sell its legal
entitlement.
5.2 Hoffman and Spitzer
In this regard, Elizabeth Hoffman and Matthew Spitzer have conducted a series
of experiments that are perhaps the best known in law and economics. The
series is based on a design introduced in the initial article (see Hoffman and
Spitzer, 1982). First, two subjects (students) were designated as A or B and one
of them was selected - by coin flip - to be the controller. The controller was
granted the power to select a number from a chart that indicated the number of
dollars that A and B would then receive. For example, in one experimental
condition, the payoff schedule was as follows (p. 86):
Number As Payoff ($) Bs Payoff ($)
0 0.00 12.00
1 4.00 10.00
546 Experimental Law and Economics 0570
Number As Payoff ($) Bs Payoff ($)
2 6.00 6.00
3 8.00 4.00
4 9.00 2.00
5 10.00 1.00
6 11.00 0.00
Note that, without the possibility of bargaining, the conventional prediction
is that A would choose number 6 and B would choose number 0. But Hoffman
and Spitzer explicitly provided for bargaining. Subjects A and B were placed
in a room together, each was given the entire payoff schedule, and the
instructions informed them that the non-controller may attempt to influence
the controller to reach a mutually acceptable joint decision and may offer to
pay part of all of his or her earnings to the controller (p. 83). In addition,
Hoffman and Spitzer provided in the instructions an agreement form and
indicated that, if the parties used the form to reallocate part of one partys
payoff to the other party, the experimenters would pay the subjects according
to their agreement (p. 84). With the possibility of bargaining, the prediction is
that, regardless of who the controller is, A and B will agree to choose and split
the largest joint payoff, number 1.
In this experimental condition, Hoffman and Spitzer (1982, p. 92) found
that nearly all (23 of 24) of the pairs did bargain to the point of their highest
joint return. They did not actually demonstrate that the bargaining produced
these optimal outcomes because they did not include a control in which
bargaining was not permitted. Harrison and McKee (1985), however, provide
exactly such a test using a very similar design except without permitting side
payments. In none of twelve such decisions did the parties choose the joint
profit maximum (p. 664). By contrast, and confirming Hoffman and Spitzer,
Harrison and McKee (p. 664) found that when side payments were permitted,
the overwhelming majority of pairs agreed on the optimal outcome. With a
controller rule like Hoffman and Spitzers, 88 percent (15 of 17) reached that
outcome; with a joint controller rule where the parties risked a poor outcome
if they failed to agree, they reached the optimal result in 97 percent of the
decisions (33 of 34). Thus, there is experimental support for the proposition
that, under certain conditions, face-to-face bargaining can induce nearly all
parties to reach an optimal outcome they would otherwise not achieve.
0570 Experimental Law and Economics 547
Hoffman and Spitzers (1982) initial experiment contained several other
conditions, each of which presented a less favorable or at least different setting
for bargaining. Their subsequent experiments also introduced new features
designed to make bargaining more difficult. In most cases, the parties still
bargained to the optimal joint outcome.
For example, in one condition of the initial experiment, they provided each
party with incomplete information: subjects were shown the schedule for their
own payoffs only, though they were allowed to share information during
bargaining. Hoffman and Spitzer (1982, p. 92) found that nearly all (19 of 20)
of the pairs still bargained to reach their highest joint return. In addition, over
90 percent (27 of 29) of 3-person groups with full information reached the
jointly optimal outcome. With limited information, 3-person groups with one
controller almost always (19 or 21) agreed to the jointly optimal outcome. But
limited information did impede such agreements when Hoffman and Spitzer
created a more complex 3-person arrangement with limited information and
two joint controllers - in which the lowest number selected by either controller
would dictate the monetary payoffs. These groups agreed on the optimal
outcome in only 60 percent of the cases (9 of 15).
In a later experiment, Hoffman and Spitzer (1985a) manipulated the
mechanism of determining which subject was the controller. They used a
simple coin flip (the original means) and a game in which the winner was
controller, each with and without a statement that the winner had thereby
earned the right to be controller. The subjects still made the optimal
agreement over 90 percent of the time (p. 275). Hoffman and Spitzer (1986)
used the basic design for groups of three, four, ten, and twenty, with full or
limited information and single or joint controllers, making single or sequential
decisions. The prior result held: of 445 experimental decisions, 93 percent . .
. chose the profit-maximizing outcome; 98 percent of the ten- and
twenty-subject decisions chose it. Efficiency [was] somewhat lower (91 percent)
with limited than with full information (94 percent), but -critically - it is at
least 90 percent for all but a few experimental treatments (p. 156). Hoffman
and Spitzer concluded that their data justifies a presumption in favor of the
Coase Theorem - by which they mean that parties will bargain around legal
entitlements to reach efficient outcomes - in a substantial class of disputes
such as neighborhood nuisances involving dog kennels or funeral parlors (p.
162).
5.3 Other Experiments on Coasean Bargaining and Efficiency
Coursey, Hoffman and Spitzer (1987) introduced a new complication by having
the subjects bargain over more than monetary payments. To introduce an item
that could affect the dignity of a subject, they made part of the payoff that
subject A, but not B, might have to hold in his or her mouth for 20 seconds an
ounce of a very bitter-tasting and unpleasant substance, sucrose octa-acetate
548 Experimental Law and Economics 0570
(SOA) (p. 223). The payoff sheet provided (p. 248):
Number As Payoff ($) A Tastes? Bs Payoff ($)
1 10 No 0
2 10 Yes 20
Coursey, et al. (1987) believed that number 2 was the
joint-profit-maximizing outcome (p. 225) because a separate bidding
experiment had shown that the average value placed on avoiding the required
taste of SOA was $4. Even if this result were rejected in favor of survey data,
the absolute maximum value for avoiding the taste is $15 (p. 223). Coursey, et
al. (1987) described the taste of SOA to all subjects but manipulated
information according to who was allowed to sample the SOA prior to
bargaining: A and B, A only, B only, or neither. In the end, none of the
variations affected the success of bargaining to reach the optimal outcome:
when B was the controller, he or she selected number 2 in every case (22 of 22);
when A was the controller, he or she selected number 2 almost 90 percent of
the time (16 of 18) (1987) (p. 227). Thus, Coursey, et al. (1987), conclude that
even when parties in the real world face physically unpleasant externalities like
loud noises or foul odors, their data suggests that parties are very likely to
bargain to the optimal result regardless of legal entitlements.
Schwab (1988) obtained somewhat contrary results using a very different
experimental design. Schwab created a bargaining scenario for students in a
labor law course and an industrial and labor relations course. Subjects were not
paid but their performance was a factor in their grade. Schwab provided the
subjects with a preference sheet allocating points for bargaining outcomes along
four dimensions: hourly wage, number of vacation days, noise reduction, and
the right of the firm to transfer work to its nonunion plant during the contract
term (the relocation clause). Subjects were only told their own preferences;
they were permitted to reveal their preferences orally but forbidden from
disclosing their preference sheet. The point allocations for each side left room
for substantial cooperative gains.
Schwab distinguishes two issues I have been discussing together: whether
the contracts achieved all possible cooperative gains and whether a legal
entitlement affected the amount of cooperative gains achieved. As to the first,
he rejects what he terms the strong efficiency hypothesis because only 20
percent of the contracts were fully efficient (p. 251). Of 108 contracts, all
included the efficient noise reduction clause and all but three contracts included
a wage that fell within the cooperative range (p. 251 n.38). But only 31 percent
(33) required a sufficient number of vacation days to exhaust the potential
0570 Experimental Law and Economics 549
cooperative gain and only 65 percent (70) included the efficient relocation
clause. Nonetheless, Schwab confirms what he terms the weak efficiency
hypothesis. For the relocation term, Schwab had created varying contract
presumptions, specifying that, unless otherwise agreed, the company either
could or could not relocate. Regardless of condition, there was no statistically
significant difference in the number of contracts requiring the company to stay
or in the number of contracts reaching the optimal result for this issue, which
varied across contracts within each condition (p. 252). Thus, the parties
achieved roughly the same less-than-perfect level of efficiency regardless of
how the legal entitlement was allocated.
Because there are many differences between Schwabs experiment and the
Hoffman and Spitzer design, it is not possible, without additional work, to
specify which conditions produced the different rates of efficient contracts.
Perhaps Schwabs results apply to complex bargaining over a set of issues while
the earlier experiments are valid for bargaining over an single issue. Or,
possibly, Schwab failed to induce the subjects to put forth enough effort because
he did not pay them for their efforts. Perhaps, however, the Hoffman and
Spitzer design is flawed because it remains abstracted from actual legal
entitlements: (i) the controller subjects are never told that the law gives them
the right to select the control number, and (ii) the non-controller subject is
never told that he or she suffers from an externality caused (in part) by the
controller. If these omissions are important, Schwabs experiment may have
elicited typical emotional reactions that impede bargaining, while Hoffman and
Spitzers design did not. To use one of Hoffman and Spitzers examples, it
would be interesting to employ their design, but to inform the subjects that, for
purposes of the experiment, they should assume that one of them owns a noisy,
smelly dog kennel and the other owns a nearby residence, and that the law
entitles one of them to select unilaterally the level of kennel operations.
Admittedly, Hoffman and Spitzer found similar results (concerning
efficiency) when subjects were told one of them earned the right to be
controller by defeating the other subject in a simple game. But perhaps parties
bargain differently if they are told - as Schwabs subjects were - that the source
of their entitlements is legal. Hoffman and Spitzer also used SOA to test
whether subjects would bargain over matters affecting their dignity. But the
abstract experimental design does not make it appear that one subject (rather
than the experimenter) is causing or threatening to cause the other to taste
SOA. Providing a real world factual scenario - where a kennel owner causes the
neighbor to smell something unpleasant - might invoke a different or stronger
set of emotions and impede bargaining.
Of course, Schwabs results confirm Hoffman and Spitzer on the claim that
legal entitlements will not affect the degree to which people bargain to the
efficient result. But the experiments do not yet justify Hoffman and Spitzers
550 Experimental Law and Economics 0570
claim for a factual presumption that parties will bargain around legal
entitlements. What their experiments appear to demonstrate is that, if potential
bargainers are (i) enticed by money or grades to meet together in a room and
(ii) invited to bargain, then the initial assignment of entitlements will not affect
the percentage of efficient agreements they create. Hoffman and Spitzer
generalize from this data to predict how people in the real world will react to
externalities. Yet many individuals may never consider offering to sell or buy
a legal entitlement that is not explicitly a market good. The neighbor of the dog
kennel may not - without the kind of prompting provided in the experiment -
consider offering the kennel owner money to limit the noise or smell of his
operations. In addition, when individuals are interested in bargaining - and
especially when large groups are involved - a crucial barrier may be the cost of
gathering the parties together at a single place and time. Indeed, one strategy
of hard bargaining is to pretend to be uninterested in even meeting with the
other side. However compelling the experiments are for demonstrating what
happens after parties meet for the purpose of bargaining, they do not provide
evidence that parties in the real world will get that far.
In sum, even though this area is one of the richest for experimental work,
these experiments only begin to identify the conditions under which
face-to-face bargaining will achieve an efficient outcome.
6. When will Legal Entitlements Affect Wealth Distribution?
6.1 Coasean Bargaining and the Distribution of Wealth
If individuals will bargain around legal entitlements, the law may not affect
allocative efficiency. But law may still affect the distribution if legal
entitlements work to enrich those who can sell them. On this score, the first
Hoffman and Spitzer study found a surprising result. Hoffman and Spitzer
(1982, pp. 92-95) found that significant numbers of controllers shared the
maximum payoff equally or nearly equally. The standard prediction would be
that a controller would demand at least his individual maxima - what he could
get without cooperation. But more controllers evenly split the payoff than
received at least their individual maxima. Over half of the 114 bargains
resulted in a division within one dollar of an even split. Thus, subjects did not
exploit the potential monetary gain from being the controller. This finding
suggests that the entitlement affects wealth less than is expected.
Subsequent experiments retested this result. Hoffman and Spitzer (1985a)
proposed that the arbitrary means of selecting the controller - a coin flip -
caused many subjects to believe that the fair distribution was an even split.
Thus, they reran the experiment using four different means of selecting a
controller: (1) Some subjects played a game and the winner was controller;
0570 Experimental Law and Economics 551
researchers told the subjects the winner had earned that right. (2) Some
controllers were selected by a coin flip and told that the winner earned the
right. The remaining controllers were selected by winning (3) the game or (4)
a coin flip, but with no statement. In the latter two conditions, with no moral
authority statement, 61 percent of the bargains resulted in nearly even splits
(p. 275). Conversely, in the first condition, with the game plus moral
authority, only 32 percent were nearly even splits. The second condition fell
in between: 50 percent nearly even splits (p. 277). Further analysis revealed
that the moral authority statement significantly affected the allocation; the
method of selection was also weakly significant (p. 280).
Hoffman and Spitzer speculate about the significance of these interesting
findings. But they do not acknowledge the potential limitation the results have
for the design of their experiment: fairness might be a restraint on bargaining.
If individuals react strongly to the perceived fairness of the situation - if they
are willing to sacrifice money in order to achieve a fair outcome - then they
might refuse to consent to a bargain that produced an unfair result, even if it
constituted the joint maximum payoff. Perhaps an individual would think it
unfair for a polluter to benefit by being paid to refrain from exercising its
legal entitlement to pollute. As stated above, one cannot confidently predict that
parties will bargain around legal entitlements in the real world unless the
experiment has attempted to elicit all the responses - including, potentially,
fairness concerns - that might inhibit bargaining. Yet the Hoffman and Spitzer
design, though it elicits such fairness concerns in the distribution of the payoff,
seems too abstract to test fairness as a constraint on bargaining. For a more
general discussion of fairness in experiments, see Roth (1995b, pp. 270-274,
279-281).
Perhaps the concern is overstated. In the similar experiment by Harrison
and McKee (1985), researchers used a coin flip to select the controller, but their
experiment provided different explanations for the payoff sharing in these
experiments. First, they found that altruistic payoff divisions declined as the
stakes increased (p. 662). Increasing the available surplus from $1 to $2
decreased such divisions from 60 percent (9 of 15) to 11 percent (1 of 9).
Second, learning decreased altruistic payoff divisions (p. 665). Harrison and
McKee created a condition involving joint property rights, where both parties
must agree to the number or they receive either a random payoff or a payoff of
zero. When subjects trained under this condition were then given the power
of a unilateral controller, they received at least their individual maxima payoff
in 76.5 percent (13 of 17) of the bargains.
With these manipulations, the legal entitlements did affect the distribution
of wealth, almost as much as theory predicts. But there is one situation where
economic theory does not expect an entitlement to affect distribution: where it
merely states a presumption. Nonetheless, Schwab (1988) found that a waivable
552 Experimental Law and Economics 0570
contractual presumption did affect distribution. In his collective bargaining
experiment, Schwab specified in one condition that, unless otherwise agreed,
the company could relocate; in the other condition, the presumption was
against relocation. The subjects often bargained around this presumption when
it was efficient to do so. But union negotiators obtained significantly better
overall contracts when the presumption favored them, while management did
significantly worse. [B]argainers ... acted as if they must purchase the right
when the legal presumption favored the other party and thus were in a weaker
bargaining position (p. 255).
In sum, the experimental results are difficult to explain. Though legal
entitlements can be made to affect distribution in the anticipated direction,
there remain some instances where they have far less effect than expected. And
a mere contractual presumption unexpectedly appears to affect the distribution
of wealth.
C. Experiments Relating to Pre-Trial Bargaining and Settlement
7. Pre-Trial Bargaining and Settlement: Introduction
Law and economics scholars have also used experiments to investigate pre-trial
bargaining and settlement. Along with empirical studies of litigation, the
accumulated evidence is beginning to have some effect on the theoretical
models describing the decision to proceed to trial. Settlement models are also
affected by psychology experiments on the subject. For example, see Korobkin
and Guthrie (1997).
As a preliminary matter, note that the Coase Theorem experiments reviewed
above (and bargaining experiments generally) are relevant to the settlement of
litigation. Both involve bargaining with potential cooperative surplus. The
Hoffman and Spitzer design is sufficiently abstract to encompass litigation
settlement, if one imagines the controller - whether A or B - as a plaintiff who
can, by going to trial, obtain a judgment equal to the maximum payoff available
to him or her on the payoff schedule. The joint maximum represents the
settlement alternative, larger than any non-cooperative outcome because it
avoids the costs of trial. If so, the results are encouraging because litigation is
a context in which parties, or their agents, usually contemplate a bargaining
solution. Nonetheless, the limitations of the Coase Theorem experiments are
significant, most notably because they do not model the risks involved in the
outcome of litigation.
0570 Experimental Law and Economics 553
8. Coursey and Stanley
Settlement experiments focus on bargaining under conditions of risk. Don
Coursey and Linda Stanley tested economic predictions about settlements rates
under different rules for assessing litigation costs: (1) the American rule, where
each party bears it own costs; (2) the British rule, where the loser pays both
sides costs; and (3) a modified version of Rule 68 of the Federal Rules of Civil
Procedure where a plaintiff pays both sides costs if he or she does no better at
trial than the defendants final settlement offer and otherwise each side pays his
or her own costs (see Coursey and Stanley, 1988). Coursey and Stanley had
pairs of subjects (students) anonymously bargain to divide 100 tokens, each to
be redeemed at the end of the experiment. Absent agreement, a random draw
provided a number representing the trial outcome according to a probability
distribution the subjects were given. Trial costs were represented by 40 tokens
which were taken from one or both subjects according to one of the three cost
rules being tested. Coursey and Stanley found that the modified Rule 68 and the
British rule produced more settlements than the American Rule. In addition,
settlements under the modified Rule 68 were more favorable to the defendant
than settlements under the American Rule, while the British rule settlements
favored the defendant more than the American rule only when the probability
of plaintiff success was less than 50 percent (pp. 174-175).
In a subsequent experiment using a similar design, Stanley and Coursey
(1990) tested certain implications of the Priest-Klein hypothesis. George
Priest and Benjamin Klein attempt to explain why litigants sometimes fail to
settle even though proceeding to trial imposes significant costs on each (given
the American rule) (see Priest and Klein, 1984; Priest, 1985). They propose
that each side, using imperfect information, estimates the value of the case with
error. When the plaintiff overestimates and/or the defendant underestimates the
trial result, there is no settlement range and the parties proceed to trial. If so,
as parties gain more information about the suit, their error range should
decline, and so should the probability of trial. Stanley and Coursey (1990)
confirmed this result. They had the color of a chip randomly drawn from an urn
determine the trial outcome. When they permitted the subjects to sample
larger numbers of chips from that urn, to determine more accurately the likely
trial outcome, the settlement rate increased. The Priest-Klein model also
implies that the settlement rate would increase as the cost of trial increased,
thereby creating greater benefits to avoiding trial. Yet Stanley and Coursey
failed to find support for this prediction.
554 Experimental Law and Economics 0570
9. Loewenstein and Babcock
Another study provides a possible explanation for this latter finding.
Loewenstein et al. (1993) created a highly realistic settlement scenario. They
provided subjects (all students) with 27 pages of testimony from an actual
accident case. They assigned pairs to the roles of plaintiff and defendant and
provided a half-hour for them to bargain over a settlement. Besides the fixed
fee paid to each subject, the experimenters provided the defendant $10 and
explained that defendant would have to pay $1 of that amount for every
$10,000 the plaintiff was awarded in settlement or by trial. The subjects were
told the trial award was based on the valuation provided for the experiment by
a judge; they were not told the amount, which was $30,560. If the parties failed
to reach agreement, the plaintiff was awarded this amount; the parties also had
to pay litigation costs, which were specified in advance but varied across
subjects. Before negotiations began, however, the subjects wrote down their
estimate of what the judge would award and what would be fair. They were
informed that these estimates would not be shown to the other side.
Loewenstein et al., confirm the unexpected finding of Stanley and Coursey:
differing levels and distributions of litigation costs did not significantly affect
the frequency of settlement (pp. 149-150; 152). The focus of Loewenstein et al.,
however, was the relevance of two other factors to settlement. (1) Psychology
evidence suggests that an egocentric or self-serving bias causes individuals
to interpret facts in ways that further their interests or self-image. (2) Economic
evidence suggests that individuals are motivated, in part, by a concern for
fairness. The first point suggests that the estimation errors regarding the
outcome of a trial are not - as the Priest-Klein model suggests - random, but
that each side tends to overestimate its chances of prevailing. The second point
suggests that parties will be less influenced by factors not relevant to assessing
fairness. Finally, given bias, a party is likely to view as fair an outcome
relatively favorable to his or her interests.
The results confirm the importance of these factors. First, even though the
parties had (and knew they had) identical information about the suit,
Loewenstein et al., found that their estimates for the case were significantly
different: Plaintiffs predictions of the judges award, on average, were
$14,527 higher than defendants. Mean plaintiffs fair-settlement values were
$17,709 higher than defendants (p. 150). These differences disconfirm the
Priest-Klein assumption that errors are randomly distributed. Second, the
difference in fairness assessments were slightly better predictors of settlement
than the difference in the predictions of the judges award (pp. 152-153). This
finding supports the importance of perceived fairness to settlement and may
explain why litigation costs were surprisingly unimportant: because individuals
based their assessments of fairness only on the merits of the case (p. 154).
0570 Experimental Law and Economics 555
A similar study by the same authors, Babcock et al. (1995), provides
striking confirmation of the effect of egocentric bias on settlement. The
researchers had the subjects (graduate students in business, law and public
policy) bargain over settlement as above, but manipulated the order in which
subjects read the case material and received their assigned role. When the roles
of plaintiff and defendant were assigned after the subjects read the case
materials, they settled 94 percent of the time. When the roles were assigned
before the subjects read the materials, the settlement rate fell to 72 percent, a
highly significant difference (p. 1339). The parties differed in their assessments
of the fair settlement and their predictions of the judges award, only when they
were assigned their roles before reading the case material (p. 1340). Thus,
parties appear to interpret information egoistically when they have a stake in
the subject matter of the information at the time they receive it. The mutual bias
decreases settlement. The authors suggest, contrary to most analyses, that
increasing the information each side has about the dispute may therefore
decrease the probability of settlement (p. 1342).
More generally, the importance of these studies is to suggest that simpler
experiments, like that of Coursey and Stanley (1988), may fail to capture some
important dynamics of settlement by abstracting away from the complexities of
a lawsuit. The simple bargaining game Coursey and Stanley use is, in their
words, devoid of any similarities to real world legal processes (p. 167). Yet
a fair test of the egocentric bias hypothesis may require a realistically complex
set of facts to permit different parties to reach different conclusions about the
expected outcome. And a fair test of the fairness hypothesis may require a set
of facts that, for many subjects, raise fairness concerns. Of course, complexity
imposes costs of its own. The point is not that we cannot learn further from
simple experiments testing how very narrow factors affect settlement, but that
we cannot fully generalize the results of such experiments until after the
findings are confirmed in more realistic settings.
10. Other Experiments on Pre-Trial Bargaining and Settlement
More recent studies continue to use very simple bargaining games to study
pre-trial negotiation and settlement. Thomas (1995) created a settlement game
with monetary payoffs. He gave the subjects (students) an estimate of the
expected outcome of trial along with a range of error uniformly distributed
around the estimate. He found support for the Priest-Klein claim that disputes
close to the decision standard - meaning where the defendants conduct is just
above or below the level at which liability is imposed - go to trial at a higher
rate than do other disputes. He could not confirm a second claim, however,
that the improvements in the ability of parties to evaluate information increase
556 Experimental Law and Economics 0570
the settlement rate, though the coefficient for error had the expected sign (p.
219).
Croson and Mnookin (1997) conducted an experiment to test the claim of
Gilson and Mnookin (1994) that parties to a lawsuit can achieve gains by
employing lawyers as agents. The claim is that lawyers develop reputations for
conducting litigation either in a highly contentious and costly manner - as
gladiators - or a cooperative mode - as cooperators. If parties who do not
trust each other choose cooperative agents, they may lower the joint costs of
conducting the litigation. To test the idea, Croson and Mnookin ran modified
prisoners dilemma games in which subjects (law students) chose one or the
other type of lawyer (or a third type without a reputation) to represent them for
10 rounds. In the litigation game, the dominant strategy was to select a
gladiator, which most subjects did. But in the prelitigation game, a subject
could change his or her lawyer if, but only if, he or she had selected a
cooperator for the prior round but the opponent had selected a gladiator. For
this game, there are two Nash equilibria - two cooperators or two defectors. The
result was that 76 percent of subjects employed cooperators in the prelitigation
game as opposed to 17.5 percent in the litigation game (p. 341). Generalizing
the result is difficult, however, since litigants in the real world are able to
switch from, as well as to, gladiators.
In sum, the experiments on litigation settlement are not yet sufficiently
plentiful to allow strong generalizations. As with experiments on Coasean
bargaining, there is some indication - not yet proved or disproved - that the
process of negotiation may be affected by the factual nature of what is being
negotiated.
D. Conclusion
Experimentation is still relatively new to economics and even more novel for
law and economics. Kagel and Roth (1995) and Davis and Holt (1993)
comprehensively review the experimental economics literature, virtually all of
which is relevant to law. Two series of bargaining experiments directly test
claims of law and economics theory: experiments related to the Coase theorem
and to pre-trial settlement. Both are still fairly undeveloped, leaving open a
great need for further work merely to resolve the different results of existing
experiments. Such work could be very fruitful as experimentation remains a
powerful tool for testing and refining theory.
0570 Experimental Law and Economics 557
Acknowledgments
A number of people assisted me by commenting on an earlier draft or
discussing the experimental economics literature, or both. I thank Rachel
Croson, Lewis Kornhauser, Jim Lindgren, Anna Marshall, Stewart Schwab,
and an anonymous referee.
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0580
LAW AND ECONOMICS OF DEVELOPMENT
Edgardo Buscaglia
Hoover Institute, Stanford University
Copyright 1999 Edgardo Buscaglia
Abstract
This chapter provides a review of the main channels through which legal
systems affect economic development. High costs for determining property
rights are still common in most developing countries. Confiscations; multiple,
high and unanticipated taxation applied to the same bundle of property rights
again and again; unclear definition of contractual obligations; inconsistent
application of the laws coupled with corruption, and ad hoc regulations make
property rights more insecure and have also caused increased transaction costs
within the marketplace. This institutional instability increases the discount rate
applied to social interactions in future periods, thereby hampering investments,
savings and the consumption of durable goods.
This chapter approaches the main substantive and procedural legal factors
that nations need to address in order to promote economic growth and
development. The substantive legal requirements for economic development are
analyzed here by identifying the efficiency enhancing sources of legal norms
(that is, bottom-up formalization of legal norms, legal transplants and legal
integration). Economic growth and social development are also affected by
legal procedures and the mechanisms through which norms are enforced and
interpreted by the court system and alternative dispute resolution mechanisms.
This chapter also identifies how corruption and the lack of efficiency and
effectiveness found in dysfunctional court systems affect investment and
economic development.
JEL classification: K00, O54
Keywords: Law and Economics, Development, Judiciary, Research
1. Introduction
To what degree does law promote economic development? To what extent does
creating wealth through the accumulation of human and nonhuman capital
require a set of rules securing property rights, governing civil and commercial
relationships, and making the exercise of the states power more predictable?
To what extent might economic growth be affected if rules are clearly defined,
made public, and applied in a consistent manner? To what extent are
562
0580 Law and Economics of Development 563
investment projects affected by mechanisms to resolve conflicts based on the
binding decisions of an independent judiciary and procedures to change the
rules when change is needed? Measuring the extent of the impact of the law is
an empirical inquiry. The answers to these questions represent the new frontier
in law and economics. In most less developed countries, uncertainty related to
the application of the law due to discretionary power and an inefficient
administration of justice are affecting trade and investment by increasing
transactions costs and fostering corruption. Observations and logical truths are
abundant, yet the empirical verification of these logical truths seems to be
scarce.
The first part of this chapter approaches the main substantive legal factors
that nations need to address in order to promote economic growth and
development. This first part will address the substantive legal requirements for
economic development by identifying the main efficiency-enhancing sources
of legal norms (that is, bottom-up formalization of legal norms; legal
transplants and legal integration). I examine the impact of legal transplants on
economic efficiency and demonstrate this by reviewing the transplantation of
trade-related intellectual property laws in Latin America. Also examined is the
incorporation of efficiency-enhancing legal doctrines through economic
integration and a jurimetric case study of trade agreements in South America.
Finally, this part of the chapter analyzes the impact of laws on organizational
structures.
The second part of this chapter addresses the procedural aspects of the law
and economics of development. I first address the role of the judiciary and its
impact on economic development. Also presented is a case study providing an
economic and inferential analysis of the court systems in Latin America.
Finally, the chapter provides an account of the symptoms of a dysfunctional
court system (that is, inefficiency, ineffectiveness and corruption) and examines
the impact of these institutional symptoms on economic development.
The conclusion to this chapter defines the scope of the field and possible
future areas of research.
The process of economic transformation through deregulation and the
privatization of the means of production in many developing countries coupled
with intensified international trade of complex goods and services requires a
legal framework with clear rules for economic interaction. The magnitude of
the economic transformation experienced by many developing countries in
recent years involves increasingly complicated contractual relationships among
savers, producers, investors and customers. This process of growth needs a
system of rules able to enhance risk management in a increasingly complex
economy. Legal, judicial and alternative dispute resolution systems are
potential institutional improvements in how society deals with higher social
complexity and increasing risks generated by human interactions. The clear
564 Law and Economics of Development 0580
identification and specification of these improved mechanisms is the first
problem waiting to be solved by the economic analysis of law in developing
countries.
A modern market economy requires laws that are able constantly to redefine
rights and market relationships when new forms of corporate structure emerge;
to provide ever-changing determinations of contractual obligations, and extend
them to new forms of financial instruments, tangible and intangible property;
to redefine and enforce the rights of victims of new technologies and activities
while protecting the environment from newly emerging risks. These are only
some examples of the tremendous flexibility that the legal and judicial systems
require in order to adapt the laws to a dynamic economic system. As Cooter
(1996a, pp. 2-3) states in his pioneering piece, if economic law is poorly
adapted to the economy, expectations conflict, cooperating is difficult, and
disputes consume resources. Conversely, if economic law is adapted to the
economy, people cooperate with each other, harmonize their expectations, and
use resources efficiently and creatively. If public institutions are defective and
political conditions too unstable, private contractual arrangements will also
become riskier and negatively affect private investment. In short, the formation
of larger markets and the possibility of longer-term contracts, both necessary
conditions for economic growth, are hampered by an unclear or undefined
system of legal rules and inconsistent application and interpretation of those
rules. The application of the economic analysis of law to development issues
sponsors a clear and consistent definition and enforcement of the conditions of
ownership in developing countries undergoing transformations. As Orr and
Ulen (1993, p. 3) argue,
a government that credibly commits itself to upholding rights of property and
contract enforcement not only provides a basis whereby partners in economic
transactions can trust each other; it also reinforces the hope that the government
itself can be trusted to transact honorably and to meet its contractual obligations.
Yet high costs for determining property rights are still common in most
developing countries. Confiscations and multiple, high and unanticipated
taxation applied to the same bundle of property rights again and again, unclear
definition of contractual obligations, inconsistent application of the laws
coupled with corruption, and ad hoc regulations have all made property rights
more insecure and have also caused increased transaction costs within the
marketplace. This institutional instability increases the discount rate applied to
social interactions in future periods, thereby hampering investments, savings,
and the consumption of durable goods. The most interesting question then
remains: What are the structures of the most effective legal and judicial
mechanisms that would be able to interpret and translate those social norms
into laws in less developed countries?
0580 Law and Economics of Development 565
The economic analysis of the law in developing countries represents an
attempt to identify changes in laws, regulations and enforcement mechanisms
that, within the legal tradition of each country, would be able to enhance
economic efficiency and improve equity. Edmund Kitch (1983) argues that law
and economics focuses on the study of the impact of a system of rewards and
penalties that affect individual behavior. These rewards and penalties are
defined by laws, regulations, doctrines, court cases, social norms, and so on.
The central goal of law and economics is then to analyze the individuals and
firms maximizing behavior within a system of rules in order to identify the
effects of laws. In this sense, law and economics follows a methodology
compatible with a legal realism and within an elaborate framework of analysis
provided by microeconomic theory. In this context, I will analyze how legal
doctrines are not hermetically sealed, self contained, or even self sustaining. I
will follow a legal realism found in law and economics where the law cannot
be understood apart from its social context. Thus, an understanding of how to
enhance a more efficient social order through legal reform will be attained
through an empirical study of human behavior.
A. Substantive Aspects of the Law and Economics of Development
2. Efficiency and the Source of Legal Norms
One recently emergent line of research in the law and economics of
development literature concentrates on the microeconomic foundations of the
sources of those rules that will allow the law and its enforcement mechanisms
to adapt to a modern economy and, by adapting, foster economic growth. This
topic is explored by Cooter (1996a) who argues that efficiency is enhanced by
a bottom up process of capturing social norms that are already in place as
informally relevant in human interaction. Norms are understood here as
coordinating mechanisms for social interaction. This decentralized approach
to lawmaking stands in sharp contrast to the centralization proposed by the first
law and development movement that during the 1960s and 1970s proposed a
clear centralization and modernization of the laws through transplants. The
most important works in this first movement can be ascribed to Trubek (1972),
Galanter (1974), Seidman (1978), and who sponsored a comprehensive,
centralized, and top-down legislative reform aimed at modernizing the public
and private dimensions of the law.
There are four legal traditions relevant in this century: civil law, common
law, administrative law and socialist law. Eastern Europe and China have
slowly shifted from a socialist legal system characterized by the production of
centralized public rules to prerevolutionary private civil law. The common or
566 Law and Economics of Development 0580
judge-made law sustained by stare decisis has suffered from the significant
expansion of administrative law. In this scenario, administrative law, as the
framework establishing the rules to be followed in the relationship between the
state and private individuals, has been the byproduct of the expansion of the
government role in western societies. Therefore, these legal traditions are in a
constant state of flux.
The civil law systems are currently facing a choice between either legalizing
and enforcing social norms in a bottom-up approach by following the policy
prescriptions of Hayek (1973) or creating regulations in a centralized top-down
manner. For example, the civil code can either capture the norms of local and
international business communities or simply impose rules on a top-down
approach. One of the most important dilemmas facing developing countries in
their current legal evolution is the choice between centralized law versus
decentralized law-making capabilities. Following Hayek (1973), one could
argue that the higher information constraints that are the product of added
social complexity require public policy to decentralize law-making by capturing
norms and thus reducing market transaction costs. As Cooter (1996a, p. 148)
states, efficiency requires the enforcement of customs in business communities
to become more important relative to the regulation of business. As he (p. 154)
also argues, customs arise when external effects align with incentives for
signaling. From this perspective, the irrelevance of the laws enacted by
parliaments in many countries must be understood as a reflection of the lack of
links between the essence of what the law stipulates and the social norms
followed by people and businesses in their daily life. When regulations or laws
show this lack of compatibility, the costs of complying and enforcing the law
become higher. These are the so-called bad laws mentioned by de Soto (1989)
in his path-breaking work in which he identifies a deficient rule by comparing
the approximate transaction cost of complying with the law against the
transaction cost of following the social norm within an informal market. In de
Sotos work one can observe that these higher transaction costs are rooted in
the drive of governments to centralize lawmaking without regard to the true
social practices followed by people. Only when the laws and regulations reflect
these practices will the transaction costs of the social interactions affected
decline and a movement towards efficiency occur. From de Sotos (1996a)
perspective, the size of many informal sectors around the globe is intimately
related to the way laws and regulations fail to capture the social practices
followed by society.
By following the pioneering studies by Cooter (1994, 1996a) and Mattei
(1993) we could argue that the laws generating obedience are the ones truly
compatible with the ethical code prevailing in society. Individuals in social
frameworks seek the kind of predictability that will tend to increase their
capacity to generate wealth through their interactions. The state of nature or
grab what you can is not a priori desirable or compatible with long-term
0580 Law and Economics of Development 567
survival under a veil of ignorance. Different levels of concentration of
political and economic power may be compatible with predictable rules of the
game. Yet for all levels of concentration of political and economic power, the
social norms and values supporting the prevailing and predictable rules of
political and economic interaction would tend to enhance allocative and
productive efficiency by reducing transaction costs of interacting. In this
scenario, civil societys norms will be found by public institutions and
transformed into formalized legal rights and obligations.
One could here extend Cooters analysis and state that, in order to enhance
efficiency, politics must follow not just the market but also the non-market
social norms. In a more comprehensive fashion, civil societys market and
non-market rules for social interaction provide a law-making guide for the
legislature and the judiciary. By making laws familiar to the individual, the
transaction costs of human interactions decrease and allow society to achieve
efficiency in its market and non-market activities. The evolution of intellectual
property laws in developing countries, described in the next section, provides
a good example of how legal transplants provided a channel through which
national laws started to capture business practices and social norms.
3. Legal Transplants and Economic Efficiency
Let us now address the economic analysis of efficiency-enhancing substantive
legal reform in developing countries. There are two main choices for a
developing country when selecting the source of its laws. A country can adopt
a law from within its own institutional mechanisms, or it can transplant rules
from outside its political-legal zone of dominance. A key need in the economic
analysis of the law is to determine a framework for predicting which of the two
options is the most efficiency-enhancing alternative. Watson (1978a) has shown
that most legal reforms are due to transplants. Therefore, we should also
explain why, from an international pool of laws available for transplant, certain
rules and institutions are commonly used while others are rejected. For
example, why is it that some countries adopt the same rules to protect
intellectual property? In more general terms, we should also explain why some
countries adopt civil law as opposed to common law systems, or separation of
powers as opposed to parliamentary systems. As Mattei (1994) and Ulen (1996)
pointed out, one reason could be simply prestige. Yet they point out that
prestige is not a measurable variable and, thus, it is difficult to verify the
hypothesis in a scientific manner. Microeconomic theory, on the other hand,
can provide a justification for the transplant by testing if the legal rules
transplanted are also the most efficient ones. In other words, an intertemporal
cost-benefit analysis may provide an explanation of why some legal rules and
systems are adopted and others rejected. Within this scenario, Eggertson (1990)
568 Law and Economics of Development 0580
and Ulen (1997) point out that the economic efficiency hypothesis proposes that
different legal systems may compute the costs and benefits of legal rules for the
same situation differently because real economic factors (such as resource
endowments and tastes) are different across regions and nations. At the same
time, it is also true that legal reforms are subject to the political supply and
demand given by vested interests. That is, professional interests which may be
threatened by any profound alteration in the legal system as it exists and from
which they have benefited. To a large extent, the successful implementation of
any reform depends on these agents, ultimately responsible for effective
law-enforcement.
4. Case Study: Intellectual Property Laws in Developing Countries
Buscaglia and Ulen (1994) apply the above cost-benefit approach to transplants
to the recent adoption of intellectual property laws under the GATT umbrella.
Recent empirical studies conducted by Foray and Freeman (1993) show that in
order to ensure a catching-up growth process, developing countries need to
expand the size of their domestic savings and human capital pools through the
application of clear laws and consistent enforcement. The observed differences
in wealth among countries has always captured the attention of scholars in
many fields. Lucas (1988) describes the powerful effects of technological
change and the need to enhance technological learning in the process of
economic development. Yet catching-up is a process that depends on much
more than just technological change, understood as increasing the
incorporation of new technologies into the production capacity of firms. Bell
and Pavitt (1993) bring to our attention the importance of technological
learning, defined as an increase in the resources needed for generating and
managing technical change. In this context, what needs to be addressed is not
just the lack of industrial capacity or technical change but also the dearth of
technological capability as the most basic and acute deficiency in most less
developed countries (LDCs). Technological learning, however, requires a
deeper transformation in a society than technological change does.
Technological learning implies the building of institutions and skills capable
of generating technical change in the future. It is at this deeper level that, for
example, the intellectual property framework will affect future technical
change.
The increasing permeability of national frontiers subject to international
trade and ideas is of such magnitude that it has forced national authorities to
reconsider the legal foundation of intellectual property rights. The Paris and
Berne Conventions provided a legal framework for more than a century
containing two main doctrines. The doctrine known as territoriality sustaining
that property rights are to be honored according to each states rules; and the
0580 Law and Economics of Development 569
doctrine of independence establishing that granting property rights within one
state did not force other states to grant the same rights. These two doctrines
have become irrelevant under the new order emerging after the Uruguay
Round. Under the supervision of the newly created World Trade Organization,
the harmony or uniformity of laws has been sought as the ideal way to
encourage the international flow of goods and services. This new framework
has solidified the view that the justification for granting intellectual property
rights, such as a patent, is based on social norms required by the need to
exchange benefits between society and the innovator. The innovator receives
a monopolistic return from an investment in order for society to be able to
benefit from an incremental diffusion in knowledge that otherwise would have
been kept as a secret.
The international enforcement of intellectual property rights experienced
a drastic evolution during the past three decades. For more than a century, the
international intellectual property regime was governed by the Paris and Berne
Conventions which provided ample scope for cooperation but at the same time
left to national legislation to define the main aspects of intellectual property
rights. After World War II, a concern with the balance between the rights of the
author and the benefits of diffusing knowledge to less-developed countries
(LDCs) as fast as possible challenged the norm based on the aforementioned
exchange of benefits between society and the innovator. The need for rapid
industrialization and vast improvements in technologies were justifications for
LDC governments to impose requirements limiting the rights and benefits of
innovators. Two typical examples of limitations to the rights of innovators
occurred in most LDCs when: (a) a patent can only be granted if the intellectual
property is worked and exploited within the national frontiers of a country (a
working requirement); and (b) the terms and royalties for licenses of
intellectual property can be determined by the government in the absence of
agreement by the innovator (compulsory licensing). Under these two types of
restrictions, LDC governments abandoned the formula of exchange based on
monopoly for diffusion and replaced it with an approach based on granting
intellectual property rights in exchange for foreign direct investment. Difficult
problems remained, however. Common features of many legal systems in LDCs
show intellectual property rights subject to inconsistent coverage, uncertain
terms of protection, arbitrary transferability, compulsory licensing regimes and
inadequate enforcement. The national character of this type of legislation,
however, has been increasingly called into question by industrialized countries.
The advanced economies challenge to the old legal order can be explained by
drastic changes in business practices and norms of behavior. More specifically,
the need for legal reforms were caused by the technological breakthroughs of
the 1970s and the subsequent revolutionary impact of microelectronics,
biological inventions, computer software and other high technology sectors.
These sectors required increasing investments in research and development
570 Law and Economics of Development 0580
paid by businesses from those industrialized countries mainly responsible for
the production of these knowledge-intensive products. Under this scenario,
international trade of knowledge-intensive products gained relevance as a
proportion of each developed countries exports and national production.
5. Trade-Related Intellectual Property Rights
The new reality shows that the United States (US), the European Union (EU)
and Japan are increasingly dependent for their competitiveness on their ability
to protect the value inherent in intellectual property. At the same time, most of
the LDCs are extremely dependent on exports to advanced economies. Many
of these LDC exports benefit from the Generalized System of Preferences (GSP)
granted by the European Union and the United States, whereby special lower
tariffs or preferences are applied to designated LDC exports. This mutual
dependence made it possible for advanced and developing economies to start
bilateral negotiations with a potential for mutually beneficial agreements in
order to find a solution to the lack of protection of intellectual property rights.
The stick in these negotiations was provided by the threat of loss of access to
the United States and European markets through the cancellation of GSP
benefits. But foreign pressure is not the only force that is able to explain legal
reforms in LDCs.
Since 1995 and under the World Trade Organization (WTO) supervision,
many less-developed countries have adopted trade-related intellectual property
rights (TRIPs) that are more compatible with the American and European
minimum standards of protection. Some may even classify these legal reforms
as transplants. As part of the GATT framework, the WTO will (a) finally
enforce a set of internationally recognized standards for the protection of
intellectual property rights for incorporation into national laws; and (b) develop
a consultation and dispute settlement mechanism for overseeing the
implementation of the international norms and resolve any government to
government disputes regarding the interpretation of such norms.
Primo-Braga (1990a) observes that modern intellectual property rules have
not been applied or enforced by governments in developing countries even
when the benefits of such rules are widely recognized by local business interests
and by the countries generating the essential technologies needed for
development. However, the forces explaining this pre-GATT inertia or the
causes behind the current emergence of a region-wide intellectual property
reform throughout Latin America have been overlooked. This oversight is
explained by the failure to recognize how the costs and benefits of legal reform
operate on a different time frame. More specifically, the costs of legal reform
are seen by politicians in less developed countries as a short-term liability
0580 Law and Economics of Development 571
hampering their chances for reelection. On the other hand, the benefits of
defining and enforcing intellectual property rights are perceived as more distant
and less tangible.
As stated in Buscaglia and Ulen (1994, p. 159), legal reforms in developing
countries must be seen as the joint effect of local political conditions and
foreign economic pressures. These two forces explain the international legal
convergence observed in the intellectual property arena. As stated above, the
foreign economic pressures to reform intellectual property laws arise
particularly because an increasing proportion of imports to Latin America
consist of information-intensive goods and services. From a domestic policy
perspective, the movement toward intellectual property reform corresponds
with the complete failure of the import substitution approach to development.
From the early 1930s until the late 1980s, most developing countries
encouraged domestic (import substitution) manufacturing investment,
suppressed agricultural prices and expanded the size of their public sector
enterprises while attempting to stimulate savings and investment through
taxation and credit allocated by the public sector. The prevailing view,
represented in Prebisch (1950), was that a shortage of domestic physical capital
was the key impediment to development. Import substitution industries grew
behind protective walls based on subsidies and tariffs in a milieu where many
other determinants of the rate of economic growth, such as investment in
human capital and the role of microeconomic incentives, were completely
ignored by policymakers. Protection of import substitution industries allowed
domestic prices and costs to far exceed international prices and created little
incentive for efficiency. These protected industries produced substitutes for
imports but usually depended on the import of raw materials and technology.
Import demand grew rapidly as these firms imported capital goods to accelerate
investment. The anti-export bias, combined with the import-substitution
program, caused a scarcity of foreign exchange and this, in turn, created a
structural barrier to the investment in expensive first-rate technologies. Within
this environment protected from international trade, however, firms could still
survive investing in second-rate technologies. As described in Buscaglia (1993)
this approach to development came to an end during the international debt
crisis of the 1980s when developing countries policymakers realized that
internal markets and import substitution were not enough to assure sustainable
growth. The demise of the import-substitution model left most developing
countries with no other option for economic growth than to eliminate trade
barriers and promote competitive exports through the incorporation of
world-class technologies. As a result of these foreign and domestic pressures,
LDCs were forced to reconsider many of their legal institutions, including their
national intellectual property laws. In this context, the international economic
and political environment described here has produced a convergence of LDC
laws towards the intellectual property legal frameworks prevailing in nations
generating standard technologies.
572 Law and Economics of Development 0580
6. Legal Transplants and Economic Integration
Legal transplants are a key main source of trade-related legal changes in
developing countries. Most LDCs have chosen an export-led approach to
economic growth and they are also eager to attract much needed foreign direct
investment (FDI). In order to enhance trade openness abroad and at the same
time attract foreign investment to their domestic markets, they must provide a
more stable environment in which to do business. Therefore, competitive
pressures arise on LDCs to harmonize their legal systems with those in
countries exporting capital by incorporating foreign legal frameworks that
developed-country firms perceive to enhance their productive efficiency.
A central topic to be addressed in law and economics of development must
focus on the study of what are the main economic factors explaining the
formation of legal transplants and legal integrations that tend to enhance
productive efficiency. As stated in Ulen (1996, p. 9), Law and Economics has
been one of the most important and productive innovations in legal scholarship
of the twentieth century. Yet its contributions to the issues of constitutional law,
including federalism, are relatively modest. From this perspective, we could
add that the attention paid to the analysis of legal and economic integration
have also been insufficient.
The mechanisms through which parliaments and the judiciary in civil law
countries would capture and translate these norms into law would require an
identification of those practices that have become standard in business
communities and a required justification of how those practices create
efficiency-compatible incentives. The efficiency aspects of these practices must
be analyzed with the aid of the theoretical and empirical tools used by
economists. For example, this approach to law-making could use empirical
techniques within the so-called jurimetric framework of analysis. In this way,
the economic impact of legal reforms could be captured through the use of
parametric and non-parametric techniques. Relatively few empirical studies
have been advanced in law and economics and even fewer within the economic
analysis of development. Yet studies by Long and Buscaglia (1997), Cooter and
Ginsburg (1996) and Buscaglia and Guerrero (1995) have clearly shown the
great advantages of applying statistical techniques to the economic analysis of
the law. Without any doubt, jurimetrics represents a real frontier in the law and
economics of development. The potential to rationalize public policymaking
with the help of jurimetric techniques represents a clear improvement in the
analysis of the economic impact of legal reforms proposed in all developing
countries.
Many may argue that civil law systems would tend to reject the economic
analysis of their laws. Yet, quoting Cooter (1996a, p. 145),
0580 Law and Economics of Development 573
Judges allegedly make law in civil law systems by interpreting codes, not finding
social norms. Compared to common law countries, the codifiers in civil law
countries apparently have more influence and the judges allegedly have less
influence. Interpreting some codes, however, looks a lot like finding social norms.
Comparative lawyers, consequently, debate whether the apparent differences in the
two systems are real or illusory
From this perspective, one could argue that civil law systems have the capacity
to react to efficiency forces as much as common law systems do. Moreover, it
may come as a surprise to many sponsoring a centralized legal system that the
civil law originally evolved as a common law system. In Watson (1978a) we
can find an excellent account of this evolution. Let us not forget that, before the
nineteenth century, the European ius commune was based on the judges
interpretation of Roman law within the local norms and practices. The
centralization of law making through legislatures aimed at replacing laws based
on social norms, practiced by people and found by judges, with what Cooter
(1996a) calls rational rules that were designed to engineer a better way of
life for society. The judge was supposed to only interpret laws generated by
legislatures and not find norms. The interpretation of norms, however, was also
subject to an implicit and subtle application of social norms as inputs in the
opinions of judges. Yet, this post Napoleonic framework took away power from
the judicial branch and made it more dependent.
The formation of trading blocks can be analyzed with the same tools that
law and economics has applied to the analysis of federalism. This approach
focuses on identifying and measuring the benefits versus the costs of generating
added political and economic integration. Long and Buscaglia (1997) recently
advanced empirical research in this area. It is useful to present a summary of
this empirical study on economic integration below. The methodology used in
this piece provides an alternative research path where the links between the
existence of legal transplants and economic structures can be explored and
discussed in future studies.
Developing nations are currently facing a unique opportunity created by
global free trade, the continuous decline in transportation and communication
costs coupled with the unprecedented availability of generic applied knowledge
and the expanding flows of international financial investments. However, many
of these countries lack the institutional capability to create or absorb the applied
knowledge aforementioned. Legal and economic reforms that are currently
occurring in LDCs are, in some cases, strengthening the foundations for
economic growth. In all cases, these legal and economic reforms are based on
strategies aimed at giving domestic producers a more important role in the
development of their economies.
574 Law and Economics of Development 0580
During the 1980s, increasing competition and volatility in world markets
have induced industrialized and developing countries alike to cluster together
in regional economic blocs. This trend was spurred by three additional main
factors: (i) technological innovations in transportation and communications
have expanded the relevant size of the markets for an increasing number of
goods and services; (ii) the overall economic slowdown in world trade during
the period 1988-92, accelerated by the collapse of the Communist regimes; and
(iii) the near failure of the multilateral trade negotiations sponsored by GATT
at the Uruguay Round. In turn, the near-breakdown in multilateral trade
negotiations served to create an environment compatible with bilateral and
regional accords.
7. Legal Integration and Economic Development
Legal integration is another main external source of legal changes that have an
impact on efficiency in many developing countries. Of central interest, in our
analysis, is why governments choose some strategies over others in pursuing
legal/economic integration. Long and Buscaglia (1997) propose that a
successful legal/economic integration is a function of the convergence of three
broad conditions: (1) the compatibility of political systems; (2) the public
sectors expectation of gains from liberalizing international trade; and (3) the
private sectors expectation of gains from regionalizing production, transferring
capital and technology and harmonizing trade-related rules. Some or all of
these factors are key driving forces behind the main trade agreements within
the western hemisphere, Europe and Asia: the North American Free Trade
Agreement (NAFTA) of the United States, Canada and Mexico; the Andean
Pact involving Bolivia, Colombia, Ecuador, Peru and Venezuela; and the
Common Market of the South (MERCOSUR) covering Argentina, Brazil,
Chile, Paraguay and Uruguay, the European Union and the Asian Economic
bloc. As a case study, the empirical study summarized below concentrates on
providing an empirical verification of the above third condition in Latin
America.
The ongoing Latin American economic transformation has created a need
for new and major legal developments. Yet, what are the main economic forces
explaining the drive to integrate throughout Latin Americas economic history?
A jurimetric analysis in Long and Buscaglia (1997) shows that growth in
international intra-sectoral trade comes hand-in-hand with the private sectors
growing demand for the harmonization of trade-related laws. In addition to the
legal issues mentioned above, harmonization does occur in many other areas.
A survey of the legal history of economic integration reveals that
harmonization occurs in specific areas such as banking, insurance, securities,
liberal professions, international securities exchange regulations and transport.
We see that the future of hemispheric integration and trade processes
0580 Law and Economics of Development 575
necessarily entails the deepening and development of these legal areas.
However, Latin American economic history has been littered with the hulls of
shipwrecked trade agreements seeking legal integration. Yet, the compatibility
in the evolutionary natures of two or more legal systems has to be introduced
as a factor that will affect the need and feasibility of legal integrations.
Moreover, the empirical review of patterns of trade in Long and Buscaglia
(1997, pp. 10-12) shows that this legal compatibility is driven by international
similarities in economic structures.
Table 1 aims at associating legal agreements seeking harmonization in
trade-related rules with other economic factors such as the number of high
growth non-agricultural trade-related sectors of the economy of selected LDCs.
A review of Table 1 below shows that there exists a strong association between
the emergence of high growth (above 5 percent annual growth in sales)
non-agricultural sectors (that is, changes in economic structure) and the
number of legal amendments in the commercial codes on the one hand and the
drive of a country to harmonize its legal system through international
trade-related agreements on the other. For example, we observe that Argentina
and Brazil who possess the most dynamic economies during the period
1850-1990 (with 16 and 14 new non-agricultural trade-related sectors
respectively) are also the countries with the largest number of amendments to
their commercial codes and with the largest number of trade-related legal
treaties signed (that is, 31 for Argentina and 35 for Brazil). As expected, more
complex economic systems (that is, a larger number of high growth new
trade-related sectors) experience more complexity in their legal systems by
undertaking more amendments in their commercial codes. At the same time,
Table 1 shows that dynamic economies are also more likely to harmonize their
legal systems through international legal agreements.
Table 1
Legal Changes vs. Economic Structure During 1850-1990
Country No. of No. of Trade No. of
Amendments in Related International
Commercial Non-Agricultural Legal
Codes Sectors Agreements
Argentina 515 16 31
Bolivia 19 1 3
Brazil 521 14 35
Chile 467 11 25
576 Law and Economics of Development 0580
Colombia 9 0 7
Ecuador 14 1 6
Peru 56 0 12
Uruguay 12 1 5
Venezuela 5 2 1
Table 2 shows a clear pattern where the regions most dynamic economies are
also the ones that are more likely to enter into international legal agreements
with each other involving harmonization of private law. One can argue that as
an increasing number of business exchanges occur in countries with
overlapping growing trade-related sectors, their need for legal harmonization
will tend to increase. This explains why in Table 2 we observe that most
attempts to harmonize legal frameworks have mainly involved countries such
as Argentina, Brazil and Chile. These countries all experienced growth in the
most dynamic trade-related sectors (for example, agro-manufacturing,
minerals, steel, financial services, transportation and energy).
Table 2
Matrix of Inter-Country Legal Agreements
Covering Commercial Areas
Arg. Bra. Bol. Ch. Col. Ec. Peru Urug. Ven.
Argentina 0 14 1 10 2 1 2 1 0
Brazil 14 0 2 7 3 2 4 2 1
Bolivia 1 2 0 0 0 0 0 0 0
Chile 10 7 0 0 2 1 3 1 1
Colombia 2 3 0 2 0 0 0 0 0
Ecuador 1 2 0 1 0 0 2 0 0
Peru 2 4 0 3 0 2 0 0 1
Uruguay 1 2 0 1 0 0 0 0 1
Venezuela 0 1 0 1 0 0 1 1 0
0580 Law and Economics of Development 577
8. Inferential Jurimetric Analysis of Legal Integration
Based on the evidence found in Table 1 and Table 2 taken from Long and
Buscaglia (1997), we can assert that many Latin American experiments aimed
at legal harmonization may have failed to produce substantive results due to a
lack of private sector lobbying pushing for compatible legal solutions
addressing trade issues. More specifically, countries with overlapping dynamic
trade-related sectors (that is, experiencing a higher proportion of intra-sectoral
international exchanges as a proportion of total trade) will at the same time
possess private sectors demanding compatible legal frameworks within the
areas affecting their products. This also explains the push for intellectual
property and competition reforms and harmonization of rules among
Argentina, Brazil and Chile. In this context, imagine two types of countries
hoping to harmonize their commercial laws: countries where private
commercial laws are not far from their evolutionary base and where no
dynamic trade-related non-agricultural sectors producing information-intensive
products exist (for example, Bolivia, Colombia, Uruguay) and, in contrast,
countries with relatively evolved commercial legal systems and with a high
proportion of their trade concentrated on dynamic sectors (such as Argentina,
Brazil, Chile). The quantitative evidence (Tables 1 and 2) and the analysis
advanced above would predict that legal harmonization between these two types
of countries will have less chances of success. In these cases, the private sectors
within each of these types of countries will demand different kinds of
commercial legal frameworks. As a result, integration will be more difficult.
For example, one can observe that private sector firms in Bolivia importing
Brazilian computer software and hardware, compact disks, or movies, do not
have an incentive to lobby for the enactment of intellectual property,
government procurement, or competition laws compatible with the needs and
interests of the Brazilian firms exporting these products to Bolivia. Figure 1
shows that the main drive to harmonize trade-related laws was concentrated
among those countries experiencing high levels of international intra-sectoral
trade. For example, we see that Brazil and Argentina with 35 and 31
trade-related legal agreements, respectively, are also the countries with the
highest level of intra-sectoral trade.
Clearly, Argentina, Brazil and Chile are the countries with the highest
levels of intra-sectoral trade as a proportion of their total trade that, according
to our argument, also possess the most dynamic private sectors lobbying for
legal integration. The number of legal agreements attached to each of these
three countries during the period 1890-1990 clearly support our claim. In fact,
those industries involved in intra-sectoral trade within MERCOSUR were the
main forces lobbying for legal harmonization of standards and regulations. Let
us note that intra-sectoral trade within MERCOSUR grew at an unprecedented
rate after tariffs were first reduced in 1988 as part of the ABIP Treaty. The
578 Law and Economics of Development 0580
relative importance of intra-sectoral trade between Argentina and Brazil
increased from 19.2 to 39 percent of total exports in Argentina and from 5.3 to
23.8 percent in Brazil. These industries included the automobile, energy, steel.
pharmaceutical, mineral and textile sectors.
Figure 1
Legal Treaties vs. Avarage Sectoral Trade: 1890-1990
One could also claim that the relatively larger countries (Argentina and Brazil),
due to the larger stakes in trade and their larger GDP, will seek to determine
a specific type of legal harmony with their main trade partners through legal
agreements. On the other hand, smaller countries in Latin America (for
example, Uruguay and Ecuador) will just free ride by transplanting legal
frameworks to their own environment. A regression analysis covering the
variables aforementioned will test this and the above claims. We can see in
Table 3 below that the number of legal agreements during the period
1890-1990 in the twenty countries surveyed is our dependent variable. The
number of amendments to the commercial codes (AMEND), the number of
non-agricultural trade-related sectors (NO_TRNA) and the average
intra-sectoral trade as a proportion of total trade (AV_INTRA) are all
predictors. These are all variables that help to predict the drive to harmonize
legal frameworks within Latin America during the period 1850-1990. As we
0580 Law and Economics of Development 579
can see, all these explanatory variables are significant at the 5 percent level. On
the other hand, the relative size of the GDP (%GDP/T.GDP) is not a significant
variable. In other words, relative size does not explain the drive to harmonize
legal frameworks. Finally, we see that 62.7 percent of the variability in our
dependent variable is explained by the independent variables included.
Table 3
Multiple Regression Analysis
DEP VAR:NO_LEGAG N: 20 MULTIPLE R: 0.792
SQUARED MULTIPLE STANDARD ERROR OF
R: 0.627 ESTIMATE: 2.04
Variable Coefficient Std Error T P
Tolerance (2-tail)
CONSTANT 146 12 0 1216 0
AMEND 10 1 95 749 2
NO TRNA 43 5 95 861 0
AV INTRA 72 23 99 316 0
%GDP/T.GDP 5 15 86 33 34
9. The Impact of Laws on Organizational Structures
The impact of substantive norms on productive efficiency needs to be assessed
by identifying the type or organizational structures that would emerge under
different sets of legal rules. The full identification of the implicit price
transmitted by institutions to firms and individuals, on the one hand; and the
specification of the institutional structure needed to attain allocative and
productive efficiency on the other, are two areas where law and economics
possesses a comparative advantage with respect to other social sciences. Thus,
the works presented in this field cover a positive and a normative approach to
the economic analysis of the law. Douglass North (1990) has already pointed
at the relationship between the property rights framework, transaction costs and
economic growth. Moreover, the study of market and non-market behavior
reacting to implicit prices established through laws falls within the best
tradition of the University of Chicago approach to law and economics. Yet
other approaches need to be incorporated into the legal and economic study of
580 Law and Economics of Development 0580
development, such as the study of the behavior of organizations and their
economic environment proposed by Oliver Williamson (1991) and the analysis
of the factors related to intermediate organizations with the potential to hamper
economic growth described by Mancur Olson (1982, 1993). In short, the
understanding of how laws have an impact on market and organizational
structures also need to be the focus of attention of development economists in
search of answers explaining the lack of international convergence in economic
growth rates.
Coase (1960) has shown that transaction costs determine the nature and
organization of economic activity and the distribution of income. One
interesting aspect to be addressed in development studies are the changes in
legal rules and their enforcement mechanisms that are needed to promote the
existence of public and private organizations in which their members increase
in wealth position is compatible with attaining the goals of the organization
and improving the overall wealth of society. In this scenario, behavioral
patterns such as low factor productivity incentives and corruption (that is, a
transfer of wealth caused by the use of public office for private benefit) can be
understood as symptoms of organizational defects explained by systems where
individuals perceive that their wellbeing does not go hand in hand with the
wellbeing of the organization in particular and society in general. In this
scenario, a pattern of defective organizational structures hampers the creation
of wealth and economic growth.
There are specific key variables whose dynamic interplay determine the
performance of all organizations. These key variables correspond to the
following two main areas: (a) the internal organization of an economic or
political unit that includes the internal structures and arrangements between the
principal and the agents by which the owner causes the managers to act for the
goals set by the owner; and (b) external incentives that are composed of all
those variables relating primarily to market factors that, although not under the
control of the principals, discipline the agents and principals in performance.
The past eight years of economic and political reforms across eastern Europe,
Latin America and Africa have made it clear to those working on public policy
reforms that the social and economic development of nations require newly
designed organizations that are able to harmonize the incentive to create
private wealth with the progress of society in general. This amounts to an
invisible hand within the organization that can be explained by its own
structure.
The links between the impact of private and public law on organizational
structures in developing countries has not been explored until recently. The
work advanced by Trebilcock (1997) goes into the main links between the
quality of public sector governance, organizational structures and the economic
progress of nations. This work covers the relationship between the nature of a
political system and its economic performance. Subsequently, it answers two
main questions: (i) what type of institutions are most conducive to economic
0580 Law and Economics of Development 581
development and (ii) what factors or conditions encourage or alternatively
impede the adoption of efficient institutions.
The research conducted by de Soto (1989, 1996a) follows an original
examination of the property rights framework in developing countries, in this
case Peru and describes the way in which the lack of predictable property rights
rules have affected the structure of private firms, investment and economic
growth. De Sotos historical analysis provides a decisive link between
ownership rules and the complexity in the pattern of market transactions.
Clearly, his analysis provides answers to key questions through the use of the
economic theory of property. First, de Soto asks what should be privately owned
in an environment where state ownership has been the norm until recently; and
second, how should property rights be enforced in order to assure a
compatibility between social norms and written law. In this scenario, de Soto
requires this compatibility in order to assure that the law will be followed by the
average citizen. In this context, he stresses the fact that in the absence of clear
and enforced legal rules, people will substitute clear and enforceable customs
and norms for the collectively enforced set of legal rules. As stated in Buscaglia
and Ratliff (1997), from an economic standpoint, regionally-determined
bubbles of customary systems may not be as efficient as a bottom-up collectively
enforced set of legal rules.
B. Procedural Aspects of the Law and Economic Development
10. The Judiciary and Economic Development
As developing countries continue their process of economic reforms, the need
for a well functioning judiciary becomes increasingly evident. Yet, the
empirical dimension of the economic analysis of legal procedures is in its
infancy. As stated in Buscaglia and Domingo (1996), democratization, growing
urbanization and the adoption of market reforms have all created additional
demands for court services throughout the region. These three factors have
increased the complexity of social interactions, thereby making the
enhancement of the judiciarys conflict-resolution capabilities even more
necessary. In addition, the shift of most economic transactions toward the
market domain and away from the public administrative sphere of the state has
created an unprecedented increase in private sector demand for an improved
definition of rights and obligations.
The judiciary is a key element of economic development. The judicial
system includes all the mechanisms needed to interpret and apply the laws and
regulations. More importantly, the judiciary is the main link through which the
economic impact of the legal system can be identified. The productive role of
582 Law and Economics of Development 0580
the judicial sector within the economic system consists of resolving conflicts by
providing the substantive and procedural structure to facilitate the exchange of
rights to physical and intangible assets. Judiciaries in most developing
countries, however, suffer from increasing backlogs, delay and corruption. As
shown in many Gallup polls, this has generated complete distrust of the system
by the private sector and the public in general. Moreover, the judiciary can also
affect the behavior of private investment. Lack of access to an equitable and
efficient judicial system creates added uncertainty and hampers the realization
of beneficial transactions. In the absence of an impartial and efficient judiciary,
the performance of mutually beneficial transactions depends upon the presence
of pre-existing reputation and repeated transactions among parties. This
requirement excludes many potentially beneficial transactions involving
previously unfamiliar parties or startup businesses from occurring.
Legal principles supporting the prevailing economic systems in many
developing countries are nominally based on the freedom to exercise individual
property rights. But legislation is meaningless without an effective judicial
system to interpret it. Consistent interpretation and application of the laws by
courts provides a stable institutional environment in which the long-term
consequences of economic decisions can be assessed by businesses and the
public. In this context, an ideal judicial system is composed of institutions
capable of applying and interpreting laws equitably and efficiently. Under most
of the judicial systems in Latin America, however, laws are not subject to
predictable interpretation. This uncertainty, coupled with delays in resolving
cases, further increases the costs of access to justice and doing business.
11. Judicial Systems in Developing Countries
The belief that the judicial sector in Latin America is ill-prepared to foster
private sector development within a market system is growing. Business
surveys conducted by the World Bank (1993) indicate that the judicial system
is considered to be among the top ten significant constraints to private sector
development. Basic elements that constitute an efficient judicial system are
missing: relatively predictable outcomes within the courts; accessibility of the
courts by the population, regardless of income level; reasonable time to
disposition; and adequate court-provided remedies. Increasing delays, backlogs
and the uncertainty associated with expected court outcomes have diminished
the quality of justice throughout the region. The judiciary is faced with several
obstacles, including a dysfunctional administration of justice, lack of
transparency and a perception of corruption.
As an example found in Buscaglia (1995), Table 4 presents country
comparisons in the monthly percentage changes in delays and backlogs in
0580 Law and Economics of Development 583
federal jurisdictions of selected Latin American countries that have reliable
data. Average changes, in monthly terms, for the period 1983-93 show a
pronounced deterioration compared to the period 1973-82, which helps explain
the publics dissatisfaction with judicial systems throughout the region.
Table 4
Change in Delay and Backlogs in Latin American Courts, 1973-93
% Change in Median % Change in Backlogs
Delay
Country 1973-82 1983-93 1973-82 1983-93
Argentina 167 478 92 479
Brazil 23 391 22 197
Chile 84 111 121 294
Colombia 34 278 91 281
Mexico N/A N/A 72 341
Venezuela 31 483 118 513
Sources: Supreme Court Bureau of Statistics for respective countries.
This data may also explain the results from a recent survey of the regions
judicial systems conducted by the World Economic Forum (1993) that shows
the majority of court users are not inclined to bring disputes to court because
they perceive the system as slow, uncertain and costly, or of poor quality.
Lack of confidence in the administration of justice is more pronounced among
small economic units and low-income families.
One of the main premises within the economic analysis of the law is that
institutions transmit implicit prices. An empirical analysis of legal procedures
must identify the extent to which the prices imposed by legal procedures change
the court users behavior. The following example given in Buscaglia (1996a)
provides an option for future research. In this example, the court system can
increase the cost of resolving disputes when times to disposition increase.
Figures 2 and 3 apply to the Civil Courts in Ecuador and Argentina. These
graphs clearly show that the yearly percentage growth in the times to
dispositions faced by the general public (measured on the horizontal axis) have
been increasing in both countries since 1984. The median percentage increase
in the times to disposition have been pronounced during the period 1984-94.
584 Law and Economics of Development 0580
This clearly represents an increase in the average costs of litigation. We observe
that the public reacts to this increase in costs by decreasing their filings per
capita. This price effect explains the decrease in the average filings per court
after discounting for changes in the number of courts, forms of case termination
and for economic and population growths within the Federal District in
Argentina and Quito in Ecuador. We can then interpret this graph as an
expression of the effects of the increase in the implicit price imposed by the
growing times to disposition faced by the general public. People react to this
added cost by reducing their filings and not redressing their grievances within
the court system. Our results also confirm the account of the informal courts of
justice given by de Soto (1989) in Peru where people quit the formal court
system and resolve their disputes within neighborhood councils.
A judicial crisis is also identified with precision for the first time in the
literature in Buscaglia (1996a) and Buscaglia, Ratliff and Dakolias (1995) by
using the quantitative measures based on growth rates in times to disposition
and growth rates in filings per court. Specifically, a judicial crisis begins at the
point where backlogs, delays and payoffs increase the cost (implicit or explicit)
of accessing the system. When costs become too high, people start restricting
their use of the judiciary, as we also see in Figures 2 and 3 below. By
examining these graphs, we see that the points of inflexion show when a
judicial crisis - more specifically, the judicial crises occurring in Ecuador in
1986 and in Argentina in 1985 - starts. Let us note that the collapse of the
Latin American judiciaries takes place under the complete absence of legally
enforced alternative dispute resolution mechanisms (for example arbitration or
mediation).
Figure 2
Ecuador's Civil Cases: 1984-1994
0580 Law and Economics of Development 585
Figure 3.
Argentina's Civil Cases: 1984-1994
12. Economic and Inferential Analysis of the Courts
The enhancement of the capability of the courts to satisfy the demand for
dispositions is one of the most challenging and important aspects of judicial
reform. Almost everywhere in Latin America, courts are unable to supply
enough services to satisfy the current demand. The lack of ability to satisfy this
demand manifests itself through the increasing backlogs and time delays
observed in Table 1. These delays are usually ascribed to lack of resources or
procedural defects. For example, it is often argued that many countries in Latin
America provide inadequate budgets to the courts, which impedes the judiciary
from sustaining even the minimal needs to ensure the publics access to justice.
It is also believed that inadequate budgets perpetuate the dependence of the
judiciary, generate corruption among court personnel and prevent the judiciary
from attracting well-qualified judges and support staff. In this context, many
judges and legal scholars argue that the judiciary must have a separate budget
subject to its control and management. The jurimetric analysis in Buscaglia and
Ulen (1997) provides a statistical framework within which those key variables
affecting the times to disposition are identified through non-parametric
techniques.
If the judiciary is to provide the impartiality and efficiency necessary for
public trust, a well defined program for judicial reform needs to address the
586 Law and Economics of Development 0580
major causes of deterioration in the quality of court services. This reform effort
must address the root political, economic and legal causes of an inefficient and
inequitable judiciary and not simply deal with its symptoms. Basic elements of
judicial reform must include improvements in the administration of the courts
and case management practices; the redefinition and/or expansion of legal
education programs and training for students, lawyers and judges; the
enhancement of public access to justice through legal aid programs and legal
education aimed at fomenting public awareness of its rights and obligations in
the courts; the availability of ADR mechanisms, such as arbitration, mediation
and conciliation; the existence of judicial independence (that is, budget
autonomy, transparency of the appointment process and job security) coupled
with a transparent disciplinary system for court officers; and the adoption of
procedural reforms, where necessary. Each component is an integral part of
judicial reform as a whole. It is unrealistic, however, to think that all the
components can be dealt with at once. Stages of action must be planned with
consideration given to the costs and benefits of reform as perceived by the
judiciary.
Some countries in Latin America have proposed allotting a pre-specified
proportion of the governments budget to the judiciary as a way to address the
low-salary problem but also as a mechanism to reduce times to disposition and
backlogs. However, a country-by-country approach is always required.
International differences in procedural requirements, substantive law and
cultural legal history mean that the resources needed by courts in commercial
jurisdictions to produce a certain type and quantity of services (for example,
1000 bankruptcy rulings) will greatly vary among countries. This means that
3 percent of the government budget devoted to the judiciary in one country may
have a very different impact on times to disposition than the same amount
devoted to the courts in another country. Therefore, it is doubtful that a higher
fixed proportion of the governments budget would necessarily improve the
functioning of the judicial system.
Based on these figures and the times to disposition in Figure 1, there is no
proven significant international correlation between judicial efficiency
(measured in terms of backlogs and times to disposition) and size of the
government budget allocated to the courts. Figure 4 clearly demonstrates this
lack of correlation within Latin America. The country-specific average
percentage changes in the median times to disposition are measured on the
vertical axis with a two-year lag after the average percentage changes in real
spending devoted to the judiciary (measured on the horizontal axis) are
introduced. The changes in real spending are adjusted for population and
economic growth in each of the countries considered. These measurements are
applied to the civil jurisdictions in each country. As we can see, countries with
the largest changes in spending are not usually those experiencing the lowest
times to disposition. For example, Brazil and Chile are clear examples of this
lack of correlation.
0580 Law and Economics of Development 587
Figure 4
Judicial Efficiency and Allocated Budget
The reason for this lack of correlation lies in the fact that, on the one hand,
additional resources (personnel and capital) initially reduce backlogs and delay
due to improvements in court productivity. But after our two-year lag, a better
endowed judiciary starts attracting additional demand (filings per court) from
citizens and businesses that otherwise would be reluctant to use the courts due
to the previously high litigation costs. The joint effects of both forces make it
difficult to determine the consequences of adding or subtracting resources
devoted to the judiciary. It is therefore much more sensible to implement a
budgetary mechanism where courts can request funds based on projected
increases in filings within each subject matter and geographical jurisdiction.
The enhancement of the courts capacity to satisfy the demand for
dispositions is one of the most challenging and important aspects of judicial
reform. Everywhere in Latin America courts are unable to perform their basic
function as mechanisms for the interpretation and application of the law. The
inability to satisfy this demand manifests itself in increasing backlogs and time
delays observed throughout the region. These delays are due, in part, to the lack
of resources or, in many cases, to procedural defects. Other reasons are the lack
of legal training, the absence of an active case management style, or an
excessive administrative burden falling on judges. For example, Buscaglia,
Ratliff and Dakolias (1995) found that approximately 70 percent of Argentine
588 Law and Economics of Development 0580
judges time is spent on nonadjudicative tasks. The same administrative duties
occupy 65 and 69 percent of available judicial time in Brazil and Peru,
respectively.
13. Corruption and Institutional Inertia: Causes and Consequences
The development of an economic theory of judicial and procedural reform is in
its infancy. Only by defining the factors enhancing or hampering judicial
reform can we propose policy prescriptions for the modernization of the
judiciary. In this context, we must take into account not only the present and
future costs and benefits of reforms to society, but also the changes in present
and future individual benefits (rents) as perceived by court officers in particular
and government officials in general. We need to examine two elements of
judicial reform implementation. First, the causes of institutional inertia that
impede much needed court reforms need to be identified. Second, we also need
to ask why reforms occur in some places but not in others by identifying the
costs and benefits of implementing judicial reforms, as perceived by members
of the court. Nevertheless, one key question remains: Why are the very judicial
reforms that would eventually benefit most segments of society often resisted
and delayed by the judiciary? The answer stems from the institutional inertia
observed during the implementation of judicial reforms.
There is a widespread perception in Latin America that government
officials use the courts as rent-seeking mechanisms. We can here identify
substantive, procedural and organizational factors explaining the increasing
presence of corrupt activities within the courts. Let us first point at the lack of
consistency found in the jurisprudence that gives judges discretionary power to
decide cases within a wide range of possibilities. The lack of a computer system
that would permit judges and lawyers to monitor the latest decisions and to
detect doctrinal inconsistencies adds to the persistence of irregularities and
corrupt practices. Moreover, poorly trained judges in an overburdened legal
system are also susceptible to corrupt influences and create an environment
where the rule of law cannot be guaranteed. From a procedural standpoint, ex
parte communication is permitted and common practice in most Latin
American countries where judges can spend a good part of the day meeting
lawyers and parties separately. Such communication creates incentives for
corrupt behavior and lack of accountability within the courts. A second
procedural element contributing to the existence of corruption has to do with
the lack of standards applied to the times to disposition experienced by each
type of case. Lack of time standards coupled with court delay allow court
personnel to charge a price for speeding the procedure. From an
organizational perspective, the concentration of power given by the multiple
roles assumed by a typical judge (that is, in most courts the judge is responsible
for strategic planning, managing personnel, administering resources, budgetary
0580 Law and Economics of Development 589
control and planning and adjudicating cases) create incentives for corrupt
behavior due to the lack of external and internal organizational control
mechanisms. Addressing these substantive, procedural and organizational
factors is a necessary condition to eradicate corruption within the court systems.
If the judicial sector and other members of the government use the courts
for rent-seeking purposes, then it should not be surprising to find members of
the bench and their clerks blocking efficiency-enhancing judicial reforms. In
this context, court reforms promoting uniformity, transparency and
accountability in the process of enforcing laws would necessarily diminish the
courts capacity to extract rents, in the form of illicit payments from the private
sector.
Previous studies argue that judicial inertia in enacting reform stems from
the long-term nature of the benefits of reform, such as added economic growth
or investment. These benefits cannot be directly captured in the short term by
potential reformers within the government. Contrast the long-term nature of
these benefits with the short-term nature of the main costs of reform, notably
a perceived decrease in rents to the courts (for example, explicit payoffs and
other informal inducements provided to court officers). This asymmetry
between short-term costs and long-term benefits tends to block judicial reforms
and explains why court reforms, which eventually benefit most segments of
society, are often resisted and delayed. Reform sequencing, then, must ensure
that short-term benefits compensate for loss of rents by court officers
responsible for implementing the changes. That is, initial reforms should allow
for short-term benefits for court officers. In turn, court reform proposals
generating longer-term benefits to the judiciary need to be implemented in later
stages of the reform process.
Additional forces also enhance the judicial reform process. We usually
observe that periods of judicial crisis come hand-in-hand with a general
consensus to reform the court system. As stated above, a judicial crisis begins
at the point where backlogs, delays and payoffs increase the cost (implicit or
explicit) of accessing the system. When costs become too high, people restrict
their use of the judiciary, as shown in Figures 2 and 3 above, to the point where
the capacity of the courts to extract rents will diminish. At that point members
of the court and governments embrace judicial reforms in order to recover their
prestige and rent seeking capacity. The judiciary would more likely be willing
to conduct deeper court reforms during a crisis as long as reform proposals
contain sources of short-term benefits, such as greater administrative power of
lower courts, judicial independence and increased court resources.
It comes as no surprise, then, that those Latin American countries
undertaking judicial reforms have all experienced a deep crisis as characterized
above - that is, sharp decreases in average filings per civil court. Important
judicial reforms are being implemented in Ecuador, Mexico and Venezuela. In
590 Law and Economics of Development 0580
each of these three cases, additional short-term benefits guaranteed the political
support of key magistrates who were willing to discuss judicial reform
proposals only after a deep crisis diminished their capacity to serve the public.
These benefits included generous early retirement packages, promotions for
judges and support staff, new buildings and expanded budgets. Nevertheless,
to ensure lasting judicial reform, short-term benefits must be channeled through
institutional mechanisms capable of sustaining reform. The best institutional
scenario is one in which judicial reforms are the byproduct of a consensus
involving the judiciary and at least one of the other two branches of power, the
legislative and executive branches. Additionally, the political leverage of
expected winners from reform should counteract the activities of potential
rent-losers.
14. The Social Impact of Corruption
In short, according to Buscaglia, Ratliff and Dakolias (1995, pp. 34-36), two
counteracting forces explain why many developing-country governments have
failed to provide an efficient judicial sector compatible with a market economy.
On the one hand, efficiency-enhancing institutional change accounts for the
actual reform and institutional transformation of Latin American judiciaries,
while on the other hand, issues related to corruption within the courts account
for institutional inertia in enacting judicial reform. Then, the nature of the
relationship between a society, its legal rules and its judicial sector can be
explained in terms of political rent-seeking activities and economic efficiency
arguments. These two influences can also contribute to the understanding of the
legal and judicial development of a nation.
Before a judicial crisis strikes, however, corruption runs rampant within the
judiciary. In all cases one can observe that corruption generates immediate
positive results for the individual court-user who is willing and able to pay the
bribe. Nevertheless, the widespread effects of corruption on the overall social
system are extremely pernicious. Those court-users who are not able or willing
to supply illicit incentives will be excluded from the provision of a supposedly
public good (that is, court services) that in reality corruption transforms into
a private good subject to an uncertain price. Even though corruption may
remove red tape for those who are able to pay the bribe, the judicial system
becomes inequitable in the perception of all of those who are excluded from the
system. This sense of inequity has a long-term effect on social interaction. A
corrupt judiciary promotes an inequitable social system where the allocation of
resources subject to adjudication is less correlated to rights and obligations and
more directly determined by the initial endowment of resources held by the
court-user.
0580 Law and Economics of Development 591
Buscaglia (1996a) shows that a perceived inequitable allocation of
resources hampers the productive incentives of those who are excluded from the
provision of basic public goods, such as court services. One may initially think
that, by eliminating bureaucratic red tape, the payment of a bribe can also
enhance economic efficiency. However, this is a fallacy. As in a typical prisoner
dilemma, corruption may benefit the individual who is able and willing to
supply the bribe. However, the macro-social environment is negatively affected
by a diminishing economic productivity over time caused by the general
perception that the allocation of resources is determined by corrupt practices
and therefore is inherently inequitable. In this respect, present corruption
decreases future productivity, thereby reducing dynamic efficiency (that is, the
present value of future national income). From this perspective, a more efficient
public court system coupled with available ADR mechanisms provided by the
private sector can foster the necessary balance between equity and efficiency in
the provision of justice - a balance that is notably lacking throughout Latin
America. Even more so, judicial reform programs must also address the lack
of court access afforded to low-income segments of the population. Court
reform increases efficiency and reduces these barriers to low-income segments,
thereby contributing to the stabilization of democracy in Latin America.
C. Conclusion
15. Scope of the Field
As a body of knowledge within the social sciences, the economic analysis of the
law certainly needs to reinforce its power to verify claims based on
observations. Here, of course, we would depart from the Austrian Schools
tradition of limiting itself to the identification of logical truths in the study of
human action and interaction and side with a legal realism which allows to
develop a more structured public policy in the legal realm. In no other area is
the development of a tool kit of empirical capabilities more necessary than in
the legal and economic study of development.
We have approached law and economics of development in this chapter by
covering the main theoretical and empirical scholarly work identifying the
substantive sources of efficiency-enhancing legal doctrines (that is, bottom-up
approach to law making, legal transplants and legal integration) in less
developed countries. We have also discussed the main procedural requirements
needed to sustain an economic system based on impersonal exchange (a judicial
sector with alternative dispute resolution mechanisms) while also exploring
some of the main symptoms of a dysfunctional judiciary (corruption and lack
of efficiency in the courts).
592 Law and Economics of Development 0580
16. Future Research Path
The measurability of the price matrix set by institutional frameworks relates,
of course, to achieving efficiency in consumption and production through much
needed reforms in private and public law. Yet these legal reforms and their
impact on efficiency must also connect to the issue of fostering political
stability through a widespread perception of equity within the members of
society. This brings us to one of the most important areas of law and economics
to be developed in future studies: the links between legal reform, efficiency and
equity. Economists tend to shy away from the microeconomic study of ethics.
Yet, as Cooters (1996b) study has shown, the rigorous microeconomic analysis
of the compatibility between equity and efficiency is real and useful. As
demonstrated in Alesina et al. (1992), developing countries face a social
environment in which a vast proportion of their population lives under material
conditions incompatible with social and political stability. Paying close
attention to the links between legal reforms and efficiency is only one step in
the right direction.. From all those possible efficiency scenarios one could
argue that the economic analysis of the law needs to provide a framework
within which one can select among the many efficiency-enhancing legal
institutions and rules that would foster a perception of equity among the
population. From this perspective, as stated in Buscaglia (1996a) a perception
of a level playing field can be traced to the individuals incentives to enhance
its own productivity within the economic system. At this point in time, there is
much more scholarship to be offered in this area.
Acknowledgments
The comments of three anonymous referees are gratefully acknowledged. The
author is also grateful for the outstanding research assistance of Brian Johnson,
Shawn McMahon and Paulina Sierra Samano. The usual disclaimers apply.
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0610
PUBLIC CHOICE, CONSTITUTIONAL
POLITICAL ECONOMY AND LAW AND
ECONOMICS
Ludwig Van den Hauwe
Brussels, Belgium
Copyright 1999 Ludwig Van den Hauwe
Abstract
The various subdisciplines within the emerging new institutionalism in
economics all draw special attention to the legal-political constraints within
which economic and political agents choose and therefore represent a return
of economics to its appropriate legal foundations. By changing the name of
his research programme to constitutional political economy Buchanan
distanced himself from those parts of the public choice literature that
remained too close to the traditional welfare economics approach. This
chapter draws lessons for law and economics from recent developments in
the re-emerging field of constitutional political economy. CPE compares
alternative sets of institutional arrangements, in markets and the polity, and
their outcomes, using democratic consent as an internal standard of
comparison. The chapter discusses the methodological foundation of the
CPE approach, presents Buchanans reconstruction of the Coase theorem
along subjectivist-contractarian lines and gives an overview of recent
contributions to the literature.
JEL classification: B41, D70, H10
Keywords: Constitutional Economics, Constitutional Political Economy,
Public Choice, James M. Buchanan, Methodological Foundation
A. The Manifold Legacy of Adam Smith
1. Introduction
As the title of this chapter suggests, the new law and economics movement
on the one hand and the now rapidly emerging field of constitutional
political economy - as well as the somewhat older public choice branch of
economics from which it emerged - on the other hand, are research traditi-
ons that are in some respects genuinely related. In other respects the diffe-
rences between them are sufficiently important, however, to warrant a more
or less detailed discussion.
603
604 Public Choice and Constitutional Political Economy 0610
Both exemplify the extension of economics beyond its traditional
boundaries - from market to non market behaviour - and both belong to a set
of subdisciplines that draw special attention to the legal-political constraints
within which economic and political agents operate. Both constitute comple-
mental facets of the emerging new institutionalism in economics.
Both may have drawn substantial inspiration from the encompassing
theoretical perspective and the reformist attitude that were characteristic of
Adam Smiths approach. Indeed, CPE can be considered to be an important
component of a more general revival of the classical emphasis, particularly
as represented in the works of Adam Smith. Among the various approaches
to the new economic institutionalism, constitutional economics is probably
the one that comes closest to what in Adam Smiths time was called moral
philosophy. It seeks to bring closer together again the economic, social,
political, philosophical and legal perspectives that were once part of the
study of moral philosophy, and which the process of specialization in
modern academia has fragmented into separate fields. Buchanans
constitutional economics is the modern-day counterpart to what Smith called
the science of legislation, an academic enterprise that is concerned with a
comparison of the working properties of alternative sets of rules, and
ultimately aims at guiding our efforts to improve the social order in which
we live by improving the rules of the game.
On the other hand, Coase, in his 1991 Nobel Memorial Lecture (Coase
1992, p. 713), made the claim that during the two centuries since the
publication of The Wealth of Nations, the main activity of economists -
including, by implication, a very substantial part of his own work - had been
to fill the gaps in Adam Smiths system, to correct his errors, and to make
his analysis vastly more exact.
The new law and economics field is usually said to have started in the
early 1960s, when Guido Calabresis first article on torts and Ronald
Coases article on social cost were published (Calabresi 1961; Coase 1960).
Coases article was without any doubt the more significant for the long-run
development of the new law and economics field.
Modern public choice - or the economics of politics - is usually said to
have been founded by such classics as Black (1958) - following earlier
papers published in the late 1940s and early 1950s - Arrow (1951), Downs
(1957) and the precursory inquiries in Schumpeter (1942) - though elements
of public choice analysis can already be found in the work of Pareto (see
Backhaus, 1978). The major breakthrough, however, came with Buchanan
and Tullock (1962). The Calculus of Consent was a seminal work in several
respects. The public choice perspective is usually characterized as combining
two distinct elements: the extension of the economists model of utility-
maximizing behaviour to political choice and the conceptualization of
0610 Public Choice and Constitutional Political Economy 605
politics as exchange. The Calculus was the first book that integrated these
two elements into a coherent, logical structure. Moreover, the Calculus
differed from the precursory works in that it embodied justificatory
argument. It sought to outline, at least in very general terms, the conditions
that must be present for an individual to find it advantageous to enter into a
political entity with constitutionally delineated ranges of activity or to
acquiesce in membership in a historically existing polity. It was recognized
that, if one remains within the presuppositions of methodological
individualism, the state or the polity must ultimately be justified in terms of
its potential for satisfying individuals desires (see also Buchanan, 1987, p.
133).
Furthermore, The Calculus of Consent confronted the market failure
presumption of the new welfare economics by demonstrating that the
problems associated with markets were ubiquitous, indeed entered into the
calculus of political consent arguably with far greater significance because of
the indivisibility of collective action (Rowley, 1993, p. xiii; Goetz, 1991, p.
10). The market failure concepts were applied evenhandedly to the
alternative institutional arrangements, especially those of political control,
and for the first time various policy arguments could benefit from a
consistent and balanced approach.
Finally, the Calculus contained the germs of the recent developement of
the research programme of constitutional political economy. It seems that
Tullocks complaint about the lack of further research along the lines
suggested in the Calculus was premature (Tullock, 1987, p. 139). The
boundary between public choice, in its non-constitutional aspects of inquiry,
and constitutional political economy may seem somewhat fuzzy. It is
generally considered that public choice, in which attention is concentrated
on analyses of alternative political choice structures and on behaviour within
those structures is, through its focus on predictive models of political
interactions, a preliminary but necessary stage to the more general
constitutional inquiry.
On the other hand, law and economics remains somewhat closer to
orthodox economic theory than either constitutional economics or public
choice. The standard efficiency norm remains central to the law and
economics subdiscipline, both as an explanatory benchmark and as a
normative ideal.
The complex relationships between law and economics and public choice
were carefully analysed in (Rowley, 1989). A masterly survey of the public
choice literature is contained in Mueller (1989). Equally recommendable is
Rowleys (1994) essay on Public choice economics in Boettke (1994). In
the present chapter we propose to draw some lessons for law and economics
from recent developments in the re-emerging field of constitutional political
economy.
606 Public Choice and Constitutional Political Economy 0610
At a time of major worldwide constitutional change, it will come as no
surprise that the focus of public choice discussion is shifting away from
ordinary political choices to the institutional-constitutional structure within
which politics takes place.
2. Leading Journal
The leading journal of the sub-discipline is Constitutional Political
Economy. Some preliminary and intuitive understanding of what CPE is all
about can be gained from explaining the logic behind the logo of the journal,
which is drawn from Greek mythology. CPEs logo is a representation of the
familiar Homeric account of how Ulysses heard the Sirens singing, and
survived (see Brennan and Kliemt, 1990). Ulysses wanted to hear the
exquisite voices of the Sirens. He was passing close by and, in principle,
there was nothing to prevent him from listening to them while continuing
his journey. However, he recognized that the power of these voices was such
that he would steer the ship ever closer to the rocks where the Sirens were
located. The ship would be wrecked and he would be unable to continue his
journey.
Formally, Ulysses faced a problem of time inconsistency in his optimal
plan. His optimal plan was to listen to the Sirens and then continue his
journey. But this was time inconsistent, because once he had embarked on
the plan by listening to the Sirens he would not be able to implement the
later part of the plan, the rest of his journey. By contrast, a time consistent
optimal plan is one that specifies a sequence of actions (At, At+1, At+2 and
so on), one for each moment in time (T, T+1, T+2 and so on), which enjoys
the property that the individual will actually choose in each time period the
action specified by the plan. Thus, when T+1 occurs, having undertaken At
in T, the individual will still choose At+1 as the best action rather than some
other, and so on.
The time-inconsistency arises because the Sirens affect Ulysses
preferences. His perception of the best action changes in the middle of the
plan and this leads him to deviate from the original version. Ulysses
implemented his optimal plan by denying himself freedom at the later stage
of the plan. Having instructed his men to tie him to the mast and to ignore
any orders to do anything other than sail past the rocks, he told them to plug
their ears and row.
Thus, Ulysses established for himself a private constitution, a set of more
or less binding rules that constrained his future choices. By exploiting
elements of his natural and social environment, Ulysses was able to subvert
certain inclinations of his future self, inclinations that he knew would be
0610 Public Choice and Constitutional Political Economy 607
destructive to his overall interests but which would nevertheless prove
irresistible when they arose.
Though the theory of private constitution is a - small - part of the domain
of constitutional political economy (Buchanan, 1990, p. 3), the principal
issue for constitutional political economy is that of forming a mutually
agreeable constitution for social arrangements among a community of
persons. Ulysses is therefore to be seen not merely as a single actor but more
particularly as representing society as a whole, and the mast and rope are to
be identified as the rules by which ordered society is governed.
As Brennan and Kliemt (1990, p. 125) point out, some care must be
taken in interpreting any such image. Following the individualist
methodology, social action must be decomposed into the actions of the
individuals of whom society is made up. The exercise of social binding,
specifically, must be seen as an intrinsically multilateral activity. Each
agrees to a set of rules and procedures because this is the price each must
pay to restrict the conduct of others. Weakness of the social will will arise
precisely because it is opportunistically rational for any individual to depart
from the collectively agreed rules and procedures.
Moreover, in the setting with which CPE is concerned, there is no
external technology available that is totally effective or not excessively
costly. The tools of enforcement and maintenance must themselves be
socially constructed. Human beings are not bound by nature to pursue rules:
they are endowed with the capacity to deviate from rules if it is profitable to
do so. Accordingly, we must search out rules which so order individuals
behaviour that it is individually profitable for most people to keep and
enforce those rules most of the time. The gains from violation should not be
too great. The analysis of the kind of rules and the associated institutional
apparatus that exhibit these properties represents a centrepiece of
constitutional political economy as an area of inquiry.
As far as dynamic choice theory in the strict sense is concerned, mention
must certainly be made of the promising and in-depth analysis of the
problem of dynamic consistency offered in McClennen (1990a). McClennen
develops his argument in the context of a critical examination of the
principles that constitute the cornerstone of the modern theory of expected
utility and subjective probability: the weak ordering and the independence
principles. McClennen argues for an alternative to the myopic and
sophisticated approaches to the problem of dynamic consistency: the theory
of resolute choice. The resolute chooser achieves dynamic consistency by
regimenting ex post choice to his ex ante evaluation of plans, thus achieving
a cooperative arrangement between his present self and his relevant future
selves that satisfies the principle of intrapersonal optimality. Technically
speaking, resolute choice characterizes a commitment to dynamic
608 Public Choice and Constitutional Political Economy 0610
consistency (DC) and normal-form/extensive-form coincidence (NEC) at the
expense of separability (SEP). Reference should also be made to McClennen
(1993).
The problem of time inconsistency is addressed formally in Klein (1990).
B. The Theoretical Foundations of Constitutional Political Economy
3. Constitutional and Sub-Constitutional Choice
One solution to the problem of defining constitutional political economy
would consist of characterizing it simply as the economic analysis of
constitutional law (see Backhaus, 1995). The examination of real-world
constitutions using the perspective of modern constitutional political
economy is certainly an interesting exercise and can provide a kind of test
for the usefulness of the CPE approach. In addition to Backhaus (1995),
reference should be made to several case studies. Holcombe (1991) analyses
the role of constitutional rules as constraints on government using three
United States constitutions: the Articles of Confederation (1781), the
Constitution of the United States and the Confederate Constitution. Brennan
and Pardo (1991) examine the Spanish Constitution (1978). Sobel (1994)
analyses the evolution of two international constitutions: the League of
Nations Covenant and the United Nations Charter. However, the aforesaid
definitional strategy may tend to be somewhat misleading. The use of the
term constitutional in the self-description of the subdiscipline is largely
metaphorical.
CPE as a scientific subdiscipline is characterized by a particular kind of
orientation in social analysis. Whereas orthodox economic analysis attempts
to explain the choices of economic agents, their interactions with one
another, and the results of these interactions, within the existing legal-
institutional-constitutional structure of the polity, constitutional economic
analysis attempts to explain the working properties of alternative sets of
legal-institutional-constitutional rules that constrain the choices and
activities of economic and political agents. The emphasis is on the rules that
define the framework within which the ordinary choices of economic and
political agents are made. Thus, CPE involves a higher level of inquiry
than orthodox economics. CPE examines the choice of constraints as
opposed to the choice within constraints.
A preliminary example can be drawn from the theory of market failure.
We know that under some conditions, and given the legal order of the
protective state (the protection of property and the enforcement of contracts),
markets fail when evaluated against idealized efficiency criteria. But in
examining allocative institutions, the economist should ask As compared to
what? (Goetz, 1991, p. 10). We know today that politics fails when
0610 Public Choice and Constitutional Political Economy 609
evaluated by the same criteria. The analysis and comparison of the working
properties of underlying sets of rules or constraints constitutes the domain of
constitutional economics.
A market is always a system of social interaction characterized by a
specific institutional framework, that is, by a set of rules defining certain
restrictions on the behaviour of the market participants. Market failure
arguments sometimes tend to ignore that the rules upon which a market is
based may well be variable and that an adjustment in these rules is possibly
a better way to deal with alleged shortcomings than to replace market forces
by a political mechanism.
When it is said that the rules upon which a market is based may well be
variable, this should not be misunderstood. It means that the rules can be
varied at the level of constitutional choice. At the level of sub-constitutional
(or post-constitutional) choice, the rules are parameters: they are items that
single economic entities cannot adjust and, indeed, must adjust to. Coases
(1960) tradable property rights are not really rules as the constitutional
economist defines them. Coases tale was about trading defined rights, about
private rearrangements of rights within a given legal structure, not about
redefining the rights that the market participants hold. We will take a closer
look at Coases contribution in the next section.
Elementary to any constitutional analysis is therefore the explicit
recognition of a notion of hierarchy. Any constitutional analysis will
distinguish between at least two levels of choice - constitutional choice and
sub-constitutional (or non-constitutional) choice - and correspondingly also
between constitutional and sub-constitutional preferences. Constitutional
choices are choices among alternative rules (constraints). Sub-constitutional
choices are among alternative strategies available within rules (constraints),
such as ordinary market choices.
4. Methodological Individualism
Only individuals choose and act. CPE is informed by an explicit
methodological individualism (Buchanan, 1990, p. 13). Whatever pheno-
mena at the social aggregate level we seek to explain, we ought to show how
they result from the actions and interactions of individual human beings
who, separately and jointly, pursue their interests as they see them, based on
their own understanding of the world around them (Vanberg, 1994, p. 1).
An aggregative result that is observed but which cannot, somehow, be
factored down and explained by the choices of individuals, stands as a
challenge to the scholar rather than as some demonstration of non-indi-
vidualistic organic unity.
610 Public Choice and Constitutional Political Economy 0610
5. Homo Economicus
Orthodox public choice models usually contain the postulate of homo
economicus: they go beyond the logical presuppositions of individualism to
incorporate non-tautological models of individual utility maximization.
Individuals are assumed to seek their own interests, which are defined so as
to retain operational content. It is increasingly recognized, however, that at
least a part of the traditional public choice emphasis has been wrongly
placed. Thus the emphasis is shifted away from the motivational postulates
for political actors to the incentive structures of politics. In Buchanan
(1993a, p. 69) it is argued that the seminal Alchian (1950) analysis of the
markets analogue to evolutionary selection can be extended to politics in
relatively straightforward fashion, the difference between the two
evolutionary models lying in the compatibility with overall efficiency. The
structure of the politics in which politicians act requires them to act contrary
to public interests if they are to survive at all. For the constitutional
economist the relevant question then becomes: How can Constitutions be
Designed so that Politicians who Seek to Serve Public Interest can Survive
and Prosper? (Buchanan, 1993b).
6. Normative Individualism
The whole exercise of CPE is ultimately aimed at offering guidance to those
who participate in the discussion of constitutional change. In other words,
constitutional economics is meant to offer a potential for normative advice in
constitutional matters and to provide a normative framework for
comparative institutional analysis. As a normative enterprise, CPE is
informed by normative individualism: the presumption that the evaluations
of the persons involved, their interests and values, provide the relevant
criterion against which the merits of alternative sets of rules are to be jud-
ged.
7. Excursion: The Wicksellian Ancestry
The distinguishing feature of the Buchanan and Tullock (1962) approach to
the study of political institutions from a normative viewpoint was to treat the
political process by which individuals advance their interests as one of
exchange. In adding this second element - politics as exchange - to the
utility maximizing models for individual choice behaviour in politics, they
were directly influenced by the great work of Knut Wicksell.
0610 Public Choice and Constitutional Political Economy 611
CPE could be characterized as Wicksellian political economy.
Wicksells influence is discussed in Wagner (1988). In his basic work on
fiscal theory Wicksell (1896) called attention to the significance of the rules
within which choices are made by political agents, and he recognized that
efforts at reform must be directed toward changes in the rules for making
decisions rather than toward modifying expected results through influence
on the behaviour of the actors.
In order to take these steps, Wicksell needed some criterion by which the
possible efficacy of a proposed change in rules could be judged. He
introduced the now-familiar (near to) unanimity or consensus test. Thus for
Wicksell the consent of the governed was the point of departure for the
evaluation of government activities.
This Wicksellian idea has had considerable influence on Buchanans
approach. According to Buchanan, politics must be understood in terms of
the model of market exchange. Thus, the political proces is conceptualized
as one of mutually beneficial exchange. It is for this reason that he is drawn
to unanimity as a collective decision rule. Since the choice among rules is
more a social choice than an exchange, the form of voluntary exchange is
political consent. Through the emphasis on consent or agreement as a
normative yardstick, the research program of CPE became closely related to
the contractarian tradition in political philosophy. As Buchanan sees it, con-
tractarian political institutions typically exhibit three attributes. Central to
the contractarian vision of the political process is the place of the individual.
Individuals own - and necessarily subjective - evaluations, their interests
and values constitute the relevant benchmark against which the efficiency or
desirability of alternative rule-regimes or institutions are to be judged.
Contractarianism complies with this criterion by according each individual
equal treatment at the constitutional stage. The unanimity rule serves to
protect the individuals rights and thereby ensures that those rules and
institutions that become imbedded in the constitution will also treat
individuals equally and impartially. Second, there is the fundamental
distinction between actions taken within the constitutional rules, and
changes in the rules themselves. The latter are to occur only at the
constitutional stage and ideally are made using the unanimity rule. The
image of political activity as a two-stage process, first developed in The
Calculus of Consent, has recurred in many of Buchanans later writings as a
sort of normative benchmark or yardstick by which to measure the quality of
a communitys political institutions. Third, actions taken in the second stage
of the political process should be effectively constrained by the rules written
in the first, constitutional stage, and this is true not only for the individual
citizen, but also for the elected representatives, and the bureaucrats and
jurists who administer the system.
612 Public Choice and Constitutional Political Economy 0610
Recapitulating and summarizing, we can say that the two most important
aspects of Buchanans position are his emphasis on rules of the game and
his analysis of efficiency as involving consent. At the most fundamental
level of constitutional choice, consent serves as the basis of justification. It
provides the ultimate criterion of efficiency. Unlike other economists who
have emphasized either the efficiency or rationality of rules, Buchanan is
concerned exclusively with whether or not people consent to them.
It should be noted that Buchanan and traditional economic analysts
develop the relationship between autonomy and efficiency in exactly
opposite ways (Coleman, 1990, p. 141). Traditional economists believe that
efficiency can be defined as a property of social states independent of the
process of voluntary exchange. For example, the perfectly competitive
market is efficient, but the outcome of the prisoners dilemma is not. And
given the logic of the relevant concepts - especially Pareto superiority - it
follows logically that people would consent to efficient rules. Consent
follows from efficiency. Buchanan puts the matter exactly the opposite way.
What people consent to is efficient. Efficiency follows from consent.
In contrast with Paretian optimum resource allocation, a situation of
Wicksellian efficiency will be characterized by the fact that citizens are
satisfied that the existing system of rules, institutions and policies of their
society is free from improper coercion (Wiseman, 1990, p. 110).
The Wicksellian criterion of social efficiency focuses on subjective choice
processes, in marked contrast to the Paretion optimality condition of
neoclassical welfare economics, which permits an external observer to use
individual utility as an objective measure of welfare. Social efficiency is too
complex a notion to be reduced to a set of technical propositions concerning
resource-use. Efficiency is not a property of social states that could be
specified or defined independently of the actions of individuals and the
process of voluntary exchange.
The limitations of conventional Pareto criteria in assessing efficiency are
also discussed by De Alessi (1992).
However, Wicksell did not move beyond the development of criteria for
evaluating policy alternatives one at a time.
Buchanan and Tullock (1962) operationalized Wicksells (1896) insights
and extended the applicability of the unanimity or consensus criterion from
the level of particular proposals to the level of rules - to constitutional rather
than post-constitutional or in-period choices.
For Buchanan and Tullock (1962, Chapter 6) constitutional design was a
matter of determining which voting rule or choice mechanism would be
specified by the constitution for each state activity. The best public decision
rule for each activity was the one that minimized interdependence costs. It
was specified that the representative individual perceived interdependence
0610 Public Choice and Constitutional Political Economy 613
costs for an activity as the sum of the anticipated external costs levied on
that individual if not part of the decision set, and the anticipated decision
making costs experienced by the individual if part of the decision set.
External costs arise because some individuals cash in the benefits of
collective decisions but shift the costs to other individuals. The group forces
an individual to contribute to collective action that is not wanted by that
individual (at that price). From the point of view of the individual in
question, external costs are the result of wrong decisions. The higher the
percentage required for a group decision, the lower the chance of wrong
decisions being made, so that the corresponding curve will show a declining
trend. Decision-making costs are the individual investment of time and
energy in the process of negotiation, expressed in money value. The closer
the requirement of unanimity comes to being met, the higher the decision
costs will be because, among other reasons, strategic behaviour of
individuals becomes more profitable. The corresponding curve therefore has
a rising trend. The sum of both external costs and decision costs was shown
to have a unique minimum somewhere between the extremes of individual
rule and unanimity rule, the exact position depending on relative external
and decision costs.
The shift of the Wicksellian criterion to the constitutional stage of choice
has some remarkable consequences. It becomes conceivable to allow for the
possibility that preferred and agreed-on decision rules might embody sizable
departures from the unanimity limit, including simple majority voting in
some cases and even less than majority voting in others (Buchanan, 1987, p.
135). The constitutional calculus suggests that both the costs of reaching
decisions under different rules and the importance of the decisions are
relevant. Since both of these elements vary, the preferred rule will not be
uniform over all ranges of potential political action. The in period Wickselli-
an criterion may remain valid as a measure of the particularized efficiency of
the single decision examined. But the in period violation of the criterion
does not imply the inefficiency of the rule as long as the latter is itself
selected by a constitutional rule of unanimity.
As a consequence, while it was recognized that unanimity and not
majority rule is the pivot of constitutional democracy, it was equally
demonstrated that at best, majority rule should be viewed as one among
many practical expedients made necessary by the costs of securing
widespread agreement on political issues when individual and group inte-
rests diverge (Buchanan and Tullock, 1962, p. 96).
The appropriate degree of inclusiveness of the collective decision-making
rule - for example qualified majority rule - as an instrument to cope with
perverse forms of uncertainty about the incidence of collective decisions is
discussed in Pinto Barbosa (1994).
614 Public Choice and Constitutional Political Economy 0610
8. The Rent Seeking Trap
It has become common to model the choice situation at the constitutional as
well as the post-constitutional stage with potentially conflicting interests
between rational persons as a classic Prisoners Dilemma (Wagner and
Gwartney 1988, p. 32; Buchanan, 1993b, p. 2). The Prisoners Dilemma
game depicts a situation in which private interests and the search for indi-
vidual gain, when generalized, become the source of mutually harmful re-
sults. In other words, private interests cannot be generalized without losses.
But what can be generalized (moral codes) does not obey private motivati-
ons. Conflicting interests are clearly involved, since everybody wants to be
the only defector.
Classic Prisoners Dilemma
C D
A C 3,3 1,4
D 4,1 2,2
In generalized Prisoners Dilemma situations, that is, social con-
stellations under which individuals, in separate and rational pursuit of their
own interests, unintentionally but systematically contribute to an overall
outcome that is undesirable for all of them (or in any case less desirable than
some alternative outcome that could be realized by concerted, organized
action) there is a possible potential for mutual gains by collective action
(collective organization).
In this way the constitution is essentially a contract intended to secure
mutual gains from social cooperation and to avoid the dominant defective
strategy in the Prisoners Dilemma game which leads to a socially inefficient
Nash equilibrium solution. Since the mutual gains from social cooperation
constitute a public good, the maintenance of the constitutional contract gives
rise to a problem that will not resolve itself naturally.
Even when it is supposed that agreement on appropriate rules can be
achieved at the stage of constitutional contract formation, it should be
recognized that individuals and interest groups inevitably will attempt to
engage in post-contractual opportunism (problem of constitutional
maintenance). Therefore the agreement, once achieved, must be enforceable.
This opportunism takes several forms. First, each individual may have an
incentive to defect from the cooperative agreement after it has been
0610 Public Choice and Constitutional Political Economy 615
concluded (compliance or unilateral defection problem). Whether or not it is
rational for persons to comply with rules that they constitutionally may agree
on is a matter of contingent, factual circumstances. It depends on whether or
not the constraints that persons face after the agreement, that is post-
constitutionally, make it rational for them to comply with previously agreed-
on rules. As Vanberg has pointed out repeatedly, their constitutional
interests and their compliance interests are not necessarily in congruence
(Vanberg, 1994, passim, for example, pp. 21-23).
A second form of post-contractual opportunism consists of rent seeking
and special interest plundering, which ultimately reduce the value of post-
contractual cooperation and undermine the constitution itself. Groups of
individuals have an incentive to seek and capture the instruments of state
power and to use them as vehicles to enrich themselves in ways that are
unattainable for private citizens.
Rent-seeking is a term used by economists to describe actions taken by
individuals and groups to alter public policy in order to gain personal
advantage at the expense of others.
The incentive to engage in rent-seeking activities is directly proportional
to the ease with which the political process can be used for personal (or
interest group) gain at the expense of others. In other words, distributional
politics is viable and tends to become dominant to the extent that differential
treatment is constitutionally permissible (Buchanan, 1993b, p. 6).
Tullock (1959) had already shown that under any voting system which
requires less than unanimous approval to implement policies, majority
coalitions of interest groups will seek to obtain public provision of special
interest projects. A few years later Tullock (1967) independently published
his innovative ideas on what came to be called rent-seeking, which he
argued entailed social costs. The latter were called rent-seeking costs or, by
some, Tullock Costs. Tullock Costs have been re-analysed recently by
Spindler (1990).
The dominant strategy for any organized interest group in a majoritarian
polity is to lobby for policies which provide large benefits to its members and
disperse the costs over everyone else. This tendency exists even in liberal
democracies. Through implicit vote-trading, a coalition of interest groups,
comprising a bare majority of voters, can get all or at least most of their
favoured projects approved for public provision. Under certain conditions,
the total costs of these projects can exceed their total benefits, while cost
spreading through the fisc induces a rational ignorance of this process on
the part of the disadvantaged majority. On the other hand, the asymmetric
distribution of cooperative benefits leads subgroups of the collective to invest
energy in the struggle for access to the governments coercive power. But the
effort may turn out to cost more than it is worth and the end result will be
616 Public Choice and Constitutional Political Economy 0610
that the collectives loss purchases the subgroups gain (Schmidtz, 1991, p.
91).
Buchanan and Lee (1991) demonstrate that the gains from politically
generated restrictions on markets, even to organized producing interests, are
more apparent than real. The analysis demonstrates that under plausibly
realistic assumptions concerning coalition sizes, excess burdens,
organizational costs and rent seeking outlay, a genuine utility-maximizing
calculus may dictate support for constitutional prohibition of all market
restrictions, by all members of the polity, including those producer interests
that might be considered to be potentially identifiable beneficiaries of
cartelization.
Principal-agent theory has been used to examine the rent-seeking
problem (Anderson and Hill, 1986; Merville and Osborne, 1990). The
principal, also the citizen, grants the agent (the government) the power of
coercion. In exchange, the agent supplies the principal with public goods.
Since the capitalized value of public assets is owned collectively, public-
good outputs of the government are like communal resources with widely
diffused benefits. It soon becomes evident to vote-maximizing agents or
legislators that they can maximize their political support by significantly
reducing the provision of public goods to the population at large in favor of
greater transfers to interest groups. These transfers are financed by general
tax collections and provide concentrated benefits to designated groups. Such
collusion between agents and special interest groups will invariably lead to
the development of a Leviathan state.
Merville and Osborne (1990) use agency theory to demonstrate formally
that, in majority-rule political systems, coalitions of minority factions will
induce politicians to systematically break the constitutional contract in order
to supply special interest projects. Unlike contracts in private markets,
political contracts are much more susceptible to this kind of opportunism.
Is the rent-seeking trap inescapable? A serious consideration of this
question will take us a long way to the understanding of constitutional
political economy.
By far the most important problem with respect to ensuring the self-
enforcing character of a constitutional contract is that it must successfully
constrain the power of the Leviathan state itself. Whereas Brennan and
Buchanan (1980) endow Leviathan with the objective of revenue max-
imization, La Manna and Slomp (1994) argue that Hobbess political con-
struct envisages a sovereign-principal who devises rules and incentives to
induce his subjects-agents to contribute to his own preservation and glory.
Leviathan is a glory seeker instead of a revenue maximizer.
Generally speaking substantive constraints on government have been
dismissed as ineffective precisely because of the wide latitude they allow for
reinterpretation. Wagner and Gwartney (1988, pp. 44-49) make a strong
0610 Public Choice and Constitutional Political Economy 617
case for procedural rules designed to uphold decentralization of
governmental powers and to prevent the formation of legislative coalitions.
Procedural rules will provide more effective mechanisms for self-enforce-
ment than will substantive restraints on government. In their view, the
weakness of substantive restraints derives from the politicization of the
Supreme Court and the ease with which legislatures can find alternative
ways to implement any given policy. They propose procedural rules
requiring larger legislative majorities for legislative action at higher levels of
government, thereby diffusing the power of the state to regional and local
governments.
Several other solutions have been proposed in the literature.
9. Judicial Independence
Does independence of the judiciary serve the long-term public good? The
traditional view of the purpose of judicial independence has been attacked as
naive by law and economics and public choice scholars. Unlike many legal
contracts, it is argued, there is no third-party enforcer, external to the
contract, who can ensure that defectors are caught and forced to comply with
the terms of the agreement. Though many countries have a nominally
independent Supreme Court whose purpose is to enforce the constitution, the
Supreme Court can only do this imperfectly in most cases, because the
judges themselves are not totally immune from political pressure by groups
wishing to subvert the original intent of the constitution. Thus, given the
unreliability of third-party enforcement, and given the strong individual
incentives to defect from social cooperation, the constitutional contract
should somehow be self-enforcing if it is to be maintained.
The interest group theory first advanced by Landes and Posner (1975)
makes the independent judiciary an integral part of the system of rent-
seeking engineered by Congress. However, the debate goes on. A very
detailed criticism of the Landes-Posner theory is contained in Boudreaux
and Pritchard (1994). They argue that the Landes-Posner theory is seriously
deficient and conclude that the United States federal judiciary is truly
independent of Congress and the President, and that this independence was
designed by the Constitutions framers as a means of furthering sound
government.
Blankart (1994) compares the legal rules for private clubs with the
constitutions of representative governments. A nearly perfect laboratory case
for a club government can be found in the example of Switzerland. The
Swiss do not have a constitutional court, but have developed instead a
system of popular voting rights serving as a substitute for a judicial review
by a constitutional court. Though this system does not work perfectly, it has
relative advantages in comparison to constitutional courts, which often tend
618 Public Choice and Constitutional Political Economy 0610
to become political decisionmakers thereby circumventing the control of
citizens-as-principals.
Moser (1994) carefully analyses the contribution of the Swiss and the US
constitutions to protect economic liberties, and compares the different
strategies that both constitutions rely on to achieve this goal. It is argued that
the substantial constitutional changes that did occur in both countries
followed strikingly similar patterns: the constitutional protection of
economic liberties was eroded in both countries, especially as far as federal
legislation is concerned, due to changes in the interpretation of the
constitution through the courts, or by formal amendment. Tucker (1992)
looks at the impact and the judicial philosophy of the now dominating
Conservative group of justices on the Supreme Court. Rowley (1992)
examines the erosion of the economic liberties of US citizens with special
reference to the takings-clause provisions of the Fifth Amendment. It is
noticed that the Court changed direction during the late 1980s as justices
appointed by Presidents Reagan and Bush gained ascendancy.
10. A Rule of Law in Politics
According to Buchanan (1993b) the direction of constitutional reform is
obvious. If, somehow, the potential for differential treatment is reduced, so
will be the inducement to rent-seeking behaviour. The off-diagonal solutions
should simply be made impossible to achieve by the introduction of some
rule or norm that prevents participants from acting or being acted upon
differently, one from the other.
If the off-diagonal attractors are eliminated, then the players operate with
the following reduced matrix:
C D
A C 3,3 X
D X 2,2
Thus the constitutional reform measure modifies the original Prisoners
Dilemma game into a reduced setting in which each player, as a member of
a political coalition, knows that any choice of an action or strategy must
involve the same treatment of all players or constituencies (Buchanan,
1993b, p. 3).
0610 Public Choice and Constitutional Political Economy 619
If and to the extent that differential treatment is replaced with equal
treatment, or with the principle of generality in politics - analogous to that
present in an idealized version of the rule of law - mutual exploitation will
be avoided and politicians who seek to serve the public interest will survive
and prosper (Buchanan, 1993b, p. 6). Therefore it seems at least conceivable
that rational persons, at the stage of entering into the agreement, may recog-
nize the rent-seeking trap and engage in concerted efforts to escape.
However, in the hypothetical matrix construction above, the interaction
was in fact assumed to occur in a state of nature, with each person holding
equal prospects for membership in the majority and minority coalitions. This
means that membership was assumed to be symmetrical among all
participants. But this assumption may turn out to be too heroic with respect
to real world settings.
The prospects may differ among persons and groups of persons so as to
create divergences in interests which may become a source of disagreement.
Thus the question remains whether it is possible to modify the constitutional
choice setting so as to reconcile such possible divergences. It appears that, at
least from the perspective of potentially-conflicting interests among
constituencies, the general problem of constitutional efficiency and
survivability does not resolve itself naturally.
11. Veil of Uncertainty and/or Ignorance Versus the Availability of Exit
Options
Is it possible to specify the conditons under which constitutional agreement
may be facilitated in real, non-hypothetical choice situations? Is it possible
to modify the constitutional choice setting so as to reconcile divergences in
interests?
In this respect, two lines of reasoning have been pursued in the
contractarian and neo- contractarian literature.
The first line of argument focuses attention on the need for a veil of
uncertainty and/or ignorance as a precondition for an efficient constitution.
Buchanan and Tullock (1962) had to present a convincing positive argument
that unanimous consent at the constitutional level was possible at all. How
can agreement be achieved on rules among persons with potentially
conflicting constitutional interests? Buchanan and Tullocks (1962)
characteristic way of approaching this issue consists of emphasizing the
uncertainty confronting all individuals taking part in constitutional
deliberations. The existence of a veil of uncertainty induces individual
participants in a constitutional process to prefer rules that do not systemati-
cally favour any particular subset of citizens.
620 Public Choice and Constitutional Political Economy 0610
The proposed remedy involves the introduction of some means of
insuring a persons inability to foresee reliably their future particularized
interests, as these may be affected by different rules, thereby inducing
persons to make constitutional choices on some assessment of the general
working properties of alternative rules, and divorced from particularized
interests. Thus, agreement is facilitated by whatever increases a persons un-
certainty about the particular effects that alternative rules can be expected to
have on them. In fact the assumption of a veil of uncertainty was also
hidden in Buchanan (1993b), discussed above.
Buchanans approach has affinities with John Rawlss (1971)
construction, who utilizes the veil of ignorance along with the fairness
criterion to derive principles of justice that emerge from a conceptual
agreement at a stage prior to the selection of a political constitution. Thus in
Rawlss construction the prospect of agreement is secured by defining
certain ideal conditions under which constitutional choices are hypotheti-
cally made. The choosers are assumed to be placed behind a veil of
ignorance, that makes it impossible for them to know anything specific
about how they will be personally affected by alternative rules. Ignorant
about their prospective specific interests in particular outcomes, they are
induced to judge rules impartially. Potential conflict in constitutional
interests is not eliminated, but the veil of ignorance transforms potential
interpersonal conflicts into intrapersonal ones (Vanberg, 1994, p. 170).
However, the constitutionalist notion of a veil of uncertainty is not very
operational. It is not clear how genuine uncertainty could be achieved in
real-world constitution formation. Moreover, in certain parts of the rent-
seeking literature there is a certain tendency to suggest that conflicts of
interest are no less characteristic for choices among rules at the
constitutional stage than for choices within rules and that therefore the idea
of some genuine constitutional agreement is a mere illusion when placed in
a real-world context. This view seems to be espoused by, for example, Sutter
(1995).
Therefore, it has been argued that the availability of exit options can
ensure a competitive setting for participants in constitutional deliberations
and can even substitute for a veil of uncertainty. This condition for efficiency
can be given operational substance in processes of real-world constitution
formation (Lowenberg and Yu, 1992).
In order to produce an efficient social contract or constitution,
deliberations must be carried out in a competitive constitutional
environment. This condition is satisfied if an exit option exists for each
contracting party. As will be argued later on, this conclusion is quite
consistent with the Wicksell-Buchanan-Vanberg contractarian consensus
test. Only in a competitive setting does unanimous agreement acquire
operational substance (normative content).
0610 Public Choice and Constitutional Political Economy 621
The notion of exit has thus been invoked to give more operational
substance to the concept of voluntary agreement. It is derived from
Hirschmans (1970) classic distinction between exit and voice. Exit (and
entry) is an important means by which individuals are able to express their
preferences, and is precisely the method through which preferences are
revealed in competitive markets for private goods.
An exit option introduces an element of market-like competition into the
contracting process, which limits the ability of any party to wield power over
another party. It is not even necessary that this exit option be exercised,
since merely the threat of its use should be enough to restrain rent
appropriation. The scope for opportunism is effectively constrained by
competition, actual or potential.
Furthermore, it is argued that exit options can help to solve the
constitutional maintenance problem by establishing a competitive
environment for post-constitutional political and market exchange
(Lowenberg and Yu, 1992).
12. Federalism, Once Again
The strengthening of regional and local government relative to national
government has been advocated by many scholars as an effective way to
restrain the growth of legislative redistribution. The existence of separate
jurisdictions with some protected powers within a constitutional federation
inhibits coercive behaviour by the government. Such an arrangement
facilitates migration at low cost between federal sub-regions and thereby
enhances competition between these sub-regions. The resulting mobility
forces competitive governmental units to supply public goods in preferred
quantities and to price them broadly in line with relative marginal
evaluations.
The foregoing is related to the Tiebout effect (Tiebout, 1956), which says
that individuals will sort themselves across communities in accordance with
their preferences for the packages of taxes and public goods provided in each
community. The ability of the owners of property rights to move to
competing jurisdictions protects them from potential rent appropriation by a
coercive government. Therefore, it is argued, a federalist constitution can
effectively constrain the power of the state. In a federal system, citizens
seeking political relief can vote with their feet.
The preceding paragraphs suggest that post-contractual exit
opportunities might be characterized in terms of Tiebout competition
between different political groupings. If the constitution permits mobility
622 Public Choice and Constitutional Political Economy 0610
and political plurality, it will help establish and maintain a competitive
political postconstitutional environment.
The unifying theme in the preceding approach to constitution formation
and maintenance is generally that of exit (or entry).
C. Outline of a Reconstruction of the Coase Theorem from a
Subjectivist-Contractarian Perspective
13. Buchanan on the Irrelevance of Transaction Costs
One way to interpret the Coase (1960) analysis consists of seeing it as a
contribution to the externality literature, though Coase would presumably
object to any use of the term externality. Put in externality language, Coase
was essentially arguing that all Pareto-relevant externalities would tend to be
eliminated in the process of free exchange contract among affected parties
(Buchanan and Stubblebine, 1962).
According to Buchanan (1984) Coase did not like the Buchanan-
Stubblebine externality paper and Buchanan conjectures that Coases
objection may have stemmed from a certain ambiguity in perspective
(Buchanan, 1984, p. 11, footnote 6).
The ambiguity in perspective Buchanan refers to is related to the fact
that there are two profoundly different conceptions of competition and the
competitive process. In the objectivist perspective, there is an efficient
allocation of resources independently of any process through which it is
generated. From this supposition, it follows that institutional arrangements
can be directly evaluated in terms of their relative success or failure in
attaining the desired pattern of resource use. Normative argument in support
of competitive institutions emerges, in this perspective, only because such
institutions tend to be relatively superior devices, instruments, or
mechanisms in generating independently derived results. Where
competitive institutions do not seem to exist, as defined by some
independently derived structural criteria (for example, the number of firms
in an industry, concentration ratios, and so on), there emerges a normative
argument for direct intervention with the voluntary exchange process as a
means of moving results toward the externally derived allocative norm or
ideal.
In the subjectivist-contractarian perspective, efficiency cannot be said
to exist except as determined by the process through which results are
generated, and criteria for evaluating patterns of results must be applied only
to processes. In this perspective, voluntary exchanges among persons, within
a competitive constraints structure, generate efficient resource usage which
0610 Public Choice and Constitutional Political Economy 623
is determined only as the exchanges are made. Competitive institutions in
this perspective are not instruments to be used to generate efficiency. They
are, instead, possible structures, possible rules or sets of rules, that may
emerge from generalized agreement. The role of the political order, of law or
government, is to facilitate agreement on institutional arrangements, and to
police rights assigned under such agreements.
In Buchanan (1984) it is argued that Coase, despite his own earlier
contribution to what can be called the subjectivist theory of opportunity cost
(see Buchanan, 1969, pp. 26-29; Coase, 1960) presented his argument -
through a series of hypothetical and historical examples - largely in terms of
presumably objectively-measurable and independently-determined harm and
benefit relationships. It is suggested that Coase was, indeed, applying
outcome criteria for allocative efficiency to results of the exchange process
rather than limiting his attention to the process itself. Therefore the whole
analysis becomes vulnerable to the critique mounted by Cooter (1982) and
others who suggest that the Coase theorem fails in non-competitive settings.
Small-number bargaining settings will necessarily fail to guarantee
efficiency due to the presence of incentives for strategic behaviour,
independently of any communication-information failures. In large-number
settings, all parties may have free-rider motivations. In both of the latter
cases, interpreted in terms of satisfying outcome criteria for efficiency, free
exchange and contract among parties do not necessarily generate an
allocation of resources to their most highly valued uses. Externalities that
are Pareto-relevant may remain in full trading equilibrium. Parties to
potential exchanges who are rational maximizers of expected utilities may
fail to reach the presumed objectifiable Pareto efficiency frontier. However,
Buchanan contends that if the whole Coase analysis is interpreted in
subjectivist-contractarian terms, the critique can be shown to be without
substance.
Buchanan (1984) is an explicit attempt to re-interpret the Coase (1960)
theorem along consistent subjectivist-contractarian (or, if preferred,
Austrian-Wicksellian) lines.
If there is no objective criterion for resource use that can be applied to
outcomes, as a means of indirectly testing the efficacy of the exchange
process, then as long as exchange remains open and as long as force and
fraud are not observed, that upon which agreement is reached is, by
definition, that which can be classified to be efficient. The Coase theorem
thus seems to become a tautology. How could, in this construction,
inefficiency conceivably emerge? Is that which is always necessarily
efficient?
Of course it is not. Already in Buchanan (1959) it was suggested that
agreement is the only ultimate test for efficiency, but that the test does not
need to be confined in application to the allocative results or outcomes
624 Public Choice and Constitutional Political Economy 0610
generated under explicitly existing or defined institutional-structural rules.
The agreement test for efficiency may be elevated or moved upward to the
stage of institutions or rules, as such.
The proper role for the normative political economist is that of
discovering potential rules changes that might yield general benefits and
then presenting these changes as hypotheses subject to the Wicksellian
contractual-consensus test. If, when presented with a suggested change in
rules, agreement among all potentially interacting parties is forthcoming, the
hypothesis is corroborated. The previously existing rule is proven to be
inefficient. Agreement on a change in the rules within which exchanges are
allowed to take place is a signal that patterns of outcomes reached or
predicted under the previously-existing set of rules are less preferred or
valued than the patterns expected to be generated under the rule-as-changed.
Hence, the new rule is deemed more efficient than the old. If disagreement
emerges on the proposed rules change, the hypothesis is falsified. The
existing rule is classified as Pareto-efficient. And, given this institutional
setting, any outcomes attained under free and open exchange processes are
to be classified as efficient.
Let us consider as an example the classic externality case from welfare
economics, the setting in which ordinary economic activity within well
defined legal rights imposes noncompensated damages on a sufficiently
large number of persons so as to insure failure of a bargained solution due to
free-rider motivation. The uncorrected outcomes in this setting should still
be classified as efficient as long as all members of the relevant community
remain free to make intervening offers and bids to those traders whose
activity is alleged to generate the spillover harms. The institutional structure
may not be efficient, however. The political economist may hypothesize that
general agreement can be secured on some change in institutional structure
and that explicit political or governmental decision rules may come to be
accepted by all parties as being preferred to the decision rules of the market.
Even though the outcomes reached may still be classified to be efficient -
given the assignment of rights, and given the institution of exchange - the
institution of voluntary exchange, as ordinarily understood, may not, in this
case, be efficient. This implication may sound somewhat paradoxical but for
the subjectivist-contractarian it creates no difficulty since he does not
acknowledge the uniqueness of the resource allocation that is properly
classified to be efficient: it depends necessarily on the institutional structure
within which resource utilization-valuation decisions are made.
There is a second seeming paradox. That political-governmental decision
rule upon which agreement is reached may not require consent of all parties
to reach particular outcomes, either explicitly or implicitly. The efficient
decision rule may be such that specific outcomes need not meet the
0610 Public Choice and Constitutional Political Economy 625
consensus test. The analysis contained in Buchanan and Tullock (1962),
which is essentially an analysis of the choice among political decision-
making rules had highlighted the fact that the costs of reaching agreement
increase significantly as the size of the group required to agree is expanded.
However, this situation need not imply that the unanimity principle for
constitutional changes is inapplicable. The members of the group may be
observed to agree on changes in the rules that produce results which, when
classified by the orthodox Pareto criterion, are clearly nonoptimal. In other
words, optimal rules may generate results that may be classified as
nonoptimal.
With majority rule, or any less than unanimity rule, for political-
governmental decisions, the decision structure can itself be efficient while at
the same time the particular outcomes attained under the structure are to be
presumed inefficient, at least in some situations, for those who are directly
coerced. Buchanan believes that to introduce transactions costs as a barrier
to the attainment of efficiency confuses rather than clarifies the complex set
of issues involved. The several so-called transaction costs barriers to
efficiency in resource allocation - information and communication
constraints, free rider constraints, strategic behaviour ... - can be more
appropriately analysed in the context of hypotheses about institutional
reform (Buchanan, 1984, p. 23).
D. Refinements and Applications: A Survey of Contributions
14. Foundational Explorations
One of the major discussions in contemporary institutional economics
concerns the relation between rationality and rule following. The problem is
akin to what philosophers will recognize as an unresolved issue in the
history of ethics. As several authors have recognized, the problem was posed
at the very beginning of the history of philosophizing about the justification
of moral rules, in Platos Republic (McClennen, 1990a, p. 262). In Plato
(1992, pp. 34-35, Book II, sec. 359) Glaucon challenged Socrates to prove
that being just is rational even if we suppose that the material rewards of
being just accrue exclusively to the unjust. The story of the ring of Gyges
seems to drive a wedge between the concept of rational choice and that of
choice that respects the usual kinds of moral constraints. In the language of
public goods theory, the challenge is to show that when the material payoff
of being just is a public good - enjoyed by everyone but its producers - there
is nevertheless a hidden private benefit that makes it rational to produce this
public good (Schmidtz, 1991, p. 165).
626 Public Choice and Constitutional Political Economy 0610
There appears to be an essential tension between the notion of rational,
self interested behaviour - as postulated in economics - and the notion of a
viable moral order. In the relevant literature this problem is referred to as
the Hobbesian problem of social order or simply the Hobbesian problem.
Vanberg (1993, 1994) presents an interpretation of the rational choice
and rule-following perspectives which allow their consistent integration into
a common theoretical framework. Hayek had already argued that man is as
much a rule-following animal as a purpose-seeking one (Hayek, 1973, p.
11). Generally speaking, Vanbergs program can be characterized as a
systematic and transdisciplinary integration of J.M. Buchanans contrac-
tarian perspective with F.A. Hayeks evolutionary approach, making use of
insights from a wide range of fields. The contractarian element in Hayeks
thought has also been identified by Sugden (1993a). The contrast between
Hayeks and Buchanans systems of ideas is highlighted by, for example,
Gray (1990).
Vanberg (1993a, p. 187) distinguishes maximizing and adaptive forms of
rationality and argues that an evolutionary perspective using the concept of
adaptive rationality may help to systematically account for observed
behavioral tendencies which appear to defy explanation in standard
rationality terms. This argument is related to Hayeks notion that rule
following is a response to humankinds imperfect understanding of their
environment. Rules are not chosen as a result of a full rational appraisal but
can best be seen as more or less reasonable adaptations to a complex world
and not necessarily as optimal in their functioning.
On one occasion, Vanberg argues that rule-following behaviour, while
relatively unresponsive to variations in particular situational circumstances,
is quite compatible with choice and calculation at the rule level
(Vanberg, 1994, pp. 16-17), thus suggesting that the problem can be thought
of in terms of a rational maximizing choice on a metalevel. However, if
maximizing itself is subject to, say, information costs, the choice of rule
cannot be seen in optimizing terms. There seems to be no alternative to
separating the concept of rationality from the notion of optimization. In this
way Simon distinguished procedural from substantive rationality (Simon,
1976). Simon argued that the orthodox neoclassical concept of rationality as
maximizing implies an unrealistic view of mans cognitive abilities, of his
access to information and his computational capacities. The alternative
concept of rationality which Simon proposes, namely that of bounded,
procedural or adaptive rationality, is in essence a theory of behavioural
learning, a theory which seeks to understand a persons current behaviour in
terms of his or her past experience. Simons theory of human decision
making views an actors choice-behaviour as based on a repertoire of
behavioural patterns, routines or programmes.
0610 Public Choice and Constitutional Political Economy 627
An extension of the bounded rationality problem has been provided by
Ronald Heiner (1983, 1990, among others). Formal economics is a theory of
perfect choice that assumes agents always make best decisions based on
available information. The latter may itself be inaccurate or incomplete, but
no further imperfection enters into the analysis about the agents ability to
decide optimally. In a sequence of articles, Heiner has made an effort to
develop a theory of imperfect choice which provides an argument for why
rational, but imperfect agents may profit from following rules instead of
attempting to maximize advantage on a case-by-case basis.
Heiners argument is that there is often a gap between an agents
competence at problem solving and the difficulty of the decision problem
faced. Given such a C-D gap, which will tend to exist in complex decision
problems, agents will be subject to unpredictable errors and mistakes in
selecting the most preferred alternative. The extent of these errors possibly
means that an agent will do better by following a simple rule rather than by
attempting to maximize in each case. Heiners analysis implies that
imperfect agents benefit from being governed by rules adapted only to
recurrent situations and from ignoring relevant, even costlessly available
information. The Heiner (1990, pp. 39-40) analysis also suggests a basic
tradeoff between reaching initial agreement over constitutional rules and the
stability of future compliance to them once they are put into practical
application. There is a basic tradeoff between ignorance and uncertainty that
promote consensus over ex ante rules (that is, before anyone has had any
actual experience living under them), and the reliability of any such advance
agreement in avoiding rules that turn out destabilizing ex post due to errors
that are self-recognized through the very ongoing experience generated by
following the rules.
Thus, maintaining allegiance to previously agreed social rules can be a
far more difficult challenge than reaching initial agreement about which
rules to begin following - especially if the initial agreement was achieved
under a veil of ignorance about the practical consequences of applying rules
to future conditions.
15. Contractarianism and Evolutionism
In the modern research programme of Constitutional Political Economy two
strands of thought are systematically interwoven: a subjectivist-contractarian
strand of Austrian-Wicksellian origin, on the one hand, and an
evolutionistic strand, which essentially works out the implications that
follow from Popperian evolutionary epistemology for the issues of socio-
economic-political organization.
628 Public Choice and Constitutional Political Economy 0610
For recent discussions of contractarianism, and apart from Buchanans
and Vanbergs own contributions, reference is made to Binmore (1990),
Hardin (1990), Mueller (1990) and Sugden (1990). Coleman (1990)
contains a valuable comparison of Buchanans form of contractarianism
with that of the philosophers John Rawls and David Gauthier. Sugden
(1993a) outlines a procedural or contractarian formulation of rights. Gaus
(1991) sketches an account of political authority and democracy that depicts
them as responses to our moral disagreements and our inability to rationally
resolve them on their merits.
The constitutional contract is often interpreted as a device to overcome
the hypothetical state of anarchy (see, for example, Buchanan, 1975). How
can, in a pre-constitutional setting that lacks any institutional forms, a
unanimous agreement on the rules and the agency enforcing the rules be
imagined to emerge? Witt (1992) conceptualizes the problem in game
theoretic terms and explores the logical basis of the dilemma that turns up in
this context. While the protective agency has to be endowed with sufficiently
powerful coercive means to prevent anyone breaking the social contract, this
concentration of power may itself induce a violation by making the pro-
tective agency usurp its power.
The implications of subjectivism are equally remarkable. Traditionally,
the subjectivists par excellence within economics were the Austrians.
Vanberg (1994, Chap. 13) has consistently worked out the implications of
subjectivism for the theory of organized, collective action. The normative
focus is shifted from endstates or outcomes, as such, to the process through
which these outcomes or endstates emerge. The relevant question becomes
whether the process by which outcomes and endstates are brought about can
reasonably be assumed to reflect the preferences of the individuals
concerned, as revealed in their actual choice behaviour. Thus the approach is
incompatible with criteria that - as is true for Benthamite utilitarianism - are
individualistic in the sense of measuring the goodness of social matters in
terms of individual utilities, but do so without reference to individuals
choices. It can be characterized as choice-individualism, as opposed to the
utility-individualism that underlies the whole tradition of the concept of a
social welfare function.
Vanberg clearly recognizes that the true problem with the agreement
criterion is not that it is too demanding but, instead, that it has too little
normative content. A criterion needs to be specified which allows one to
distinguish between constraints that are judged to render the respective
individual choices involuntary, and those that do not. His analysis reaches
the conclusion that a consistent normative-individualist approach needs to
rely on a combined and simultaneous application of a purely procedural, rule
oriented, as well as a substantive, avoidance/exit-cost criterion. The avoidan-
ce/exit cost perspective arguably provides a more operational specification of
0610 Public Choice and Constitutional Political Economy 629
the contractarian norm than the notion of a hypothetical contract to which
Buchanan (1975, 1977) as well as Rawls (1971) appeal. The exit perspective
is consistently followed by, for example, Lowenberg and Yu (1992) and
Mbaku (1995).
The evolutionistic strand of thought in fact consists of a complex set of
more or less interrelated theses some of which are more controversial than
others. The least problematical ingredient is reflected in the idea, related to
Hayeks limits of reason insight, that, in the realm of rules and institutions
no less than in other areas, we can never know ex ante what the best
solutions to our problems will be, if alone - as Popper has pointed out in his
critique of historicism - because we cannot know today what we will know
tomorrow. In fact, we cannot know ex ante what our future problems will be.
Therefore, we need to rely at least to some extent on the explorative
potential of open ended, competitive processes and on the kind of experience
that accumulates in trial and error learning. But there is no reason to expect
that what survives necessarily coincides with what is desirable in the sense
of being responsive to the interests and preferences of the persons involved.
It would seem entirely unfounded to expect an unqualified evolutionary
process generally to produce such favourable conditions. On the other hand,
a recognition of the limits of our reason should not imply that we cannot
say something about the kinds of conditions and process-characteristics that
enhance responsiveness to the interests and preferences of the persons
involved. Indeed, creating and maintaining such conditions has to be the
primary task for deliberate constitutional design. There is room for both
evolutionary learning and constructive design, not only as compatible, but
also as indispensible and complementary elements of an appropriate socio-
economic-political order. This insight leads Vanberg to develop the notion
of constitutionally-constrained evolution (or competition), a combination
of deliberate design and evolutionary learning: the design of a framework of
meta rules - the idea of a meta constitution - within which efforts in
constitutional construction are subject to a kind of evolutionary competition
that promises to make selections in favour of rules that serve the interests of
the respective constituencies. The programme culminates in a theory of
institutional competition among jurisdictions viewed as a knowledge-
creating discovery process (Vanberg, 1994, p. 284; Vanberg and Kerber,
1994).
Institutional competition has been analysed from a variety of
perspectives. Wiseman (1990) argues that analysis of voice and exit
dimensions of a fiscal constitution is a means of appraising the efficiency of
social arrangements. Marlow (1992) argues that ones view toward the
design of voice and exit options is affected by ones perception of the
appropriate size of government. It is recognized that the design of voice and
exit options in the fiscal constitution exerts a predictable influence on policy.
630 Public Choice and Constitutional Political Economy 0610
Sinn (1992) analyses competition among governments on the basis of a
model that views countries as clubs.
Evolutionary themes are further explored in the following contributions.
Parisi (1995) contains a sophisticated outline of a theory of spontaneous law.
Wohlgemuth (1995) contrasts the neoclassical and the market process
conceptions of economic and political competition and develops an
alternative agenda for many fields of public choice. Gruner (1995) examines
evolutionary stability of social norms in a formal socioeconomic equilibrium
model. The institutional evolution of the Icelandic Commonwealth (930-
1264 AD) is discussed in Solvason (1993).
It has almost become a commonplace to state that game-theoretic notions
and approaches capture essential elements of the evolutionary paradigm.
Most of the arguments can be related to repeated coordination (Warneryd,
1990), Prisoners Dilemma (see Axelrod, 1984) or hawk dove (Sugden,
1989) games. Generally speaking, the extension of the market analogy to the
constitutional level, that is, to the rules and institutions within which market
coordination takes place, is not corroborated by the game-theoretic analysis
of invisible-hand processes. This analysis does not warrant the conclusion
that invisible-hand processes will operate to generate efficient results, except
under a highly restrictive set of conditions. This point is illustrated by, for
example, Warneryd (1990). Warneryd discusses the evolutionary game
theoretical approach to the emergence of conventions, that is, institutions
that solve recurrent coordination problems. It is argued that conventions
may be said to minimize transaction costs, but that they need not be
efficient.
16. Compliance, Renegotiation, Secession
Constitutional preferences, like any other preferences, can be assumed to
embody two conceptually distinct components, an interest-component and a
theory-component. Rational actors will have reasons to be concerned, not
only about the interest dimension, but also about the theory dimension in
constitutional choice.
Both concerns have certain implications for the kinds of procedural
constraints that can be expected to facilitate actual agreement, implications
that need not be in perfect accordance.
So far as the interest dimension is concerned, it has been a central tenet
of constitutional political economy at least since Buchanan and Tullock
(1962) that constitutional deliberations must take place behind a veil of
uncertainty in order for a constitution to be efficient. The prospects for
reaching constitutional agreement are enhanced by whatever tends to
increase persons uncertainty about the particular effects that alternative
0610 Public Choice and Constitutional Political Economy 631
rules can be expected to have on them, that is, by whatever tends to thicken
the veil. The veil notion can be seen as a summary label for factors that, by
increasing uncertainty, tend to alleviate potential conflicts in constitutional
interests.
It should be noted that potential knowledge-based disagreement
obviously requires the opposite cure. The prospects of agreement on
desirable or efficient rules and the prospects for adopting such rules are
enhanced, not by creating uncertainty, but, on the contrary, by raising the
level of mutually-shared information and knowledge on the general working
properties of alternative rules. The Buchanan-Tullock veil of uncertainty
and the Rawlsian veil of ignorance are assumed to render persons
uncertain or ignorant about their particularized interests while not inhibiting
their capability accurately to anticipate the general effects of potential
alternative rules. In other words, their constitutional theories are supposed to
be perfect and non-controversial. Informational problems with regard to the
general working properties of rules do not exist.
This section is concerned with the interest dimension, that is, with the
difficulties involved in any attempt to achieve agreement on rules among
persons with potentially-conflicting constitutional interests. Moreover, once
agreement has been achieved, the agreement must be enforceable because
each individual has a subsequent incentive to defect from the cooperative
agreement.
It is recaIled that in the contractarian and neo-contractarian literature
two lines of reasoning have been pursued which focus central attention on
the interest-component in constitutional choice with a view toward
modification of the constitutional choice setting so as to reconcile potential
divergences. Both are concerned with the general problem of constitutional
efficiency and survivability.
The first line of argument, which is discussed in this section, focuses
attention on the need for a veil of uncertainty as a precondition for an
efficient constitution. The second line of argument adopts an exit (entry)
perspective.
Though Rawlss idea of constitutional choice behind the veil of
ignorance and Buchanans notion of conceptual agreement cannot be
expected to provide a workable criterion upon which actual normative
judgements on existing social arrangements could be based, they do serve a
useful heuristic function by directing attention to the question of whether -
based on our general understanding of the nature of human choice - it can be
plausibly assumed that some existing set of rules could have been voluntarily
agreed upon by all participants at some original stage of decision.
A notion that is typically used in this respect in contractarian theories is
fairness. Fairness can be induced by two independent factors: (1)
632 Public Choice and Constitutional Political Economy 0610
uncertainty, as has been indicated already, and (2) the concern for stability,
which will be discussed below.
In real-world settings persons are typically not totally ignorant about
their particular constitutional interests. But they are not perfectly certain
about these interests either. They typically find themselves behind a veil of
uncertainty that prevents them from accurately anticipating the particular
ways in which they will be affected by the prospective working properties of
alternative rules.
The veils thickness may vary, depending on certain characteristics of the
actual choice situation. As the veils thickness increases so will the prospect
of achieving agreement. The variables that affect the veils thickness can to
some extent be manipulated and rational actors can take deliberate measures
designed to put themselves behind a thicker veil, thereby enhancing the
prospects of realizing potential gains from constitutional agreement.
In this respect the following observations are made. The degree of
uncertainty is, in part, a function of the sort of rules that are under
consideration. The essential dimensions here are the generality and the
durability of rules. The more general rules are and the longer the period over
which they are expected to be in effect, the less certainty persons can have
about the particular ways in which alternative rules will affect them. They
will therefore be induced to adopt a more impartial perspective and,
consequently, they will be more likely to reach agreement. The veil of
uncertainty works by moderating the differences among identifiable
constitutional interests, thus inducing fairness or impartiality and facilitating
agreement in constitutional choice.
There is an additional factor through which fairness can be induced,
independent from the uncertainty factor, but working in the same direction.
This factor is the concern for stability. The possibility of realizing gains by
operating under constitutional constraints is not just a matter of securing
some initial agreement; it is also a matter of a sufficient level of ongoing
agreement, of continuing acquiescence in an ongoing co-operative
arrangement. Stability refers to the viability of a constitutional arrangement
over time. Rational actors can be expected to take considerations of stability
into account when engaging in constitutional choice. To the extent that
fairness and stability are interrelated, the concern for stability will induce a
concern for fairness or impartiality even in persons who may be perfectly
aware of the particular effects that alternative rules will have on them. It is
not the uncertainty about ones own particular position that will induce
impartiality, but the anticipation that a constitutional arrangement is
unlikely to be stable if it is only designed to serve ones own particular
interests.
How precisely are stability and fairness interrelated? Two aspects of the
stability problem should be distinguished. They are not always sufficiently
0610 Public Choice and Constitutional Political Economy 633
separated in discussions on the issue: the compliance problem and the
renegotiation problem.
First, in order for a constitutional arrangement to be stable over time it
has to command a sufficient level of compliance. However, compliance with
rules is certainly not a direct function of their fairness. The fact that rules
are perceived as fair by the relevant group of persons does not, per se,
guarantee a willingness to comply with those rules. The compliance problem
results from the fact that there may be potential gains from defecting.
Whether such gains exist or not is not per se dependent on the fairness
properties of the arrangement. To the extent that such gains exist, a
compliance or unilateral defection problem is present even with perfectly
fair rules.
Second, constitutional arrangements should also command a sufficient
level of ongoing agreement. A constitutional agreement that favours
particular interests may be achievable under suitable conditions, but such
agreement can be expected to be less robust with regard to potential changes
in circumstances than fair arrangements. Unfair arrangements may tend to
give rise to the renegotiation problem. It is especially with regard to
renegotiation rather than with regard to compliance that the concern for
stability can be expected to induce a concern for fairness. There is a much
more direct relation between the fairness issue and renegotiation than there
is between fairness of rules and compliance with rules.
For further discussion on the foregoing and related issues, reference is
made to the following contributions.
Several fundamental issues relating to the problem of constitutional
stability are discussed in Ordeshook (1992). Twight (1992) assesses the
extent to which consensuality is likely to characterize the process of
constitutional revision. Theoretical and empirical grounds are provided for
concluding that non-consensual constitutional revision is often the rule
rather than the exception. The endogeneity of politically relevant transaction
costs and their manipulation by self-interested political actors in a post-
constitutional environment are central to the analysis. The theory of
constitutional maintenance is equally examined in Niskanen (1990).
Constitutional renegotiation may end in impasse. Young (1994)
examines the political economy of secession. Special reference is made to
the case of Quebec. The author explains why secessionist movements have
not been successful in industrialized welfare states, even when the structural
preconditions are largely present, as in cases like Scotland and Belgium. A
formal analysis of constitutional secession clauses using game theory is
made in Chen and Ordeshook (1994).
634 Public Choice and Constitutional Political Economy 0610
17. The Common Law and its Efficiency
Buchanan (1977) criticized Posner (1972) for its failure to make the vital
distinction between the two functional roles in which lawyers may find
themselves: Posner appears to offer potential advice and counsel to future
judges and legislators alike. But, recalls Buchanan, the judge should not
change the basic law because by such behaviour he would be explicitly
abandoning the role of jurist for that of legislator. In his role of jurist he
should enforce existing law instead of enacting new legislation. Buchanan
referred explicitly to Leonis (1961) distinction between law and legislation.
It follows from Buchanans argument that there is no justification at all for a
judicial introduction of the putative efficiency norm, presumably to be
imposed independently of the political process. This view is implied by the
adoption of the subjectivist-contractarian consensus or unanimity rule as a
benchmark for efficiency. The normative economist can advance alternative
sets of rules as a hypothesis to be tested in the political exchange process,
but he should never be allowed to take the arrogant stance of suggesting that
this or that set of institutions is or is not more efficient.
In a similar vein De Alessi and Staaf (1991) argue that the law and
economics view of the common law as an efficient process that promotes the
evolution of efficient rules through an auction-like mechanism is flawed
because it fails to cope with the problem of aggregating preferences. They
argue that the belief that the efficiency of the common law is enhanced by
assigning disputed rights so as to lower transaction costs is also flawed. The
common law provides a form of unanimity by allowing individuals to
contract around the rule and provides order by maintaining transitivity,
through the use of precedent, in the application of the rule to new situations.
Aranson (1992) highlights another problem: in the neoclassical approach
to law and economics, the common law judges, in rendering decisions that
maximize wealth, are placed in the position of calculators of comparative
values. However, this task confronts the courts with an insoluble economic
calculation problem, analogous to the problem faced by central economic
planners. Therefore, courts should prefer to stay as close by as they can to a
rights-based jurisprudence.
Wagner (1992) argues that social processes regarding the formation of
rules should be assessed in terms of their ability to provide a framework of
stable rules guaranteeing the stability of expectations and allowing people to
plan their economic activities. The dichotomy between statutory and
common law is overdrawn, because both derive from the same source in a
setting where there are no longer polycentric sources of competing authority,
since the contemporary nation-state - presumably Wagner has the United
0610 Public Choice and Constitutional Political Economy 635
States of America in mind - has the capacity to absorb all alternative sources
of authority into itself.
More radically Benson (1992b) argues that the government-backed
common law system is more likely to adopt inefficient rules than a genuine
customary law system. Though he recognizes that much of common law was
simply a codification of the basic norms common to Anglo-Saxon society,
Benson recalls that common law was also royal law and that even during its
earliest periods of development some aspects of it were legislated and
imposed by authoritarian kings. Furthermore, when a governments judges
make new law through precedent, it becomes enforceable law for everyone in
the society whether it is a mutually beneficial law or not. Common law
precedents are backed by the coercive power of the state and, therefore they
take on the same authority as statute law.
Yandle (1991) develops a vision of the Common Law as an organic
Constitution, reflecting evolved social norms, a result that causes ordinary
people to accept the authority of judges.
18. Studies in the History of Ideas
There now is a fair number of review articles on Buchanans thought.
Besides those already mentioned, reference can be made to Brennan (1987,
1990), Congleton (1988) and Yeager (1990).
In Germany, institutional analysis has a long and autonomous tradition,
which has not been given proper international recognition. This applies
especially to the neoliberal Ordnungstheorie, of which Walter Eucken is
generally acknowledged to be the leading representative. Leipold (1990)
examines the methodological and theoretical similarities and differences
between Euckens Ordnungstheorie and Buchanans Constitutional
Economics. Though there is no tradition of pluralism in German history,
some German thinkers developed ideas which came remarkably close to
later English and American pluralists. This development, particularly as
exemplified in the work of Georg Beseler, Otto Gierke and later Hugo
Preuss, is dealt with in Dreyer (1993).
Aranson (1991) argues for the coherence of Calhouns political thought,
when read in the light of modern public choice theory and contrary to earlier
interpretations.
Madisons constitutional political economy is carefully examined in
Dorn (1991). James Madison was instrumental in the design, ratification,
and implementation of the American Constitution. He also was the major
force behind the Bill of Rights. It is in the light of these accomplishments
that Madison has been called The Founding Father. Because he focused on
636 Public Choice and Constitutional Political Economy 0610
the rules or principles of a liberal order rather than on the outcomes, James
Madison can properly be viewed as a pioneering constitutional political
economist. Drawing on the political theory of Locke and the economic
theory of Smith, Madison successfully combined the two to form a coherent
theory of constitutional economics. Adopting a self-interest postulate, he
showed that social and economic order are best achieved by allowing open
competition to prevail under a rule of law protecting private property and
freedom of contract. Thus, he clearly recognized the close relation between
political order and economic order, and he anticipated many of the themes
in the public choice/constitutional economics literature.
One of the insights of Madison and other framers of the US constitution
was that a bicameral legislature might function as a device to limit the
power of legislative coalitions. The idea was that each house would be
elected differently and consequently would represent different interests. The
requirement of a simultaneous majority in both houses in order for
legislation to be enacted would then guarantee a broad social consensus. It
should be noted that the differences between the two chambers have been
eroded subsequently. However, the argument for bicameral legislatures on
efficiency grounds and the urge that the two houses be elected by radically
different methods, was at the theoretical level revived in this century by
Tullock (see Buchanan and Tullock, 1962, Chap. 16, written by Tullock; see
also Tullock, 1987).
Elazar (1991) argues that the work of an early political scientist,
Johannes Althusius, who developed his theory of the polity on the eve of the
modern epoch at the end of the sixteenth century, offers an important
starting point for building a postmodern theory of political and social
organization. Althusius (1991) is a collection of excerpts from his Politica
Methodice Digesta (1603/1614).
Sir Edward Cokes role as a constitutional entrepreneur in seventeenth-
Century England is highlighted in Yandle (1993).
19. Variations on Hayekian Themes
Constitutional political economy shares much of the spirit of Hayeks
inquiry into the interrelation between the order of rules and the order of
actions, and of his message that changes in the order of rules are the
principal means by which we can hope to improve the socio-economic-
political order under which we live (Vanberg, 1994, passim). It will come as
no surprise, then, that several contributions elaborate explicitly on Hayekian
themes. Buchanans personal recollections of F.A. Hayek are set out in
Buchanan (1992).
0610 Public Choice and Constitutional Political Economy 637
Streit (1993) brings out clearly how Hayeks approach to the social
sciences, especially to economics, is rooted in his epistemological position,
particularly as he set it out in Hayek (1952). Butos and Koppl (1993) outline
a theory of expectations based on Hayeks cognitive theory. The central tenet
of the theory, which is intended to have both policy implications and testable
empirical content, is that economic expectations will serve as reliable guides
to action only when certain filtering conditions, that is certain consti-
tutional constraints such as the atomicity of the market process and the
stability of the rules governing that process are satisfied. A failure of either
condition creates a loose system constraint and thus a loose link between
environment and expectation, as the theory of big players illustrates. Big
players, of which central bankers are a prototypical example, introduce a
wedge between epistemic knowledge and social reality. The theory
highlights the connection between the choice of constraints and its epistemic
consequences. The big player theory also suggests a possible direction for
future empirical work in a Hayekian tradition. Within the adopted
framework neoclassical economics and radical Keynesianism may be
seen in a sense as limiting cases. When certain filtering conditions are in
place, the results of the market process may be described by neoclassical
models of rational maximizing and action will seem predictable at least at
some aggregate level. To the extent that these conditions fail, the market
process will be influenced by animal spirits and the like and action will seem
unpredictable to the observing economist. Thus the evolutionary logic of
Hayekian economics provides the general theoretical foundations for special
empirical theories, such as the big player theory, which may identify the
precise causes and consequences of observed deviation from the neoclassical
model.
It is to be regretted that the recently developing literature on, say,
monetary constitutionalism has largely failed to incorporate these Hayekian
insights. Recent events in the European Monetary System on the one hand,
and monetary disintegration in the former Soviet Union on the other, have
revived interest in the question of how to design and choose a monetary
regime that ensures monetary stability for both parts of Europe. Even among
economists who are otherwise considered staunch advocates of laissez-faire
policy, money is still regarded as the prime and uncontroversial example of
a good that has to be provided by government. Buchanan (1962), accepting
the premise that money is a public good that can only be provided by
government, derives its optimal properties from a constitutional perspective.
In the same vein Spinelli and Masciandaro (1993) argue for a
constitutionalization of the target of monetary stability in Italy.
Hefeker (1995) has argued that the objective of monetary stability can be
achieved either by complete monetary union or by currency competition and
that both regimes may be viable solutions depending on the circumstances.
638 Public Choice and Constitutional Political Economy 0610
His paper makes the case for monetary union in Western Europe, even
though he recognizes that monetary union is no alternative for Eastern
Europe and the former Soviet Union.
We believe that the critical examination and evaluation of the properties
of alternative monetary regimes constitutes one of the most interesting and
exciting lines of future research within the field of constitutional economics.
Choi (1993) offers a critical evaluation of Hayeks atavism of social
justice thesis, suggesting an alternative explanation for the widespread
demands for social justice in contemporary society, based on the analysis of
the nature of entrepreneurship and its tendency to incite envy.
Tuerck (1995) re-interprets Hayeks theory of mind in the light of
contemporary philosophy of artificial intelligence.
20. Towards a Constitutional Economics of the Firm
Vanberg (1992a) compares four theoretical approaches to the study of
organizations that can be identified in the relevant literature: the goal
paradigm, the exchange paradigm, the nexus of contracts paradigm, and the
constitutional paradigm. It is argued that the latter provides the more fruitful
theoretical perspective in that it reconciles an individualist methodology
with an account of organizations as corporate actors, as units of collective
action.
In search of a more decisive argument in the controversy concerning
alternative forms of ownership of firms and allocation of capital, Pelikan
(1993) complements and qualifies the standard incentive argument by an
argument considering a less well explored factor: the competence with
which firms are organized and managed. Alternative forms of ownership of
firms are assessed according to their impact on this competence. The general
conclusion is that private and tradable ownership of firms is a necessary
condition for efficiency of supply. The competence argument strengthens the
neoliberal defence of private ownership and market competition. It is in
allocating the authority to organize supply to agents of high relevant
competence, and in demoting from this authority agents of low competence,
that private and tradable ownership of firms is shown to have its decisive
comparative advantage.
Kiser (1994) rationalizes public enterprise by analysing the constitutional
choice between private and public ownership of production arrangements.
Arguing that results depend on who does the choosing, the article compares
choices by self-governing citizens with choices by self- directed
governmental officials. The resulting institutional theory identifies four
conditions that cause citizens to favour public over private ownership:
natural monopoly, output and process invisibilities, the production of
consumer necessities, potential producer moral hazard. None of the
0610 Public Choice and Constitutional Political Economy 639
conditions refers to the standard concept of economic efficiency, which
guides most economic comparisons of public and private enterprise.
Langlois (1995) argues that Hayeks theory of spontaneous order can in
fact include the case of such apparently purposive and extramarket forms as
the business firm. In other words, Hayeks theory of the market as a
spontaneous order has implications for the theory of the firm that the
mainstream Coasean approach has yet fully to absorb. Langlois picks up a
number of suggestions in Hayeks evolutionary theory of social institutions
and uses them to draw a picture of the firm that is somewhat different from
that drawn by neoclassical transaction-cost analysis. In the Hayekian picture,
firms and markets are both systems of rules of conduct. Both are systems for
economizing on knowledge in the face of economic change, albeit quite
different kinds of knowledge and change. Moreover, there is a sense in
which the firm exists not in order to centralize control over knowledge but -
like the market - precisely to decentralize the use of knowledge. In the end,
it is argued that the firm is no model for political planning for one very
simple reason: the firm does not plan.
Adelstein (1991) draws upon the contractarian distinction between
constitutional and operational levels of personal choice and an evolutionary
analysis of the growth of firms to illuminate the complex issues surrounding
the emergence of large-scale economic organization in the United States in
the years since 1870.
21. Redistribution
There have been two recent attempts to provide a rationale for redistribution
within the scope of constitutional political economy. Kliemt (1993b) argues
that redistribution can be institutionalized at the constitutional level to attain
a minimum welfare state without violating basic principles or incurring
risks beyond those that are present in the minimal state itself. Wessels
(1993) describes a situation in which individuals may unanimously agree to
transfer income at the constitutional stage on the grounds that redistribution
provides income insurance. Both are criticized, invoking the usual
arguments, by Pasour (1994).
22. European Integration
Streit and Mussler (1994) analyse the changes in the economic constitution
of the European Community since its foundation in 1958. It is argued that as
far as the economic constitution is concerned, the Treaty of Maastricht is
640 Public Choice and Constitutional Political Economy 0610
dominated by traits which are characteristic of modern welfare states. The
editors of Constitutional Political Economy took Vibert (1995) as a starting
point to devote the 1996 Vol. 7 No. 4 issue of their journal to the theme
Europe: A Constitution for the Millennium. This special issue includes
articles by Blankart (1996, pp. 257-265), Buchanan (1996, pp. 253-256),
Frey (1996, pp. 267-279), Holcombe (1996, pp. 281-291), Mueller (1996,
pp. 293-302), Ostrom (1996, pp. 303-308), Sobel (1996, pp. 309-316) and
Vaubel 1996, (pp. 317-324).
23. Other and Related Subjects
A constitutional approach to international private law is contained in
Schmidtchen and Schmidt-Trenz (1990). Constitutional issues concerning
transition in Eastern Europe and the former Soviet Republics are discussed
in Sunstein (1991), Apolte (1995) and Ordeshook and Shvetsova (1995).
Brunetti and Weder (1994) argue that establishing strategies for the control
of state discretionary power is a crucial precondition for overcoming
credibility problems and generating long-term economic growth in less
developed countries. Kratochwil (1992) suggests an alternative approach to
the study of international politics. A critical examination of the Clean Water
Act from a constitutional perspective is contained in Meiners and Yandle
(1992). Pauly (1994) examines the concept that social insurance for medical
care may represent a kind of constitutional choice.
Kuran (1993) argues that public opinion breeds tyranny by forcing
individuals to refrain from voicing their genuine thoughts and feelings.
Several devices to cope with the emergence and persistence of certain social
taboos are discussed. Lipford (1992) applies constitutional economics to the
constitutions and rules that govern seven of the eight largest US Christian
denominations. A positive theory of economic fairness is constructed in
Isaac, Mathieu and Zajac (1991). Public debt repudiation is analysed, using
Jeffersons model in Gunter (1991).
E. Conclusions
Throughout the writing of the present article we constantly had in mind the
editors aim of providing the readers of the Encyclopedia of Law and
Economics with a well-informed overview of the existing literature. Some
readers may find that our strategy of favouring comprehensiveness at the
expense of structure has to some degree distracted from the flow of
argument. However, we are reasonably confident that the unifying theme
0610 Public Choice and Constitutional Political Economy 641
underlying the whole will be clear. The various subdisciplines of Public
Choice, Law and Economics, Constitutional Political Economy and others
all represent, as opposed to the independence-isolation of economics, a
return of economics to its appropriate legal foundations. But this theme only
loosely connects the subparts and sections of this article. In fact the four
subparts and even most of the subsections can be read largely independently.
This can only add to the readers convenience
Admittedly, and strictly from the title, the public choice element was
somewhat neglected, relative to the constitutional political economy element.
This bias is explained by our own priorities, but only in part. It was
Buchanan himself who in the 1980s changed the name of his research
program to constitutional economics. Early on, Buchanan had made it clear
that he regarded the traditional approach to economic policy advice based on
welfare economics as a scientifically flawed and politically alarming
development. Welfare economics draws its conclusions from a comparison
of the working properties of real markets with idealized criteria. Then,
confronted with the inefficiencies of reality compared to the idealized model,
the market failure approach proceeds to suggest alternative measures which
consist in real government interventions which are assumed to eliminate the
inefficiencies. Thus, welfare economics runs the danger of becoming a
nirvana approach (Demsetz, 1969), meaning that it fails to identify the
relevant alternatives for drawing its conclusions. First, in judging the real
economy in order to arrive at policy advice, the relevant alternative is not an
idealized market but another real economy, one that would emerge under a
different set of constraints. This means one has to compare alternative
institutional arrangements, in markets and the polity, and their outcomes.
Second, such a comparison requires a criterion that is equally apt in
evaluating the economic as well as the political order, that is a non-ideal,
internal standard of comparison. For Buchanan, democratic consent
provides this kind of criterion (Pies, 1996, p. 26).
Despite its general direction towards a comparison of alternative
institutional arrangements, large parts of the public choice literature seem
like an empirically oriented welfare economic analysis of the political sector
and use the welfare-economic concept of normative efficiency as a bench-
mark, thus more or less duplicating the nirvana approach. The term
constitutional economics clearly distanced Buchanans paradigm from
those parts of the public choice literature that make welfare economic
efficiency the measure of all things. The term more adequately describes the
topic of his institutional, rules-directed analyses.
642 Public Choice and Constitutional Political Economy 0610
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0620
LAW AND MACROECONOMICS
Richard L. Gordon
Professor of Mineral Economics, Pennsylvania State University
Copyright 1999 Richard L. Gordon
Abstract
This chapter argues that imperfections in the working of individual
(nonfinancial) markets are not a clear source of macroeconomic instability and
that better regulation of these markets is not the way to stabilize the economy.
Improvement here means both increased surveillance and removing
government-fostered deficiencies. The basic arguments are (1) the
long-standing disarray that distinguishes macroeconomics from
microeconomics greatly increased starting in the 1970s, (2) great dispute exists
over the workability of different classic macroeconomic measures, (3) despite
at least seven decades of advocacy of microeconomic measures for
macroeconomic goals, no defensible case exists, (4) support for microeconomic
measures rests on a belief in a high degree of market failure about which
microeconomists have become more skeptical, (5) these weaknesses imply that
no clear macroeconomic benefits offset the microeconomic drawbacks of
regulations of individual markets, and (6) extensive deregulation would
produce substantial microeconomic and macroeconomic benefits, but the
microeconomic case is much stronger.
JEL classification: K00, E00
Keywords: Macroeconomics, Keynes, Law and Economics
1. Introduction
This chapter examines contentions that imperfections in the working of
individual (nonfinancial) markets are a source of macroeconomic instability
and that better regulation of these markets is the most feasible way to offset
these imperfections. Improvement here means both increased surveillance and
removing government-fostered deficiencies. The overriding theme is the
approach has little support.
The basic arguments are (1) the long-standing disarray that distinguishes
macroeconomics from microeconomics greatly increased starting in the 1970s,
(2) great dispute exists over the workability of different classic
macroeconomic measures, (3) despite at least seven decades of advocacy of
microeconomic measures for macroeconomic goals, no defensible case exists,
(4) support for microeconomic measures rests on a belief in a high degree of
660
0620 Law and Macroeconomics 661
market failure about which microeconomists have become more skeptical, (5)
these weaknesses imply that no clear macroeconomic benefits offset the
microeconomic drawbacks of regulations of individual markets, and (6)
extensive deregulation would produce substantial microeconomic and
macroeconomic benefits, but the microeconomic case is much stronger.
Dealing with these points requires much effort. The prior two paragraphs
not only make sweeping assertions, but use numerous ambiguous terms. The
article then seeks to undertake four tasks. (1) The terms are clarified. (2)
Selected parts of the debates over macroeconomics are reviewed. As the
literature review below seeks to suggest, the chapter necessarily cannot even
fully cover every idea encountered. Choice is limited to those that seem more
relevant. Others can (and indeed in the refereeing process did) stress different
viewpoints. (3) The microeconomics of market behavior are sketched. (4)
Perspective is provided on the history of proposals to use microeconomic
policies to secure macroeconomic goals.
2. The Nature of Macroeconomics Recalled
While economists occasionally use the term macroeconomics to describe any
highly aggregative analysis, the more usual concepts relate to economy-wide
instabilities, particularly in unemployment rates but also involving inflation
and balance of payments problems. This clearly is the stress of the many
macroeconomics texts. Since the rise of extensive formal studies of
macroeconomics, the traditional concerns with the allocation of resources in
markets became microeconomics.
Actually, both branches deal with the total economy. Macro concentrates on
how the combined behavior produces instabilities. Micro stresses how well each
component of the economy performs the task of making useful goods available
to consumers.
Nothing in economics is neat, and this is true of the borders between macro
and microeconomics. The banking system is both a micro and a macro concern.
The role of banks in money supply is a basic concern of macroeconomics. The
role of banks in serving individuals involves employing the standard tools of
microeconomics. In practice, a further fuzzing arises from conventions adopted
in standard texts. Economic growth, at least as conventionally modeled, is
clearly a microeconomic problem, and any correction is by policies affecting
individual markets. To be sure, more applied discussions recognize the impacts
of alternative government tax and spending policies. For example, US political
debates present, albeit in the overly loose fashion necessarily adopted in
political debates, a choice between a Democratic model focusing on growth
promoting government spending and a Republican view focused on making
662 Law and Macroeconomics 0620
more money available for private sector investment. Conventionally, micro
texts at both the advanced undergraduate and graduate level ignore economic
growth. (A major exception is Mas-Colell, Whinston and Green, 1995). Macro
texts, in contrast, typically cover growth.
Unemployment is central because it is harder to explain or correct than
inflation and balance of payments problems. The basic causes and cures of the
last two were established by the eighteenth century (as in David Humes essays
that relate to economics). In contrast, neither what causes unemployment nor
what if anything can be done about it is well determined. Many explanations
exists, but all have severe (and widely examined) drawbacks. This chapter
argues that indeed these defects are so severe that any public policies must
assume that they are dealing with a mysterious disease whose origin and
untreated response are unknown.
What is most important here is that macroeconomics concentrates on
monetary and fiscal policy. Increasing or decreasing control of individual
nonfinancial markets has a decidedly secondary role. Macroeconomic theorists
who contend that problems in nonfinancial markets or in their regulation are
the main cause of instability often do not advocate cures involving directly
altering control of these markets. One has to resort to nonconformist writings
to find strong arguments for regulatory approaches to instability. Kelmans
(1993) effort to examine the issue tries valiantly to find good rationales but only
identifies drawbacks.
3. The Tools to Consider
The central policy distinction made here is between the monetary and fiscal
policies that are the focus of traditional macroeconomics and regulatory
initiatives. Monetary policy relates to control by various means of the supply of
money in the economy. (Such financial innovations as mutual funds that invest
in short-term securities and allow owners to withdraw funds by writing checks
and credit and debit cards have increased the always difficult problem of
distinguishing money from other financial assets. This problem is not relevant
here.) Fiscal policy relates to the effects of government tax and spending policy.
Regulation here means those government policies that control the behavior
of individual firms and households in the economy. The concept considered
here is somewhat broader than that used in other discussions of regulation. In
particular, a key element proves government policies governing the
compensation and rights of workers and the treatment of trade unions.
Regulatory economists tend to leave most of these issues to labor economists.
Stress is on good market controls; the only labor policies treated are health and
safety regulation. Regulatory policies are the focus of many articles in this
encyclopedia. For that reason and because of space limitations, I neither
delineate in detail nor evaluate the microeconomic problems of such policies.
0620 Law and Macroeconomics 663
The formidable difficulties of producing predictable results from such policies
is taken as proved elsewhere.
A more critical consideration is that the scope of proposed regulations may
be greater when macroeconomic considerations are added to microeconomic
concerns. The macroeconomics literature talks of incomes policy that involves
controls of prices and wages throughout the economy. Microeconomic practice
emphasizes concentrating on sectors in which monopoly power exists or
markets fail to internalize all costs. This distinction can be interpreted in at
least three different ways. First, the two arguments may be equivalent ways of
stating the same view; economywide may really only mean monopoly sectors.
Second, macroeconomists may see more monopoly than do microeconomists.
Third, macroeconomists may feel that many sectors that cause no
microeconomic problems are macroeconomic threats. Some indications arise
that enthusiasts of wage and price controls, in fact, see a greater prevalence of
extensive monopoly power than do microeconomists specializing on monopoly
problems.
4. An Overview of the Macroeconomic Policy Debates
Stress here is on conflict between Keynesians and classical economists. Both
approaches encompass many different, often mutually incompatible specific
analyses. For present purposes, examples of each position that seemed most
germane are presented. The Keynesian position is identified with the view that
real economies have features that produce large, undesired, and undesirable
instability and that feasible active public policies exist to improve on
unregulated performance. Active means closely viewing economic behavior and
reacting to it.
The classical position involves numerous criticisms of the Keynesian
outlook. In particular, an influential new classical group of macroeconomists
has dramatically expanded the demonstration of the impediments to successful
government programs to stabilize the economy. A key unfluence on acceptance
of the case is rejection by economists from all viewpoints of the 1930s belief
that deep extended depressions are an ever present danger. The arguments are
not conclusive. However, they have enough plausibility that serious
consideration must be given the possibility that feasible active policies are
ill-defined, if not nonexistent.
Even if this conclusion is rejected, it still can be inferred that whatever is
done must be limited by implementation problems. Behind the bitter debates
may only be a minor quarrel about exactly how small is the scope for action.
The analysis here focuses on this narrowing of the ambitions of active monetary
and fiscal policy from the more ambitious proposals of the 1936 to 1968 period.
To the extent they support anything, modern Keynesians advocate restrained
intervention that has been called coarse tuning (Lindbeck, 1993, p. 154) (in
obvious response to the excessive prior claims that one could fine tune the
664 Law and Macroeconomics 0620
economy). Much effort was devoted to arguing that active policies were
desirable without indicating whether the activism significantly differed from
following policy rules. Attention turns to arguing that, given these limitations
and the widely known microeconomic drawbacks, increased regulation of
nonfinancial markets is not an attractive alternative stabilization policy.
Unfortunately, reasonably treating these supposedly limited questions
requires examination of most of the thorniest issues of both macroeconomics
and microeconomics. In particular, the proposition that regulating individual
markets is a desirable macroeconomic policy presumes that actual economies
are best described by theories of imperfect markets. Acceptance of the empirical
relevance of such theories, moreover, does not suffice to justify market
regulation. It must also be shown that such regulation is a desirable way to
offset the effects of market imperfections. In particular, the intervention must
reduce unemployment and not produce other effects, such as increased inflation
or undesirable impacts on the regulated markets, that cause harms that
outweigh the employment benefits.
The issues have been major concerns in economics for nearly seven decades.
All of the key questions remain unresolved and indeed often not even clearly
raised. The characteristics, causes and cures of economic instability and how
best to analyze them are all bitterly debated. A growing stress on theoretic
prowess may have caused analysts inadequately to consider the empirical
relevance of the theories. At least three issues arise about macroeconomics. The
first is what comprises the theoretically sound models of instability. The second
is which of these models best explains reality. The issue about theory choice
stressed here is whether market imperfections are the primary causes of
economic instability. It must be shown that the theoretically possible alternative
mechanism prevails in practice.
The third concern stressed here is what the realistic models say about the
correctability of behavior. They must show that the characteristics of the
economy also allow effective stabilization policy.
5. Viewpoints
The combination of possible viewpoints produces a mass of alternative
positions about problems, solutions, and the best ways to analyze them. Even
without considering the many variant positions on how to analyze the issues,
at least five policy postures can be delineated. Several different ways exist to
reach each of the policy outlooks. Given the underlying complexity, the
categories are devised as epitomes to make the discussion manageable. (The
classification initially was designed to recognize distinctions made by Kelman,
1993, and overcome their drawbacks, particularly his failing to distinguish
between the two radically different branches of new classical economics.) The
classification is among traditional Keynesians, microinterventionists,
0620 Law and Macroeconomics 665
deregulators, microkibbitzers (or Kennedy Keynesians), and skeptics about intervention.
To examine alternative routes to these policy postures, the valuable
ambitious survey by Snowdon, Vane and Wynarczk (1995) distinguishes among
classical Keynesians, new Keynesians, post Keynesians, monetarists, market
clearing classicists, real business cycle advocates, and Austrians. As discussed
below, the last four each develop somewhat different cases against active
stabilization policy.
The position associated here with Keynesians, as noted, is that active
monetary and fiscal policy is effective and preferable as an anti-unemployment
tool. This certainly is the classical Keynesian position, and a large part of new
Keynesian economics is devoted to defending against new classical criticism.
Some post-Keynesian economists advocate wage and price controls.
Monetary and fiscal policy can take many forms. Thus, general approval of
active stabilization involves support of many different specific practices. What
is feasible is ill-discussed. The present treatment stresses the problems of any
forms of activism and does not examine exactly what might be feasible. For
reasons discussed below, labeling these views Keynesian is common but not
necessarily universal.
The microinterventionists and deregulators believe that better government
supervision of individual firms throughout the economy can contribute to
reducing unemployment or at least allow the reduction to occur with less
inflation than if only monetary and fiscal policy are used. Microinteventionists
believe that unemployment is a serious problem originating from inherent
market frictions and most appropriately cured by increasing regulation of
individual markets. Deregulators, who tend to doubt the severity of economic
instability, see government as creating the critical barriers to good performance
and want to decrease regulation.
The increased regulation outlook had its height in the 1930s. The extensive
thrashing about for explanation of the profound economic collapse in that
decade produced many theories. A number stressed the role of rigidities in the
economy. The supporters differed considerably in what they proposed.
Suggestions were then made for either extensive national economic planning
to regulate private market behavior or radically restructuring the economy by
vigorous application of US antitrust laws (see below). Some of the advocates
survived long after World War Two but attracted little intellectual support.
Politicians, to be sure, have acted on acceptance of the belief. In contrast, the
overregulation thesis is largely noted in passing by the most avid
antigovernment economists. (Kelman gives the macroeconomic elements of
these arguments greater prominence than they ever have secured in the
economic literature.)
The failure of massive depressions to emerge since World War Two
lessened, but did not eliminate, concerns. The question of whether more
666 Law and Macroeconomics 0620
directly confronting market or government imperfections was an effective
strategy persisted but never dominated. Support for such measures was limited.
At least two episodes arose in the United States. They were inspired largely
by the persistent problems of taming inflation generated by the Korean and Viet
Nam wars. Towards the end of the Eisenhower presidency, much discussion
arose of cost inflation. The Kennedy administration devised a response, but it
was the alternative option discussed next. The Nixon administration was
enduring inflationary problems reflecting lingering effects of the Viet Nam War
and then was hit with the 1973-74 oil price shocks. The administration adopted
first a set of general price controls and then initiated what proved an extended
concentration on regulating energy for many reasons including alleged
macroeconomic benefits. The much explored energy experience (see Bradleys
massive 1995 effort to sum up the experience) illustrated the severe
microeconomic problems that can arise.
Many of those involved during the 1980s in developing more acceptable
theories of how rigidities cause economic instability are cautious about making
policy suggestions. The point is made in the editors introduction to Mankiw
and Romers anthology of US writings developing such models. One author in
Mankiw and Romer (Bryant, 1983, vol. 2, p. 28) notes almost anything can be
modeled as optimizing behavior. The Winter 1993 issue of the Journal of
Economic Perspectives had a symposium on the work in which the new
Keynesians Romer, Greenwald and Stiglitz, a leading old Keynesian, Tobin,
and a new classical economist, King all express reservations about the
empirical relevance of the theories. Robert J. Gordon (1990) (from a
distinguished family of economists to which I am not related) has separately
discussed the drawbacks. All sides argue that it is still not established what
rigidities are most critical and how they operate. Thus, the latest work on
imperfections at most is the basis for eventual development of policy advice.
When John F. Kennedy was elected, his official and unofficial economic
advisors adopted a compromise between Keynesianism and microintervention.
Recognizing the drawbacks of explicit controls, the advisers proposed a halfway
house approach of wage-price guideposts to indicate to industry what would be
noninflationary wage and price changes. Estimates were provided of the rates
of wage and price increases consistent with overall price stability. Industry and
trade unions were exhorted to keep wage and price changes within these
guideposts. This was a curious, justly largely forgotten episode since economic
analysis tends to scorn reliance on unenforceable pressures. Indeed, the only
reason that this approach is mentioned is that Mankiw and Romer included a
paper by Okun advocating among other things a return to guideposts (and
proving a link, badly missing elsewhere in the anthology, to precursor work
from 1935 to 1970).
0620 Law and Macroeconomics 667
6. The Skeptics
The skeptical view stressed here is that high unemployment is transitory, of
ill-understood origins, and cannot be alleviated by public policy. Skepticism,
as discussed below, involves various challenges to belief that instability is
correctable. Objections are both theoretical and practical. It is argued that
theories stressing instability have questionable theoretic basis and little
empirical relevance. Another contention is that instabilities are so difficult to
recognize and so transitory and policy responses are so slow and variable that
intervention is likely to be harmful.
Skepticism, as treated here, is an extension of the Milton Friedman position
and its development by the macroeconomists using, among other things, the
assumption of rational expectations. That last assumption is compatible with
many different further premises; the new classics initially concentrated on
models in which policy ineffectiveness is likely. The main difference of the
present discussion is its greater stress on the absence of a convincing
explanation for the causes of unemployment.
The absence of such an explanation strengthens skepticism. Thus, this
article stresses the defects of business cycle theories with a clear message of any
type on both causes and policies. I read Friedman as saying only that passive
monetary is the least worst available alternative. The wildly implausible idea
that all problems will vanish under a monetary rule has its supporters, but
Friedman does not seem one of them. Similarly, I note with no enthusiasm
efforts of real business cycle theorists to suggest business fluctuations are not
a policy issue because they arise from voluntary changes in the willingness to
work.
7. The Rise of Macroeconomics
Historically economics concentrated on attainment of efficiency in the
marketplace. Disturbances such as unemployment, inflation and problems with
international balances of payments were considered secondary. Textbooks prior
to the end of World War Two I hardly mentioned the issues. Writings existed,
but they apparently commanded limited attention. (The impression about
earlier textbooks is based on sampling made over many years. Here,
Samuelsons complaints (for example 1977, p. 770) that the issues were
ignored when he was an undergraduate in the 1930s should be contrasted with
the mass of material cited in Haberlers Prosperity and Depression.) The
persistence of massive unemployment in North America and Europe in the
1930s shattered the prevailing beliefs. Economists struggled to devise better
explanations of economic instability. The result of all this was the emergence
of macroeconomics.
The new realm of macroeconomics was dominated for a long time by
models inspired by the work of John Maynard Keynes in the General Theory
668 Law and Macroeconomics 0620
of Employment, Interest, and Money. Keynes presented an exposition on the
causes of instability (or at least of a depression as prolonged as that in the
1930s) that secured wide acceptance as the needed answer. Given the ambiguity
of Keyness work and the need to deal with circumstances radically different
from those of the 1930s, enormous explanation, refinement and revision have
occurred.
Keynes-inspired economics has at least three major components - a
framework for analyzing economic instability, a vision about the nature of the
instability, and views on stabilization prospects given the instability. Much
controversy appropriately arises about what is the correct view of each area. A
more unusual aspect of the debate is the preoccupation about whether a given
interpretation is one advocated by Keynes. This contrasts with the excessively
short memory of many microeconomists who often write as if general
equilibrium theory leaped from Walras to Arrow and Debreu without the
intermediate assistance of even Hicks and Samuelson. For most purposes, the
debate about interpreting Keynes is a distraction from the fundamental
questions about what is the most useful way to model the economy.
The difficulty of determining what Keynes meant arises from the loose,
often ambiguous, exposition in the General Theory. Examining the mass of
Keyness other writings apparently increases the uncertainty about his beliefs.
Similarly, those who differ with some possibly quite substantial part of the
Keynesian position as defined here may or may not still identify themselves as
a Keynesian in a looser sense.
The greatest consensus exists about the basic analytic framework. That used
generally is an extension of J.R. Hickss pioneering 1937 effort to provide a
systematic formulation of what Keynes meant. The accord, however, consists
only of agreement to employ a few equations dealing with, among other things,
the supply and demand for four goods - production as a whole, labor, money
and an interest bearing security.
Considerable variation prevails in the specification of equations in different
theoretic exercises. In many cases, these alternatives are presented as one
providing a superior view of actual economic conditions. Others are simply
efforts to test the sensitivity of results to the assumptions. (Hickss version of
Keynes was one of the earliest to argue that the General Theory did not assume
imperfect competition. Hicks concentrates on differences between Keynes and
the classics about the sensitivity to interest rates and the level of income of
demands for money and investment goods and the supply of savings. The labor
and good production market are absent from Hickss models but appear in
Modiglianis widely cited 1944 effort to summarize the debate.)
As discussed more fully below, many macroeconomics models of persistent
unemployment long have assumed some departure from the (idealized)
assumptions of the microeconomic theory of competitive markets. Some
observers, notably Patinkin (1965), correctly argue that this approach trivializes
and misrepresents Keynes and thus that an alternative view of Keynes was
0620 Law and Macroeconomics 669
needed. (Patinkin makes this case tacitly.) The implications of major departures
from the core assumptions of the theory of competitive markets are too obvious
to justify terming the consideration of imperfections a revolution. The attacks
on classical economics in General Theory are deemed to suggest flaws in the
old analysis less obvious than neglect of market imperfections.
Patinkin focused on an issue that then and now traditional theory cannot
treat, the speed of adjustment. He suggested that this adjustment might be too
slow, where too slow means slow enough that governmental intervention could
effectively speed the process. This viewpoint, however, has received few
adherents. Economic rigidity models of various forms discussed below remain
the mainstay of theories of persistent unemployment. Keyness exposition is too
fuzzy to resolve definitely whether he postulated a more subtle problem,
overstated the newness of his theory, or both. Validating Patinkins view of
Keynes or the similar contentions of Clower (1965) and Leijonhufvud (1968)
is not feasible or essential. The observation that the implications of market
imperfections is (better) treated by classical economics remains valid whatever
Keynes believed.
Haberlers (1958) study of economic instability largely written before the
appearance of the General Theory anticipates the concern over stress on market
imperfections: It might therefore just as well be maintained that rigidity of our
economic system, or its financial or monetary organisation, or particular
features of the latter, are the causes of the cycle as that inventions or crop
changes or changes in demand are responsible (p. 6).
By itself, this debate over what comprises the most relevant macroeconomic
models and how consistent that model is with that of Keynes could be and often
is a mere intellectual exercise. The germane concern is about the practical
implications of whatever is the right model. In particular, the central issue is
whether the characteristics of actual macroeconomics justify and permit
effective countercyclical policies.
8. Alternative Views on the Stability Problem
While many different models exist, the number of possible outcomes is limited.
The basic possibilities are stagnation (unemployment that inspires no market
generated corrections), a business cycle sufficiently prolonged that public policy
can lessen its impacts, and a business cycle so transitory that public policy
cannot lessen the impacts. Feasibility depends upon the comparative length of
the cycle and of policy response.
The stagnation idea was one that arose in the depression of the 1930s and
died with the boom after World War Two. Whatever Keynes believed, some of
those whom Keynes inspired initially argued that unemployment was chronic.
The original Keynesian approach, therefore, stressed the existence of inherently
correctable persistent demand deficiencies in the economy. Fears of massive
670 Law and Macroeconomics 0620
persistent unemployment faded and with them interest in equally massive and
slow moving programs of government spending.
The alternative view that temporary periods of unemployment, the problem
often called the business cycle, arise now predominates. The Keynesian
position is that public policy can fruitfully counteract these transitory
downturns. The classical approach stressed here is essentially an attack on the
legitimacy of this extension to short recessions of claims plausible to persistent
depressions. (In fact, such concerns have been raised within the Keynesian
traditions, see Phillips, 1950, 1954, 1956 and Allen, 1956.)
Inflation proved a more persistent problem than many Keynesians (but not
Keynes himself) expected. Reflecting these changes, Keynesian economics
greatly altered its focus from 1936 to its crisis in the 1970s. The revised belief
was that the fluctuations that did occur had characteristics that should and
could be counteracted by active government policies. The initial successes in
the 1960s produced faith (indeed in the worst cases arrogance) that this view
had been vindicated.
9. The Return of Classical Macroeconomics
During the years immediately after World War Two, only a few economists,
most notably Milton Friedman, argued that the problems and the ability to deal
with them had been overstated. To be sure, there were a substantial number of
older economists, of whom Haberler is an example, who were unimpressed by
Keyness analysis when it appeared and never recanted. Paul Samuelsons
fascination (for example 1977, p. 878) with Kuhns concept of scientific
revolutions undoubtedly involved appreciation of Kuhns concept of a
recalcitrant old guard who refused to recognize the truth. Long before Kuhn
provided supporting rationales, the Keynesians were quite successful at
dismissing older critics as obdurate. The revival of more classical approaches
implies the dismissals may have been premature. The old school lived to see
their earlier doubts gain support that attracted new disciples. Snowdon, Vane
and Wynarczk (1995, p. 21) suggest that indeed Kuhns analysis is generally
inappropriate for economics because no outlooks are abandoned.
Stagflation (high unemployment, inflation, and slow growth) in the 1970s
caused greater attention to Friedmans views. A group of economists termed the
new classical economists developed models that raised the possibility that
Friedmans criticisms understated the drawbacks of intervention.
Friedman and similar critics stress the existence of long and unknown lags
in the recognition of problems, design of response, and reaction to the response.
Given all these lags, active public policy cannot clearly produce improvement
and might even be harmful. This position has been enormously influential.
Many fully accept the arguments. More importantly, those who defend active
0620 Law and Macroeconomics 671
stabilization policy advocate actions far less ambitious than those proposed in
the 1960s.
After the disastrous performance in the 1970s, Friedmans argument that
instability was not necessarily inherent and definitely was not correctable
received increased attention. This encouraged economists too young to be
influenced by the experiences of the 1930s to examine what lay behind the
earlier beliefs. In particular, economists such as Lucas and Sargent developed
an alternative, more formal analysis to deal with Friedmans assertions. (At
least three major anthologies are available on new classical economics: Lucas
and Sargent, 1981, a large collection of pieces by many writers who deal with
economics principles, statistical techniques, and empirical evidence; Lucas,
1981a, a collection of work authored or co-authored by Lucas; and Miller,
1994, a collection stressing later work, all associated with the Federal Reserve
Bank of Minneapolis.) The new analysis showed that under some conditions
intervention was totally ineffective.
10. Market Clearing Rational Expectations Models
Since this result depended on introducing expectations into macroeconomic
models and the developers relied specifically on a theory of expectations
developed by Richard Muth, one name given the application to
macroeconomics was based on the term rational expectations which Muth
used to describe his approach.
Since the theory also insisted that it should be assumed that markets clear
rapidly, the alternative name of market clearing macroeconomics was also used.
The meaning of market clearing used by the group seems widely
misunderstood. Lucass formulation seems to indicate nothing more than an
analytic strategy (1981a, p. 226). He felt that assuming perpetual
disequilibrium was too permissive. However, he adds that equilibrium states are
not always desirable. One way of interpreting him is by recalling Alfred
Marshalls period analysis. In Marshall, markets always clear but not all the
ultimately desirable responses are made immediately. Reality consists of a
successions of ever better adjustments to underlying conditions. Nevertheless,
the new classical economists tend to see a rapid full adjustment.
Finally, the approach was dubbed new classical since it in many ways
suggested that classical competitive theory was still the most practically
relevant model. One of the critical ways was to assert that prior models lacked
microfoundations. By this was meant that no plausible microeconomic
theories existed to justify many parts of the prior interventionist
macroeconomic models. This applied at least to the assumptions about
expectations, the specification of equations in econometric models of the
economy, and the assertions of price rigidities.
672 Law and Macroeconomics 0620
In the most dramatic applications, the approach showed cases in which
active policy would be ineffective. (Lucass work provided a starting point, but
the fullest developments were in papers in Lucas and Sargent, notably those
authored by Sargent and Wallace.) These new classical economists contended
that Keynesian arguments, particularly those associated with the Lipsey (1960)
and Samuelson and Solow (1960) developments of Phillipss 1958 analysis of
an inflation unemployment trade-off, depended on assuming that the public was
irredeemably stupid. The new classical economists argued that, if the public
anticipated that monetary expansion would occur, they would neutralize its
output effects by inflating prices by the amount of the monetary expansion. The
result is an immediate consequence of the key assumptions of competitive
markets that adjust slowly but not interminably and of decision makers capable
of anticipating public policy. The essence of the case is that the models assume
enough flexibility in the economy to rule out any output of monetary expansion
except that resulting from failure to anticipate.
Another key contention was that statistical analysis could not establish
which theory was correct. The new classical argument was extended to remind
macroeconomists of the classic econometric problem of observational
equivalence (see, for example, Sargent, 1976b). In many cases including those
of concern here, observable behavior can be consistent with many radically
different theories. (The basic idea is that we only observe the interaction of
supply and demand. An approach called identification is used to move
backward from the observed results to determining the equations that produced
the equilibrium. However, models tend to be overidentified, that is, consistent
with an infinite number of conditions.)
The new classicists also adopt Friedmans concerns about the enormous
data needs for successful stabilization. Much effort has been devoted to showing
the imperfection of the models and how to develop models in which active
stabilization works. This seems an inadequate response. The new classicists are
challenging the empirical validity of faith in active instability. A response must
include convincing factual evidence to the contrary.
While the new classical economists described their work as supporting
Friedmans arguments, he was not pleased. He joined many Keynesians with
concerns over the allegedly high degree of rationality assumed (see his
comments to Snowdon, Vane and Wynarczk, 1995, p. 175). He felt that his
arguments were more plausible than the assumptions of rationality made by the
new classical economists. These complaints may exaggerate the differences.
Friedman had suggested the idea that real effects of monetary policy were
possible only if people were temporarily fooled.
The new classical economists made the sensible extension of specifying
what was required to eliminate surprise. The analysis leaves some room for
temporary surprise. More critically, however, the approach at least implicitly
warns that all theories of the business cycle, particularly the monetary, rely to
various degrees on the assumption of transitory, potentially ultimately
0620 Law and Macroeconomics 673
correctable confusion over what the monetary authorities are doing. Lucas
himself relies on such a lag. The minimum contribution of a rational
expectations benchmark is warning that the magnitude and duration of effects
depends upon precisely what economic analysis cannot treat, the precise degree
to which reality differs from idealized conditions.
A further implication is that, as is surely true in 1997, after decades of
active monetary policy the private sector will better understand and anticipate
the actions of the monetary authorities. In short, monetary policy can create
disturbances, but their nature is too unclear and so subject to eventual erosion
to permit counteraction. Attacks on rationality, moreover, have overstated what
one must know. What is involved is knowledge about what the monetary
authorities are doing and what it implies. The leading newspapers and
television networks have managed to grasp such information.
Houthakkers (1957) research on the operation of futures markets suggested
that the few full-time professionals with knowledge of market conditions
dominated the markets and made them efficient. (This is an implicit application
of Hayeks arguments about how markets economize on knowledge
acquisition.) Similar specialists could operate in other markets to ensure they
two were guided by the best possible knowledge.
11. Further Challenges
Friedman in collaboration with Anna Schwartz (1963, 1982) added another
element to the anti-intervention case. They examined the monetary record in
first the United States and then the United Kingdom and observed a high
correlation between money supply movements and economic instability. They
concluded that monetary policy seemed the cause rather than merely reacting.
A major part of the analysis was a detailed description of policies before and
during the great depression. The review led them to attribute the depression to
overly aggressive monetary restriction in the late 1920s and failure to expand
money in the 1930s by the US Federal Reserve Board. Two leading subsequent
commentators, Kindleberger (1986) and Temin (1989), disputed Friedman and
Schwartzs explanation of why the Federal Reserve acted improperly but agreed
that bad monetary policy was the critical cause. A symposium in the Spring
1993 Journal of Economic Perspectives (C. Romer, Margo, Calomiris and
Temin) reinforced this viewpoint.
These conclusions dispute the central premise of Keynesian economics
stressing inherent, correctable instability in the economy. Clearly, as Friedman
and Schwartz know, strong associations simply suggest linkages. Ultimately,
we rely on our judgments about the plausibility of different explanations. If
Friedman and Schwartz are right, the Keynesians identified the disease (bad
policy) as the cure. This is an ultraclassical (almost Austrian) conclusion that
in macroeconomics as well as microeconomics government is better thought of
674 Law and Macroeconomics 0620
as a threat than as an all knowing benevolent force. This, in turn, hits at a main
weakness of the neoclassical synthesis, the inconsistencies between its views of
government in microeconomics as opposed to macroeconomics. It is possible
that macroeconomic problems are so much more serious or more tractable that
government can be trusted more in macroeconomics than in microeconomics.
It also is possible that the drawbacks that arise in microeconomic problems also
occur in macroeconomics. These conclusions become muted but still relevant
if less classical explanations are more valid. We are left with concerns that, as
already noted, all responsible observers share, about the severe limits to active
intervention.
12. Real Business Cycles
Some new classical economists, as noted, responded to discontent with the
explanations given of business cycles by proposing new real (in the economic
sense of non-monetary) theories of the business cycle in which variations in
employment were voluntary responses to changing market conditions such as
sudden changes in the productivity of the economy. This is a very different
approach that, if valid, would be the ultimate challenge to Keynesian
economics. Countercyclical policy would be interfering with efficient behavior.
Real business cycle theory to date is severely (and properly) criticized
because it is as unconvincing as all the prior simple explanations. In particular,
no plausible justifications were provided for belief in developments that would
inspire massive but temporary voluntary decisions of some workers to stop
working. (Even the advocates recognize the difficulty of identifying real
phenomena that explain historical experience. The summer 1989 issue of The
Journal of Economic Perspectives presents papers by Plosser, a developer, and
Mankiw, a skeptic.)
Snowdon, Vane and Wynarczk note the thread in real business cycle
analysis that emphasizes the cycles are random deviations from trends. The
discussion fails to cite Slutskys classic paper that deals with possibility that by
its nature economic evolution will have random deviations from trends. This
earlier work relies on the broad view that the complex processes involved
cannot be expected to operate smoothly. This seems more satisfactory than the
view that the unevenness has a cause.
13. The State of Policy
New classical economics, Austrian economics, and Friedman all effectively
argue that Adam Smiths concerns about the difficulties in determining the
public good applies as much to stabilizing the whole economy as to regulating
0620 Law and Macroeconomics 675
individual markets. Keynesian belief in the opposite presumption is
challenged to provide a convincing counterargument.
The arguments were essentially a formalization of a key tacit premise in
macroeconomics. It was an act of judgment, heavily influenced by the great
depression, that stabilization policy was needed. Keynesian economics and the
broader neoclassical synthesis in which it was embedded effectively argued that
the dangers of unemployment were so severe and readily correctable that it was
obvious that economists should suspend their traditional distrust of
intervention. The continuation of this approach after 1945 involved a giant leap
that was never well justified. What was true for a chronic depression was
clearly less justified for a world of milder business cycles.
As long as the policy seemed to work, it escaped challenge. Leaps of faith
seemed good enough. Once the program faltered, economists felt emboldened
to restate the traditional doubts about intervention. These new classicists
challenged the prevailing evaluation criteria by suggesting many reasons why
this approach was suspect.
Given the strong commitment among macroeconomists to active
stabilization policy, these views have been resisted vigorously. Stress is on
complaints that the models assume an implausibly high degree of rationality,
postulate unrealistically well functioning markets, and inadequately explain the
business cycle. A striking contrast between the new classical and new
Keynesian analyses is that the former involved extensive consideration of the
theory and practice of statistical testing of hypotheses while the latter
concentrates on pure theorizing. As suggested above, these complaints
inadequately consider whether the flaws suffice to justify active stabilization
policy. As discussed below, to date, the most that the Keynesians can claim is
that such justification might exist. Thus, the attacks on new classical economics
seem incomplete.
The Keynesians might have explicitly countered with what they seem to
believe, that the risks of inaction were too great to allow reliance on simple
rules. Probably because they recognize that the new classical economics also
warns that action also poses possibly greater dangers, Keynesians have tried to
refute the criticisms.
Unfortunately, the situation precludes a conclusive resolution. The situation
is standard in economic policy debates. We have two radically different
judgments of what constitutes the prudent strategy. One side is concerned with
the perils of inaction and urges continued effort. The other side concentrates on
the evils of intervention and urges radically altered less intrusive controls. This
obviously cannot be settled here. What is critical is that the doubts are sufficient
to justify restraint about adopting radical new measures.
676 Law and Macroeconomics 0620
14. Confronting Cyclicality
Keynesian and other widely used macroeconomic models have a flaw of dealing
only with equilibrium at a specific moment. A long tradition has at least tacitly
recognized that this approach ignores the expansion of the economy and the
variations in expansions traditionally termed business cycles. Early Keynesians
expressed their recognition by developing models explicitly treating cycles.
More classical economists directly attacked neglect of cyclicality as a fatal flaw
of Keynesian economics.
In its most general and useful sense, the business cycle idea suggests that
increased unemployment occurs in an ever-changing economy and that
economy may spontaneously generate measures to eliminate the unemployment.
To understand the debate, we must recall now abandoned work in economics.
Staring in the 1930s, various economists, most notably the very young Paul
Samuelson, tried to devise macroeconomic models that accounted for these
cyclical forces. Samuelson and those who followed him concentrated on the
existing theory most readily reduced to a manageable model. In particular, he
treated an accelerator model in which investment depended on the most recent
change in national output. (By modern standards, this is a hopelessly naive
model since it ignore anticipations.) This effort reached a dead-end in the
1950s (see Allen, 1956). The models had become unmanageable long before
they produced a plausible analysis of cyclicality. Macroeconomists abandoned
not only the development but also the recollection of cyclical analysis. In the
process of abandoning this approach, a critical insight was weakened. Studies,
particularly those of Phillips (1950, 1954, 1956, 1957), of stabilization policies
in a cyclical economy showed the difficulty of producing desirable results in a
steadily moving economy. A basic problem of any interventionist strategy is
that long effort has failed to produce a convincing analysis of cyclicality. It can
be argued that the analysts have lost sight of the difficulties involved.
Cycle theory was followed by steady-state growth theory that traced the
effects of steady increases in the ability to produce. Here too, the difficulties of
analyzing complex cases long hindered progress; some signs of revival have
arisen but are treated here. However, the pioneering models in this realm are
widely cited in later macroeconomic models.
Shortly after the appearance of the General Theory, the League of Nations
published a survey of business cycle economics. The review was by Gottfried
Haberler, an Austrian trained economist long associated (particularly in his
long career after the book was published) with anti-intervention views on the
economy. (Haberler revised the book twice for the League and finally in 1957
the Harvard University Press issued a fourth edition. The last is used here.
According to that edition, every edition had two main parts, the survey of
different theories and a Synthetic Exposition Relating to the Nature and
Causes of Business Cycles. The fourth edition omitted much material from
earlier editions, retained a chapter on Keynes added to the second edition, and
0620 Law and Macroeconomics 677
added reprinted of later articles.) The discussion provides a richer view of
proposed explanations and their drawbacks than appears in subsequent work.
Haberler begins by discussing the problems of explanation. He suggests, for
example, that some supposedly single-cause models at least tacitly postulate
additional influences. Supply or demand shock-based models make
presumptions about the adaptability of the economy and particularly the
monetary system to shocks. Monetary theories may implicitly concern the
response of the monetary authorities to external forces. His basic posture is that
the theories are at best incomplete and often indefensible. Subsequent work has
neither added plausible new explanations nor overcome the severe deficiencies
of prior concepts.
15. The Causes Considered
Haberlers survey of views distinguishes several categories of causes - purely
monetary theory (nonmonetary, monetary, and demand change),
overinvestment theories, changes in costs, horizontal maladjustments,
overindebtedness, underconsumption, psychology and harvests. However, over
half his discussion of explanations is devoted to overinvestment.
Haberlers monetary theory is devoted entirely to the views of R.W.
Hawtrey. The latters theory holds that business cycles are due entirely to
unwise fluctuations in the money supply. Emphasis is on the effects on real
interest rates. (This is a stronger and thus less convincing argument against
active monetary policy that the later view of Milton Friedman that stable
growth has better effects than active monetary management. Hawtrey as
interpreted by Haberler argues that active monetary policy is cause rather than
cure or aggravating force.) As proves true of many of the models discussed, this
theory involves precisely the dependence on failures of anticipation about which
the rational expectations approach warns.
The alternatives to a purely monetary approach tend to involve a generic
problem of imbalances among supplies, demands and prices. Haberlers
discussion of specific theories thus often expands upon his initial warning that
whatever problem a given theorist stresses, the analysis typically involves the
interaction of several forces.
Monetary overinvestment theories such as Wicksells (and Hayeks as
epitomized by Snowdon, Vane and Wynarczk) differ from Hawtreys pure
monetary theory by stressing the influence on investment of changes in real
interest rates. Haberler starts his review of nonmonetary overinvestment
theories by noting that the lack of explicit consideration of money is a flaw. The
theorists are compelled to assume an elastic currency or credit supply in order
to prove what they wish to demonstrate (p. 73).
Haberler then turns to a central ideal in business cycle theory, the
acceleration principle, used in Samuelsons model (1966, vol. 2, pp.
678 Law and Macroeconomics 0620
1107-1124) and its extensions. This theory builds on the fact that investment
either replaces retired capital goods or adds to productive capacity. A simple
rule is that investment to add new capacity is proportional to the change in
output in the recent past. While the level of economic output changes slowly,
the changes and thus investment can move radically. Haberler ends his
discussion of qualifications to the theory with consideration of expectations. He
notes any investment, directly or indirectly is looking forward to, and is made
in the expectation of, a future demand for consumers goods (p. 97). His
concern is more qualified than that of the 1970s. Haberler talks only of types
of investment which look forward to their utilisation to a very distant future
(p. 98).
The cost change theory that Haberler stresses is that as a boom proceeds,
firms start operating on a steeply rising portion of their cost curves. Haberler
recognizes that this would not be problematic unless real wages and prices
failed to adjust to these changes. Horizontal maladjustments are the lack of
correspondence between demand and supply in goods and factor markets.
According to Haberler (1957, p. 115), the overindebtedness theory is most
satisfactory in warning that existing debt hinders response to downturns and
less satisfactory in suggesting that the rise in burdens restrain activity and
produce downturns. The financial organization explanation is that valuing
financial assets in nominal money reduces price flexibility.
Haberler views overconsumption as a grab-bag of illformulated, often
invalid theories. The valid theories, moreover, are often restatements of theories
best classified under his other categories. He indicates that many theories
involve economically unsound ideas that consumption is inherently unable to
expand as rapidly as productive capacity. Haberler indicates that valid theories
involve short-run imbalances among consumption, savings, investment and
productive capacity. In some of these models, stress is on income distribution
effects. A shift of income from wages to profits undesirably reduces
consumption.
Haberler views psychological theories as attempting to postulate swings
arising from optimism and pessimism distinct from the fluctuations observed
in other theories. Haberler notes the difficulties of distinguishing these effects
but does not deny their existence.
As suggested above, Haberlers leaves us with many ideas and no clear way
to determine whether any of those that are theoretically sound are empirically
relevant. In short, he documents the case that a satisfactory explanation is
unavailable. It is argued above that little progress has been made in the last six
decades at overcoming these problems.
16. Imperfect Competition and Unemployment: The Microeconomic
Background
One critical controversy in macroeconomics centers on whether the traditional
flexible competitive market outlook or alternative imperfect market or defective
0620 Law and Macroeconomics 679
governments models best describe actual economies. The macroeconomic
debates are echoes of the microeconomic debate over what is the empirically
most valid model of the economy. Since the relevance of the associated
macroeconomic models depends on the underlying microeconomic work, the
nature of the latter must be considered.
The history of the microeconomics of imperfect markets is convoluted. A
particular concern is that theory and practice may have radically diverged. The
case for regulating markets arose in ill-formulated work in the 1930s. Means
(1939, 1972) became the quintessence of the process due to his long-standing,
diverse and often discussed efforts. His most persistent idea was that industrial
prices were excessively rigid. This view was, in typical Means fashion, derived
solely from observation of data. Reaction to arguments lacking either theoretic
basis or proper skepticism about the problems of data interpretation clearly
were a major inspiration for Edward S. Masons efforts to encourage sounder
work on the issues (as is clearly shown in the germane articles in the anthology
of his writings (1957) and in his later (1982) essay reflecting on economics at
Harvard in the 1930s).
The results were development of both sounder theories and better empirical
analyses. The theory has produced an overwhelming number of models. By
sheer count, those models that postulate market imperfections seem to
dominate. Even the term is loaded in this direction. Imperfect, in practice,
means a departure from the idealized assumptions used in general equilibrium
models that are the primary tools of modern economic theory. However, the
essence of models is deliberate simplification. Reality thus is more complex
than the model. Theorists often fail to consider how these complications alter
what is optimal. In addition to the attention to market failure, important work
has been done on developing models suggesting the microeconomic drawbacks
of regulation, government failure.
An important aspect of the evolution was the emergence starting in the
1970s (and still continuing) of theories inspired by the formalism of post World
War Two economic theories. This new work displays both the strengths and
weaknesses of formalism. The inadequate microfoundations displayed by those
like Means have been banished. However, theory only establishes what might
happen. Empirical verification is needed to determine the practical relevance
of alternative visions. A tendency exists relentlessly to follow every idea
without concern about relevance. The emphases in the theorizing seem better
explained by the greater ease with which market imperfections can be analyzed.
The literature is too vast to treat adequately here. Among the more
important overviews are the essays in Schmalensee and Willig, the treatises by
Tirole, Krouse, and Spulber (who uniquely does reflect on the limits to
applications), and the texts by Scherer and Ross (1990) and by Carlton and
Perloff (1994). The critiques of Schmalensee and Willig by Peltzman (1991),
Fisher (1991), and Klevorick (1991) all reflect the concern expressed here over
680 Law and Macroeconomics 0620
inadequate consideration of empirical relevance. This, in turn, reflects a
broader discord about the practical importance of monopoly that these critiques
neglect.
Applied economics and even public policy has moved towards discontent
with regulation that is so widespread that its nature can only be sketched here.
Both regulation of individual markets and the efforts to use broad antitrust
policies to regulate competition are under severe challenge.
With antitrust, the moderate position is that long-standing proposals
massively to restructure industry lack justification for action and that policies
over mergers, price fixing, and other trade practices must be administered with
greater concern for promoting competition. Bork, 1978, and Posner, 1976, in
their books on antitrust state well all but the first of these points. The best
indicator of what has happened with restructuring is the lack of efforts since the
late 1960s to promote the approach.) However, the Chicago position on flawed
regulation has regularly led to conclusions that satisfactory administration is
intrinsically impossible. Failure to apply this proposition to antitrust invited
and ultimately received challenge (see McChesney and Shughard, 1995).
The views on more specialized policies ranges from condemnation (for
example, for most agricultural, transportation, and energy intervention) to
desires for radical reform (for example, for environmental regulation). The
challenges involve a mixture of skepticism over both whether any of the market
imperfections cause significant problems and whether public policy can make
things better. No one book can do all this justice, but Viscusci, Vernon and
Harrington (1995) covers much of the critical ground from a careful analytic
view. The Cato Institute, a vigorous advocate of limited government, prepares
more sweeping but much less analytic surveys of interventions that seem
unsound.
One polar extreme is the Chicago position that monopoly is rare and
transitory unless supported by government policy. Some economists (for
example, Scherer and Ross, 1990, p. 541, talk of Chicago being fervent in
advancing simplistic theories of economic behavior and Bresnahan in his
comments in Fisher, 1991, p. 227, talks of the too-hasty Chicago consensus)
profess scorn for this outlook. However, this does not produce great concern
over monopoly or enthusiasm for regulation. Scherer and Rosss attacks on
Chicago, for example, preface sections absent from earlier versions extensively
discussing previously neglected Chicago arguments.
The point here is that the ability of market regulation to accomplish
anything is under severe challenge. Thus, a case for regulating on
macroeconomic grounds must overcome three problems - (1) proving possible
imperfections exist, (2) showing that they have important macroeconomic
effects, and (3) devising workable policies to overcome the problem.
0620 Law and Macroeconomics 681
17. The Effort at Application
The case here is that work to date falls far short of fulfilling the requirements
just set. It is suggested that all that has been done yet is produce theories that
show how imperfections might produce major macroeconomic effects.
Empirical verification has not been provided. Moreover, considerable evidence
exists that even the developers of the theory are concerned about this limitation.
Stress here is on a group of US economists who have termed themselves
new Keynesians and Europeans who have emphasized labor market
imperfection issues. New Keynesian analysis is the effort of a newer generation
of economists to evaluate the attacks on the Keynesian faith of the leading
academics (notably Samuelson in his textbook and Tobin in his extensive
writings on macroeconomics) of the immediate post-World War Two years. US
new Keynesians come from leading universities, particularly those in the
forefront of advancing the Keynesian revolution, and publish in the major long
established journals.
The focus is governed by the high accessibility of the work, particularly in
the Mankiw and Romer anthology noted above. The term new Keynesian might
suggest that active macroeconomic is feasible. However, even the advocates of
the concepts are more cautious. They admit that the work only suggests
arguments that might lead to revival of belief in active monetary and fiscal
policy. Mankiw and Romer (in their introduction) add that some of the
developers of the models reach the new classical conclusion that it is infeasible
in practice to implement such policies.
Whatever their influence on microeconomics, the models of imperfect
markets were seized upon (in many cases by their developers such as Carlton,
Stiglitz and Shapiro, all also contributors to Schmalensee and Willig) in the
1980s as the basis of more sophisticated models of the macroeconomics
implications of violations of core assumptions. In the process, newer forms of
disfunction were discovered (see below).
This methodology can be contrasted with the older post-Keynesian
movement. As one proponent of the group (Sawyer, 1991, p. 202) notes, the
term post Keynesian evolved from a umbrella for all reviews of Keynes to a
description of a specific approach to macroeconomics that includes concern
over the impacts of market imperfections. The post Keynesians, however, seem
to revel in unorthodoxy and separation from the rest of the macroeconomics
profession (see Snowdon, Vane and Wynarczk, 1995, pp. 367-380).
18. New Keynesian Models
New Keynesian economics is a collection of more traditional analyses of market
imperfections. Many, but probably not all, of the proponents sought to refute
the new classical approach. Stress was on models with sound microeconomic
682 Law and Macroeconomics 0620
bases in which instability was inherent. Usually, these models provide
microeconomic justifications for assuming good or factor price rigidities that
lead to persistent unemployment. However, the models include some with
characteristics that can preclude the existence, uniqueness, or stability of
equilibrium. The details are not critical here. Bryants observation strongly
holds. With enough assumptions about market imperfections, theorists can
develop models that inevitably lead to persistent unemployment. Mankiw and
Romer divide the contributions into seven parts - costs of price change, the role
of contracts, good market monopoly, coordination failures, labor market
behavior, imperfect credit markets and cyclical behavior of the goods markets.
Costs of price changes, infelicitously termed menu costs by Mankiw
(Chapter 1 in Mankiw and Romer, 1991), are the expenses of making,
reporting and implementing a price change. (Except as noted, all the ideas
presented here come from Mankiw and Romer and the attacks on them come
from the articles noted above.) As pioneering work by Barro (1972) (a new
classical economist) showed, when price changing is expensive, it is no longer
optimal to respond instantaneously to price changes. The price change should
occur only when the transaction costs are repaid by higher profits from
operations. Between price changes, the price should be a (time-weighted)
average of the prices that would clear the market under flexible pricing. A
series of articles (for example, Mankiw and Akerloff and Yellen, 1985 - chapter
2 in Mankiw and Romer) examined how pursuit of such policies might
increase macroeconomic instability by inadequately responding to changing
market conditions.
As is standard in this literature, doubts have been raised about the
theoretical and empirical plausibility of the models (see the articles noted above
and Snowdon, Vane and Wynarczk). Even the menu metaphor is viewed
skeptically. It is pointed out that announcing price changes often is cheap.
Cheap changes such as scribbled entries or mimeographed inserts were possible
long ago - for example, when I worked in my fathers restaurant in the 1950s;
modern technology allows cheap production of formal looking updates. The
new Keynesian literature often cites an unpublished study that recognized that
the large US mail order retailers issue new catalogs far more often than they
change prices. It is suggested that better explanations must be provided about
why frequent price changes are undesirable.
Another concern is that reliance on long-term contracts can be
destabilizing. Those presenting such models clearly recognize that the problem
with such contracts is that they inevitably involve incorrect specification of
future economic conditions. The first work in this realm took the existence of
contracts as given, and only later was a transaction cost justification developed.
The theories stress the difficulties of changing contracts. Stanley Fischers 1977
article (chapter 7 in Mankiw and Romer and also in Lucas and Sargent) on the
subject examines the role of adjustment clauses in contracts but only notes that
the right clause would be more complex than those actually chosen. This
seems too pessimistic. Actual contracts have explicit provisions to increase
0620 Law and Macroeconomics 683
response to changing conditions. Bad contracts are renegotiated. (This criticism
emerged from my experiences with energy contracts rather than from the
literature.)
Another type of model simply considers the macroeconomic consequences
of oligopoly. Most of these models examine how with monopoly labor supply,
macroeconomic policy can offset the supply restriction and expand output.
Examples are noted below.
Another, particularly complex, family of models deals with what are termed
coordination failures. These involve situations in which the characteristics of
the economy produce multiple equilibriums, the free market choice may not be
optimal, and public policy can move the economy to a more efficient
equilibrium. An article (Cooper and John, chapter 16 in Mankiw and Romer)
synthesizing the work suggests that the problem is best viewed of one of an
economy operating under the principles of the noncooperative games so beloved
by new industrial organization theorists. At a minimum, this raises the
problem, on which the game theorists have lavished much attention, that
noncooperative behavior is not good for the decision makers and should be (but
not necessarily is) abandoned when interactions regularly reoccur. Those
skeptical of game theory would argue that its microeconomic limitations make
it a poor basis for macroeconomics.
Another area is alternative labor market models that postulate conditions
under which wages should be less flexible than traditional theory seems to
suggests or reexamine the nature of unemployment. American new (and old)
Keynesians focus on such ideas as efficiency wages that postulate that effort is
increased by paying higher wages. A European alternative due to Lindbeck and
Snower (1988) is of a conflict between insiders (the already employed) and
outsiders (those not employed). Without unionization the insiders have the
advantages of training, experience, and ability to harass newcomers.
Unionization furthers insiders advantages. Another European analysis by
Layard, Nickell and Jackel (1991) relies on less traditional concepts such as
mark-up prices. As discussed below, these European analyses have a much
heavier policy content than models in Mankiw and Romer.
Attention also is given to why capital markets may be imperfect. Another
form of imperfection involves the alleged cyclicality examined by Haberler in
the relationship between price and marginal cost.
Two eminent older Keynesians, Hahn and Solow (1995) produced another,
much less successful, effort to revitalize the case for intervention. They only use
theoretical models (which are less transparent than those in Mankiw and
Romer). Thus, Hahn and Solow too are subject to the prior criticism of
inadequate testing. They conclude, But whatever the answer, imperfect
information is not of itself an argument for inaction (p. 152). This seems at
best an ex cathedra argument for supporting active policy. It does not even
address the question of how much activity is feasible. Their case, moreover, is
not helped by the strategy employed. The bulk of their book develops a series
of difficult-to-comprehend models in which instability arises and can be cured
by the right policy. These models have the drawbacks of lack of clear difference
684 Law and Macroeconomics 0620
in substance between those in Mankiw and Romer and considerably lesser
clarity.
Snowdon, Vane and Wynarczyks survey of the work notes the work has
been, until recently heavily biased towards theoretical developments (p. 328),
yielded numerous elegant theories which are often unrelated (p. 328), and has
not produced uniform policy conclusions (p. 326). On the last, Snowdon, Vane
and Wynarczyk add that most new Keynesians see a need for government
actions for coarse-tuning - policies designed to offset or avoid serious macro
level problems (p. 326). (Coarse tuning was Lindbecks term for limited
intervention, 1993, p. 154.) At least as defined by Mankiw and Romer, the new
Keynesians are necessarily too diverse to form a clear approach. At least two
of those included in Mankiw and Romer, Solow and Okun, are veteran
traditional Keynesians. At least two others, Hall and Taylor, are skeptical about
intervention.
The new Keynesians have only demonstrated something that the new
classicists never attacked, the existence of more theoretically sound models of
market imperfections that cause economic instability. In the worst cases, the
success of active intervention depends upon knowing what model characterizes
the economy. At best, the theories have established that in principle rational
expectations need not by themselves render policy ineffective. The nature and
correctability of actual economic instability remain where they always have
been, uncertain and controversial.
19. The Policy Failure Alternative
A curiosity here is that so little attention has been given to the possibility that
bad regulation is a major cause of instability. Aspects of a bad policy model
were (a secondary) part of the early classical approach to instability and at least
one new theory revives this approach. The traditional arguments noted how
trade union insistence on rigid nominal wages was the major barrier to effective
macroeconomic adjustment. Union success was blamed on the willingness of
governments to support union activity. While many expressions of this view
appeared, that from Mises (1966, pp. 769-779) seems to be the only one still
widely available.
This is not a central point of Austrian macroeconomics. The epitomes both
by Mises (1966, pp. 538-586) and by Snowdon, Vane and Wynarczk suggest
that the crux is a monetary theory involving uneven receipt of the increased
money supply that produces incorrect perceptions and distortions in the
behavior of real variables. Mises (p. 580) talks of the futile attempts to explain
the cyclical fluctuations by a nonmonetary doctrine, Snowdon, Vane and
Wynarczk (p. 363) view wage and rigidity arguments as elements added on to
explain the severity of the great depression. It is presumably the existence of
0620 Law and Macroeconomics 685
such views that caused Patinkin to criticize interpreting Keynes as postulating
only market imperfections.
Among the newer work, only the European models stressing labor market
defects have a strong government failure component. The microeconomic
defects of regulation are clear. Skepticism about macroeconomic explanation
implies that one cannot and thus should not add macroeconomic justifications
to deregulation. However, glimmers of concern do arise. Snowdon, Vane, and
Wynarczyk (p. 327) note that the insider-outsider approach produced numerous
suggestions to increase labor market flexibility. These include easing up on
existing policies such as job security legislation, laws encouraging
unionization, and unemployment insurance. However, new programs are
proposed to retrain, increase labor mobility particularly by making the housing
market function better (without discussing whether this means more aid or
removal of government controls), and profit sharing. Lindbeck and Snower
(1988, pp. 260-268), Lindbeck (1993, pp. 150-169), and Layard, Nickell, and
Jackman all examine some of these alternatives.
Goff (1996) has surveyed the role of regulation in the US economy and
attempted to measure its impact. Such a process is hindered by lack of a clear
measure of the extent of regulation. Goff, therefore, employed a standard
method for dealing with the problem, statistically generating an artificial
measure, that is, the weighted function of observable indicators such as that
perennial - the size of The Federal Register, the US governments report on its
new proposed and adopted regulations, the budgets of regulatory agencies, the
ratio of lawyers to engineers and scientists in industry, litigation and state
government employment. Given this index, Goff seeks to test whether changes
in regulation affected performance. His tests are avowedly simple. He examines
the association between changes in the trend in key measures of
macroeconomic activity are correlated with increasing regulation. He is well
aware that other forces may be at work, but at the simple level at which he
worked, he can only introduce two alternative variables, oil prices and
non-defense government spending. In any case, he concludes that regulation
reduced growth in gross national (sic) product by 0.9 percentage points.
20. Conclusions
The present discussion has argued that considerable debate prevails in
macroeconomics about the nature of economic instability and whether
governments can act to counteract them. The policies advocated range from
ones that heavily limit government flexibility to those that encourage extensive
action including and possibly centering on regulation of individual industries.
What seems to be the moderate position at the end of the twentieth century is
that governments should cautiously alter monetary and fiscal policy in response
to changing circumstances. Caution is the minimum response necessitated by
686 Law and Macroeconomics 0620
new classical criticisms. Market regulation remains suspect by both new
classicists and the believers in the neoclassical synthesis. This suspicion arises
from the presence of much evidence of the drawbacks of regulation and the
absence of evidence that regulation is stabilizing. Efforts over six decades have
only strengthened these doubts.
21. Background to the Chapter
The author is a specialist in applied microeconomics who examines
macroeconomics mainly to determine its relevance to efforts to justify control
of individual markets on macroeconomic grounds. My research activity is
devoted entirely to study of markets and their regulation. This article is heavily
influenced by the universal occurrence of severe government failure in
everything that I have studied. My teaching included a long period teaching a
graduate theory course. All this has required persistent examination of the
literature in microeconomic theory. I have reviewed macroeconomics to
evaluate proposals to regulate energy markets in the interest of macroeconomic
stability. Prior writings that caused the invitation to write this article were
inspired by recognition that energy economists were accepting macroeconomic
arguments for intervention that were not well supported in the macroeconomic
literature.
I am Professor Emeritus of Mineral Economics, College of Earth and
Mineral Sciences, The Pennsylvania State University, University Park Pa,
16802. Since I was born in 1934, I am too young to have first hand knowledge
of the 1930s, but old enough to be aware of prior work inadequately considered
by the new Keynesians and their inspirations among the new industrial
organization theorists.
My examination of literature, in any case, is selective. This article extends
research undertaken for my 1994 book, Regulation and Economic Analysis. My
starting points were the then current editions of several undergraduate texts in
macroeconomics, the very advanced survey by Blanchard and Fischer, and four
anthologies noted in the text of major articles on macroeconomic. This
suggested much additional reading including a return to some old favorites
remaining in my personal library. This reading has unearthed far more
references than can readily be mastered. A referee alerted me to a particularly
valuable survey of the work (Snowdon, Vane and Wynarczyk) and European
work on imperfect labor markets.
22. Bibliographic Note
Thousands of books and articles on these issues have appeared. The books
include many comprehensive textbooks and a few more specialized surveys.
0620 Law and Macroeconomics 687
Despite their mass, no single book fully covers all the issues or adequately cites
the literature.
The articles appear in the many journals directed at professional
economists, the various periodicals produced by banks, particularly the regional
Federal Reserve Banks in the United States, and symposium volumes
originating from among others again the regional Federal Reserve Banks and
research institutes such as Brookings and the National Bureau of Economic
Research. Numerous anthologies, some devoted to a topic and others to a
specific author, have appeared. Some major articles have multiple incarnations.
Among the participants in the debates for whom anthologies of relevant
writings exist are Keynes, Hicks, Samuelson, Tobin, Friedman and Lucas.
Each item consulted adds references to more publications. The listings here
are deliberately limited. I have selected anthologies, texts and treatises that
collectively include or discuss a large part of macroeconomics from the 1930
to the 1990s. Much of the material contained is not explicitly cited. Thus, while
some classics are not listed, they often are contained in what is cited. Another
limitation is that no pretense was made exhaustively to examine the many texts
designed for the second (in US academic jargon, intermediate) undergraduate
course in macroeconomic theory. My citations of texts consist of two long
extant ones that are frequently cited and one, recommended by a colleague, that
I found a good alternative; the citations whenever possible are to the latest
edition of which I was aware rather than to the edition actually examined.
In the process of preparing my 1994 book, I began compiling a master
bibliography of works cited in summary volumes on microeconomics and
macroeconomics consulted. Part of the effort was to overcome the irritating
failure of many authors to provide an integrated bibliography. My bibliography
became unmanageably massive as I extended its reach. The germane literature
in macroeconomics alone is too extensive to treat adequately and the literature
on modern industrial organization, while smaller, is still overwhelming.
The books cited here include anthologies that contain at a minimum
important parts of the literature and at their best helpful guides to the rest of the
literature. Miller alone of these books has a unified bibliography. Mankiw and
Romer have an extensive bibliography (broken into separate parts by topic
areas), but it falls far short of presenting everything cited in the book. Among
surveys, Snowdon, Vane and Wynarczk uniquely provides a unified and
extensive bibliography. Blanchard and Fischer prepare separate bibliographies
for each chapter. Even when a bibliography exists, it does not necessarily
provide all the critical information. In particular, often the reprinting in
anthologies is not noted. Generally, I have provided both the original citation
and at least one of the reprints of which I was aware for articles. However, I
have not attempted to examine every writers collected works. The main
exception is Samuelson. So much of what is cited comes from inaccessible
original sources such as symposium volumes that his collected works are the
best source.
688 Law and Macroeconomics 0620
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0630
OTHER SOCIOLOGICAL APPROACHES
Ian R. Macneil
Wigmore Professor of Law
Northwestern University
Copyright 1999 Ian R. Macneil
Abstract
The following aspects of law and economics important to understanding
comparisons to be made to other sociological approaches are set out: (1) the
fundaments of economic behavior; (2) the many worlds of law and economics;
(3) the unity of law and economics; and (4) Posnerian law and economics.
Other sociological approaches to law, particularly American, are described: (1)
case-law research as a sociological approach to law; (2) approaches based on
particular theories; (3) empirical sociological approaches generally and as
compared with law and economics, particularly Posnerian law and economics;
and (4) empiricism as the meeting ground between law and economics and
other sociological approaches, a meeting ground in which empirical product
rather than competing theories may be the most important aspect. Finally, the
positions of law and economics and other sociological approaches as
competitors are explored
JEL classification: K00
Keywords: Case-Law, Empirical, Law and Economics, Posner, Sociology
1. Introduction
Any comparison between law and economics and other sociological approaches
is complicated by the fact that there is neither a single law and economics
approach nor a single noneconomic sociological approach to law. Moreover,
when law and economics takes a serious empirical turn it may for all practical
purposes be indistinguishable from empirical noneconomic sociology (see
Sections 10 and 11). To deal with these problems of diversity and to make
comparison feasible in the small compass of this part, I shall focus on what may
be called the Posnerian approach to law and economics (see Section 5). (There
is a danger in this, as it is all too easy improperly to equate law and economics
with the Chicago School, and particularly Posnerian, economics, see Donohue,
1997. There is, however, no intention of doing so here.) On the sociological
side I shall range somewhat more broadly (see Section B).
Part A treats a number of aspects of law and economics important to the
comparisons to be made to other sociological approaches: (1) the fundaments
694
0630 Other Sociological Approaches 695
of economic behavior; (2) the many worlds of law and economics; (3) the unity
of law and economics; and (4) Posnerian law and economics.
Part B describes other American sociological approaches to law: (1)
case-law research as a sociological approach to law; (2) approaches based on
particular theories; (3) empirical sociological approaches generally and as
compared with law and economics; and (4) empiricism as the meeting ground.
Finally, Part C considers law and economics and other sociological
approaches as competitors.
A. Law and Economics
2. The Fundaments of Economic Behavior
To understand law and economics it is essential to understand what its
practitioners mean by economic behavior.
First, economic behavior is the behavior of individuals, not collective
behavior as such. Second, it is behavior that individuals choose from among
available alternatives. It is thus distinguishable from behavior over which an
individual literally has no control at the time it occurs, as for example where
an person with an unfastened seatbelt is thrown against a windshield in a
head-on automobile accident. Third and finally, it is behavior an individual
chooses by somehow assessing (by no means necessarily consciously) that the
benefit of the behavior to the individual exceeds its costs. The latter aspect is
so vital to economics that economists have sanctified it by adding an appealing
adjective, rational.
This adjective is not intended in economics to mean reasonable - its
ordinary usage - and its meaning in law and economics is unclear. (Ronald
Coase, 1993, p. 98, cautions against any economic concept that includes the
word rational.) Nonetheless, its repeated use by economists has led to such
analysis being called rational choice theory. (It is by no means clear what this
third element - with or without an adjective - adds to the second. When an
individual chooses to behave in a specified manner, no matter how
self-destructive, bizarre, or even utterly mad that behavior may appear to
others, the individual obviously at that instant perceives the benefits as
exceeding the costs. Only unchosen behavior, that is, beyond any control by the
individual, could be otherwise.)
It is also important to point out what law and economists typically do not
mean by economic behavior. Economic is not limited to matters relating to the
production, distribution and consumption of material goods and services, the
common usage of the term. Typical law and economists most emphatically do
not mean that economic analysis is possible only of behavior relating to
696 Other Sociological Approaches 0630
material matters. Thus, as used in law and economics, no one, economist or
otherwise, can gainsay that rational choice theory can be applied to any subject
about which people make choices. Failure to recognize this can lead to
confusion and misplaced criticism of law and economics (see Cotterell, 1995,
particularly pp. 347-348, 357 n.2). To avoid such confusion economics is here
limited to mean rational choice theory, and never used in its common-usage
sense.
One of the many consequences of these characteristics of rational choice
theory is that it cannot recognize within its theoretical structure any kind of
relationship among people other than that of competition. Thus the model
epitomizes Mrs Thatchers alleged dictum, There is no society, only
individuals. (This is not to say, of course, that the model cannot be or is not
used to analyze behavior in what even law and economists - but only while
stepping outside their model - would recognize as relationships, including those
in which they recognize altruistic elements. Again, of course, the model can
also be used to analyze an individuals choice among his or her own competing
desires, desires which may impinge differentially on relations with others. This
is not, however, a recognition of relations within the theoretical structure of the
model, such as is typically found in other sociological approaches.)
3. The Many Worlds of Law and Economics
In spite of the dominance of rational choice theory, any given work in law and
economics may differ from another in at least any of the following somewhat
overlapping respects:
a. Normativism and positivism: ranging from insistence that economic
analysis is nothing but positivist prediction to full recognition that it is
necessarily normative from start to finish.
b. Objective of analysis: determining (1) Pareto-superior positions, (2)
Kaldor-Hicks efficiency, (3) wealth maximization, (4) distributional effects,
or (5) some combination.
c. Rational behavior: meaning of:
(1) Nature: ranging from any chosen behavior to requiring inclusion of
varying degrees of knowledge, thoughtfulness, and reasonableness
(rationality in the usual sense of the word) in the behavior;
(2) Consistency of behavior: varying assumptions of consistency of
behavior over time;
(3) Boundedness: accepting or not recognizing boundedness of rationality;
(4) Consistency of use of the term throughout the work in question.
d. Transaction costs: recognition and assessment of impact: (1) ignored, (2)
recognized but explicitly excluded, (3) analyzed as supplemental to
0630 Other Sociological Approaches 697
theoretical analysis, (4) entire focus on transaction costs, (5) treatment
ranging from casual to systematic empiricism.
e. Relations, recognition as such: ranging from no recognition of relations
other than competition among individuals to primary focus on relations in
the institutional school of law and economics (see Section 2).
f. Empiricism: ranging from entirely theoretical to heavily empirical.
g. Distributional effects: (1) ignored, (2) recognized but explicitly excluded
on varying grounds, such as ceteris paribus, unimportance, or on the
grounds that they should be dealt with apart from the subject being
analyzed, for example through general taxation and welfare, (3) treated as
essential aspect of analysis.
h. Individualism: attitudes towards: ranging from strongly individualistic to
a variety of non-individualistic positions.
i. Market-solutions: attitudes towards: ranging from pro-market to neutral to
anti-market (the latter being rare).
j. Politico-legal goals: ranging widely over the political spectrum with
varying ranges of obscurity and clarity.
k. Power: from ignoring to considering power either as a benefit individuals
seek that affects choices or as a social subject requiring analysis per se.
Some of the diversity of these many worlds is shown by De Geest (1995),
who, however, suggests a unity greater than that perceived by the authors of
this part.
4. The Unity of Law and Economics
In spite of the foregoing, three factors bring considerable unity to law and
economics.
First is the centrality of rational choice theory (see Section 2) with its
foundation in the individual. Second, the field remains an area dominated by
theoretical and deductive, rather than empirical and inductive, analysis,
although the latter seems to be growing in importance. See Donohue (1997);
Shelanski and Klein (1995). Third, at least in the United States, there is a
dominant school of law and economics, epitomized by the work of Richard
Posner (see generally Posner, 1992), to which I now turn.
5. Posnerian Law and Economics
The Posnerian school falls at the following locations on the spectra set out in
Subsection 3:
698 Other Sociological Approaches 0630
a. Normativism and positivism: focuses on allegedly positive prediction and
typically claims great formal predictive power, even as it fails to recognize
limitations in rational choice theory that require empirical rather than
formal proof of conclusions;
b. Objective of analysis: seeks to promote efficiency and wealth
maximization;
c. Rational behavior: meaning of: is often unclear on the operational meaning
of rationality;
d. Transaction costs: treatment is often cursory and may be inconsistent with
the Coase theorem as now generally understood;
e. Relations, recognition as such: rejects any idea of relations, other than
those of competition among individuals (see Section 2.);
f. Empiricism: empirical work may or may not be done, as it is unnecessary
in light of claims to positive prediction by the theoretical model;
g. Distributional effects: treats distributional effects as beyond the pale;
(Posner himself has dealt at considerable length with distributional issues
such as measuring inequality, redistribution through liability rules, and
taxation, see Posner, 1992, pp. 455-515. Nonetheless it is difficult to find
Posnerian analyses of particular subjects where treatment of distributional
issues goes beyond, at most, a slighting acknowledgement that the only
justification for ignoring the result produced by rational choice theory
would be to redistribute wealth.)
h. Individualism: attitudes towards: has a strong individualist bias, including
large organizations within the concept of individuals except when
analyzing internal operations of an organization.
i. Market-solutions: attitudes towards: favors market-solutions; opposes not
only government regulation but also any social governance other than that
of competing individuals;
j. Politico-legal goals: is often accused of right wing political biases. To
paraphrase Posner: Suspicion persists that [law and economics] owes a lot
more to visceral [right]-wing political preferences than to any body of
theory. (Posner, 1995, p. 269);
k. Power: ignores power either as a benefit individuals seek that affects
choices or as a social subject requiring analysis per se.
B. Other Sociological Approaches
For an extensive treatment of law and the social sciences see Lipson and
Wheeler (1986); respecting law and sociology see Arnaud et al. (1993).
0630 Other Sociological Approaches 699
6. Introduction
In contrast to rational choice theory, noneconomic sociological approaches treat
collective behavior or relationships rather than focusing on individuals as such.
They may or may not pay much attention to choice, viewed either individually
or collectively. They may or may not pay much attention to the idea of benefits
and costs in choosing. And they may or may not pay much attention either to
vague concepts of rationality as found in economic analysis or to rationality in
the ordinary sense of reasonableness.
Given their social orientation, noneconomic sociological approaches often
recognize and focus heavily on social, as distinguished from individualistic,
concepts. Thus, for example, in his excellent article comparing law and
economics and sociological approaches to law, Cotterell mentions among others
such concepts as: law, social change, legal relationships, social relationships,
solidarity, general social trends, enduring patterns, mediating forces, culture,
broad movements, legal modernity and more specifically, power and
governmentality, (Foucault), self-referential systems of communication
(Luhmann), the life world and the public sphere (Habermas), and other
concepts developed by such diverse scholars as Marx, Tnnies, Durkheim,
Weber, Parsons, Neumann and Unger (Cotterell 1995). Althusser, Gramsci and
Gurvitch would have been worthy additions to this list.
Like economics, sociology means many things, and a wide variety of
sociological approaches to law other than law and economics exist, far more
indeed than in the world of law and economics itself. (These include law and
anthropology, untreated here only because it has its own treatment in 0640. As
Cotterell says, [In] address[ing] the complexities of laws relations to culture
... it seems that no useful line can now be drawn between anthropological and
sociological research (Cotterell, 1995, p. 350). For example, Roscoe Pound
advanced the idea of sociological jurisprudence early in this century, and that
concept has been important to the study of law ever since. Even legal
philosophers one does not usually think of in such terms may consider
themselves sociological. For example, as Posner (1995, p. 279, n. 2) points out,
H.L.A. Hart described his The Concept of Law as an essay in descriptive
sociology. Jurisprudence, sociological or otherwise, is not, however, what is
generally meant by law and sociology, and I shall address it no further. (We
thus omit consideration of such important works as Black, 1989.) Instead, from
among the many possibilities in this complex world of law and sociology, focus
here is on three kinds of sociological approaches to law: case-law research,
particular-theory approaches, and empiricism with little or no theoretical base.
700 Other Sociological Approaches 0630
7. Case-law Research as a Sociological Approach to Law
The term case-law research is used here to mean research aimed at finding
out what judicial and/or administrative decision-makers have done respecting
particular issues. (Case-law research may be and often is, of course, conducted
in connection with more formal approaches of various kinds, such as law and
economics and various critical theories. The discussion following is limited
largely to case-law research not so connected, although much of what is said
applies to such instances as well.)
It is seldom, if ever, recognized in academia that - at least as conducted in
the United States - ordinary case-law research is a form of sociological study
of law. This omission calls for explanation given that such research is by far the
most common form of American legal study - both within and without the
academy. In spite of the proliferation of academic and quasi-academic journals
it may safely be assumed that the majority of such research is done in the day-
to-day world of lawyers and judges, administrators and legislators, and their
various staff members. Nonetheless, even with the exclusion of such work of
the real world, academic case-law research, that in law reviews, other legal
periodicals, and monographs of various kinds overwhelms in volume all the
more formal scholarly approaches put together.
In the light of this dominance, it is worth pausing to consider what
case-law research is in the American context, what are its advantages and
disadvantages as a form of sociology, and the general ignoring of such work as
a sociological approach.
Nature of American Case-Law Research
The vast bulk of American case-law research focuses on opinions of appellate
federal and state courts, although there are important exceptions, particularly
where the law is much involved with administrative agencies, as in taxation,
various kinds of regulation and government procurement.
The day has long since passed, if it ever really existed, when researchers
into American case-law thought they would find Langdellian scientific
principles operating in the cases. (There is, of course, an important exception,
namely researchers who hold to some theory such as the implementation of
principles of efficiency by common law courts or particular theories of
oppression characterizing various critical approaches.) The Realist movement,
if it did nothing else, legitimized examining cases to see what the courts really
were doing, rather than just what they were saying, in laying down the rules of
law. (One should properly say re-legitimizing following the long post-Civil
War period of relative dominance of the formal style, see Llewellyn, 1960.
This is not to say that in such research logic-chopping based exclusively on
words is not only commonplace, but probably a good deal more common than
0630 Other Sociological Approaches 701
more purposive analyses. Nonetheless, the better work - whether of practitioner,
bench or academic - never slights the latter.
Case-law research of this kind is what Twining (1974) has called a
method of detail. And it is often, although by no means always, also a kind
of thick description (Geertz, 1973, ch. 1), as summarized by Cotterell (1995,
p. 350):
Thick description moves social interpretation away from a search for abstractions
that attempt to explain complex patterns of actions in terms of a minimum of
rationally organized principles related to a general theory. It seeks rather a
portrayal of complexity in all its ambiguity and richness. Geertz remarks that the
study of mankind often involves substituting complex pictures of social phenomena
for simple ones while trying to keep the persuasive character of the earlier simpler
ones. (Geertz, 1973, pp. 33-34)
The work of Childres and Spitz (1972) on the parol evidence rule illustrates
how purposive case-law analysis can result in thick description, as does
Feinman (1995). Childres and Spitz examined a large sample of cases applying
a rule stated by the courts as unitary. From the facts of the cases, as distinct
from the words of the opinions, Childres and Spitz concluded that in fact there
were three markedly different rules, depending upon whether the contract in
question was a formal contract, an informal contract, or involved an abuse of
the bargaining process. (In quite rare instances work of this kind purports to
apply statistical principles.)
An important characteristic of the bulk of case-law research is that it is
atheoretical. The researcher typically is interested in finding out what is going
on and then drawing various conclusions respecting such things as what the
law is in terms of formal rules (favorite of law students), what it is in terms of
actual application, what policies are or are not being implemented, and how all
these things might be changed for the better as the particular researcher views
the world. (Only when the research is conducted in the context of a particular
theory, for example law and economics, can it be said to be theoretical in
nature.)
Case-law Research as Factual rather than Legal Research
The great bulk of case-law research is aimed at enhancing knowledge about the
law itself (for whatever purpose). Nonetheless it can be and is conducted for the
purpose of learning about party behavior as such. Among many possible
examples outside the field of criminology are Frasco (1991) (survey of exclusive
dealing and tie-in cases to ascertain motivations for such contracts) and
Kaufmann and Stern (1988) (the perception of relational exchange norms in
commercial litigation; database is trial court records). (Legal historians, who
often do not consider their work a sociological approach nonetheless often rely
on case-law research to learn about society itself.) A great deal of legal history
702 Other Sociological Approaches 0630
is of this nature (see Wahl, 1998, for a survey of all of the nearly 11,000
Southern appellate cases involving slavery). The two motivations for research
can easily merge in light of the impact of law on party behavior, as Mnookin
and Kornhausers (1979) phrase bargaining in the shadow of the law
suggests.
Limitations of Case-Law Research as Sociology
Most case-law research is casual in the sense that it is neither exhaustive of all
the cases on a given subject nor a statistical sampling of all such cases.
(Studies of the kind mentioned in the preceding paragraph tend to be
exceptions.) Rather the selection is likely to be made on the basis of
hierarchical importance of the courts or agencies rendering the decisions, often
with jurisdictional and/or geographical considerations in mind. Casual does
not, however, mean lacking in thoroughness, as to which the work varies
greatly.
In addition, the formulation of just what constitutes the given subject is
generally far less stringent than is expected in formal sociological approaches.
The most important limitation of all is the pathological nature of cases.
Invariably they concern situations where not only have things gone wrong, but
they have gone wrong so seriously that the resulting conflicts were not settled
without litigation, and generally were not settled even after at least one court
or agency had rendered a decision. Moreover, the facts of cases are not the
facts of the situation giving rise to them, but those facts strained through and
distorted by the highly adversarial processes of the legal system. Thus study of
cases presents a highly solipsistic and distorted view of both the general social
circumstances being examined and the particular facts of each case.
Finally, those who believe that some theoretical base is essential to
worthwhile legal research will see atheoretical case-law research as useless.
Those who believe further that a particular theoretical base is essential to
understanding law and advocating legal policy will likely see atheoretical
case-law research as harmful for obscuring the truth.
The Non-Recognition of Case-Law Research as a Sociological Approach to
Law
There are probably many reasons why case-law research is seldom if ever
recognized as a sociological approach to law. Most, if not all, of the limitations
described above make it far less systematic and and aimed at truth-seeking than
a word such as sociology generally suggests. Moreover academic case-law
research likely is tainted in many minds by the similarity of its basic techniques
to case-law research in the real world of the law. The latter is always highly
instrumental and typically highly adversarial, neither characteristic being
appropriate to a scholarly investigation in the traditional sense. Finally, for all
its factual orientation, case-law nonetheless generates general rules. Case-law
research thus can be - and, where formality dominates the law, is likely to be
0630 Other Sociological Approaches 703
- nothing more than a way of distilling general rules, as the maddening habits
of most law students bring home to every American law teacher. To the degree
this is true, case-law research is no more sociology that would be reading a civil
code.
The consequences of non-recognition of case-law research as part of the
world of law and sociology are quite serious. Probably the most important is the
exclusion of a vast body of information as being essentially unworthy in
systematic sociological investigation. Nonetheless, flawed though it is,
information derived from case-law research is far from useless. This is
particularly so because of the close relation between academic case-law research
and that in the real world of the law. Another consequence is that such
non-recognition exacerbates the separation of academic scholarly work from the
work of the legal profession and legal institutions (see Edwards, 1992). Yet
another is that it distorts the perceptions of the relationships between competing
approaches to the law (see Section 5). Closely related to this is the present day
derogation of such work in American law schools. Even the highest quality of
original but straightforward case-law research is unlikely to yield tenure in elite
American law schools, or perhaps even to generate summer-research grants.
8. Approaches Based on Particular Theories
Professor Cotterell has described sociology of law as the effort to develop
systematic, empirically oriented, theoretically guided knowledge of law as a
social phenomenon (Cotterell, 1995, p.347). Except that the empirical
orientation is often quite thin, this is an accurate description of some
sociological approaches to law, hereafter called theory-driven. (Relatively
non-theoretical empirical sociological approaches, see Section 9, do not, of
course, fit this description.)
Such approaches are like law and economics in that they are based on
particular theories. Marxian analysis, now in considerable eclipse, is perhaps
the first to come to mind. But of the five examples Richard Posner recently
gave of sociology of law being done under other names in the United States
(Posner, 1995, p. 265) four - critical legal studies, critical race theory, feminist
jurisprudence, and gay and lesbian studies - are theory-driven. (Regarding
critical legal studies see Kelman, 1987; critical race theory: Crenshaw et al.,
1995; Delgado and Stefancic, 1993; feminist jurisprudence: Decoste, Munro
and MacPherson, 1991; George and McGlamery, 1991; Symposium, 1993; gay
and lesbian studies: Arriola, 1994; Eskridge, 1994; Robson, 1992; Robson and
Duberman, 1997.) Such theory-driven sociology of law is particularly prevalent
in Europe. Van Loon, Delrue and van Wambeke (1995, p. 380), for example,
704 Other Sociological Approaches 0630
note that a lot of the European sociologists of law (of course, also with
exceptions) strive for a major theoretical image. (For examples see Section 6.)
Again like law and economics, in such theory-driven approaches the
positive truth of the basic theory, if any is claimed, is assumed rather than
proved empirically. Indeed, it is in the nature of such theories that they cannot
be proved empirically in anything remotely close to scientific proof. (Many if
not most rational choice theorists would probably argue that the positive nature
of rational choice theory has been proved repeatedly, and needs no further
proof. But what in fact has been proved repeatedly is that - at best - with proper
empirical bases it can produce relatively positive conclusions respecting
particular applications. Even so, as suggested in Section 10, it is probably the
empirical base that supplies whatever positivism exists, rather than the theory.)
These theory-driven sociological approaches, at least American versions,
tend to be also like law and economics in that systematic empirical work is
likely to be thin on the ground. For example, critical empirical studies seem to
come more from individuals like Richard Abel (1989, Abel and Lewis,
1988-89), who is related to the critical legal studies movement than from those
commonly viewed as at its center, such as Duncan Kennedy, Mark Tushnet or
Roberto Unger (to the extent it can be said to have a center).
Nonetheless, these theory-driven sociological approaches differ from law
and economics in a number of respects.
First, their analysis is almost always founded less on individual behavior
than on behavior of groups identified by such factors as class (in the case of
Marxian analysis and often critical legal studies), race, gender, and sexual
orientation.
Second, the focus of analysis is typically on power relations in which power
respecting material affairs as such - the principal focus of law and economics
- may or may not be a principal concern. Power respecting ideology and
culture-formation are of particular interest to many scholars of theory-driven
sociological approaches.
Third, within particular subject areas competing theories exist, thereby
multiplying diversity of approaches.
Fourth, although all these theory-driven sociological approaches are
related, at least in the United States, to groupings with significant
socio-political power in the nonacademic world, at the present time they all
remain relatively marginal in American law schools. Their heaviest impact in
the latter is probably collectively in terms of fostering academic atmospheres
which may, for lack of a better description, be described as politically correct.
In particular, neither collectively nor separately have they achieved the power
position, at least in American law schools, of the law and economics
movement.
The foregoing non-mainstream attribute is related to a fifth characteristic:
these approaches are all related to particular social causes. (One need not,
0630 Other Sociological Approaches 705
however, go as far as Posner, 1995, p. 269, who said: Suspicion persists that
critical legal studies owes a lot more to visceral left-wing political preferences
than to any body of theory.) None of the causes they represent have, however,
been able to achieve more than limited acceptance either within or without
academia as compared to the prevailing socioeconomic patterns of modern
capitalist-consumer society. To a degree this is true also of law and economics.
The latter has nonetheless been markedly more successful in achieving standing
and power for its advocates, at least in American law schools, than have all the
theory-driven sociological approaches combined.
9. Empirical Sociological Approaches-General
Van Loon, Delrue and van Wambeke (1995, p. 380) have pointed to the
greater emphasis on induction, on empiricism, and on methodology in the
United States compared with Europe. They went on: The American scholars
- of course, with exceptions - tend to build theory inductively, from the bottom
up, driven by data, policy concerns and empirical observations. (see also
Posner, 1995, pp. 272-273). Van Loons word theory needs to be treated
gingerly. The theory produced by or related to such work, in America at least,
is not macrotheory of the type I have called theory-driven law and sociology.
Rather it tends, at most, to be what Cotterell calls middle-range theory, usually
concerned with analyzing the causal effects of legal change on wider social
change or with specifying the social mechanisms by which law can bring about
or hinder social change Cotterell (1995, p. 352).
Rubin has made these points more specifically in terms of a particular field,
contracts:
American sociology tends to be heavily empirical, but law schools lack the
intellectual infrastructure to carry out sustained empirical research. Unlike
economics, no dominant theoretical approach has emerged in sociology, and the
theories of Americas leading theoreticians such as Talcott Parsons and Herbert
Garfinkel proved difficult for contracts scholars lacking sociological training to
apply. The same is true for German social theory, which may represent a more
promising approach. While jurisprudence has been receptive to Habermas and
Gadamer, contract scholarship has tended to overlook the more applicable work of
their contemporaries such as Niklas Luhmann, Gunther Teubner, and Claus Offe.
The result, once again, was the delayed development of a theory for understanding
and evaluating the contractual process itself, as opposed to the judicial rules that
are applied when that process goes awry. (Rubin, 1995, pp. 113-114)
706 Other Sociological Approaches 0630
Before proceeding, the obvious should be noted: theory-driven and empirical
approaches as I have used the terms are not watertight compartments. To
whatever degree there is serious empirical work they can easily overlap.
Richard Abel has already been mentioned as an example of a theory-influenced
(driven may be too strong a word in this case) scholar doing extensive
empirical work. On the other hand, van Loon and his colleagues, who appear
more in the American mode as they describe their work in van Loon and
Langerwerf (1990), van Loon and Wouters (1992), nonetheless relate it to
Durkheim and Weber (van Loon, Delrue, and van Wambeke, 1995, pp.
382-384)
American sociology of law is related historically to the American Legal
Realist movement, which may be summarized by the words in 1926 of Charles
E. Clark and Robert M. Hutchins quoted in Schlegel (1980, p. 459): We regard
the facts as the prerequisite of reform. The strongholds of that movement were
Yale Law School and to a lesser extent, Columbia Law School (see generally
Schlegel, 1995). More recently the University of Wisconsin Law School is often
considered the center of law and sociology, although the American Bar
Foundation is a very important non-law school center. The realist movement
is often thought to be dead. It is, however, difficult to understand exactly what
that means when present-day names like Lisa Bernstein, Howard Erlanger,
Lawrence Friedman, Mark Galanter, John Heinz, Willard Hurst, Richard
Lempert, Stewart Macaulay, Robert Mnookin, Ralph Nader, H. Laurence Ross,
David Trubek, William Whitford and David Wilkins, to mention a few, are
considered. Although law and society is a broader concept than law and
sociology, all elements of the law and society movement are, in a sense, realist
(see Friedman, 1986).
Oddly enough, criminology, which is a major if not the major area of
mainstream academic sociology and law, is less likely to come to mind. This
seems to be because the subject has never established a significant foothold in
the curriculum of American law schools. For example, the leading list of
American law school teachers by subjects contains headings for Criminal
Justice and Criminal Procedure (AALS, 1995, pp. 1077-1091), but none for
Criminology. So too, names like Morris, Zimring and Jacobs, and their related
criminology centers, appear in the AALS Directory, but not as teachers of
criminology (AALS, 1995, pp. 691, 989, 529). (Stanton Wheeler at Yale Law
School is, however, an exception.) This is in sharp contrast with the
comparable list in the United Kingdom, where the list of teachers with a
particular interest in Criminology is larger than for either Criminal Justice or
Criminal Procedure, although smaller than for Criminal Law (SPTL, 1996, pp.
129-130). (Penology and Sentencing add quite a few more names to
Criminology. The comparison between Britain and the United States is rough,
because the SPTL lists research interests rather than subjects taught. See,
however, SLSA (1996, pp. 282-283, 306) which shows both research and
0630 Other Sociological Approaches 707
teaching interests, with about two and half times as many members listing
criminology in the latter category as in the former.)
As with law and economics the empiricism of other sociological
approaches may range from the most casual to the most systematic. The more
systematic it is the more it is likely to be recognized as a sociological approach.
10. Empirical Sociological Approaches - Comparison with Posnerian Law
and Economics
Like all noneconomic sociological approaches, empirical approaches focus on
collective behavior rather than on individual behavior as such, and are thus
sharply different from Posnernian law and economics. Beyond that, the eclectic
nature of empirical sociological approaches limits comparison to generalities
of the following kinds.
a. Normativism and positivism: The very nature of the complexities examined
and the obvious limitations of the investigative techniques available render
ludicrous any claims to the kinds of genuine positivism claimed for
Posnerian law and economics. The most that can ever reasonably be
claimed is to have made a heavily persuasive case for the existence of
particular facts, causes, desirable routes of change, and the like.
b. Objective of analysis: The objective is to ascertain the social facts seen by
the researcher as pertinent to the subject of investigation as defined by the
researcher. Thus maximization of wealth as defined by the economic
model, the goal of Posnernian law and economics, may (unlikely) or may
not be the goal sought by the researcher, and if it is is almost sure to be but
one of many.
c. Rational behavior: meaning of: To whatever extent, generally very limited,
the noneconomic researcher is concerned with rational choice theory,
rational means what it means in the theory. As was seen in Section 2,
however, the word has many meanings in economics. The obfuscation of
the term as used in economics is likely to be exacerbated when used by
noneconomic sociologists on account of their tendency to conceive of
economics as limited to material human affairs. Thus the word can in their
hands, but probably does not, have the same meaning as in Posnernian law
and economics. Thus noneconomic use of rational is likely to refer to
reasonableness, its common meaning among everyone except economists.
d. Transaction costs: recognition and assessment of impact: Noneconomic
sociological approaches in a sense treat nothing but transaction costs. The
phrase transaction costs postulates, however, at least relatively discrete
transactions as the focus of analysis. It is itself a markedly discrete way of
708 Other Sociological Approaches 0630
thinking about the way exchange occurs in relations (see Macneil, 1981).
Thus noneconomic empirical sociological approaches deal with transaction
costs. Unlike Posnernian law and economics, such treatment is typically
from relational perspectives, and quite likely occurs without calling the
subject studied transaction costs.
e. Relations, recognition as such: Noneconomic sociological approaches by
definition focus on relations of all kinds and are thus antithetical to
Posnernian law and economics with its focus on individuals whose only
relationship is competitive.
f. Empiricism: This is the core of this approach, and is in sharp contrast to
Posnernian law and economics, where it is typically slighted.
g. Distributional effects: Likely to be considered where viewed as pertinent
and significant to the subject, and thus once again sharply at odds with
Posnernian law and economics.
h. Individualism: attitudes towards: Nothing in the nature of empirical
noneconomic approaches favors or disfavors individualism, and it is thus
theoretically more neutral than Posnernian law and economics on this
score. But see the discussion of attitudes towards market-solutions below;
similar things could be said about individualism.
Noneconomic empirical sociologists are less likely than Posnerians to
consider large organizations to be individuals for the purpose of
investigation.
i. Market-solutions: attitudes towards: Nothing in the empirical approach as
such favors either market or nonmarket solutions, and it is thus
theoretically more neutral than Posnernian law and economics on this
score. Nonetheless empiricists with a strong bent towards market solutions
are likely to end up in the law and economics camp, empirical side, rather
than in noneconomic sociology. This is particularly so of American legal
educators, given the power in American law schools of law and economics,
especially Posnernian law and economics, see Posner (1995). Thus
American empirical sociological approaches are more likely to be
conducted by individuals who range from having relatively neutral views
about market-solutions to those who heavily favor governmental and other
regulatory solutions.
j. Politico-legal goals: There is nothing in the nature of noneconomic
empirical sociological approaches that precludes right wing political
biases. Nonetheless, in the American context at least, those engaging in
such approaches are probably generally thought of as political liberals
ranging from middle to leftish, but not radicals in the various critical
camps mentioned in Section 8.
k. Power: In contrast to Posnernian law and economics, power may be
recognized as an important factor either explicitly or implicitly.
0630 Other Sociological Approaches 709
11. Empirical Studies: the Meeting Ground
Empirical work apart from case-law research has been mentioned respecting
all three of the major sociological approaches treated in this part: law and
economics, other theory-driven sociology, and other nontheory-driven empirical
sociology. (This is not to suggest that any social investigation can ever be free
of ideology and unexpressed theories.)
Empirical work is where all approaches can meet in equal competition. Or
to put it in another way, where empirical work is a central focus of study the
approach behind it may be singularly unimportant. Consider, for example,
Ellicksons investigation of the ways in which farmers and ranchers in Shasta
County, California work out animal trespass disputes. Ellickson used social
science methods in his study, focusing on a local case study (a narrow but deep
wedge of location and time), gathering demographic and documentary
evidence, and conducting extensive field interviews with a range of
participants. He then used this finely detailed, highly localized data as a basis
for theorizing about a broader slice of reality (Larson , 1995, p. 229, citing
Ellickson, 1986, pp. 627-628; see also Ellickson, 1991).
Ellickson concluded that high transaction costs were such a barrier to legal
recourse that neighbors instead had worked out their problems in a neighborly
fashion, developing a set of customary norms that became their Order Without
Law Larson (1995, p. 232 n. 278). As noted, this investigation was
conducted in terms of transaction costs by its author, a devoted law and
economist. See Ellickson (1993). Moreover, he keyed his work to Coases
theory about social costs, Coase (1960), a Posnerian Bible until Coase
explained what he really meant: what matters is not what happens theoretically
when there are no transaction costs, but what happens in reality when there are.
Coase (1993).
To those of genuinely empirical bent, what counts about Ellicksons Shasta
County study is not its origin in the mind of a law and economist or what it
may or may not show about rational choice theory. What matters is the quality
of his empirical work and the knowledge of human behavior that can be derived
therefrom.
This is equally true of sociologists proceeding from other viewpoints. To
those of genuinely empirical bent, what counts about the studies of van Loon,
Delrue and van Wambeke of litigation, for example, is not their origin in the
minds of Weberian-Durkheimians or what they may show about
Weberian-Durkheimian theory. What counts is the quality of their empirical
work and the knowledge of human behavior that can be derived therefrom.
Various authors have talked about the coming together of law and
economics and sociology - Campbell (1996), De Geest (1995), Posner (1995) -
as well as economics and sociology more generally - Baron and Hannan (1994).
Posner, for example, urges the erasure of the remaining disciplinary
710 Other Sociological Approaches 0630
boundaries that are retarding the complete merger of sociology with the other
scholarly disciplines that study law (Posner, p. 266).
If such a merger is in prospect the question is how they come together, and
here there are great variations. It is clear enough that Posner means a merger
along the lines of the Norman conquest of the Anglo-Saxons, with Posnerian
law and economics in the role of the Normans. (Just as Norman England was
a merger and not genocide, so too Posner would leave something of
noneconomic sociology intact, such as the impact of social class on
economically inexplicable behavior, see (Posner, 1995, p. 278.) De Geest, on
the other hand, sees law and economics as already a combination of economics,
sociology, psychology and other sciences, a pattern very much at odds with
Posnerian law and economics.
I too see a possible merger in the offing, one closer to De Geests than to
Posners position. What is suggested here is that empirical studies of law
themselves may be in the process of establishing a field of study that essentially
transcends the economic and noneconomic boundaries. In that field the
competition will be over empirical quality with theoretical approaches playing
only a secondary role. Out of such an eclectic body of research could come an
eclectic social science in which a wide variety of theories all were viewed as
valuable analytical tools, but with none having a monopoly on whatever limited
positivism is possible in social investigation. For a suggestion of a merger along
somewhat similar lines relating to crime, see Panther (1995, pp. 372-375).
C. Standing in the Competition of Law and Economics and Other
Sociological Approaches
There can be little doubt that much competition exists among the proponents
of these various approaches for prominence in the study of law. Richard Posner
has proclaimed more or less total victory in this competition for law and
economics, at least insofar as American legal studies are concerned (Posner,
1995).
12. Victory?
It would be foolish to deny that law and economics has become the most
powerful single monofocused discipline in American legal studies. Nonetheless,
the victory is neither as complete nor as satisfactory from a Posnerian
standpoint as might appear from reading Posners account. Before taking up
more serious aspects, it might be noted that although Posner professed to be
unaware that sociology of law is commonly taught in American law schools
(Posner, 1995, p. 275), half again as many names are listed as teaching Law
0630 Other Sociological Approaches 711
and the Social Sciences as Law and Economics in AALS (1995, pp. 1153-1154,
1158-1160). It is true that the former category is a potpourri. It even includes
some teachers, for example, Guido Calabresi, who prefer their law and
economics teaching to be so categorized rather than under the more specialized
heading. Nonetheless, a riffle through the entries for some of the teachers so
listed suggests that some form or aspect of law and sociology is taught in
American law schools a good deal more than Posner suggests. (In terms of
expression of law teacher interests the picture in Britain is dramatically
opposite from Posners view. Only 5 law teachers identify an interest in law and
economics, compared to 14 for sociology of law and 7 for socio-legal studies.
SPTL (1996, pp. 130, 135, 136).) I turn now to more significant tests of
success.
First, when academic case-law research of the type described in Section 7
is counted as a noneconomic sociological approach, law and economics falls
into a very distant second place. Moreover, academic case-law research has a
mighty sibling in the day-to-day work of bench and bar. Although law and
economics may dominate a few areas of legal practice, most notably antitrust
and restrictive practices, and may, as Posner claims, have had an effect on the
deregulatory movement, it is a long, long way from dominating or even playing
a major role in most areas of the law. There are undoubtedly a growing number
of judges relatively literate in law and economics. That does not, however,
mean that they are necessarily converts who view economic analysis as a
primary, much less the primary, tool of their trade. (For a critical discussion of
the relationship between theoretical studies like law and economics and the
legal profession, see Edwards, 1992.)
Second, as noted in Section 3, there are many worlds of law and
economics, a field not originated by Posner. Nor, in spite of Posners prolific
work and the dominance of Posnerian thinking, by any stretch of the
imagination has Posnerian law and economics ever occupied the entire field of
law and economics. Furthermore, even apart from its diverse origins, the
centrifugal forces afflicting any maturing ideology seem to be well and truly
loose in law and economics. Moreover, other theories, in particular game
theory, have come muscling into law and economics. Game theory proceeds
from the individualistic benefit/cost concept as does law and economics.
Nonetheless, game theory, with its stress on asymmetric information and
strategic behavior, brings uncertainties to the picture utterly inconsistent with
the kinds of claims to positivism often made on behalf of law and economics.
([T]he strong predictions of the price theoretic models quickly degenerate into
a fragmented array of models whose predictions are highly dependent on the
nature of the initial assumptions, Donohue, 1997).
An illustration of the centrifugal forces affecting law and economics comes
from the institutional school of which Oliver Williamson is the leading voice.
712 Other Sociological Approaches 0630
Williamson responded to Posners analysis of that school (Posner, 1993), in the
following manner:
Posner (1) has not understood the Coasian message (or does not like what he
hears), (2) misconstrues transaction costs economics, (3) misconstrues game theory,
(4) has a truncated understanding of bounded rationality, the economics of
information, and maximizing, and (5) mischaracterizes empirical research in
transaction cost economics. (Williamson, 1993b, p. 99, replying to Posners attack
on Williamson, 1993a. Such comments hardly augur well for a unified law and
economics under the Posnerian banner)
The presence of these forces swirling around Posnerian law and economics goes
blithely unrecognized in Posners mention of Guido Calabresi as one of the six
law and economics academics on the federal Courts of Appeal (Posner, 1995,
p. 281, n. 30). Calabresi, who with Coase has legitimate claim to be the
co-founder of law and economics, never has been in the Posnerian school.
Moreover, four years before this citation of his name appeared, Calabresi
specifically and vigorously rejected several of the most fundamental principles
underlying Posnerian law and economics (Calabresi, 1991).
Given these divergent forces, whatever claim may be made for a victory of
economic analysis over other sociological approaches does not, as Posner
clearly would like us to think, support a claim of such victory for Posnerian law
and economics.
Third, and perhaps most important respecting any claim of a Posnerian
victory, is the impact of empiricism on the relationship between law and
economics and other sociological approaches. As suggested in Section 11, what
matters about empirical work is its quality, not the particular intellectual camp
from whence it comes, for example, Ellicksons Shasta County study
(Ellickson, 1986). Ellickson analyzed the outcome from the standpoint of
transaction cost economics. The social facts as found by Ellickson, however,
equally vindicate relational contract theory in which transaction costs are
viewed as too narrow a social concept (Macneil, 1981). Thus, in terms of the
empirical work itself, Ellicksons work is just as much a part of the
noneconomic sociological approach of relational contract as it is a part of law
and economics. Ellicksons fine work turns out not to be victory of law and
economics over a noneconomic sociological approach, but a victory for
empiricism.
The dangers to Posnerian orthodoxy, or even to the minimum of economics
orthodoxy, of high quality empirical work by law and economists should be
obvious. Such work focusing on transaction costs, and/or taking into adequate
account assymetric information and the possibilities of strategic bargaining,
may come perilously close to demonstrating the validity of noneconomic
approaches with their emphasis on complex social worlds. It could thus lead to
what Posner (1995, p. 266) called an erasure of the remaining disciplinary
0630 Other Sociological Approaches 713
boundaries. A merger of law and economics and other sociological approaches
at the empirical level with theory being very much of secondary importance is
not, however, the erasure Posner had in mind. His was an erasure of
disciplinary boundaries whereby rational choice theory would take over the
world. (Not surprisingly he denies this in idem. pp. 277-279.)
13. The Causes of the Relative Success of Law and Economics in America
Posner attributes his claimed victory of law and economics to the following:
Max Webers bequest to sociology of a useless methodology, idem. pp.
267-268); insofar as criminology is concerned a discredited approach to
criminality and its control (p. 270); the lack of theoretical and empirical [sic!]
ambition of American sociology of law compared with law and economics (p.
272); a lack of normative punch compared to law and economics (p. 273); the
failure of law and sociology to retool with the methods of a rival discipline,
that is, law and economics (p. 274), prevented by such factors as the
left-liberal bent of law and sociologists who perceive law and economics as
being politically conservative, reluctance to accept the knowledge-claims of
other disciplines, and professional envy (pp. 274-275).
Whatever one may think of the merits of Posners factors purporting to
foster the relative success of law and economics included, his list is far from
complete. Other factors are not only important, but might well be thought to be
substantially more important than those listed.
Perhaps the most important factor Posner omits is the political climate
developing in America (and elsewhere) as law and economics was getting its
foothold in American law schools. Reactions against the State from right and
left achieved national prominence with the Republican nomination of Barry
Goldwater in 1964 and the anti-war movement of the late 1960s and early
1970s. Opposition to the bureaucratic welfare state legacies of the New Deal,
Fair Deal, and Great Society increased during the period until it culminated in
the presidency of Ronald Reagan in 1980. Anti-regulation, pro-market
positions such as those of Alfred Kahn respecting the airlines became
politically respectable in a way that they had not been since the days of the
Hoover administration. Nor was this confined to the far right or even the right.
On the international scene the liberal establishment, heavily eastern and
Republican, long had been supporters of free trade. It is hardly surprising that
law and economics, particularly of the ideological Posnerian variety, thrived in
such an atmosphere. Nor is it surprising that sociological approaches more
likely to be neutral or favorable towards regulation were less likely to thrive.
(Interestingly enough, Mrs Thatchers 1979 triumph seems to have largely
failed to produce a similar pattern in British academia; perhaps this in part
714 Other Sociological Approaches 0630
reflected that, unlike Ronald Reagan, she never enjoyed the support of much
more than 40 percent of the electorate.)
Even the most casual observation of American law schools, particularly the
more elite law schools, reveals how responsive their curricula and research are
to what is going on in the outside world. The 1940s saw a proliferation of law
school activity in areas like labor law (collective bargaining and unfair labor
practices) and administrative law reflecting the the New Deal. Comparative and
public international law blossomed in the postwar Cold War era with
Americas new world role. Law and poverty and civil rights courses came with
the Lyndon Johnsons Great Society. Courses and studies relating in a wide
variety of ways to international trade have blossomed as its importance to the
American economy have become more and more widely recognized. It is hardly
surprising that a market-oriented and often right-wing subject like law and
economics thrived in the 1970s and thereafter. Indeed it would have been
simply amazing had it not.
A second factor in the relative success of law and economics undoubtedly
has to do with the speed and simplicity of effort required for various kinds of
intellectual work. For example, case-law research and empirical studies based
on published statistical information can be done in a library with far greater
speed and simplicity of effort than empirical studies can be done in the field.
This is almost certainly the primary reason that the empirical studies
envisioned by the early American realists, and sometimes conducted on a pilot
basis, caught on in American law schools only to a extremely limited degree.
Theoretical law and economics can in turn be done with far greater speed and
simplicity of effort than can be case-law and other library-based research.
None of the foregoing is to make any judgment whatever about the
intellectual challenge or difficulty of the different kinds of enterprise. It is
simply that most thought-experiments based on hypothetical situations can
typically be done faster than activities requiring fact-gathering, and that library
fact-gathering can typically be done faster than field fact-gathering. Thus
theoretical law and economics is in cost terms at a significant advantage in
competition with case-law research. It is at an even greater advantage in
competition with empirical approaches, particularly field studies. In an
academic world increasingly focussed on publish-or-perish this has made law
and economics singularly attractive to those with real or imagined ability to
carry out such analysis. This is especially true in any law school where
article-counting is an important aspect of promotion and tenure.
The big challenge to law and economics on this score will come to
whatever degree it shifts towards empiricism and particularly towards the more
time-intensive forms of field study such as that of Ellickson in Shasta County.
To whatever degree law and economics shifts in this direction its competitive
advantage will tend to disappear.
0630 Other Sociological Approaches 715
A third important factor in the relative success of the law and economics
movement has been its considerable financing from sources with pro-market,
and often right-wing, ideologies, of which the Olin Foundation stands out. This
financing included particularly a major effort to proselytize law teachers.
Starting in the late 1960s Henry Manne, a Chicago School enthusiast,
organized a well-financed and most attractive summer program, first at the
University of Rochester and later at the University of Miami. A very substantial
number of law teachers were both taught the basics of law and economics and
propagandized about its merits by this program. (It was nicknamed Pareto in
the Pines and after its move south, Pareto in the Palms.) Manne continued such
well-funded programs and others after moving to Emory University in 1980
and later founding a law and economics law school at George Mason
University. Nothing on a remotely comparable scale has ever been available to
provide financial support for noneconomic sociological training and
propaganda.
D. Conclusion
In conclusion, the great and probably unbridgeable gulf between various other
sociological approaches and Posnerian law and economics is much smaller
respecting other varieties of law and economics, particularly institutional law
and economics. These smaller gaps are likely to become smaller yet to whatever
extent both law and economics and other sociological approaches move in the
direction of empirical studies.
Acknowledgements
I am indebted to Jane E. Larson for reviewing the manuscript and making
many helpful comments, including her point concerning legal historians and
case-law research in Section 7, as well as for supplying references, particularly
for the theory-driven sociological approaches mentioned in Section 8. The
following also very kindly brought to my attention a number of important
bibliographical items: David A. Campbell, John J. Donohue III, August 16,
1999 and Patrick J. Kaufmann. Finally I am everlastingly indebted to my wife
Nancy for helping me work through problems relating to the many weaknesses
of rational choice theory, with the result that I decided to limit the critique here
to its Posnerian variant.
716 Other Sociological Approaches 0630
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718 Other Sociological Approaches 0630
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0640
THE LAW AND ECONOMICS OF
ANTHROPOLOGY
Robert Cooter
University of California at Berkeley
Copyright 1999 Robert Cooter
Abstract
I briefly review the classics of legal anthropology and discuss the economic
analysis relevant to it.
JEL classification: K00
Keywords: Law, Economics, Anthropology, Property, Social Norms
Just look along the road, and tell me if you can see either of [the messengers].
I see nobody on the road, said Alice.
I only wish I had such eyes, the King remarked in a fretful tone. To be able
to see Nobody! And at that distance too! Why, its as much as I can do to see
real people, by this light! (Lewis Carrolls Through the Looking-Glass,
Chapter 7)
As a rule of thumb, an academic subject exists when someone teaches it
regularly at a major university. By this standard, the subject of law, economics
and anthropology does not exist. A review essay requires eyes that the King
attributed to Alice. In contrast, legal anthropology exists and so does the
economic analysis of law. I will offer some remarks on how these two subjects
relate to each other.
1. Legal Anthropology
Legal anthropology is a small subject that is taught in a few universities,
especially in America (Kuppe and Potz, 1994). I recently asked teachers of law
and anthropology at major American universities to send me the reading lists
for their classes. The readings were all over the map both literally and
figuratively. The struggle in anthropology over the subjects identity has
infected law and anthropology. Some strands in modern anthropology, such as
symbolic anthropology (Geertz, 1983), have no apparent relationship to the
economic analysis of law. Others, such as economic anthropology (Dalton,
1967; Plattner, 1989) and anthropological materialism (Harris, 1968), have a
modest relationship to the economic analysis of law. In general, the analytical
techniques used in the economic analysis of law are not understood or
appreciated by anthropologists.
719
720 The Law and Economics of Anthropology 0640
Reviewing the different strands of anthropological thought is a difficult task
(Ortner, 1984) and relating them to the economic analysis of law in a brief
article is impossible. I will attempt something more limited and modest. My
main aim is to describe for law and economics scholars their subjects frontier
with anthropology. Legal anthropology has a small, classical literature, which
I will describe briefly. Then I will review in more detail the aspects of the
economic analysis of law that relate to classical concerns of anthropology.
Legal anthropology developed its classical literature (Conley and OBarr,
1993) in the twentieth century when anthropology books and monographs
devoted to law first appeared. Malinowski (1926), who first conducted
systematic field research on tribal law, debunked the myth that tribal law
consists of strict prohibitions and harsh punishments resembling criminal law.
Instead, he observed an elaborate system of compensation in Polynesia for harm
done to others, resembling the modern law of property and torts, but without
anything similar to formal courts. He commented on the usefulness of such a
system and tried to explain how it worked .
Llewellyn and Hoebel (1941) interviewed Cheyenne Indians in the 1920s
and reconstructed their legal order as it existed in the 1860s before conquest
and subjugation. This study applied the case method of the common law to
tribal law, thus minimizing the distinctiveness of techniques required in legal
anthropology. The cases consist of memories, stories and myths about law and
government. As practiced by Llewellyn and Hoebel, the case method explores
the purposes and uses of political practice and law, which makes legal realism
resemble functionalism.
Bohannan (1957) observed disputes in the customary courts (moots) of the
Tiv in colonial Nigeria. Like Llewellyn and Hoebel, he analyzed cases, but in
greater detail and subtlety, revealing the cultural obstacles to understanding
exotic legal systems. Bohannans concern over objectivity and neutrality in
comparing cultures anticipates recent methodological discussion in
anthropology. Gluckman (1965) provided the same kind of in-depth study of
the legal culture of another African group, the Barotse. Pospisil (1958)
extended this tradition by attempting something resembling a codification of
the customary law of a group in New Guinea who lived in the 1950s under
limited Dutch legal control.
The small, classical literature aimed at describing aspects of tribal law that
the modern state had not changed or distorted. More recent studies in this
tradition explicitly concern the way custom responds to state and market
(Collier, 1973; Moore, 1986; (Nader, 1990; Sierra, 1995), including the
attempts of subordinate peoples to secure themselves against exploitation
(Nader, 1990; Comaroff and Roberts, 1981). Whereas the classical literature
concerned tribes, modern studies in legal anthropology often concern formal,
non-western legal systems, such as Islamic or Buddhist law (Fikentscher,
0640 The Law and Economics of Anthropology 721
1995), thus effacing the distinction between legal anthropology and
comparative law. Contemporary anthropologists have also developed an interest
in the way contemporary customs interact with modern law in countries like the
US (Greenhouse, 1986).
2. Economic Analysis
I now turn to the smattering of articles on anthropology that fit within the
modern law and economics movement. In an earlier review Brenner (1983),
stresses population growth as the destabilizing influence that causes innovation
and economic development in tribes. Only a few papers in law and economics
concern law among tribal people. Perhaps the most discussed is the paper by
Demsetz (1967) which proposes a simple theory of the origins of property.
Demsetz reasoned that private property emerges from a prior rule permitting
open access to resources, and this event should occur at the point in history
when the benefits of the change exceed the costs. He observed that when
everyone has open access to a resource, over-exploitation produces a
dead-weight loss, as with over-fishing on the high seas. In contrast, private
ownership can eliminate this dead-weight loss, but, unlike open-access, private
property requires costly definition and enforcement of ownership rights. So
Demsetz predicts that privatization will occur when the dead-weight loss of
open access exceeds the transaction costs of exclusion by private property
rights.
For evidence in favor of this theory, Demsetz relies upon secondary sources,
notably concerning the fur trade among North American Indian tribes. More
careful examination proves that Demsetz got some important facts wrong.
Tribal people live among kin with extensive, complicated obligations to each
other, including obligations about using land. These obligations create a very
different legal regime from open access. So the characteristic movement in
tribal property law is not from open access to private ownership. Rather, new
customary rights in property continually evolve from old customary rights in
property (Cooter, 1991). Tradition persists by continually inventing new things.
Economists often contrast individual and group ownership, but these labels
are too imprecise to fit customary law. Research on property rights has revealed
variety and detail in the political arrangements by which small groups manage
their assets (Eggertsson, 1992; Ellickson, 1993; McCloskey, 1975a, 1975b;
Ostrom, 1990). Even without individual ownership, small groups of people
living intimate lives seldom suffer the political paralysis that causes deadweight
losses like the infamous tragedy of the commons.
Note that the Demsetz paper reveals a characteristic weakness of
anthropological work among law and economics scholars: they lack intuition
because they have never done field research. For an early exception in property
law, see Trebilcock (1981).
722 The Law and Economics of Anthropology 0640
In another paper with high ambition, Posner (1980) interprets the behavior
of tribes as a response to missing insurance markets. The combination of the
hazards of primitive life and the absence of insurance, according to this view,
causes people to form long-run relationships and redistribute wealth. Like
Demsetz, this paper contributes to anthropology by raising the level of
generality in formulating familiar trade-offs.
Risk-reduction is important to cases where customary law allows relatively
open access to a resource, such as summer grazing land in Mongolia.
Variations in weather impose risks on people living off the land. A customary
rule of open access enables people to relocate quickly from one micro-climate
to another, thus reducing climatic risk (Cooter, 1995; McCloskey, 1976;
Nugent and Sanchez, 1993). Open-access, however, discourages investments
to improve the land. So the trade-off is between dead-weight loss and
risk-spreading, not the trade-off between dead-weight loss and transaction costs
of exclusion as proposed by Demsetz.
3. Social Norms
As explained, legal anthropology especially concerns customary law.
Proponents of legal decentralization typically admire custom because it arises
spontaneously, outside the state (Hayek, 1976; Leoni, 1991). The informality
of social norms obscures their operation and causes observers to under-estimate
their importance relative to formal law. Modern business is often conducted in
rational ignorance of the law (Macaulay, 1963). Informal law plays an
especially important role in basic markets where state enforcement of contracts
fails, as in capital markets in developing countries (Winn, 1994). Over-zealous
regulation forces informal law to operate in opposition to formal law, which
impairs economics development (De Soto, 1989).
In recent years, economic theories have corrected the tradition of
underestimating informal norms. The analysis of social norms has become
central to the law and economics agenda, especially after Ellicksons research
on liability for straying cattle framed legal decentralization in terms of the
Coase Theorem (Ellickson, 1991). Two bodies of theory are joined in the
economic analysis of social norms. First, game theory has been adapted to the
specific circumstances in which social norms direct behavior
(Ullmann-Margalit, 1977; Taylor, 1987). Second, competition among social
norms resembles competition in evolutionary biology, so the application of
game theory to evolutionary biology provides models for understanding social
norms (Hirshleifer, 1987; Frank, 1988; Gruter, 1991; Gruter and Masters,
1992).
The economic analysis of social norms, such as the customary law of
property or customary obligations of redistribution, draw upon a fundamental
0640 The Law and Economics of Anthropology 723
result in game theory: one-shot games with inefficient solutions, such as
prisoners dilemma, often have efficient solutions when repeated between the
same players (Fudenberg and Maskin, 1986). This generalization grounds the
utilitarianism of small groups, by which I mean the tendency to create efficient
rules for cooperation within small groups. Kinship provides a framework for
repeated interaction among the same people. Consequently, game theory
predicts that kin groups such as tribes can solve problems of internal
cooperation without relying upon state law. Landa has used this result to study
groups of Chinese traders (Landa, 1981).
Kinship, however, is not the only basis for dense social networks in intimate
societies. Much like kinship, trade organizations can provide a framework for
repeated interaction (Cooter and Landa, 1984). Historical institutions such as
the medieval law merchant can be understand in this light (Milgrom, North and
Weingast, 1990; Greif, 1993). Bernstein has demonstrated this fact in careful,
detailed studies of modern diamond exchanges (Bernstein, 1992) and
commodity trading associations (Bernstein, 1996). Social groups, in which
people have repeated transactions with each other, must be distinguished from
social categories by which people are classified. Unlike social groups, people
who fall in the same social category might not have ties to each other, so they
may have inefficient interactions (Posner, 1995).
I have reviewed various economic studies of social norms. The economic
analysis of social norms requires a comprehensive vision, but none has emerged
as yet. According to one approach, law should ideally correct failures in the
market for social norms, rather like regulations should ideally correct failures
in the market for commodities (Cooter, 1994). This approach requires an
analysis of the incentive structures in society that cause the evolution of
efficient social norms, and, conversely, the incentive structures that cause social
norms to fail. The application of game theory to customary forms of
discrimination suggests an important kind of failure (Akerlof, 1980, 1985;
McAdams, 1995; Posner, 1996). A thorough development of a theory of the
evolution of social norms would provide the foundation for a theory of
adjudication, especially in the area of common law.
4. Conclusion
I organized my description of the law and economics of anthropology in terms
of these underlying ideas: property, long-run relationships and social norms.
Now I need to mention some loose ends that do not fit my categories. First,
some law and economics scholars have examined issues concerning American
Indians (McChesney, 1990; Cornell and Kalt, 1993; Anderson and McChesney,
1994). Second, some studies in comparative law and economics have an
724 The Law and Economics of Anthropology 0640
anthropological flavor (Kuran, 1995). Finally, a few brave scholars have
attempted to cross the deep divide between meaning and behavior in social
science by using the tools of law and economics to interpret stories and parables
from the Bible (Levmore, 1995; Miller, 1994, 1995, 1996a), or by trying to
adapt the rigorous individualism of economics to encompass a theory of culture
(Audain, 1995). These papers parallel the strong turn towards interpretivism
in anthropology in general (Geertz, 1983) and in legal anthropology in
particular, which stresses the distortion of the meaning of law as a consequence
of political domination (Comaroff, 1992; Williams, 1994).
Finally, I want to conclude by remarking on the interaction between
anthropology and economics. In anthropology as in politics, the confidence of
colonialism dissipated into the self-doubt of post-colonialism. Economics, in
contrast, retains its brash self-confidence. Given these facts, some
anthropologists associate economics imperialism with the mentality of political
colonialism. Abandoning such ideological conceptions would create a better
atmosphere for anthropology and economics to learn from each other. The
economic analysis of legal anthropology remains more aspiration than reality.
Economists believe correctly that they can bring more systematic analysis to a
range of topics in anthropology. Adapting economic theory to new institutions
and cultures, however, requires careful field research. Without a commitment
to field research, economic theory remains too remote from its object of study
to convince anthropologists immersed in other cultures.
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0650
NEW ECONOMIC HISTORY AND LAW AND
ECONOMICS
Alexander J. Field
Professor of Economics at Santa Clara University
Copyright 1999 Alexander J. Field
Abstract
This chapter reviews the contributions of the new economic history in light of
their relationship to the study of law and economics. After reviewing the
progress of the subdiscipline over the past century, and comparing the
approaches of new and old economic historians, the chapter provides an
overview of some of the most important controversies in the field and offers a
bibliography with references to the relevant literature.
JEL classification: K0, N0.
Keywords: New Economic History, Law and Economics, German Historical
School
1. Introduction
The purpose of this chapter is to give readers a broad overview of the new
economic history and its relationship to the study of law and economics. The
emphasis is not primarily on contributions specifically concerned with law and
institutional structure as explananda per se - such matters are treated elsewhere
in these volumes. Rather the focus is on what the field of the new economic
history is, what its relationship is to the old economic history, and how its
methodology and concerns relate to those of the economics discipline on the
one hand and the study of law and economics on the other.
To understand the relationship between law and economics and the new
economic history, it is important to understand what the new economic history
is (or was, since it is hardly new anymore) and what it reacted against.
Economic history began its life as a specialized social science subdiscipline
with close links to legal and institutional scholarship, and considerable shared
interest in documenting rule variation and its independent causal influence on
economic life. Receptivity to that methodological stance waned during the
heyday of the new economic history, although there is evidence in recent years
that it is beginning to wax again.
728
0650 New Economic History and Law and Economics 729
The new economic history was born in the United States in the late 1950s
and early 1960s, and has subsequently come to have increasing influence in
Europe and the rest of the world as well. Prior to the late 1950s scholarship in
the area of economic history had a strong institutional, legal, and arguably
statistical focus, but was largely agnostic when it came to the desirability of
applying formal economic theory to historical inquiry. Attitudes toward theory
changed with the advent of the new economic history, and with these came
differences in how old and new economic historians defined their tasks. A
strand of continuity over the last century has been a subject of concern in the
history of growth and development. In this context, economic history is
distinguishable from the history of economic thought, a branch of intellectual
history.
2. The Legacy of the German Historical School
The first professor of economic history in the United States, William J. Ashley,
assumed his position at Harvard University in 1892, seven years after the
founding of the American Economic Association and eight years after the
establishment of the American Historical Association. The initial memberships
of both of these associations were heavily influenced by ideals and scholarship
developing within German universities, which led the world in doctoral
instruction at the end of the nineteenth century. Indeed, up until the 1880s it
was impossible to obtain a PhD in the United States; the first American
programs were established at Johns Hopkins University and Clark University
at the end of the century.
The German tradition of economic scholarship, associated with such
scholars as Wilhelm Roscher, Gustav von Schmoller, Karl Knies and Werner
Sombart, emphasized inductive generalizations reached through the careful
study of primary materials, and defined itself in opposition to the more abstract
deductive approach popularized in England by David Ricardo and others.
German economic scholarship was dynamic and developmental, in that it
sought to delineate and understand how economic categories changed and
evolved over time, leading to various stage theories, or at least typologies of
economic progress. The ambitions of German historical economists were hardly
modest: they looked forward to a victory over the English approach as complete
as had been Adam Smiths over Mercantilist doctrine (Gay, 1941, p. 10).
This ambition was overreaching, a conclusion announced as early as 1901
by Thorstein Veblen and affirmed consistently by scholars thereafter (Veblen,
1901). Neither the extensive description of legal and institutional environments
nor the development of stage theories of economic development would halt the
elaboration, development and growing influence of partial and general
equilibrium analysis known generically as neoclassical economics. But the
730 New Economic History and Law and Economics 0650
failure of the historical school to supplant economic theory led many
economists to dismiss its concerns, in particular the emphasis on description
of the institutional and cultural context within which economic activity takes
place as a starting point for static economic analysis, and the focus on the
process of economic growth and development - the how and why of
institutional change over time and its consequences - as of limited relevance to
economic inquiry. Specialized scholars in economic history rejected, and
continue by and large to reject, this view. But the drift away from the German
tradition within US economics departments left a major unanswered question:
what was to be the role of legal and institutional scholarship and more
particularly what were economic historians supposed to do within economics
departments? This question has been finessed during the twentieth century, and
remains with us today. In England and Europe, on the other hand, it was
largely resolved politically, although not intellectually, through the
establishment of separate departments of economic history.
The finessing began with the first US appointment in the field. When
Ashley migrated from England to assume the first American chair in economic
history, he took pains to distance himself from the German tradition by
rejecting any ambition to supplant economic theory. In exchange, he asked that
the study of economic history in economics departments be let alone. Thus
was a truce declared. He proposed an historic division of labor within
economics departments, with economists concerned with static analysis within
existing institutional structures, and economic historians assuming the tasks not
only of documenting the historical trajectories of development, but also of
describing institutional structure, documenting its changes across time and
space and considering its impact on economic growth. The position of
economic history vis vis historical scholarship was reaffirmed by Ashleys
successor at Harvard, Edwin Gay, in his presidential lecture inaugurating the
Economic History Association in 1940. Gay, a student of Schmoller, who had
in turn been a student of Roscher, candidly reiterated the view that the full
hopes of the historical economists have not been realized and are not realizable
(Gay, 1941, p. 13).
But the rejection of the full hopes of the German school did not mean for
Ashley or for Gay that economic historians in the United States rejected
wholesale its concerns or methods. The most important area of continuity
between the German and English traditions in Europe and indeed between the
old and new economic history in the United States has been a subject concerned
with the process of economic growth and development. A key difference
between old and new economic history, we shall see, has been the role allotted
to legal and institutional structure as independent factors accounting for
variations in economic performance over time. For old economic historians that
role was much larger, which is why, for them, delineation of structure was the
starting point (although not, in principle, the ending point) for analysis.
0650 New Economic History and Law and Economics 731
One can appreciate the old economic history perspective on the tasks of
economic history in this excerpt from a paper published in 1913 by Guy
Callender in the American Historical Review. Callender, then professor of
economic history at Yale, began by contrasting the lack of interest in economic
history he experienced that year at the annual meeting of the American
Economic Association with that displayed by historians at their conclave. He
noted that relative interest levels in the two disciplines appeared to have
reversed over the previous two decades and went on to reaffirm the
indebtedness of economic history to the German historical tradition, as well as
the primacy of institutional analysis as the starting point for economic inquiry:
economic history owes its existence to [the historical school] Economic
science ought to be primarily a theory of development and not merely an
explanation of the way in which human beings produce wealth and share it as
income under a given set of social conditions.
Callenders vision of economic history as a fundamentally empirical
science, concerned with growth and development, recognizing that institutions
have consequences for economic performance and may change over time in
ways we should try and understand, is a statement of the tasks of economic
history that continues to have relevance today. But only parts of it would have
found favor at the height of the new economic history revolution. Although new
economic historians were as concerned as was Callender with understanding
growth and development, institutional variation was not the first thing they
turned to in accounting for it.
A second arguable area of continuity among old and new economic history
has been an emphasis on the use of statistics to measure economically
important magnitudes. Sir John Clapham, in his inaugural lecture for the first
chair in economic history at Cambridge University in England proclaimed it
the obvious business of an economic historian to be a measurer above other
historians (cited in McCloskey, 1987, p. 41; from Clapham 1930, p. 68), and
most new economic historians would embrace the sentiment. The continuity is
arguable, however, because old economic historians interest in statistics was
often limited to documenting the historical record.
New economic historians have been interested in doing more than just
clarifying the record per se: they have yearned to verify conjectures, to test
hypotheses. New economic historians have been more likely to say, well, if
this is true, then that must be true. Lets go look at the data and see if it is.
They have also been armed with more powerful statistical techniques - in
particular multiple regression - and much cheaper computational tools than
were available to their predecessors. And they have approached with
enthusiasm the task of teasing out relationships and possible causal connections
from the experiments provided by history in what of course has had to remain
a nonexperimental science.
732 New Economic History and Law and Economics 0650
Another reason the continuity is arguable is that in the first half of the
twentieth century the most dedicated analyzers of quantitative historical data
were not economic historians per se but rather students of business cycles
associated with the National Bureau of Economic Research. Wesley Mitchell,
Arthur Burns and Simon Kuznets were certainly sympathetic to the study of
economic history, but it was not their primary professional identification. This
anomaly led Carter Goodrich to wonder, on the eve (or morning?) of the
revolution in 1960, whether economic history [was] one subject or two? He
commented that the study of business cycles and conventional economic
history are for the most part carried on in separate compartments and that
twice during the present century a vigorous body of research concerned
with economic changes over time [has] developed largely in isolation from
conventional economic history. (The first was the study of business cycles, the
second the resurgence in the 1950s in interest in economic growth.) In each
case the new work was quantitative in method, and the result was the
phenomenon of two separate bodies of scholarship - the one written in prose
and calling itself economic history, the other written mainly in figures and
calling itself by another name (Goodrich, 1960, p. 531).
Goodrich concluded by asking plaintively whether If these are tasks that
can be done better by scholars operating under another banner, is there any
remaining purpose for us to serve? The partial isolation of the field from work
relevant to its main concerns was something that new economic historians
wished to remedy, and it is one area in which there has been partial success.
A final area of continuity between the German and English/American
traditions was in the commitment to describing and communicating to students
the important and essential features of legal and institutional environments,
even as this commitment received less and less affirmation from mainstream
economists. Here one finds the weakest link between old and new economic
history - a point of obvious relevance to scholars in the law and economics area.
Both old and new historians have sought to understand and explain growth.
Old economic historians, and institutional economists such as John R.
Commons, were interested in institutions, not so much in and of themselves,
as for the insight they might offer into variations in economic performance.
Nevertheless, for old economic historians, one started with the institutions, and
in that sense they were primary (Redlich, 1965, p. 482).
3. The Committee for Research in Economic History and the Founding of
the Economic History Association
It is fair to say that throughout the first four decades of the twentieth century,
American scholarship proceeded very much in the shadow of Europe. The
0650 New Economic History and Law and Economics 733
outbreak of the World War Two in Europe created conditions under which the
modern American university would blossom, both because of the interruptions
of contacts and scholarly materials from overseas and because of the exodus of
scholars (and scholars to be) from the war-torn continent. The latter migration,
which brought to the United States such luminaries as Alexander Gerschenkron
and Simon Kuznets, enriched economic history in the United States as it did
other scholarly fields, and the increased difficulty of maintaining scholarly
contact with Europe helped lead to the establishment in 1940 of a US based
Economic History Association (EHA).
Although an Economic History Society (EHS) had existed in England since
1926, and been supported by American scholars, there were concerns that the
EHS was partial to European topics and thus intermittent pressures for a new
association on the western side of the Atlantic. The war catalyzed these
concerns, and the establishment of the EHA along with its journal, the Journal
of Economic History, announced and ratified at meetings of both the American
Economics and the American Historical Associations in 1940, fleshed out the
thesis against which the antithesis of the new economic history would be
opposed (Lamoreaux, 1998).
Two other developments should be noted in order fully to appreciate the
historical setting in the United States in the late 1950s and early 1960s, within
which the new economic history strode brashly forward. The first was the
establishment, also in 1940, with Rockefeller Foundation support, of the
Committee on Research in Economic History, administered for the first 10
years through the Social Science Research Council, and incorporated separately
thereafter. (The other, dealt with subsequently, was the rapid growth after 1957
of the American university system, the consequence of demographic trends and
the launching of Sputnik.) The purpose of the Rockefeller grant was quite
simply to develop the field of economic history. To do this the committee
supported studies of the role of government and its relationship to economic
development, of entrepreneurship within the private sector, of the banking
system and its role in mobilizing capital and facilitating interregional and
intersectoral intermediation, and of historical statistics (Cole, 1953, p. 79).
The latter initiative is probably least well known yet illustrates how interest
in statistical data does represent at least a weak strand of continuity between the
concerns of the old and new economic history. CREH funding partially
supported the preparation of the first edition of Historical Statistics of the
United States, published by the Federal governments Bureau of the Census in
1949 (Cole, 1953). This publication and its successors both reflect and have
served as a starting point for much research in US economic history, providing
authoritative statistical series extending far beyond those available in current
editions of the Statistical Abstract of the United States or Economic Report of
the President. A second edition of Historical Statistics appeared in 1960, with
734 New Economic History and Law and Economics 0650
data through 1957, and a Bicentennial edition in 1975, with data through 1970.
A new millennial edition is now under preparation by a consortium of
economic scholars in universities (because of budget cutbacks the United States
Census Bureau has been unwilling to fund a revision) and is scheduled to be
published in both print and electronic editions by Cambridge University Press
in the year 2000.
The other CREH initiatives, particularly those in the areas of institutional
structure, strengthened old economic history traditions that new economic
historians would enthusiastically reject. The committees grants in the
institutional area reflected a view that governments of American states had, in
the early history of the republic, played an influential role in fostering economic
development and that the increased federal role evident in the New Deal should
be understood as a change in the locus of regulatory influence and government
action to improve economic performance, not wholesale abandonment of a
laissez faire past. CREH funding supported the well-known works by Oscar and
Mary Handlin on the role of government in Massachusetts (Handlin and
Handlin, 1969), as well as Louis Hartzs 1955 treatise on government in
Pennsylvania, The Liberal Tradition in America. Less familiar are CREH
funded studies of Georgia (Heath, 1954) and Missouri (Primm, 1954).
The intellectual framework underlying these grants was the old economic
history belief in the need for an intellectual division of labor between scholars
who would describe the institutional setting within which economic activity
(and the processes that led to its change over time) took place, and those who
would model and study behavior within such settings. The position of economic
historians within economics departments had traditionally reflected this
division of labor, but it was and continued to be an awkward division because
the intellectual tools needed to do the former well were different from those
required to excel at the latter. Analyzing economic behavior within an
institutional framework required tools of great analytical sophistication whereas
studies of an evolving institutional environment required sensitivity to context,
nuance and skills in the interpretation of documentary materials, all more likely
to be found in humanities as opposed to mathematics or statistics departments.
It was this divergence of traditions and methodologies, particularly with
respect to the use of formal economic theory in historical analysis, that the new
economic historians would ultimately try to bridge. Fogel (1965, p. 95) argued
in 1965 that the new economic history represents a reunification of economic
history with economic theory and thus brings to an end the century old split
between these two branches of economics. The new economic historians
possessed stronger training in statistical methods and econometrics than did
their predecessors. But the emphasis on the use of statistics for measurement
was not, as has been noted, entirely new. In that sense the term Cliometrics
(from Clio, the muse of history), sometimes used synonymously for the new
0650 New Economic History and Law and Economics 735
economic history, is misleading to the extent that it focuses on a less
fundamental methodological initiative.
The more fundamental departure involved the selfconscious use of formal
economic theory to model historical questions and, in so doing, identify
empirically measurable magnitudes of interest and what might reasonably be
inferred from them (McCloskey, 1978, p. 15). But the precise extent to which
the revolution represented a rejection or abandonment of the historical division
of labor announced by Ashley was always unclear. From the standpoint of law
and economics - and the future of historical economics - the big and
unanswered question remained: what was to be the role of legal and other
institutions in the study of economic history, or, for that matter, economics?
New economic historians dealt with the issue, with one or two notable
exceptions, largely by ignoring it.
It was perhaps not coincidental that neither the Handlins nor Hartz had
doctorates in economics or resided in economics departments (Oscar Handlin
was in History and Hartz in the Government department, both at Harvard).
Indeed, by the late 1940s, it was rare to find individuals within economics
departments who had the background or interest to conduct such studies. The
studies of the states role in economic development were conducted by scholars
outside of economics, scholars frankly more attuned to the historical analysis
of the particular than were most economists by this time.
A second main CREH initiative, however, addressed private action within
the governmental structures that Hartz and the Handlins were examining. This
led to the establishment at Harvard in 1948 of a Center for Entrepreneurial
History, an effort reflecting a Schumpeterian view that the driving economic
forces within the private sector (circumscribed by legal, cultural and
institutional structures) was the entrepreneur. Philosophically, this represented
an extension, in a sense, of the great man tradition of political and diplomatic
history to economic history. The actual role played by Schumpeter in this center
is unclear. He commented extensively on Coles 1946 proposal for such a center
in an essay published in part in the Journal of Economic History in 1947 as
The Creative Response in Economic History and in full in a recent edited
collection of papers by Richard Swedberg (Swedberg, 1991, pp. 406-428). But
Schumpeter spent most of the last years of his life (he died in 1950) at work on
his monumental History of Economic Analysis.
In spite of Schumpeters presence and legacy in the department, this
initiative did not find more fertile intellectual ground within the Harvard
department than had the state institutional studies. The methods used to study
entrepreneurs were not those favored by the developing science of economics,
and most found it hard to see how a doctorate in the field was of much help in
pursuing such studies. Finding little to assist them analytically or theoretically
within economic theory, entrepreneurial historians turned to other disciplines,
736 New Economic History and Law and Economics 0650
such as social psychology, for inspiration (McClelland et al., 1953). Thus the
two main CREH initiatives had relatively little influence on scholars interested
in historical economics who also had some systematic exposure to formal
economics.
Establishment of the Research Center in Entrepreneurial History did,
however, lead to the establishment of a second American journal in the area,
Explorations in Entrepreneurial History, a journal that would be renamed
Explorations in Economic History in 1969, presumably to distance itself
somewhat from its intellectual origins and broaden its appeal. (A third
American outlet, an annual, Research in Economic History, began publication
in 1979.)
The final factors reinforcing the growth of the new economic history were
US demographic trends and the launching in October of 1957 of Sputnik. The
Soviet scientific and propaganda triumph led to a great deal of national soul
searching and a substantial increase of US funding for scientific, including
social scientific research. Although the baby boom in the US peaked in that
year, the enormous number of children born after World War Two and their
eventual demands for higher education, contributed, along with Sputnik, to a
golden age for American academicians between 1957 and 1969. These were
years of great expansion in the capacity of the American University system as
undergraduate enrollments soared and faculty shortages developed. New and
expanded graduate training programs designed to address these shortages
served in the short run only to worsen them as they added their own demand
for new faculty to an already undersupplied pool (the phenomenon can be
understood in economic terms as a capital stock adjustment phenomenon). The
real income of scholars and funds available for research increased over these
years until the expanded graduate programs eventually flooded the faculty
market as the 1970s began, and the macroeconomic legacy of the Vietnam war
led to more moderate levels of support for scientific research (Field, 1987a).
4. The New Economic History - Goals and Agenda
The new economic history defined itself and made its greatest impact during
these golden years. What the insurgents promised was an extension of the
revolution in method then sweeping the economics profession as a whole, a
revolution that emphasized much greater use of analytical, mathematical and
statistical methods, to economic history. The old intellectual guideposts were
vigorously attacked. In particular, two pillars of the CREH initiatives and the
traditional economic history - (1) the emphasis on description of institutional
or legal structures as the first step in understanding the process of development
and (2) the study of entrepreneurial behavior within those structures - was, if
not rejected, at least very substantially reduced in the attention devoted to it.
0650 New Economic History and Law and Economics 737
First, the causal importance of entrepreneurial choice, vision, and action
was downplayed. As William Parker put it, in discussing how rational
businesspeople had responded to the changes in prices resulting from
technological change, capital accumulation, demographic growth and the
expansion of natural resources, there is not much room here for good and bad
entrepreneurs (Parker, 1971, p. 6). As a consequence of such attitudes,
students of entrepreneurial history felt themselves increasingly less welcome
within the Economic History Association (Lamoreaux, 1998).
Gone also was much reverence for studies of evolving institutional
structures, such as those by Hartz and the Handlins, with their implicit
assumption that politics and public policy choices mattered because they
influenced the environment within which economic activity took place. Fishlow
and Fogel (1971, p. 18) argued that the shift to an explicit concern with long
run economic growth and development meant an inevitable shift of focus from
earlier writing in which the description of the institutional structure was the
central objective. In principle the concern of old economic historians with
institutions was instrumental - the ultimate purpose was, or should have been,
to shed light on economic performance. In practice, Fishlow and Fogels
implicit criticism is probably fair: scholars did end up focussing centrally on
description of the institutional structures, spending less time articulating clearly
what their impact was on performance. In any event, instead of entrepreneurs
and institutions, much greater emphasis was now placed on technological and
demographic change and their consequences, worked out and understood
within the analytical framework provided by formal economic theory. Such a
framework could, of course, be used to explore the consequences of variation
in rule structures, but such issues were less frequently explored.
Why did the new economic history give law and institutions so little
intellectual shelf space? Some scholars were influenced by residual Marxian
views that the forces of production (technology) ultimately influenced the
relations of production (institutions, culture). Thus it was deemed less
important to study the evolution of institutions per se - since ultimately they
were epiphenomenal. It was far better to go right to the source: the
technological and demographic prime movers of history. Ironically, these
residual Marxian tendencies often dovetailed conveniently with a conservative
approach to public policy issues, in the sense that at one level, institutions did
not matter all that much and therefore it was not worth spending a great deal
of time studying them or exploring the consequences of changes or variation
in them (Field, 1991, pp. 2-4).
In some instances this view was supported by careless interpretations of the
Coase theorem (Field, 1991, pp. 10-16). Coase, of course, never developed his
analysis as a theorem - this language, common in economic discourse, itself
reflected the encroachment within economics departments of the culture and
738 New Economic History and Law and Economics 0650
language of mathematics departments - but his articles did suggest that,
assuming there were no transactions costs, the initial assignment of economic
rights should not affect the ultimate economic disposition of a resource. Coases
analysis was microeconomic, and it is not clear he ever intended it to apply at
the level of macroinstitutional structure. He admitted that the institution of
slavery probably did affect the disposition of resources - for example, black
labor in the New World - but took this to be the exception, rather than the rule.
For older economic historians, and those interested in general in the
consequences of institutional change and variation, the impact of an institution
such as slavery on the regional and sectoral distribution of inputs is, of course,
the rule rather than the exception. Moreover, transactions costs do exist, and
consequently some institutional rules are superior - more efficient - than others,
in the sense that they economize on transactions costs or allow risk to be borne
by parties who are better situated to do so. That indeed, is the insight that
underlies much recent law and economic literature, and represents a productive
way in which law and economics scholars have tried to make endogenous the
choice of legal rules.
Coases position on the role of legal institutions as exogenous determinants
of performance remains, however, ambiguous. In a 1997 retrospective, the law
and economics scholar William M. Landes wrote that he (Landes)
was genuinely interested in explaining legal rules and doctrine from an
economic perspective. Coase was not. He believed that knowledge of law and
legal institutions was valuable because it helped one understand how explicit
markets truly worked ... (Landes, 1997)
That sentiment, of course, would place Coase squarely in the intellectual
traditions represented by old economic history.
For whatever reasons, new economic historians were, on balance, less
interested in legal, political and constitutional issues, particularly at the macro
level. Either such issues were ignored, on the grounds that for the regions and
time periods under investigation such conditions were relatively stable, or had
variations whose effects were swamped by variations in other (technological or
demographic) variables; or attempts were made to explain change with
reference to technological and demographic models which did not in turn make
reference to institutions as givens within the explanatory model. One of the
most ambitious attempts along these lines was that by North and Thomas,
which attempted to account for eight centuries of European development in 158
pages, trying to appeal only to technological and demographic variables, and
avoid reference to ad hoc political or institutional conditions or changes as
causal factors in their own right (North and Thomas, 1973; Field, 1981).
0650 New Economic History and Law and Economics 739
Why this aversion to explicitly recognizing institutional factors as both
consequential and in part exogenous? Probably because there was a sense that
to do so was to allow the camels nose under the tent, to take the first step down
the slippery slope of adhocery whereby the methodology and concerns of the old
economic history would reintroduce themselves. If one analyzes the North and
Thomas argument carefully, however, one finds that they are in fact, and
scarcely surprisingly, forced to violate their methodological strictures in order
to tell their story. In subsequent works North appears to acknowledge this, by
explicitly discussing the impact on behavior of such factors as ideology (North,
1981, 1990) but the underlying methodologically individualist research
program persists.
Having rejected or drastically downplayed the old economic historys
concerns with entrepreneurship and institutions, the revolutionaries levied a
more general methodological criticism. Rightly or wrongly, they stigmatized
their older colleagues as having been satisfied with general and vague
qualitative statements about causal factors in economic growth. Cliometricians
insisted that explanatory hypotheses be explicitly set forth and that scholars go
beyond the simple qualitative statement that something mattered, to exploring
exactly how much it mattered. For example, Robert Fogel and Albert Fishlow
rejected the argument by W.W. Rostow and others that the railroad was
critical or indispensable for nineteenth century American economic
development on the grounds that one could not attach economic magnitudes to
these qualitative evaluations (Fogel, 1964; Fishlow, 1965a). They explored the
indispensability thesis about American railroads using a counterfactual
methodology by asking how much lower would have been GNP if the railroad
had not been developed, in one case in 1859, in the other in 1890. The
difference between GNP as it was in actuality and what it would have been in
the absence of the railroad represents the social savings of the innovation.
Historians objected strongly to the counterfactual methodology but, as
noted, the charge that previous students of historical economics had been
uninterested in measurement is unfair. What was true was that more conscious
theorizing now made it possible to tease out new and intriguing inferences from
quantitative data, and helped direct researchers towards particular (and
sometimes different) magnitudes. In retrospect, the indictment of old economic
historians as uninterested in measurement and prone to set forth casual,
qualitative and empirically unsubstantiated causal hypotheses could with rather
more justification have been levied at many of the mathematical theorists then
coming to dominate economic departments.
Is this entirely coincidental? If one takes the methodenstreit of the early
1960s at face value, it concerns how theoretically self conscious economic
history should be. But perhaps old economic historians were merely stalking
horses in a struggle as much within economics itself as to how empirically and
740 New Economic History and Law and Economics 0650
historically focused the larger discipline would be. This is a speculative
hypothesis, and the evidence supporting it inconclusive. McCloskey, writing in
1976, did not think this was so - (s)he felt that the attack on old economic
history - certainly a far weaker adversary than those gradually importing math
department values into economics departments, represented a political error,
a failure by economic imperialists to insure sufficient levels of domestic
support (McCloskey, 1976, p. 438). It was easier to beat up on the old economic
historians, but perhaps not wiser in the longer run. McCloskey also studied the
percentage of column inches devoted to economic history in the main general
interest economic journals in the United States (American Economic Review,
Quarterly Journal of Economics, Journal of Political Economy) and found a
significant downward shift between the periods 1925-44 and 1945-74; there is
little evidence that this trend has been reversed in the last quarter century.
Callender, of course, was already bemoaning this neglect in 1913.
Certainly Douglass Norths comment in 1965 displays little ambivalence
about who the heroes were:
In summary, it is my conviction that we need to sweep out the door a good deal of
the old economic history, to improve the quality of the new economic history, and
it is incumbent upon economists to cast a skeptical eye upon the research produced
by their economic history colleagues to see that it lives up to standards which they
would expect in other areas of economics. (North, 1965, p. 91)
The irony is that comments such as those of North have, on balance,
fostered neither hostility toward economic history nor a critical perspective on
its practice. Rather they run the danger of feeding indifference. Such
indifference impoverishes economic analysis as a whole, but its prevalence is
not entirely the fault of mainstream economists. Both economics and economic
history might well have been healthier had a different course been pursued by
the revolutionaries, had they not embraced so uncritically the potential of
neoclassical economic theory to illuminate historical inquiry. As McCloskey
noted, The days are passing when the social sciences bridged the two cultures,
literary and scientific, and economics burned the bridge long ago (McCloskey,
1976, p. 439).
In general, economic theorists have actually been less enthusiastic about the
power of their tools to illuminate historical inquiry (in some cases the
skepticism seems to spill over to contemporary data as well) than have been
new economic historians. Simon Kuznets summarized discussion of a variety
of methods papers at the 1957 EHA annual meetings and noted, somewhat
surprisingly, that
0650 New Economic History and Law and Economics 741
Three theorists on a panel were rather skeptical of the value of greater
integration of economic theory and economic history . On the other hand, at
least some of the panel discussants and Gerschenkron from the floor, appeared
to feel a greater need for reliance (in economic history) on economic theory...
it did seem as if almost all economic theorists participating in the discussion
were doubtful of the value of theory in work on economic history, while at least
some economic historians felt that it [was] needed. (Kuznets, 1957, p. 550)
One detects a similar reticence on the part of theorists at a 1984 AEA
session to propagandize too highly for the value of their tools in historical
inquiry (Solow, 1985, p. 328).
5. Economic History, Douglass North and the Nobel Prize
The Nobel prize in economics was first awarded in 1969, and a review of
recipients with work touching on economic history, law and economics, and
their relationship provides perspective on the recent evolution of these
disciplines. Simon Kuznets was the first of five honorees with such
connections. Although Kuznets, who received the award in 1971, did not
consider himself primarily a new economic historian, he trained many of its
pioneers (such as Robert Fogel and Stanley Engerman) and his development of
national income accounting reflected the new economic historys passion for
measurement. Kuznets work laid the foundation for modern empirical
macroeconomics and macroeconomic history, even though, as noted by
Goodrich above, the National Bureau tradition proceeded largely independently
from economic history.
Five years later (1976) Milton Friedman received the award. From the
standpoint of economic history, his greatest contribution has been in the area
of monetary history, in particular the monumental 1963 work coauthored with
Anna Schwartz, A Monetary History of the United States (Friedman and
Schwartz, 1963). Friedmans work, and the reaction to it, played an important
role in seating the study of cyclical macroeconomic phenomena squarely within
the purview of economic history. Part of the success here, however, is
attributable to a shift toward a more contemporary focus on policy issues by the
National Bureau under the leadership of Martin Feldstein, with the
consequence that historical studies of business cycles no longer play as central
a role in the Bureaus agenda.
Fifteen years later, in 1991, Ronald Coase won the prize. Coase is a pivotal
figure in the development of industrial organization as well as law and
economics, and his contributions are discussed in detail elsewhere in these
volumes. To the extent that economic historians have developed a more
sophisticated approach to economic and legal institutions, his ideas have been
742 New Economic History and Law and Economics 0650
important. Yet for reasons having to do with the sociology of the profession, his
overall influence on economic history has been curiously weak. This is because
scholars who start out self-identifying as economic historians, but become
interested and proficient in a Coasian type of analysis, generally begin
publishing in law reviews or law and economics journals. There is little bias
against an historical perspective in law; indeed one might argue that such a
perspective is essential, and thus the barriers to exit in this direction are weak.
Finally, in 1993, two pioneers of the new economic history, Robert Fogel
and Douglass North, received the prize. Fogel was a central player in two of the
defining intellectual debates of the Cliometrics revolution, the study of how
indispensable were the American railroads and, in a book coauthored with
Stanley Engerman in 1974, Time on the Cross, the economics of slavery. This
latter work, which attempted to turn upside down much received wisdom about
how efficient the slave plantation system had been, and how well slaves were
housed, fed, clothed and treated, engendered enormous controversy within the
profession. In the last two decades, Fogel has pioneered in the use of historical
demographic data to study variations and changes in the standard of living.
Douglass North made important empirical contributions to the economic
history of the antebellum period, in particular his study of the US as an export-
led economy from 1790 to 1860 (North, 1961). But his greatest professional
success has been in trying to fill the gap left by the new economic historys
attack on the older legal/institutional tradition. For many scholars outside of the
profession, North is the new economic history. But there is a real question as
to how central Norths institutional work is to the new economic history or
what exactly law and economics scholars should draw from it. How to
reintegrate institutions with historical analysis without reembracing the errors
of the old economic history? As noted, in his 1973 work with Robert Paul
Thomas, instead of making the study of the institutional framework the starting
point of analysis, North struggled bravely to avoid appeals to ad hoc
explanations, and instead to develop endogenous theories of institutions: that
is, August 17, 1999 theories that would explain within a general (not historical
or case-specific) framework, how and why institutions varied over time and
space. The problem with such an approach is this. If we take the fundamental
task of economic history to be understanding and explaining economic
performance over time, then an interest in institutions - by old or new economic
historians - is ultimately relevant only to the degree that it can shed light on
such performance. To the extent that institutions are made endogenous -
determined within the context of a general theory by more fundamental factors
such as technology or demography, they cannot play an independent role in
accounting for variation in performance.
These are the dimensions of the intellectual box that North - and scholars
in many other disciplines - have struggled mightily to escape from. In a 1971
book coauthored with Lance Davis, Davis and North were willing to take the
0650 New Economic History and Law and Economics 743
initial constitutional setup as given, but then went on to describe how private
groups motivated by self interest seized profitable opportunities to make
institutional innovations. Ex post one can certainly find many cases where such
a perspective makes good narrative history. But whether Davis and North
actually succeed in developing a general theory, an explanatory framework
that leads to refutable hypotheses, remains questionable. This was the view of
Olmstead and Goldberg (1975), who also pointed out that many of the factors
(such as public opinion) that North and Davis took as exogenous environmental
factors, could in fact also be affected by expenditures of resources by private
groups.
In the previously discussed The Rise of the Western World, coauthored with
Robert Paul Thomas (North and Thomas, 1973), North tried to make
endogenous the entire institutional structure of Western Europe, accounting for
the breakdown of feudalism and the rise of modern economic and political
institutions with reference only to more fundamental factors, such as
demographic change and, to a lesser degree, new technology. The key
component of their analysis is the labor to land ratio, whose rise, caused by
population growth, is supposed to account for the demise of feudalism. But
feudalism in western Europe broke down both as population rose, prior to the
Black Death, and when population fell, after the plague. Moreover, falling
population appears to have been associated with a recrudescence of feudalism
in Eastern Europe, and it was precisely the scarcity of labor that Evsey Domar
has used to explain the initiation and persistence of coerced labor regimes, both
in Eastern Europe, and in the American South (Domar, 1970). Looked at
objectively, one extracts from the work a theory that says that rising labor to
land ratios lead to breakdowns of coerced labor regimes, except when they do
not.
In later work, North (1981, 1990) has made valiant attempts to respond to
such criticisms, but as one reads his contributions, one cannot help but continue
to ask how much of the explanation represents ex post rationalization for
what has happened. One continues to be troubled by the paucity of testable
hypotheses, as compared, for example, with his earlier empirical studies of the
US as a (cotton) export led economy prior to the Civil War (North, 1961). That
theory generated predictions that other scholars such as Fishlow (1965b) could
then test (in a way not favorable to the North hypothesis) but in the process our
understanding of antebellum economic history advanced.
Northian institutional economic history tends to be neither quantitatively
empirical nor, because of its sweep, informed by detailed knowledge of law in
its particulars. In contrast, scholars in the law and economics area must possess
such understanding. In the United States, a minimum familiarity with the law
of property, contracts, civil procedure and torts (at least at the level it is taught
in a typical first year law school curriculum) as well as some Constitutional
Law is in general a precondition for success in the field. Particularly in
744 New Economic History and Law and Economics 0650
countries with an Anglo Saxon tradition, legal research and historical archival
research have important similarities: the role of precedent (stare decisis) means
that history matters (although in legal research the archives are more likely
to be computer searchable).
Legal scholarship, in general, has a solid grounding in the history and
historiography of the law, as reflected for example in the enormous footnote
apparatus of a typical law review article. Empirical economics and economic
history, in general, have a firm grounding in the statistical record. Northian
institutional economic history, written almost exclusively from secondary
sources, often lacks much of either. Armchair economic theorists, and North,
have a fondness for stylized facts but stylized facts are sometimes simply
wrong, and someone has to be responsible for trying to ensure that the
generalizations are reasonable. It falls to economic (and legal) historians to be
at least as concerned with accurately characterizing the stylized facts as
explaining them.
North, as we have seen, has been a continuing proponent of revitalizing
economic history through the introduction of the perspectives of economic
theory, and the urge to generalize in his work often militates against detailed
immersion in the particulars of a topic. But importing even a little bit of the
attitude toward data of theoretical economists into historical, let alone legal or
institutional scholarship, creates real problems. In an effort which has been
relatively exceptional in recent years, however, Wallis and North (1986) did try
empirically to estimate the size of the transactions economy: that part of
economic activity devoted to negotiating and transactions among individuals,
as opposed simply to producing the goods or nontransactions services (like
haircuts).
In reflecting on Norths contributions, one is struck by the extent to which
the interface between law and economics and economic history might benefit
from more contributions such as McCurdy (1978). This article, although
published in the Journal of Economic History, displays the legal historians
knowledge of constitutional and statutory law and attention to detail sometimes
lacking in Norths grand excursions. I mention McCurdys article first because
it is relatively obscure and second because it deals with private actions to
achieve institutional change - in this case those of American corporations such
as Singer to eliminate state created obstacles to interstate trade, and in so doing
help forge a national market. Such actions in response to opportunities for gain
are of course the main subject of Davis and North.
When all is said and done, however, North deserves credit for the
indefatigable way in which he has worked successfully to reinject a concern
with legal and institutional arrangement back in to the new economic history.
What can law and economics scholars learn from Norths sweeping forays into
institutional and economic history? Probably not too much about law and
0650 New Economic History and Law and Economics 745
economics. But his work can open up for them a better understanding of the
broad macroeconomic concerns about growth and development that are second
nature to practicing economic historians and remain at the core of the
discipline. Interested readers should consult Norths numerous publications (see
bibliography) as well as surveys such as Libecap, (1978, 1986).
Returning to Fogel, the publication of Time on the Cross in 1974
engendered enormous publicity and an equally massive intellectual reaction
(see David et al., 1976). Looking back from the perspective of the late 1990s,
the controversy over slavery in the 1970s, which continued a conversation
begun by Conrad and Meyer in 1958, was in a very real sense the beginning of
the end of the new economic history as a revolutionary movement (Conrad and
Meyer, 1958). There have been few contributions in the last two decades that
have engendered anywhere near as much heat, with the possible exception of
relatively recent work on technological lock-in (Arthur 1994; David, 1985).
This reduction in heat has not been entirely regrettable. Some of the
criticisms of the old economic history evidenced more bluster than substance,
and when the dust settled and these critiques were subject to more dispassionate
analysis, were found to have weak intellectual foundations. Although there
were a few more displays of revolutionary rhetoric in the late 1970s, the field
began to exhibit more intellectual maturity. The sense of superiority that
economic historians trained as economists maintained vis vis their colleagues
trained as historians began to weaken, and a rapprochement of sorts took place
at least with those historians who remained active in the Economic History
Association because of their interest in the application of social science
methods to history.
Although mathematical symbols and econometric results continue to appear
frequently within the pages of economic history articles, text and narrative hold
their own as important parts of the exercise in persuasion. And so an uneasy
methodological truce has been reestablished, with economic history in the late
twentieth century perhaps now poised to provide object lessons both to
historians and to economists about how to conduct empirically based,
analytically sophisticated inquiries into social phenomena.
But the fundamental issue of the role of legal and institutional analysis
within economics and the role of economic historians in addressing such
phenomena remains unresolved. The finesses simply have not been successful.
Perhaps the scholar who came closest to striking the right balance in recent
decades was Jonathan Hughes. Hughes, although a new economic historian,
was always something of a maverick, publishing entrepreneurial history when
it was no longer fashionable, and, when it was no longer fashionable,
continuing to treat the institutional environment as consequential and at least
partially exogenous, and thus deserving of detailed attention in its own right
(Hughes, 1966, 1977). His approach to institutions can also be appreciated by
746 New Economic History and Law and Economics 0650
reading the first sections of his textbook (Hughes, 1990).
6. What have been the Contributions of the New Economic History in
Recent Decades?
The best current overview of the contributions of the new economic history to
the economic history in the United States is Atack and Pasell (1994). This is
the second edition of a volume that appeared first in 1979 as Lee and Passell.
The second edition is more comprehensive and balanced; the first, for example,
devoted almost a third of its text to slavery, reflecting the extent to which that
topic dominated discussion in the 1970s. For a survey of the state of the art in
economic history circa 1972, readers should consult Davis, Easterlin and
Parker, 1972. For a textbook on American topics with a somewhat more
chronological approach, see Hughes (1990). Although this essay focuses largely
on American topics, readers interested in what the new economic history has
accomplished for the historiography of British growth should consult Floud and
McCloskey (1994). For a modern survey of the role of technological change in
economic development, see Mokyr (1990). For membership lists, online book
reviews, sample syllabi, discussion groups, and more, consult the website
maintained by the Cliometrics society at http://cs.muohio.edu. The Cliometrics
association also publishes a newsletter, which in recent years has printed
interviews with new economic history pioneers.
Identifying the significant post-slavery controversy developments in US
economic history is difficult. Southern agriculture has continued to figure, with
important books by Ransom and Sutch (1977) and Wright (1978, 1986).
Ransom and Sutch (1977) and Wright (1986) both focus on the post bellum
period, as do Alston and Ferrie (1985). The greater interest in post Civil War
topics was reinforced by the publication in 1977 of Alfred Chandlers The
Visible Hand. The book was influential not only because of its masterful
reinterpretation of the dependence of the rise of the modern business enterprise
on new communication and transportation technologies (the telegraph and the
railroad), not only for the stimulus it has given to the study of post Civil War
topics, but also because it was significant in reintegrating the sophisticated
study of business history into the agenda of economic history (Field, 1987a;
Temin, 1991; Lamoreaux and Raff, 1995; Lamoreaux, Raff and Temin, 1998).
The 1980s also saw an emphasis on the systematic analysis of height by age
data to shed new light on variations in standards of living across time and
space. This has been part of a broader increase in the interests of new economic
historians in historical demography (Steckel, 1995). Another notable
development has been increased interest in the phenomenon of technological
lock-in - the idea that economies might be subject to technological hysterisis
0650 New Economic History and Law and Economics 747
and thus path-dependent. The argument is that accidents of the past can matter,
determining everything from the shape of a dollar bill to our dependence on
internal rather than external combustion (steam) engines for road transport
(David, 1985; Arthur, 1994). While this literature has developed largely out of
an interest in technological trajectories, it has great potential relevance for the
study of legal structure and institutions. Indeed, since there is broader variation
in legal structures at moments in time than there is in technological practice,
lock-in effects might be more significant in the analysis of law than in
technology per se. This is largely an unexplored area (Field, 1991), however,
and the empirical significance of technological lock-in remains under debate
(Liebowitz and Margolis, 1990), although it has figured heavily in the 1998
Department of Justice antitrust proceeedings against the Microsoft corporation.
Other major trends in the 1980s and 1990s have included an emphasis on
what might be called applied labor economics using older data - with analysis
applied to everything from the traffic in indentured servants in the colonial
period (Galenson, 1981) to the earnings of women (Goldin, 1990). But
macroeconomics has not been entirely eclipsed, particularly in studies of the
Great Depression. Its history remains in an unsettled state, but not for want of
attention, with a new international perspective (Eichengreen, 1992; Temin,
1989), which emphasizes the deflationary consequences of failure to abandon
gold as well as new work by Field (1992) and Romer (1992) exploring internal
reasons why the depression in the United States was so long and a number of
contributions focusing on the role of financial structure (see Calomiris, 1993
for a review of recent research on financial aspects of the downturn).
In other work Romer has questioned the conventional wisdom that the post-
World War Two period has in fact been less volatile than prior periods.
Romers methodology was thought provoking, but the contribution is notable
also because it signals the degree to which, whether on the microeconomic or
macroeconomic side, the great unexplored frontier for economic historians lies
in the post-World War Two period. It is symptomatic that the Atack and Passell
survey stops in 1940, and the postwar sections in standard economic history
texts tend to be relatively weak. When the new economic history began in the
late 1950s, the end of the World War Two was barely a decade in the past, and
consequently it was hard to think of the postwar period in historical terms.
More than half a century has now elapsed since 1945, a half century that will
benefit in the future from the detailed attentions of economic historians. Such
work will likely cause us increasingly to rethink interpretations of prior periods.
748 New Economic History and Law and Economics 0650
7. Conclusion
Scholars in law and economics should read economic history not so much
because of what it will teach them about law, but because of what it can teach
them about economies. In spite of all the methodological writing about the
differences between old and new economic history, one constant throughout the
century during which the subdiscipline of economic history has had a distinct
existence has been an empirical concern with the process of economic growth
and development. This theme unifies the practitioners of the German historical
school, with their tastes for inductively developing stage theories of growth,
through the old economic history up through and continuing with the new
economic history. The general understanding of the trajectories of growth and
development, and the creative use of the framework of economic theory to
account for these are valuable complements to the knowledge base typically
possessed by the law and economics scholar. So too is the consistent approach
to data and measurement - particularly because the study of law and economics,
with the possible exception of studies of criminal law, is not in general
empirically quantitative.
The contributions of the new economic history to legal analysis per se are
less clear, with the possible exception of recent work on lock in. First of all, law
and economics scholars will already be familiar with much of it, because
individuals who may have begun in economic history have mastered the body
of knowledge possessed by law and economic scholars and have consequently
published in Journal of Law and Economics or various Law Reviews. A search
of the Econ Lit database (published for the American Economic Association by
Silver Platter) for economic history and law brings up over a thouand citations,
but most of them are not in economic history journals.
Law and economics researchers interested in institutional and legal
structure per se may actually find more of interest in the writings of old
economic historians. But for economic historians, the interest in law and
institutions has, at least in principle, always been instrumental - the payoff
comes in understanding how variation in such structures may affect
performance. Naturally, time in the classroom and time in the library is limited
and old economic historians can be faulted for sometimes appearing to lose
steam after describing the changing institutional structure, perhaps assuming
that the connections with economic performance were obvious. They are not.
On the other hand, new economic historians have often ignored the
institutional structure or tried to make it endogenous. It is in understanding the
links between legal and institutional structure and performance that lie the
greatest challenges to scholars in law and economics and economic history.
0650 New Economic History and Law and Economics 749
Acknowledgments
I would like to thank Peter Temin, Gavin Wright and an anonymous referee for
their helpful comments.
Bibliography on New Economics History and Law and Economics (0650)
Because a comprehensive list of references to specific contributions in the new
economic history would be far too extensive for this collection, I focus on some
main contributions which will give the reader a sense of the contributions, as
well as a selection of survey and evaluative pieces that help to provide an
overview.
Alston, Lee J. and Ferrie, Joseph P. (1985), Labor Costs, Paternalism and Loyalty in Southern
Agriculture: A Constraint on the Growth of the Welfare State, 45 Journal of Economic History,
95-117.
Arthur, Brain (1994), Increasing Returns and Path Dependence in the Economy, Ann Arbor,
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Ashley, W.J. (1893), On the Study of Economic History, 17 Quarterly Journal of Economics.
Ashton, T.S. (1946), The Relation of Economic History to Economic Theory, Economica NS May
1946, reprinted in the Study of Economic History, edited by N.B. Harte, London, Frank Cass,
1971, 161-80
Atack, Jeremy and Passell, Peter (1994), A New Economic View of American History, 2nd edn, New
York, W.W. Norton.
Callender, Guy S. (1913), The Position of American Economic History, 19 American Historical
Review, 80-97.
Calomiris, Charles (1993), Financial Factors in the Great Depression, 7 Journal of Economic
Perspectives, 61-85.
Chandler, Alfred (1977), The Visible Hand: The Managerial Revolution in American Business,
Cambridge, Harvard University Press.
Clapham, J.H. (1930), Economic History as a Discipline, V Encyclopedia of the Social Sciences,
New York, Macmillan.
Cochran, Thomas C. (1959), Recent Contributions to Economic History: The United States, The
Twentieth Century, 19 Journal of Economic History, 64-75.
Cole, Arthur H. (1953), Committee on Research in Economic History: A Description of its Purposes,
Activities, and Organization, 13 Journal of Economic History, 79-87.
Conrad, Alfred and Meyer, John (1958), The Economics if Slavery in the Antebellum South, 66
Journal of Political Economy.
David, Paul A. (1985), Clio and the Economics of QWERTY, 75 American Economic Review,
332-337.
David, Paul A. et al. (1976), Reckoning with Slavery : A Critical Study in the Quantitative History
of American Negro Slavery, Oxford, Oxford University Press.
750 New Economic History and Law and Economics 0650
Davis, Lance E. and North, Douglass C. (1971), Institutional Change and American Economic
Growth, Cambridge, Cambridge University Press.
Davis, Lance E., Easterlin, Richard and Parker, William (1972), American Economic History: An
Economists History of the United States, New York, Harper and Row.
Domar, Evsey (1970), The Causes of Slavery and Serfdom, A Hypothesis, 30 Journal of Economic
History, 18-32.
Eichengreen, Barry (1992), Golden Fetters: The Gold Standard and the Great Depression,
1919-1939, New York, Oxford University Press.
Engerman, Stanley L. (1992), Coerced and Free Labor: Property Rights and the Development of the
Labor Force, 29 Explorations in Economic History, 1-29.
Field, Alexander J. (1981), The Problem with Neoclassical Institutional Economics: A Critique with
Reference to the North-Thomas Model of Pre-1500 Europe, 18 Explorations in Economic
History, 174-198.
Field, Alexander J. (1987a), The Future of Economic History, in Field, A.J. (ed.), The Future of
Economic History, Boston, Kluwer-Nijhoff.
Field, Alexander J. (1987b), Modern Business Innovation as a Capital Saving Innovation, 47 Journal
of Economic History, 473-485.
Field, Alexander J. (1991), Do Legal Systems Matter?, 28 Explorations in Economic History, 1-35.
Field, Alexander J. (1992), Uncontrolled Land Development and the Duration of the Depression in the
United States, 52 Journal of Economic History, 785-805.
Fishlow, Albert (1965a), American Railroads and the Transformation of the Antebellum Economy,
Cambridge, Harvard University Press.
Fishlow, Albert (1965b), Antebellum Interregional Trade Reconsidered, in Andreano, Ralph (ed.),
New Views in American Economic Development, Cambridge, Harvard University Press.
Fishlow, Albert and Fogel, Robert, (1971), Quantitative Economic History: An Interim Evaluation -
Past Trends and Present Tendencies, 31 Journal of Economic History, 15-42.
Floud, Roderick (1994), The Economic History of Britain Since 1700 , 2nd edn, Cambridge,
Cambridge University Press.
Floud, Roderick and McCloskey, Donald (1994), The Economic History of Britain Since 1700, 2nd
edn, Cambridge, Cambridge University Press.
Fogel, Robert, William (1964), Railroads and American Economic Growth: Essays in Econometric
History, Baltimore, Johns Hopkins University Press.
Fogel, Robert, William (1965), The Reunification of Economic History with Economic Theory, 55
American Economic Review, 92-98.
Fogel, Robert, William and Stanley Engerman (1974), Time on the Cross: The Economics of
American Negro Slavery, Boston, Little Brown.
Friedman, Milton and Schwartz, Anna J. (1963), A Monetary History of the United States, 1867-1960,
Princeton, Princeton University Press.
Galenson, David (1981), White Servitude in colonial America: An Economic Analysis, Cambridge,
Cambridge University Press.
Gay, Edwin F. (1941) The Task of Economic History, 1 Journal of Economic History, 9-16.
Goldin, Claudia, Dale (1990), Understanding the Gender Gap: An Economic History of American
Women, New York, Oxford University Press.
0650 New Economic History and Law and Economics 751
Goodrich, Carter (1959), Recent Contributions to Economic History: The United States, 1789-1860,
19 Journal of Economic History, 25-43.
Goodrich, Carter (1960), Economic History: One Field or Two?, 20 Journal of Economic History,
531-538.
Gras, N.S.B. (1930), Economic History in the United States, Encyclopedia of the Social Sciences,
New York, Macmillan.
Handlin, Oscar and Handlin, Mary Flug (1969), Commonwealth: A Study of the Role of Government
in the American Economy: Massachusetts, 1774-186 (rev. Edn), Cambridge, MA, Belknap Press
of Harvard University Press.
Heath, Milton Sydney (1954), Constructive Liberalism, the Role of the State in Economic
Developments in Georgia to 1860, Cambridge, Harvard University Press.
Heaton, Herbert (1941), The Early History of the Economic History Association, 1 Journal of
Economic History, 107-109.
Higgs, Robert (1985), Crisis, Bigger Government, and Ideological Change: Two Hypotheses on the
Ratchet Phenomenon, 22 Explorations in Economic History, 1-28.
Hughes, Jonathan (1966), The Vital Few; American Economic Progress and its Protagonists, Boston,
Houghton Mifflin.
Hughes, Jonathan (1977), The Governmental Habit: Economic Controls from Colonial Times to the
Present, New York, Basic Books.
Hughes, Jonathan (1990), American Economic History, 3rd edn, Glenview, Scott Foresman.
Kuznets, Simon (1941), Statistics and Economic History, 1 Journal of Economic History.
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545-553.
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and Wood, Gordon (eds), Imagined Histories: American Historians Interpret the Past, Princeton,
Princeton University Press.
Lamoreaux, Naomi and Raff, Daniel M.G. (1995), Information and Coordination: Historical
Perspectives on the Organization of Enterprise, Chicago, University of Chicago Press.
Lamoreaux, Naomi, Raff, Daniel M.G. and Temin, Peter (1998), Learning by Doing in Markets,
Firms and Countries, Chicago, University of Chicago Press.
Landes, William (1997), The Art of Law and Economics: An Autobiographical Essay, American
Economist, 31-42.
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Norton.
Libecap, Gary D. (1978), Economic Variables and the Development of the Law, 38 Journal of
Economic History, 338-362.
Libecap, Gary D. (1986), Property Rights in Economic History: Implications for Research, 23
Explorations in Economic History, 227-252.
Liebowitz, Stanley J. and Margolis, Stephen E. (1990), The Fable of the Keys, 31 Journal of Law and
Economics, 1-25.
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McCloskey, D.N. (1987), Econometric History, London, Macmillan.
752 New Economic History and Law and Economics 0650
McCurdy, Charles W. (1978), American Law and the Marketing Structure of the Large Corporation,
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Cambridge, Cambridge University Press.
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Cambridge University Press.
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Institutions Governing Public Choice, 49 Journal of Economic History, 803-832.
Olmstead, Alan and Goldberg, Victor P. (1975), Institutional Change and American Economic
Growth, 12 Explorations in Economic History, 193-210.
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History, 3-14.
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1920-1860, Cambridge, Harvard University Press.
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Emancipation, Cambridge, Cambridge University Press.
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Interdependence, 25 Journal of Economic History, 480-495.
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American Economic Review, 314-334.
Romer, Christina (1992), What Ended the Great Depression?, 52 Journal of Economic History, 757-
784.
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Temin, Peter (1969), The Jacksonian Economy, New York, W.W. Norton.
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Information, Chicago, University of Chicago Press.
Umbeck, John (1977), The California Gold Rush: A Study of Emerging Property Rights, 14
Explorations in Economic History, 197-226.
Usher, Abbot Payson (1949), The Significance of Modern Empiricism for History and Economics,
9 Journal of Economic History, 137-155.
Steckel, Richard (1995), Stature and the Standard of Living, 33 Journal of Economic Literature,
1903-1940.
Swedberg, Richard (ed.) (1991), Joseph A. Schumpeter: The Economics and Sociology of Capitalism,
Princeton, Princeton University Press.
0650 New Economic History and Law and Economics 753
Veblen, Thorstein (1901), Gustav Schmoller's Economics, 16 Quarterly Journal of Economics,
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Whaples, Robert (1995), Where is there Consensus among American Economic Historians? 55
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0660
CRITICAL LEGAL STUDIES
Wayne Eastman
Rutgers University, Graduate School of Management
Copyright 1999 Wayne Eastman
Abstract
This chapter focuses on the relationship between critical legal studies as an
intellectual movement in American law schools, and law and economics, in
both Chicago and other forms. The critical legal studies critique of law and
economics can reasonably be understood as an effort to foster alternative,
radical approaches to law and economics that acknowledge and proceed from
politically-charged contradictions within the discipline. The intellectual
engagement between critical legal studies and law and economics over the last
twenty years has not mediated the contradiction between the critical legal
studies and law and economics views of law.
JEL classification: K00
Keywords: Critical Legal Studies, Ideology, Rhetoric, Law and Economics.
1. The Institutional and Political Context
In the 1970s, just as the Chicago school of law and economics (0200, 0500) was
moving beyond the relatively narrow doctrinal areas in which it had earlier
been cabined, another movement, antithetical to the free market conservatism
of the Chicago school and the kindred though distinct Virginia school (0610),
arose in American law schools. This movement, critical legal studies (CLS),
was launched as a theoretical school in substantial part through writings by
Roberto Unger (1975) and Duncan Kennedy (1976, 1979) of Harvard Law
School, and was institutionalized through the Conference on Critical Legal
Studies, begun in 1977.
CLS drew much of its inspiration and many of its adherents from the rise
in the 1960s in the United States and Europe of an egalitarian, anti-statist New
Left politics. Though partisans of both the Chicago school and CLS tended to
share a jaundiced view of the liberal centrist, New Deal/Great Society,
welfare/warfare state, their diagnoses of what was wrong with that state and
the social order in which it was embedded were profoundly different. Where
Chicago school academics saw inattention to the price mechanism and upheld
an idealized common law that harkened back to the visions of late nineteenth-
century laissez-faire legal theorists, CLS academics saw a troubling adherence
to routine, hierarchy, and rationalized violence in the liberal order.
754
0660 Critical Legal Studies 755
The sharply different political visions of CLS and Chicago law and
economics, along with differences in cultural politics between typical partisans
of the movements, reflected in matters such as hairstyle and dress, did not in
themselves determine that there would be intellectual engagement between CLS
and law and economics. But they foreshadowed that any engagement would
likely be a conflictual one, and that once CLS arose as a distinct and assertive
movement, the publication of an early article on legal form by Duncan Kennedy
(1973) in the then-new Chicago school Journal of Legal Studies (0100) would
not be followed by further articles by CLS advocates in the law and economics
journals.
Beyond the general political divisions between them, the shared
jurisprudential ambition of both CLS and Chicago law and economics to decode
and translate the law according to their own distinctive methodologies - to, as
it were, provide a Rosetta Stone for law - has been a crucial additional factor
that has led to persistent conflict between CLS and law and economics. That
conflict can be traced back to the underlying tension between the law and
economics commitment to understanding law centrally in terms of economics
and the CLS commitment to understanding law centrally in terms of
politically-charged, deep-rooted yet also contingent patterns of contradiction.
This chapter essay will focus on the relationship between CLS as an
intellectual movement in American law schools, one with the general approach
to interpreting law noted above, and law and economics, in both Chicago and
other forms. It does not deal with critical or leftist legal academic movements
in general, such as Law and Society, that may have some interest in law and
economics; nor does it deal with European scholarship that denominates itself
as critical and that has some relationship to American CLS, but that is more
closely connected outside the UK to a European tradition of contrasting formal
approaches to social, or welfare state, approaches to law (see, for example,
Wilhemsson, 1993 on critical contract law) and in the UK to a class-oriented
analysis drawing on Marxism (see, for example, Fitzpatrick and Hunt, 1987).
The intellectual engagement between CLS and law and economics over the
last twenty years has not mediated the contradiction between the CLS and law
and economics views of law. At least two major reasons for the impasse can be
offered. First, the engagement has overwhelmingly consisted of CLS analyses
of law and economics, and the relative absence of back-and-forth exchange has
made change in the terms of the debate difficult. Second, there has been a
question as to whether advocates of law and economics and CLS believe there
is any substantial value in appropriating at least some aspects of the other
movements approach; in the absence of such a belief, attempts from either
CLS or law and economics to mediate the basic tension between the movements
are unlikely.
756 Critical Legal Studies 0660
The relative dearth of law and economics attention to CLS can be taken as
reflective of law and economics supporters by and large viewing CLS as a
movement that, whatever its merits as jurisprudence, has little or nothing to
contribute to the law and economics project of relating economic reasoning to
law. On the CLS side, the situation has been more complex. To interpret the
CLS treatment of law and economics as a justification for a dismissive stance
toward the genre by the legal left is oversimple, since that interpretation misses
the substantial degree of attraction to as well as repulsion from law and
economics in CLS work.
The two major figures in the CLS engagement with law and economics,
Duncan Kennedy and Mark Kelman, have been substantially involved in doing
what can be termed CLS law and economics, that is, law and economics from
a CLS perspective (Kelman, 1979a, 1991a, 1993; Kennedy, 1987, 1992, 1994),
as well as in critically analyzing non-CLS law and economics (Kelman, 1979a,
1979b, 1980, 1983, 1984, 1985, 1987a, 1987b, 1988; Kennedy, 1981a, 1981b,
1982, 1985; Kennedy and Michelman, 1980). Nevertheless, their work,
especially their more theoretically aggressive work, and that of other CLS
supporters has been more widely viewed as a powerful criticism of prevailing
assumptions and practices in law and economics than as a charter for an
alternative, radical law and economics. Though Kennedys and Kelmans own
practice contains an implicit defense of the value of doing radical law and
economics and suggests certain contours that it can take, CLS law and
economics is at this point a developing rather than a fully developed genre. Its
future prospects will depend in part on whether CLS supporters can provide a
persuasive rationale for how CLS analysis can aid in doing law and economics,
as well as more examples of CLS law and economics.
2. The CLS Critique of Law and Economics: An Overview
The major theme in CLS analysis of law and economics, which is closely
parallel to the major theme in CLS analysis of law more generally, can be
readily summarized: law and economics, though typically couched as an
apolitical, technical exercise, is in fact an intensely political project. Arguments
in law and economics both rely upon and themselves embody controversial
political judgments. Law and economics argument, like legal argument, is
ideological; both genres are structured by intractable though not immutable
political contradictions. The dream of a meaningful technical efficiency
discourse purged of political contradiction is a chimerical nightmare, both
because it is false and because adherence to it tends to move political argument
rightward to a band between pragmatic, technocratic centrism and free-market
libertarianism. (How this rightward tendency operates and whether it is
0660 Critical Legal Studies 757
potentially reversible in a revised law and economics are matters as to which
there is no discernible consensus in CLS scholarship, in contrast to the
consensus prevailing on the political nature of law and economics.) The central
CLS theme of politics repressed and regained - which implicitly and sometimes
explicitly relies on the idea of an awakening, an opening of argument to radical
political possibilities (Kelman, 1987a, 294-95) - is present both in early and in
more recent and contemporary CLS work on law and economics. Significant
subthemes of the CLS critique of law and economics as political that have also
persisted over time and that will be examined in this chapter include
questioning the coherence of the notion of efficiency; questioning the scientific
and logistic pretentions of law and economics rhetoric; and criticizing the
Coase Theorem and transaction costs analysis.
One qualification to the general point that CLS analysis of law and
economics parallels CLS analysis of law should be noted. In contrast to certain
Marxist and other traditional leftist critiques that stress the function of law in
upholding a coherent set of ruling-class interests, CLS has consistently
emphasized the presence of multiple, contradictory strands within law. The
Gramscian ideological hegemony that some CLS scholarship has seen as
upheld and constituted through law is itself a field of contradiction, rather than
a coherent articulation of a single set of ruling-class values. In thinking about
law and economics, though, CLS supporters have sometimes been drawn
toward viewing the genre as univocal and unambivalent, in a way that contrasts
with the general CLS method of identifying contradiction in law and that in
effect adopts (from an unfriendly perspective) the Chicago schools vision of
law and economics as a genre that avoids the intractable political divides that
attend law. How CLS views law and economics is consequential for CLS in the
following way: an understanding of law and economics as a univocal
instantiation of a particular set of values, especially conservative ones, is likely
to rationalize disengagement from economics by the legal left. At any rate, such
an understanding is less likely to foster CLS involvement in law and economics
than an understanding of law and economics as an active field of ideological
contestation, especially one that allows for the expression of radical as well as
liberal politics.
3. Leaders in the CLS Engagement with law and economics
Just as the vitality of Chicago law and economics as a mainstream, politically
conservative academic movement has depended significantly upon the
organizing energy and intellectual ambition of Richard Posner, the vitality of
CLS as a dissenting, radical academic movement has in large part been a
product of the organizing energy and intellectual ambition of Duncan Kennedy.
758 Critical Legal Studies 0660
Before going to law school, Kennedy studied economics as an undergraduate
and graduate student, and this biographical detail has shaped both his work
and, through him, the direction of CLS. Even work by Kennedy that is not
primarily concerned with law and economics, such as his analysis of how
contract law is structured by a persistent tension between individualism and
altruism that plays out in the form as well as the content of legal directives
(1976), is marked by an attention to law and economics (see, for example,
Kennedy, 1976, pp. 1746-51, describing laissez-faire and the altruist case
against it, and pp. 1762-64, arguing that transaction costs analysis does not
provide an objective basis for legal decisions). Both because of Kennedys role
in CLS in intellectually inspiring others work and because of his own
extensive body of law and economics work, which not only makes fundamental
criticisms of mainstream approaches to law and economics but also includes a
diverse group of articles in which he does law and economics from a CLS
perspective, Kennedy has been the central figure in the CLS engagement with
law and economics.
The second major figure in doing work that brings CLS and law and
economics together has been Mark Kelman of Stanford Law School. Where
Kennedy has written on a wide variety of legal topics in addition to law and
economics, Kelman has devoted himself centrally to analyzing and doing law
and economics, and his work over the years shows a close involvement with
mainstream law and economics and economics literature. His A Guide to
Critical Legal Studies (1987a) contains an analysis of law and economics that
is the clearest, most thoroughly worked out effort within the CLS literature to
relate the critique of law and economics to the CLS critique of law more
generally. In that work, Kelman contends that Chicago school law and
economics represents an effort to repress intractable contradiction in liberal
legal thought by unreflectively elevating certain privileged positions or poles,
notably individualism and value subjectivity, over their polar opposites,
altruism and value objectivity. These opposite positions are also subordinated,
but less thoroughly so, Kelman suggests, in mainstream legal argument and in
non-Chicago law and economics work, such as Calabresi's (1970), whose less
monolithic repression of contradiction makes it less representative of law and
economics as an intellectual genre than Chicago work.
Kelmans image of law and economics in A Guide to CLS as pervaded at
a deep level by a Chicago ideology that fails to acknowledge contradiction and
strives for a unified, gapless view of the world might be taken as a brief against
radical or even liberal involvement in the genre. Given among other things
Kelmans own extensive involvement in doing law and economics and the
possibility of splitting open a gapless law and economics discourse into one
more obviously laden with contradiction, that is hardly an inevitable
interpretation of Kelmans thesis. Nevertheless, his analysis in A Guide to
CLS and certain of his other work (see, for example, Kelman, 1984) suggests
0660 Critical Legal Studies 759
an ambivalence about law and economics that is illustrative of a dilemma that
has faced CLS supporters over the years, one that has often been misunderstood
by those outside CLS. CLS as a movement has been devoted to rather than
deprecatory of contradiction; given that perspective, discourses laden with
profound internal contradiction are fine to participate in, contrary to
mischaracterizations of CLS as supporting withdrawal from legal discourse
because of its internal contradictions. Rather, the problem for CLS in regard to
law and economics and particular subgenres of law and economics, such as
efficiency arguments, lies with how to open up to contradiction discourses
whose premises or rhetorical conventions are, or are perceived to be, structured
so as to shut contradiction out.
4. The Incoherence of Efficiency
In modern law and economics (and economics more generally), efficiency is the
central concept, the means by which normative evaluation and technical,
value-free analysis are reconciled and brought together. That is, efficiency is
the master device for mediating the fact-value antinomy (Unger, 1975) that
pervades the social order in which law and economics is embedded. This CLS
understanding of the linchpin role of efficiency in contemporary economic
argument, which is differently expressed but hardly different in substance from
that within mainstream law and economics, has naturally led to CLS
scholarship that critically analyzes the notion of efficiency. The CLS article
that focuses most directly and thoroughly on that theme is Duncan Kennedys
Cost-Benefit Analysis of Entitlement Problems (1981a); early work of
Kelmans on the Coase Theorem (1979b, 1980) and ambivalence and regret in
consumers (1979a) makes related points, and complements and extends the
discussion in Cost-Benefit Analysis of some topics, such as offer-asking price
disparities.
Kennedys general claim in Cost-Benefit Analysis is that efficiency claims
lack the objectivity, coherence and autonomy from political value judgments
that liberal law and economics (and presumably conservative law and
economics as well, which he does not focus on) demands from them. After an
historical review contending that efficiency arguments based on internalizing
externalities became the mainstay of postwar liberal law reform movements in
areas such as products liability, he describes how liberal law and economics
responded creatively to Coases criticism of Pigous externalities analysis by
broadening externalities to include psychic costs (such as unhappiness of New
Jersey suburbanites at the destruction of Alaskan wilderness) that high
transaction costs prevented from being recognized, but that should be
recognized under liberal law and economics version of Coasean analysis.
Kennedy goes on to argue that proponents of liberal law and economics have
760 Critical Legal Studies 0660
switched among different plausible methods of valuing entitlements in an ad
hoc fashion that serves liberal policy goals but vitiates efficiency as a neutral,
apolitical criterion. Consumers ask much more to give up a right than they will
offer to obtain a monetarily equal right; it is not wrong to use high values to
measure externalities, but any set of prices one uses involves a political
judgment (see also Baker, 1975). He makes further arguments that the hope to
achieve a determinate liberal efficiency calculus falls victim as well to problems
of totalitarianism (that is, overcoming externalities and transaction costs entails
an overweening state apparatus), wealth effects (that is, valuations and thus the
efficiency calculus are distorted by wealth), and multiple equilibria (that is,
determinate efficiency analyses break down when bargaining is allowed on all
topics, rather than just one or a few).
In Cost-Benefit Analysis, Kennedy does not criticize the political values
of the practitioners of liberal law and economics (who as identified by Kennedy
include a writer also identified with CLS, Thomas Heller, 1976, and another,
Frank Michelman, who co-authored an important law and economics article
with Kennedy (Kennedy and Michelman, 1980)). As Kennedy articulates it, his
dispute with liberal law and economics is a formal one, based on his
disagreement with liberal law and economics reliance on efficiency claims that
conceal the political, value-laden nature nature of the choices that liberal law
and economics supporters argue for. In a conclusion that in a sense reverses
that of his earlier Form and Substance in which he argued that the enterprise
of liberal law reformers such as Skelly Wright should be wished what success
is possible short of the overcoming of its contradictions (Kennedy, 1976, p.
1778), in Cost-Benefit Analysis Kennedy gives an equivocal, highly skeptical
answer to the question of whether there is any role at all for efficiency in law
and economics analysis: Coasean transaction costs analysis fails to increase the
normative bite of economics, and the possibility of applying a technical
efficiency criterion successfully is just as implausible, even absurd, as it was in
the days of pre-Coasean welfare economics (1981a, pp. 444-45).
A noteworthy point about the early CLS critique of efficiency that is
epitomized in Cost-Benefit Analysis is the relatively limited, technical nature
of the claim that efficiency is incoherent. In contrast to domains such as
contract law, in which Kennedy and other CLS scholars traced out persistent,
deep-seated conflict between different political visions, the incoherence of
efficiency is presented in Cost-Benefit Analysis in terms of offer-asking price
disparities and wealth effects rather than of fundamental value contradictions
inhering within the prevailing rhetoric of efficiency. Cost-Benefit Analysis
and the succeeding articles that criticize and defend Kennedys arguments
about the inability of efficiency discourse to provide determinate, apolitical
conclusions on policy questions (see especially Carlson, 1986; Kelman, 1987b;
Markovits, 1984) make an implicit choice to evaluate efficiency rhetoric on the
basis of whether it can live up to a promise to provide determinate answers to
0660 Critical Legal Studies 761
policy questions. Though this way of evaluating efficiency accords with a
significant strain in CLS that condemns rhetoric that makes false claims of
determinacy and objectivity, it could be taken to imply the conclusion that
efficiency rhetoric would be more worthwhile to deploy by CLS lights if it were
possible to purge it of its incoherence. But that conclusion is exactly backward.
Instead, the objection in early CLS work to the deployment of the rhetoric of
efficiency in law and economics is explicable if it is seen in terms of a belief
that efficiency arguments were too circumscribed by their premises and too
lacking in expressible political contradictions to be of significant value. (Other
beliefs defensible at the time, and arguably still, may well of course have
motivated CLS reluctance to deploy efficiency arguments, including a belief,
suggested in the conclusion to Cost-Benefit Analysis that efficiency analysis
overall serves as a brake on reformist enthusiasm by postulating an
efficiency-equity tradeoff, and a concomitant belief, pursued in later work by
Kennedy (1982, 1987), and discussed in the section of this chapter on CLS law
and economics, that CLS work in law and economics should eschew efficiency
arguments in favor of distributional arguments.) What could make efficiency
discourse worth deploying from a CLS perspective - and what certain recent
CLS or CLS-like scholarship has reflected - is an understanding of efficiency
as ridden with internal, politically-fraught contradiction.
The best-articulated recent working out of what could be described as a
developing CLS position that efficiency discourse contains within it different
models that are in serious political tension with one another and that have quite
different, though not determinate, implications for law, is contained in Bill
Brattons Game Theory and the Restoration of Honor to Corporate Laws Duty
of Loyalty (1995). (Bratton, 1989a, describing different economic approaches
to the firm, foreshadows some of these themes.) In his 1995 article, Bratton
compares Jensen and Mecklings contractual, agency-theory view of the firm
to Kreps game-theoretic view of the firm, in which cooperative outcomes
depend on at least the possibility of honorable behavior, and argues that Kreps
approach could (and, he suggests, should) lead to corporate law more
supportive of the duty of loyalty than 1980s decisions influenced by the Jensen
and Meckling model. Though Brattons article is less insistent about the
irrefragibility of contradiction than CLS scholarship has traditionally been, his
is very much an argument about repressed internal political tension within the
notion of efficiency, and as such (respecting that Bratton in the article does not
identify his analysis with CLS) constitutes a significant contemporary CLS
contribution to the critique of law and economics.
Another recent article, How Coasean Bargaining Entails a Prisoners
Dilemma (Eastman, 1996b), is also structured in part around the notion of
politically significant contradiction within efficiency discourse. The formal
claim is that there is an equivalence between two stories, the Prisoners
762 Critical Legal Studies 0660
Dilemma and Coasean bargaining to achieve a surplus, that are generally seen
as having very different meanings; the substantive claim is that efficiency
discourse operates to repress awareness of contradiction by setting up two
different stories with presumably different logical groundings, although these
logical twists are actually the same. Though the articles focus on the formal
link between Coasean bargaining and the Prisoners Dilemma suggests that its
objective is the traditional CLS one of debunking scientic pretension in law and
economics, the overall argument, like that in Brattons article, assumes and
operates from the premise that there are meaningful political contradictions
within the efficiency idea.
In developing further CLS analyses of contradictions within efficiency,
there is relevant material to be drawn from Kelmans early arguments about
psychological division in Choice and Utility (1979a). Kelmans strategy was
to debunk neoclassical theory that overlooked ambivalence and regret, but one
could now point to economic approaches advanced since 1979, such as regret
theory, that incorporate at least part of his argument and that are in
politically-salient tension with subjective expected utility theory. Or (riskily for
noneconomists, but CLS scholars accustomed to taking intellectual risks should
not, one trusts, be paralyzed by this one) one could propose new law and
economics models that are at least plausible in the terms of efficiency discourse
and are also in self-conscious political tension with other, prevailing models.
Another significant source for the developing CLS argument about
persistent contradiction within efficiency comes from work by mainstream law
and economics scholars that has arguably though not necessarily been
influenced by CLS. Cooter (1982) notes the sharp contrast between the
optimistic Coase Theorem and a pessimistic Hobbes Theorem that assumes
strategic behavior will block desirable bargains. Neither approach to achieving
efficiency is analytically preferable; rather, as Cooter notes, values and
assumptions about human nature are at stake in any effort to mediate between
them. A similar, somewhat broader point, is made by Hovenkamp (1992), who
analyzes the inconsistent views of human nature and rationality in the Coase
Theorem, price theory, and Arrows Theorem/social choice theory, which all
enjoy high standing within orthodox efficiency analysis despite their
contradictory features. Ian Ayres makes good observations on the politically
significant contrast between game theory and price theory as approaches to
efficiency, and the likely political correlates of the ascendancy of game theory
(Ayres, 1990). Ayres own game theoretic work, though it avoids assertive
claims about contradiction, persistently deploys efficiency arguments in a
fashion that flips Chicago orthodoxy. For example, Ayres and Talley (1995)
argue that liability rules generate higher welfare than property rules under
certain assumptions, an argument that flips the Chicago law and economics
case for property rules in low transaction cost situations. Interestingly, Louis
0660 Critical Legal Studies 763
Kaplows and Stephen Shavells response to Ayres and Talley is an
indeterminacy argument that leaves the original Chicago claim undefended; the
articles together suggest the space that has opened up in law and economics
efficiency arguments for flipping and indeterminacy exercises that CLS
scholars should be interested in carrying out and opening to radical as well as
liberal politics.
5. The Coase Theorem
Coasean analysis points out that externalities do not in and of themselves
warrant regulation, given the possibility that the parties can reach an efficient
outcome through bargaining. A major liberal law and economics response to
that point, essentially the one criticized by Kennedy in Cost-Benefit Analysis,
has been to stress the pervasiveness of transaction costs. This liberal response,
plausible as it is in terms of Coases argument, gives significant ground to the
Chicago, anti-regulatory position: compared to the Pigouvian externalities
framework, the externalities plus transaction costs framework requires an
additional layer of justification for legal intervention, since the mere existence
of externalities is no longer a sufficient warrant to regulate.
Since transaction cost analysis as a replacement for Pigouvian externalities
analysis entailed a significant though indeterminate conservative,
anti-regulatory shift in presumptions, the general reluctance within CLS to
jump on board the Coasean bandwagon is entirely explicable. The transition
from Pigous framework to Coases involved a shift of the ideological playing
field toward the libertarian, Chicago right, and CLS as a left-of-center
academic movement has had good reason to contest that shift, rather than
simply play according to the new, Coasean rhetoric, as liberal law and
economics was doing. Opting out of law and economics efficiency rhetoric,
which CLS verged on doing in the early 1980s, can be seen as one response to
the problem of a rightward shift in efficiency analysis. A second CLS response
has been to develop arguments that Coases analysis was wrong, or should be
interpreted in a different way.
The initial major CLS work on the Coase Theorem was by Kelman (1979b,
1980, 1985). Kelman (1979b) makes a multi-pronged attack on the Theorem
that criticizes both its empirical plausibility and its normative implications.
First, because the amount that consumers want to give up an entitlement is
likely to be much higher than the amount they will pay to obtain an entitlement
they do not have, the Coase Theorem proposition that under zero transaction
costs the same efficient pattern of activity will take place regardless of the legal
rules in effect is likely to be wrong in practice. If neighbors have an initial
entitlement to be free of pollution, it is unlikely the manufacturer will be able
to buy them out; on the other hand, if the manufacturer has the initial
764 Critical Legal Studies 0660
entitlement to pollute, it is much less likely, even with costless bargaining, that
the neighbors will value freedom from pollution enough to bribe the
manaufacturer not to pollute. Second, the Theorem works (that is, is
counterintuitive rather than simply a truism) because it points out typically
unsuspected opportunities to bargain, such as between the rancher and the
farmer in Coases original example. Kelman criticizes the Theorems implicit
support for making bargaining ubiquitous in strong terms: The real substantive
vision of the Coase Theorem, its real cultural contribution, is to a particular
worldview that seems to me both a distorted description and a horrifying
covert ideal (Kelman, 1985, p. 1046).
In contrast, Schlag (1986) describes the Coase Theorem not as a charter for
bargaining and commodification but rather as a potentially radical vehicle for
the critique of legal concepts; he suggests that this critique can begin by
substituting conceptualization for choice of liability rule in statements of the
Theorem. His second take on the Theorem, and the transaction costs analysis
associated with it, is less optimistic; he argues that transaction costs analysis
has fallen prey to the same limitations and rigidities that were criticized by
Coase in Pigouvian externalities analysis (Schlag, 1989).
Recently Eastman (1996a) has translated the Coase Theorem into
game-theoretic terms. He argues that what distinguishes the Theorem from
standard game-theoretic analyses is a Coasean assumption of payoff mutability,
under which people engage in promises and threats in an effort to enhance their
positions. Understanding the Coase Theorem in terms of this everything is up
for grabs assumption leads to quite different implications for law than those
associated with standard interpretations of the Theorem. While the
conventional wisdom associated with the Theorem supports bargaining and
worries only about strategic behavior as an obstacle to desirable agreements, the
game-theoretic understanding points out the significance of undesirable threat
bargaining, and suggests a potential value for legal regulation that inhibits
opportunities for threat bargaining.
6. The Critique of Law and Economics Rhetoric
CLS scholarship from its inception has had a distinctive concern with the form
in which academic and judicial arguments are made. In law and economics,
that CLS concern has focused on arguments and interpretations that are
ideological but are made in a fashion that suggests they are scientifically
grounded in foundational logic or hard data. Through unmasking claims to
scientific status, CLS advocates have hoped to bring political division to the
disciplines surface and possibly to move liberals to the left.
Kennedys first major published article on law and economics, Are
Property and Contract Efficient?, written with Frank Michelman (Kennedy
0660 Critical Legal Studies 765
and Michelman, 1980), a Harvard colleague of Kennedys sympathetic to but
not affiliated with CLS, is a central work in the critique of law and economics
rhetoric. The basic point of the article is straightforward: arguments for the
efficiency of private property (or alternatives to private property, such as the
state of nature or forced sharing), and parallel arguments for the efficiency of
free contract (or alternatives to contract), need to be made on a contextual,
empirical basis. The efficiency of property or contract does not logically follow
from the assumption that people are rational satisfiers of their desires. The
authors modestly present their argument as one that should not surprise
economically-sophisticated readers, describing the succession of efficiency
arguments they debunk as mistakes, or traps for the unwary.
The major arguments for the efficiency of private property over forced
sharing or the state of nature that Kennedy and Michelman attack in their role
as trap-shooters are briefly summarized below, along with the articles
rebuttals:
1. Security increases production - not necessarily, since people may work
more if outcomes are uncertain; a state of nature or forced sharing might go
along with an order under which there would be more rather than less
industry.
2. Theft is inefficient - under private property, transaction costs may inhibit
efficient transfers that would take place in a state of nature; there is no prior
guarantee that private property will lead to more efficient transactions.
3. Private property reduces uncertainty - not necessarily; it all depends on
whose uncertainty we are talking about, since more certainty for one party
entails less certainty for another, as Hohfeldian analysis demonstrates.
4. Private property aids coordination - not necessarily, since private property
is highly vulnerable to strategic behavior and associated prisoners
dilemmas that might be averted under forced sharing, or by a strong hand
arising out of a state of nature.
5. Private property leads to an optimum work-leisure tradeoff - the tradeoff
will vary according to the parties initial entitlements, but there is no basis
for imputing inefficiency to state of nature or forced sharing tradeoffs
relative to private property tradeoffs.
Given the stark oppositions Kennedy and Michelman employ (for example,
between private property and forced sharing for needs, their article has a
radical flavor, rather than the liberal flavor that would have been created by an
argument that there is no necessary inefficiency associated with, say, Swedish
social democracy compared to the less egalitarian American order. But because
they do not challenge the efficiency criterion as incoherent and necessarily
beset by political tensions, their article can be and has been (Kelman, 1987a)
characterized as a criticism of an unwarranted conservative tilt in law and
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economics rather than as a CLS argument.
Even allowing for the articles acceptance of the efficiency criterion,
though, there is a significant sense in which it can and should be regarded as
a major contribution to the CLS critique of law and economics. The basic point
of the article is a claim about indeterminacy, specifically about the
indeterminacy of the relationship between efficiency and institutional
arrangements. This point resonates in CLS terms in a way that it does not in
the terms of liberal or conservative law and economics. In a variety of domains
apart from the critique of law and economics, CLS supporters have contended
that mainstream legal argument unwarrantedly asserts or implies that there is
a determinate, foundational link between logic and policy; sometimes CLS
supporters have tried to tie their arguments to philosophical critiques of
foundationalism (see, for example, Peller, 1985; Singer, 1984). Liberal law and
economics, it would seem, lacks the distinctive interest in this issue of
rhetorical form that CLS has had. Of all the critical works on law and
economics, Kennedy and Michelmans article stands out as the one that is most
clearly organized around the indeterminacy theme. Though it is quite right that
the articles indeterminacy claims can be seen, as the authors suggest, as simply
upholding economic conventional wisdom, the indeterminacy claims also serve
as a criticism of law and economics rhetoric that implies a logic-based,
determinate, efficiency foundation for some version of market capitalism. In
that sense, Kennedy and Michelmans article is arguably the single one in the
critique of law and economics that has the sharpest connection to the general
CLS criticism of mainstream legal rhetoric; ones reaction to the articles basic
indeterminacy theme is an excellent test for gauging ones overall reaction to
the CLS critique of law and economics.
The CLS critique of law and economics rhetoric invites questions as to
whether the desired outcome is an abandonment of law and economics, a
modification of law and economics rhetoric in order to make it more politically
candid and less scientistic, or a sort of public advisory system about the hazards
of law and economics, along the lines of the small craft warnings issued by the
Coast Guard. The second alternative seems to be the preferred one among CLS
supporters. For example, in the work of Mark Kelman (see especially Kelman,
1984, 1991a), one senses that the aim is modifying law and economics rhetoric
rather than extirpating the genre (or simply advising its consumers), given
Kelmans own work in law and economics as well as his disagreement with
those on the left who wish to ignore economic arguments (Kelman,1991b).
Similarly, in a recent article that presents alternative versions of the Prisoners
Dilemma, the Coase Theorem, and price theory in the course of criticizing false
determinacy in law and economics rhetoric and making a case for internal
contradiction in efficiency claims, Eastman (1996c) endorses what amounts to
a mend it, dont end it attitude to law and economics that supports the telling
of heterodox law and economics stories rather than abandonment of the genre.
0660 Critical Legal Studies 767
To the extent CLS scholarship comes down in favor of the use of law and
economics in some form, there is an issue, which CLS work to date has not
dwelt on, as to the basis on which one might justify that stance. Kennedy (1992,
p. 1314) makes a brief, ambivalent defense of the rhetoric of cost/benefit
analysis: It is more authentic for me, than the voice of role-reversed male
sensitivity ... This is so even though I am constituted in ways I dont like, and
think are dangerous, by this very language (it speaks me) and wish it were
a different, better vehicle. One can, as Eastman (1996c) does, simply
rationalize law and economics as a storytelling project that is not necessarily
worse than other, less logistic, types of storytelling. But this elides the issue, a
sensitive one on the (post)modern, self-consciously non-foundationalist left, of
whether one believes that through the logistic storytelling of law and economics
one is discovering things about how the world works, or at least about how
certain human communities organize their concepts. The issue is not significant
to the extent CLS is not engaged in doing law and economics, but becomes a
probably unavoidable, if perhaps annoying, issue for a
philosophically-reflective CLS movement, some of whose supporters are
committed to some kind of law and economics.
7. CLS Law and Economics: The Distributive Turn and The Ideological
Turn
Instead of making general arguments aimed at justifying CLS participation in
law and economics, the leading figures in the CLS involvement with law and
economics, Kennedy and Kelman, have done law and economics without
extensive elaboration of their reasons. CLS law and economics as embodied in
their work has spanned a wide gamut formally, ranging from technical analyses
employing price theory (Kennedy, 1987) to relatively nontechnical arguments
(Kennedy, 1992). But it is not patternless. Two main tendencies can be
identified in their critical law and economics: (1) the distributive turn - that
is, analyses of the distributional consequences of contractual terms and legal
rules and strategies (Kennedy, 1982, 1987, 1994); and (2) the ideological turn
- that is, work that may make cost-benefit or efficiency arguments in a fashion
paralleling that in liberal law and economics, but with an overt specification of
the ideological context and purpose of the arguments (Kelman, 1979b, 1991a,
1993; Kennedy, 1992; Kennedy and Specht, 1994). Of the two, the distributive
turn has been the better articulated as a method (particularly in Kennedy, 1982,
1987). But the ideological turn, though currently less realized
methodologically, is also a significant element in certain CLS law and
economics, and is likely to assume increasing significance to the extent CLS
scholarship further develops the analysis of internal contradictions within
efficiency discourse and deploys efficiency arguments.
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As a technical method, the distributive approach as carried out in Kennedy
(1987) employs conventional price theoretic analysis for purposes of analyzing
distributional consequences, thus flipping the mainstream preference for
analyzing efficiency consequences. The basic idea in Kennedys article is that
selective intervention to enforce the warranty of habitability (selective in that
it focuses on periods when landlords in declining neighborhoods would
otherwise milk their properties by ending maintenance, even though the
property remains profitable enough to maintain), can redistribute income to
tenants without reducing the supply of low income housing. Because the
technical apparatus employed by Kennedy is that of neoclassical price theory,
his method is well-suited to being adopted or adapted by non-CLS law and
economics scholars. A potentially promising channel for future development
of the distributive turn in CLS law and economics lies in the deployment of
game theory rather than, or along with, price theory. The opportunities price
theory alone offers for CLS are arguably constrained by its built-in opposition
between distributional and efficiency analyses; the overt, surfaced quality of this
opposition within the mainstream to some extent defangs a CLS project of
surfacing contradiction, though it does not vitiate the value of work that
upholds the subordinated, distributional part of price-theoretic analysis.
The turn toward highlighting the ideological context and nature of the law
and economics arguments one makes is seen in law and econmics work by
Kelman that could otherwise be plausibly classified as liberal law and
economics. For instance, his analysis of concepts of discrimination (1991a) has
a central logical nub (that even unbiased tests that predict the job performance
of blacks and whites equally well may result in substantially higher proportions
of blacks who could do the job successfully not getting hired) that could
reasonably be viewed as liberal law and economics. But Kelmans analysis of
that point is embedded in a lengthy analysis of the ideological correlates of
different approaches to understanding discrimination. His logicizing of
different stories of discrimination is law and economics; his placing all these
stories, in their logicized as well as their initial forms, in ideological context is
CLS, and makes the overall project of the article one in CLS law and
economics. The combination of logicizing and ideological analysis makes the
article quite complex, more so than either mainstream law and econmics that
ignores the ideological content of the arguments it makes or critical literature
that eschews law and economics logicizing. This complexity is arguably a
major virtue of CLS law and economics that takes the ideological turn; it will
require some adjustment for academic readers accustomed to established forms
of law and economics and CLS.
The structural complexity of CLS law and economics that places its
arguments in ideological context is also shown in Kennedys Sexy Dressing
(Kennedy, 1992), which makes a cost-benefit argument that men have an erotic
0660 Critical Legal Studies 769
self-interest in fighting the sexual abuse of women. Here, Kennedy combines
Calabresian, Posnerian law and economics with Saussurian structuralism,
postmodern pro-sex feminism, simultaneously self-critical and self-justifying
straight white male middle class radical introspection, and close reading of
many fashion magazines. The resulting article is a sufficiently complex brew
to make any suggestion for further complexifying it, or work drawing upon it,
seem counterintuitive, even outright wrong. But in terms of CLS law and
economics there is a plausible case for heightening the formality of the law and
economics argument in ambitious articles like Sexy Dressing. Doing so would
not only tend to stretch the boundaries of law and economics but also might
heighten tensions that ideologically-reflective CLS law and economics plays off
of and tries to accentuate. Sexy Dressing, in this view, should not be seen as
a non-law and economics article with minor law and economics window
dressing, or as a sui generis effort unsuitable for emulation by anyone without
command of all the elements in Kennedys eclectic theoretical toolkit. Rather,
the article can serve as a template for future CLS law and economics projects,
ones that may well complexify or tech up their law and economics to a greater
extent than Kennedy chose to in his article.
8. Additional Themes in the CLS Engagement with Law and Economics:
Historical, Philosophical, and Discipline-Specific Work
CLS work relating to law and economics is by no means limited to the broad
subjects treated thus far. Although this review essay focuses on themes in CLS
scholarship on law and economics that cut across particular areas of law,
arguably the most significant work in terms of the long-term viability of the
CLS engagement with law and economics is discipline-specific work in
corporate law, labor law, housing law and other areas.
An area in which a substantial body of CLS law and economics has
developed is housing law and policy (Aoki, 1993; Ford, 1994; Fox, 1991;
Keller, 1988; Kennedy, 1987, 1994; Kennedy and Specht, 1994; Kinning,
1993; Kolodney, 1991; McUsic, 1988). That work has considerable diversity
in approach, ranging as it does from Kolodneys use of tipping models to
analyze gentrification (1991) to Kinnings empirical survey of selective code
enforcement in Minneapolis (1993) to Kellers proposal for a tort remedy for
breaches of landlord duty (1988) to Fords mixture of economic analysis,
critical legal theory, critical race theory, and aspirational proposals for
combatting segregation (1994). But for all these differences in approach, the
housing literature constitutes a collective whole that is identifiably CLS law and
economics in its simultaneous commitment to economic analysis and to critical
analysis of the politics of law.
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Although housing law stands out for its overall body of CLS law and
economics, there are other areas of law in which CLS scholarship has fruitfully
engaged law and economics, among them antitrust (Peritz 1984, 1989, 1990),
debtor-creditor (Carlson, 1992, 1994), labor and employment (Klare, 1988;
Stone, 1991), contract (Kennedy, 1976, 1982), discrimination (Kelman, 1991a),
critical race theory (Audain, 1995), transitional economies (Alexander, 1994;
David Kennedy, 1991), property (Alexander, 1982), tort (Kennedy, 1982;
Kelman, 1988), international law (David Kennedy, 1994), and tax (Heller,
1979). Also worthy of note is work that, although done by writers not
necessarily identified with CLS, applies a critical approach of identifying
contradiction and parsing the politics of legal and economic argument:
Brattons work in corporate law (Bratton 1984, 1989a, 1989b, 1995) is
especially noteworthy in this regard, and one could also note Millons (1990)
work on corporate law and Harrisons (1995) on contract law. A final category
of work worth noting is scholarship by certain founding figures in CLS whose
interests were centered around the application of social science to law, not
through law and economics but through empirical sociology in the radical
Weberian tradition (see, for example, Richard Abel, 1982, on tort law and
David Trubek, 1984 on the use of empirical methods in CLS). Though their
work is more in keeping with the Law and Society movement than with CLS
as it developed through the theorizing of Unger and Kennedy, some work in
this line, such as Trubeks, deals with both CLS and social science, if not law
and economics in particular.
A considerable amount of CLS scholarship is historical, and some of that
work deals with law and economics. For example, in Essays on the Fetishism
of Commodities (1985), Kennedy carries out an historical analysis of the role
of law in classical economics, Marxs discussion of commodity fetishism and
neoclassical economics and argues that a realist understanding of law
destabilizes the sense of law as a coherent block that appears in classical
economics, in Marxs response to it, and in neoclassical economics effort to
overcome and partially acknowledge Marxs critique. In a more contemporary
context, Bratton (1989a) provides an historical examination of theories of the
firm.
Finally, some CLS scholars, such as Unger, have had a particular concern
with philosophy, or with the work of particular philosophers. On occasion, such
concerns have intersected with the analysis of law and economics in CLS work.
Work by David Carlson criticizing Chicago work on bankruptcy in the course
of analyzing Rawls political philosophy, and arguing that the notion of the
perfect market embodies in Derridean terms an incoherent philosophy of
presence that both presupposes and negates the idea of an opportunity cost
(Carlson, 1993), exemplify this intersection. A further subtheme in the CLS
critique of law and economics that is to some degree related to the concern with
analyzing the work of particular philosophers involves personalizing the
critique, by focusing specifically on the work of Richard Posner (see, for
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example, Balkin, 1987; Minda, 1978; for a good example of such work by an
author less identified with CLS, see also West, 1986).
9. Carrying the CLS Critique Forward: The Ideological Structuring of
Economic Argument
CLS scholarship has focused its attention on law and economics, instead of the
economic discourse from which law and economics draws. One can certainly
understand the reasons that have led legal critics to engage in a critique of the
work of legal economists such as Posner rather than of economists more
generally. But given that economics, for all the formidable and specialized
analytical talent of many in the discipline, operates under social scientific
rhetorical constraints that inhibit the critical analysis of how economic
arguments are constructed and achieve their effects, there is a significant gap
that CLS can help fill. The critique of law and economics is also the critique
of economics, and there is a relative openness in law reviews, much of it won
by CLS efforts over the years, to the kind of serious critical analysis of patterns
of argument that is not currently cognizable within the conventions of social
science publication. What follows are preliminary observations on the kind of
critique of economic argument that CLS is particularly qualified to make.
These observations are followed by an analysis of the contents of a recent issue
of the American Economic Review, designed to show how a critical theory of
the ideological structuring of economic argument can be hooked up to current
practice in the field. Finally, the analysis of the ideological nature of economic
discourse will be drawn on for a brief how to guide for creating critical law
and economics.
On economic arguments: A starting point of CLS theory on this point is that
economic discourse is ideological. What does that mean? Just as legal discourse
is largely constituted by liberal and conservative argument bites, economic
discourse largely consists of similar ideological argument bites, more logically
elaborate than in law, that are associated with economic models. Public
goods, externalities, and underconsumption are a few terms evoking
argument bites and models that are typically though by no means necessarily
liberal (asymmetric information, adverse selection and relational
contracting are others); rational expectations, monetarism and supply side
evoke typically conservative argument bites/models (also transaction costs,
Coase Theorem contract law).
How does economic argument work? One tries to make a connection
between analytical logic and a real world situation. Typically, what makes the
connection interesting is that it has ideological, liberal-conservative
significance. Empirical economics is also ideological; what makes an empirical
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study work is that it suggests - and it may do so allusively rather than
dogmatically - a moral about the way the world works.
Both legal argument and economic argument involve issues of
methodological or stylistic politics as well as issues of substantive politics. In
law, many cases involve politics at the level of form or style - for example, in
deciding whether to use a standard or a rule. In economics, similar formal
choices exist as to type of analysis on conducts - say game theory vs.
supply-demand analysis - and as to level of technicality.
In one type of legal argument, one tries to rationalize a field, such as First
Amendment law, by providing a theoretical rationale for deciding cases in a
certain way - for example, the government must not restrict speech based on the
notion that one way of seeking the good is superior to another way. Here legal
argument is ideological in a way that is closely parallel to the way economic
argument is ideological. Talent in making legal arguments to rationalize a field
involves the ability to convert a politically significant analytical framework into
something that can be plugged into a variety of real world situations. Similarly,
economic models can potentially be applied to a wide array of circumstances;
talent in making economic arguments in part involves the ability to see how the
logic of certain models can have a home in novel contexts.
10. An Example of the Ideological Structuring of Economic Argument:
Articles in an Issue of American Economic Review
The CLS understanding of economic argument as ideological should be
justifiable in relation to specific cases. What follows is an examination of all
the articles in a recent issue of a leading American economics journal, carried
out in some detail for one article and more briefly for the remaining thirteen.
(The reader who wants exposition of the general CLS position on law and
economics rather than a fairly detailed empirical case for its plausibility may
wish to skim or skip this section.) Apart from whatever value the examination
of these articles may have in informally testing the CLS proposition that
argument in economics is ideological, another purpose of the examination of
the articles conducted here is to suggest potential ways to create law and
economics in general and CLS law and economics in particular.
Rat Race Redux: Adverse Selection in the Determination of Work Hours
in Law Firms (1996), the first article in the issue in question, shows how
suboptimal rat race equilibria with excessively high hours can develop as a
result of partners using hours worked as an indicator of how associates will
behave if they become partners. The article uses an adverse selection model
with two imperfectly observable types of lawyers - long-hours workers and
0660 Critical Legal Studies 773
short-hours workers - to show how employers desire to differentiate between
long- and short-hours workers can lead to inefficiently high hours equilibria.
Maximum hours laws can break the inefficient separating equilibrium and lead
to an efficient equilibrium.
The authors note how Akerlof originally set up a rat race equilibrium in a
highly unrealistic fashion that might have created the impression that such a
situation is an impractical oddity. Their model, on the other hand, is clearly one
that is designed to be significant in real-world terms:
Rat race equilibria reduce access to powerful positions for those unwilling to
tolerate excessive work hours early in their careers. This selection process may have
the effect, although not the intent, of keeping a disproportionate number of qualified
women out of leadership positions in business and professional organizations. (p.
347)
Adverse selection models have grown enough in influence and recognition
to be applied in a context that gives them a sharper left/liberal edge, as in Rat
Race Redux, which makes an argument with a conclusion parallel to Schors
in The Overworked American (Schor, 1991). Compare the early use of adverse
selection to defend lemon disclosure laws in the used car market - here the
model was being used in a more politically innocuous, centrist fashion.
Akerlofs expressing his rat race equilibrium in an unrealistic fashion was quite
possibly related to the existence of a centrist consensus that the issue of high
professional-managerial work hours was not one to be taken seriously. Rat
Race Redux, which does take the issue seriously, challenges that centrist
consensus.
In thinking about the development of adverse selection models from Akerlof
to Rat Race Redux, one sees a rational basis for the intuition that novel as
opposed to accepted high-tech methods in economics may well have a centrist,
nonradical cast. To introduce a new high-tech model on behalf of a way of
thinking about the world that is not already familiar to readers is to court
bafflement. Tech works - produces a nod and a sense of aha insight on the
readers part - by linking up a more or less recondite, intricate and aesthetically
pleasing set of logical/mathematical operations with a real world phenomenon.
But if the authors attitude toward the real world phenomenon is itself recondite
and counterintuitive, the result of combining that attitude with unfamiliar high
tech may well be confusing at best and incomprehensible at worst. A genre of
CLS law and economics that creates new technology would be a very fine thing
indeed to have. But a more plausible direction for CLS law and economics
involves turning technology that is already recognizable from its use on behalf
of centrist conclusions to more radical ends, as Rat Race Redux ably does.
In Rat Race Redux as with economic arguments in general, the tech can
be flipped. Instead of the articles overwork equilibria, what about an
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underwork equilibrium? Suppose the partners in a law firm believe that success
depends on identifying future partners who will fit in well into their white shoe
club, and weeding out associates who will not. Type 1 attorneys are the
clubbable ones, while Type 2 are the overly aggressive, unclubbable ones,
who generate more short-term billings from their high hours, but who are not
desirable as rainmakers or future members of the partnership. Of course,
knowing the partners preferences, Type 2 associates have an incentive to
disguise their status by not working longer hours. But by establishing a firm
culture with a sufficiently white shoe atmosphere and low work hours ceilings,
the partners can drive out the Type 2 attorneys by making the firm an
uncomfortable place for them to work. The result is an inefficient underwork
equilibrium.
Readers may differ in their evaluation of the relative plausibility of the Rat
Race and Reverse Rat Race stories. In my view, the authors rat race story
seems like a much convincing evocation of contemporary Wall Street law firms
than the flipped story, but that is of course not a matter of the logic of adverse
selection tilting one way or another but of contingent, empirical factors. The
point here is not to insist on one story or the other, but to support the critical
intuition that the logical apparatus of the adverse selection model does not in
itself carry the day for a particular political moral.
Rat Race Redux illustrates the complexities of telling an economic story
that resonates in critical terms. The article accomplishes the considerable feat
of telling a clever story with a potentially radical moral while using standard
economic assumptions. But in relation to the adverse selection model, the lower
work preference attorneys whom the partners are trying to ferret out are like the
lemons in Akerlofs used-car story - not people one necessarily feels empathy
or support for. The adverse selection story of Rat Race Redux is technically
prettier than the simpler, keeping up with the Joneses Prisoners Dilemma
story of competition for material goods leading people to work excessively long
hours that Schor (1991) tells. But Schors Dilemma story accords more readily
with the spirit of the case for reducing work hours than the adverse selection
story of attorneys trying to disguise their low work hours preferences. Both
stories are good liberal law and economics stories that can be made radical by
being told with attention to thir ideological context; whether one values the
greater technical elegance of the Rat Race Redux adverse selection argument
or the closer connection to critical feeling in the Overworked American
Prisoners Dilemma argument is a matter of aesthetic and political judgment.
The CLS law and economics analysis just carried out for Rat Race Redux
can be compressed into a brief description of the articles story, its ideology, its
legal implications, and possibilities for reversing or flipping the storys moral.
What follows is a concise analysis of Rat Race Redux and of all the remaining
papers in the issue of AER in which in appears.
0660 Critical Legal Studies 775
(1) Rat Race Redux: Adverse Selection in the Determination of Work Hours in
Law Firms, Renee M. Landers, James B. Rebitzer and Lowell J. Taylor, AER,
Vol. 86 (1996): 329-348.
The story: Adverse selection/asymmetric information. Adverse selection may
lead to an inefficiently high number of hours worked, with firms setting a very
high hours standard to drive out asssociates who pretend to be interested in
working long hours to win the favor of partners.
The storys ideology: Liberal/radical.
Legal implications: Cut work hours.
Possibilities for flipping the model: Adverse selection may lead to an
inefficiently low level of hours worked, given an incentive of associates to
pretend to be clubbable to win the favor of partners.
(2) Veblen Effects in a Theory of Conspicuous Consumption, Laurie Simon
Bagwell and B. Douglas Bernheim, AER, Vol. 86 (1996): 349-373.
The story: Signalling/asymmetric information. Given certain assumptions about
demand for luxury goods by lower income and high income households, a
desire to signal wealth can produce willingness to pay a high price for a good
that is identical in quality to a lower price good (that is, a Veblen effect).
Excise taxes on such a luxury good are nondistortionary taxes on pure profit.
The storys ideology: Liberal.
Legal implications: Tax luxury goods.
Possibilities for flipping the model: The argument here flips itself in a sense,
in that the authors discuss how the presence of Veblen effects depends on
empirical assumptions about luxury and budget goods. This type of flipping,
though, leaves the overall politics of the model unscathed. That is, by
employing a model that assumes the significance of status concerns in
motivating people, the articles perspective accords well with liberal skepticism
about the value of material acquisitiveness; noting that the Veblen effects are
empirically contingent does not flip the models politics. One way to produce
a flipped, conservative version of this article would involve setting up an
analytical model that overall embodies conservative skepticism about liberal
values (a public choice model might be good for that purpose) and then going
through the technical hoops to show how how, based on certain plausible
assumptions about the shape of functions, a particular inefficiency will be
generated.
(3) The Gender Gap, Fertility, and Growth, Oded Galil and David N. Weil,
AER, Vol. 86 (1996): 374-387.
The story: Assuming that men have an advantage in brawn while the sexes
are equal in brains, an increase in capital per worker will raise womens
relative wages, which in turn will decrease fertility, which in turn will increase
776 Critical Legal Studies 0660
capital per worker. Thus, a positive feedback loop exists; further, technology
is a way to escape high fertility/low capital equilibria.
The storys ideology: Conservative.
Legal implications: The gender gap will likely narrow without legal
intervention, which reduces the case for such intervention.
Possibilities for flipping the model: The optimistic invisible hand story of
increasing growth and gender equality that is told here depends on a model that
employs a simple brains vs. brawn dichotomy. Alternative models that
employ different dichotomies - for example, models in which higher capital
levels increase returns to very high levels of work hours as opposed to moderate
hours, or to mathematical as opposed to verbal skills - could be used to suggest
that economic growth without legal and political activism by and for women is
likely to generate an increasing rather than a diminishing gender gap.
(4) The Timing and Incidence of Exploratory Drilling in Offshore Wildcat
Tracts, Kenneth Hendricks and Robert H. Porter, AER, Vol. 86 (1996):
388-407.
The story: Free rider effect/asymmetric information. Holders of oil leases face
a free rider problem, in that the outcome of ones neighbors drilling provides
useful information. An empirical study indicates that many tracts are drilled
toward the end of the lease period, suggesting that companies are often
unsuccessful in cooperating to solve the free rider problem.
The storys ideology: Liberal.
Legal implications: Although the authors do not give policy implications, one
can infer that it might be a good idea for the government to require winning
bidders to drill (assuming the free-rider behavior here is socially undesirable).
Possibilities for flipping the model: Since this is an empirical study, flipping
does not work in the same way here as it does with theoretical papers. One
could reinterpret the results to emphasize that leaseholders most of the time
avoid a war of attrition in which they wait to see what others do, and thus bill
the study as supportive of a conservative position that free rider inefficiencies
can be resolved without outside intervention, rather than a liberal position that
free rider market failures are widespread.
(5) The Swing Voters Curse, Timothy J. Fedderson and Wolfgang Posendorfer,
AER, Vol. 86 (1996): 408-424.
The story: Winners curse/asymmetric information. Abstention from voting can
be rational for less-informed voters, because they have an interest in allowing
voters who know which candidate is preferable to control the result.
The storys ideology: Conservative.
Legal implications: Efforts to create higher turnout through, for example,
mandatory voting laws are misconceived, as are efforts to reduce the difference
0660 Critical Legal Studies 777
in turnout in the US between more educated and less educated people.
Possibilities for flipping the model: The article uses the winners curse
apparatus in a way that lends implicit support to a traditionalist conservative
belief in the superior qualifications of some voters to decide elections. (The
model also upholds a centrist, ticket-splitting view of politics by postulating
two classes of voters: independents who are sensitive to the state of the world
and partisans who are not.) The contrary liberal argument about abstention
(which is probably more orthodox than the articles conservative argument, at
least among policy intellectuals) is a free-rider claim about an individually
rational incentive to abstain that is collectively undesirable. This liberal
argument supports voluntary or mandatory measures to increase turnout, and
can be given a sharper edge by combining it with an argument that the
substantial social class disparity in abstention in the US is a rational response
to class bias in the US political system, rather than to deference by the less
educated to the superior judgments of the more educated.
(6) How do Senators Vote? Disentangling the Role of Voter Peferences, Party
Affiliation, and Senator Ideology, Steven D. Levitt, AER, Vol. 86 (1996):
425-441.
The story: The liberalism or conservatism of senatorial voting, as measured by
ADA score, is more dependent on the senators own ideology than on other
factors such as party affiliation and degree of constituency liberalism.
The storys ideology: Unclear.
Legal implications: Unclear.
Possibilities for flipping the model: This is a methodological article that studies
liberal-conservative politics but does not itself have a clear liberal-conservative
significance. The model assumes that the senators ideology is the residual
influence, which is certainly debatable - what about error in measuring other
variables, or unmeasured potential influences such as the economic interests of
the senators constituency? But the articles modeling of the centrality of
ideology does not have a clear methodological politics; the model could accord
either with a new left/CLS belief in the value as well as the inevitability of
ideology and ideological debate, or with a new right/public choice belief in
representatives ideology as rent-seeking.
(7) Revenue Effects and Information Processing in English Common Value
Auctions, Dan Levin, John H. Kagel and Jean-Francois Richard, AER, Vol.
86 (1996): 442-460
The story: Behavioral economics/winners curse/auction theory. Theoretically,
one would expect English common value auctions in which the high bidder
wins at the second highest price to raise more revenue than first price, sealed
bid auctions, because bidders can use other bidders behavior to help them
778 Critical Legal Studies 0660
avoid winners curse problems. Experimentally, though, sealed bid auctions
raise more revenue from inexperienced bidders, who suffer from the winners
curse; for experienced bidders, English auctions did increase revenue.
The storys ideology: Liberal.
Legal implications: The recommendation for the government to use English
auctions to maximize revenue does not necessarily apply when bidders are
inexperienced.
Possibilities for flipping the model: Behavioral economics typically deals with
whether people do or do not conform to rational choice predictions in
practice. Articles such as this one that show people acting irrationally are not
politically clear-cut. This empirical study has been classified as having a liberal
politics, both because a finding that people do not actually act in accord with
rational choice predictions helps undermine one of the tenets of free-market
ideology, and because the authors here were sympathetic in their attitude
toward the heuristic their experimental subjects used as a substitute for
maximizing. At the same time, the study, like much behavioral economics, has
potential to be understood in a conservative fashion as a how-to manual on how
to take advantage of people whose behavior does not accord with rational
choice.
(8) Avoidable Cost: Ride a Double Auction Roller Coaster, Mark H. Van
Boening and Nathaniel Wilcox, AER, Vol. 86 (1996): 461-477.
The story: Double auction markets such as those employed on stock exchanges
are usually supported as efficient, but in a situation characterized by high
avoidable costs (that is, high costs for any level of production above zero, as
with flying a plane), experiments indicate that double auctions may well be
inefficient. There, cooperative institutions may well have a role in creating
efficient outcomes.
The storys ideology: Liberal.
Legal implications: For regulators to impose double auction markets is not
necessarily a good idea; sometimes cooperative institutions may work better.
Possibilities for flipping the model: Although the overall point about the failure
of a competitive market is a liberal one, in the regulatory context the message
may be opposed to certain antitrust initiatives assocated with political liberals.
More broadly, the conservative flip on this type of experimental economic work
would involve looking at an institutional situation in which the prevailing
(liberal) assumption is that free-rider problems or other market failures will
prevent an efficient solution from being achieved in the absence of regulation,
and showing experimentally that, at least in a significant category of these
situations, efficient solutions will in fact be reached without regulation.
0660 Critical Legal Studies 779
(9) Holdups, Standard Breach Remedies, and Optimal Investment, Aaron S.
Edlin and Stefan Reichelstein, AER, Vol. 86 (1996): 478-501.
The story: The law and economics literature contains both arguments that
contracting parties will underinvest because their relationship-specific
investments will be subject to opportunism and that they will overinvest
because an expectation measure of damages will compensate them for
inefficient investment. For the parties, the solution to the investment problem
is to specify a quantity at which the opportunism tax on investment is balanced
by the breach subsidy to investment. For the legal system, both expectation
damages and specific performance will lead to efficient outcomes when only
one party makes relationship-specific investments; only specific performance
is efficient when both parties do so.
The storys ideology: Conservative.
Legal implications: If possible, grant specific performance when both parties
make relationship-specific investments.
Possibilities for flipping the model: The story here has been classified as
conservative because the contemporary liberal position on contractual
opportunism and regard for the others welfare seems to rely centrally on
notions of moral standards, such as good faith and promissory estoppel, and
status, such as inequality in bargaining power and unconscionability, that the
model eschews in favor of apparently nonevaluative, nonstatus-based decision
making rules. At the same time, the storys recommendation of specific
performance by itself could be either liberal or conservative, depending on
factors such as the status of the parties that the model abstracts from. Also, at
a general level, a political preference for specific performance over expectation
goes along with liberal doubts about the effectiveness of markets; the
combination of all these factors, along with certain differences between the
political center in legal and economic discourse (the failure of the model to
consider value-oriented alternatives to rule-based decision -making, which
makes it right of center in relation to law, does not necessarily do so in relation
to economics) makes the politics of the model complex, though fair to classify
in the final analysis as conservative. One way to flip this model into a liberal
one would be to begin from a set of assumptions under which opportunism and
lack of regard for the others welfare will generate inefficient results absent
particularized, status-conscious legal strategies. Another, critical approach to
flipping the story would be to structure a model in which the assumptions lead
to no efficient solution being available either through the parties negotiation
or through regulation.
780 Critical Legal Studies 0660
(10) Employee Buyout in a Bargaining Game with Asymmetric Information,
Avner Ben-Neur and Byoung Jun, AER, Vol. 86 (1996): 502-523.
The story: Asymmetric information/signalling. Employees who do not know the
true profitability of a firm can make offers to buy the firm as well as wage
demands; unprofitable owners will agree to sell, while profitable ones will
prefer to meet the wage demands.
The storys ideology: Liberal.
Legal implications: The expansion of negotiations between employers and
employees from wages only to employee ownership (and by extension, from
wages to other typically unnegotiated subjects) enhances efficiency by providing
opportunites for overcoming asymmetric information problems.
Possibilities for flipping the model: A conservative flip: Suppose the employees
have private information about their likely future contributions to the firm; the
employer allows profitable and unprofitable employees to signal their status
by telling all employees they are subject to downsizing and allowing them all
to quit with a bit of severance pay, as well as by making a wage offer. The
general point in flipping the liberal, potentially radical, model presented in the
article is that the additional subjects that are placed on the table to facilitate
efficiency-enhancing signalling need not be subjects that accord with a liberal
(or radical) reformist agenda; they may be instead be subjects like mass
termination of employees that accord better with a conservative politics.
(11) Aggregation Without Separability: A Generalized Composite Commodity
Theorem, Arthur Lewbel, AER, Vol. 86 (1996): 524-543.
The story: A methodological piece that focuses on technical assumptions
underlying the construction of price indices.
The storys ideology: Unclear. The story lacked the ideologically significant
punchline that nearly all the other articles had. Certainly the general topic of
price indices and inflation is a politically sensitive one, and there may be a
hidden moral that escaped this reviewers attention.
Legal implications: Unclear.
Possibilities for flipping the model: Unclear. For one with a closer sense of
different schools within econometrics, the article would quite possibly embody
a methodological politics (just as a law review article that apparently eschews
substantive political storytelling in favor of a focus on methodological or
procedural matters embodies some kind of politics of form), and possibilities
for flipping would accordingly present themselves.
(12) Voluntary Export Restraints, Antidumping Procedure and Domestic
Politics, B. Peter Rosendorff, AER, Vol. 86 (1996): 544-561.
The story: Signalling. Anti-dumping legislation leads to inefficient voluntary
export restraints as the outcome of a game in which actions on anti-dumping
0660 Critical Legal Studies 781
petitions signal the desire of governments for voluntary export restraints by
foreign producers. Given the median voter theorem and widely dispersed stock
ownership, governments may well value firm profits more than tariff revenues,
while at the same time asserting a rhetorical commitment to free trade.
The storys ideology: Conservative.
Legal implications: Anti-dumping laws are undesirable.
Possibilities for flipping the model: Here, the signalling model relies on
assumptions that welfare is lowered by tariffs and voluntary export restraints;
given that, the pro-free trade politics of the story are both transparent and
readily flipped by making different assumptions.
(13) Entry, Exit, Growth, and Innovation over the Product Life Cycle, Steven
Klepper, AER, Vol. 86 (1996): 562-583.
The story: The idea is to explain a pattern in which product markets are
characterized by an initial phase with innovative products and competing
designs to a later stage in which a dominant design emerges, market shares
stabilize, and larger firms predominate. The model assumes that the ability to
appropriate returns from process R&D (that is, production-oriented rather than
new product-oriented R&D) depends on firm size, which leads to large firms
and a shutout of new entrants.
The storys ideology: Conservative.
Legal implications: An anti-regulation, hands-off message is the logical
accompaniment of this type of economic storytelling.
Possibilities for flipping the model: This is economics in the conservative genre
of providing a more or less sunny explanation of why things are the way they
are, or at least seem to be. The corresponding liberal genre would explain the
product life cycle in a less sunny fashion, perhaps by using monopoly power
rather than process R&D as the driving assumption in the model. Either way,
the aesthetics of the exercise depend on whether the particular simple
conditions of the model seem to determine the situation in a persuasive,
interesting fashion.
(14) Heterogeneity, Stratification, and Growth: Macroeconomic Implications
of Community Structure and School Finance, Roland Benabou, AER, Vol. 86
(1996): 584-609.
The story: Sorting families homogeneously in schooling minimizes the costs of
existing heterogeneity, but integration reduces heterogeneity faster, thus
reducing growth in the short term but raising it in the long term.
The storys ideology: Liberal.
Legal implications: Integrate and equalize. Specifically, avoid stratification in
schooling through school finance reform, and state rather than private or local
control of schools.
Possibilities for flipping the model: The liberal heart of the story - the
782 Critical Legal Studies 0660
long-term positive effects of socioeconomic (and by extension racial and ethnic)
integration overriding the short-term negative effects - depends on the
assumptions made in the model about economic heterogeneity and its negative
effects. To tell a conservative story, switch the negative assumptions about
heterogeneity. To tell a radical story about, say, the superiority of raising
children in kibbutzes rather than in individual homes, only a small tweaking
of the model would be necessary.
11. Law and Economics: A Critical How-To
A theoretical law and economics story may begin with a logical puzzle or it
may begin with a question about a rule, an institution or peoples actions. But
whether the initial kernel is a real world situation or a logical model, the
point of the storytelling exercise, as suggested by the foregoing review of
current economic articles, is to hook up logic with some significant situation
in a politically significant fashion. Or, to put the how-to process for doing law
and economics in outline form:
1. Start with either a juicy logical twist or some significant real-world
situation.
2. Now connect up your starting point to a real-world situation, if you started
with logic, or to a neat logical point, if you started with a situation.
3. Make sure theres something politically significant - that is, ideologically
pointed - in the connection you make.
Since the linking of logic, situation, and moral in law and economics
storytelling/model building involves a substantial degree of creativity, it is not
possible to produce a law and economics story in the same way that one can
produce results using the formula for quadratic equations. A major premise of
CLS law and economics is that one has a high level of freedom in hooking up
logical models and salient real world situations. That freedom to choose a
particular phenomenon out of all the ones in the world to which the model
might be applicable makes hash out of any claim that the logic has now been
shown to have determinate real-world implications. The inventive researcher
trying to think of an application for the model is in effect rummaging through
a huge number of potential real-world situations, very likely without being
aware of how many she is implicitly considering and rejecting. When she finds
a phenomenon for which there is a feeling of match or fit, the connection she
draws between the logic and the phenomenon may be convincing to her and to
her readers. But she has not proven that the connection is something other than
fortuitous, and she and her readers, no matter how plausible they find the
connection, should carry more than a twinge of doubt about it, given the
0660 Critical Legal Studies 783
uncontrolled way in which models are linked to phenomena in law and
economics.
More doubts are in order. Even if one believes there is a truly pretty and
convincing connection between a particular logical twist and a particular
phenomenon, one has not shown that the logic is the driver of the phenomenon.
What one has shown by mapping logic onto phenomenon is a connection, an
analogy of sorts. One has not shown causality. It is just as plausible - more
plausible in most circumstances in law and economics - to view the link
between logic and phenomenon not in terms of an underlying, causally prior
mathematical substrate of the phenomenon, but in causally agnostic terms.
Discovering that logical twist A has a pleasing, powerful correspondence to a
particular facet of the world does not show that that facet is determined by the
logic. When one discovers a pleasing, powerful connection between a legal
category and a phenomenon, one is, as a participant in the culture of modern
legal science, skeptical about any claim that the legal category somehow
captures or causes the situation; rather, one is likely to believe, in keeping with
the arguments of antiformalist critics in law, that the sense of connection or
correspondence between legal models and phenomena reflects socially and
politically contingent states of consciousness rather than the causal efficacy of
legal categories. A similar caution, rather than an overexuberant sense of
economic reason as laying bare the logic of the worlds workings, would seem
to be advisable in economics in general and in law and economics in particular.
A how-to approach to creating law and economics stories that reflects CLS
assumptions about the ideological, contested, and indeterminate nature of law
and economics arguments is of course not uniquely the property of those who
want to tell critical rather than other kinds of stories. But there is at least some
reason to believe that understanding law and economics as a process of
ideological storytelling is more empowering for CLS law and economics than
it is for, say, Chicago law and economics. A group of law and economics
practitioners who can candidly talk about how to put together and flip
ideological law and economics can arguably do a better job at it than those
whose rhetorical conventions make that kind of discussion taboo, at least in
public. To be sure, there is the counterclaim that CLS law and economics, at
least if it takes the ideological turn of exposing the politics of its own
arguments and even considering how they could be flipped, is shooting itself
in the foot compared to law and economics that represses at every turn its status
as ideology. But it could also be the case that politically-reflective CLS law and
economics such as Kelman (1993) and Kennedy (1992) might over time benefit
in the marketplace of ideas from the way it can make other versions of law and
economics seem simplistic.
784 Critical Legal Studies 0660
12. Conclusion
The CLS critique of law and economics can reasonably be understood as an
effort to foster alternative, radical approaches to law and economics that
acknowledge and proceed from politically-charged contradictions within the
discipline. Thus understood, the relative lack of engagement of much of the
legal left with economics becomes a sign of loss rather than victory for the CLS
critique. At the same time, though, the growth of a larger and more politically
diverse law and economics movement becomes interpretable as a success, one
that may be related in part to CLS denunciations of the right-wing tilt in the
Posnerian, Coasean version of law and economics. Though CLS attacks on
ideological tilt in law and economics have not made for amicable relations
between the movements, the CLS critique has likely enhanced the viability of
liberal law and economics. Liberal dissent from Chicago orthodoxy has been
easier to take by comparison with the more fundamental CLS critique, and the
rise of liberal law and economics in the law reviews has enhanced the academic
credibility of a movement under attack as right-wing ideology. Nor was the
opening to liberalism especially threatening to conservatives if liberal law and
economics could be contained, as it has been thus far in the US, within the
framework of continuing conservative control of the major journals and
professional association in the discipline.
Given the predominant role of Chicago, law and economics over the last
twenty years has helped move law in the US to the right. But in the future, law
and economics may well help move economics to the left. The law and
economics project can certainly operate in the direction of making legal
argument more purportedly scientific and value-free, but it also inherently has
the potential to tip in the direction of making economics a more overt domain
of logicized ideological argument. The politics of such a tipping are themselves
contingent, but there is a major future risk for the right in the contemporary
burgeoning of law and economics that, in the US, has been one of the rights
great intellectual triumphs.
As for CLS: the movements identity has always been as a
counterhegemonic, dissenting one, and there is no likelihood of that stance
changing. But especially given the continued rise of law and economics, a
counterhegemonic, dissenting CLS involvement in the discipline as critics and
also as participants is both likely and called for. Legal leftist ambivalence about
employing the masters tools of technical economic analysis can and should
be overcome, aided by the realization that such tools are not the predetermined
property of the liberal center and the right but are available for deployment on
behalf of more radical visions.
0660 Critical Legal Studies 785
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Tushnet, Mark (1991), Critical Legal Studies: A Political History, 100(5) Yale Law Journal,
1515-1544.
Unger, Roberto Mangabeira (1975), Knowledge and Politics, New York, Free Press.
Van Wezel Stone, Katherine (1991), Employees as Stakeholders Under State Nonshareholder
Constituency Statutes, 21 Stetson Law Review, 45 ff.
Vracar, K. Stevan (1994), Preispitivanja pravne metodologije: Nagovestaji drzavno-pravnog
integralizma (Reexamination of the Legal Methodology: Indications of State-Legal Integralism),
Belgrade, Naucna knjiga.
West, Robin (1986), Submission, Choice, and Ethics: A Rejoinder to Judge Posner, 99 Harvard Law
Review, 1449-1456.
West, Robin (1989), Taking Preferences Seriously, Tulane.
Wilhelmsson, Thomas (ed.) (1993), Perspectives of Critical Contract Law, Aldershot, Dartmouth.
Other References
American Economic Review (1996), 86(2) (all articles).
Ayres, Ian (1990), Playing Games with the Law, 42 Stanford Law Review, 1291 ff.
Ayres, Ian and Talley, Eric (1995), Solomonic Bargaining: Dividing a Legal Entitlement to Facilitate
Coasean Trade, 104 Yale Law Journal, 1027 ff.
Calabresi, Guido (1970), The Cost of Accidents: A Legal and Economic Analysis, New Haven, CT,
Yale University Press.
Cooter, Robert (1982), The Cost of Coase, 11 Journal of Legal Studies, 1 ff.
Hovenkamp, Herbert (1992), Rationality in Law and Economics, 60 George Washington Law
Review, 293 ff.
Markovits, Richard S. (1984), Duncans Do-nots: Cost-Benefit Analysis and the Determination of
Legal Entitlements, 36 Stanford Law Review, 1169 ff.
Schor, Juliet (1991), The Overworked American, New York, Basic Books.
Posner, Richard A. (1972), The Economic Analysis of Law, Boston, Little Brown.
0710
RATIONAL CHOICE THEORY IN LAW AND
ECONOMICS
Thomas S. Ulen
Alumni Distinguished Professor of Law, College of Law, University of
Illinois at Urbana-Champaign and Professor, University of Illinois Institute
of Government and Public Affairs
Copyright 1999 Thomas S. Ulen
Abstract
The great appeal of law and economics has been its use of a coherent theory
of human decision making (rational choice theory) to examine legal rules
and institutions. While the innovations and accomplishments of that theory
in the analysis of the law have been many and important, there has been a
great deal of dissatisfaction among more traditional legal scholars with the
rational-choice foundation of law and economics. This chapter, first,
explains rational choice theory and its importance in the economic analysis
of law; second, summarizes some of the literature from economics, cognitive
psychology, and other disciplines that have been critical of rational choice
theory; and, third, speculates on the impact of those criticisms on the
economic analysis of law.
JEL classification: K00
Keywords: Rationality, Bargaining, Human Decision Making,
Methodological Criticism
1. Introduction
When law and economics was a new field in the legal curriculum and just
becoming a regular part of academic legal discourse, the use of
microeconomic theory to discuss traditional legal topics aroused interest but
also suspicion and hostility. Prominent among the reasons for this suspicion
and hostility was the feeling that the economists account of human decision
making - rational choice theory - was so deeply flawed that conclusions
derived from that account ought to be taken with a very large grain of salt, if
not rejected outright. To take one example, the economic theory of the
decision to commit a crime asserted that the potential criminal evaluated the
expected costs and expected benefits of the criminal act and committed the
crime only if the expected benefits exceeded the expected costs.
790
0710 Rational Choice Theory in Law and Economics 791
Many traditional legal scholars, judges and practitioners to whom such
examples of law and economics were given felt that the root of their
unhappiness with the conclusions of the new discipline lay with the
economists contention that all decisions (like that to commit a crime) are
the result of rational deliberation. The rational utility- or profit-maximizers
of microeconomic theory seemed to bear very little correlation to the
flesh-and-blood human beings with whom the law dealt. Therefore, to the
extent that law and economics used rational choice theory as its principal
theory of human decision making, the field had a difficult time in
convincing traditional legal scholars that it should be taken seriously.
In this chapter I first describe the rational choice model of decision
making and then give some examples of the use of that theory in law and
economics. Next I describe some criticisms of rational choice theory that
have been made principally by cognitive and social psychologists. And
finally, I speculate on the implications of these criticisms for the economic
analysis of law.
A. Rational Choice Theory
Rational choice theory is at the heart of modern economic theory and in the
disciplines contiguous to economics, such as some parts of political science,
decision theory, sociology, history and law, that have adopted the theory as
their model of decision making. In this section I define rational choice, show
how it is used in economics and describe its use in other disciplines and
suggest why traditional scholars in those other disciplines find problems
with rational choice theory.
2. Definitions of Rational Choice
There is no widely accepted definition of rational choice theory, but there are
two important senses in which the term is used. The first is an informal
sense: choice is said to be rational when it is deliberative and consistent. The
decision maker has thought about what he or she will do and can give a
reasoned justification for the choice. And taking choices over time or
focusing on their choices about particular things, such as food or class
choices in college, one expects rationality to lead to consistent (and
relatively stable) choices. That is, one expects that there will be no wild and
inexplicable swings in the objects of their choices and that the means chosen
to effectuate the goals of the decision maker will be reasonably well-suited to
the attainment of those goals (Nozick, 1993)
792 Rational Choice Theory in Law and Economics 0710
Like many informal definitions this one is highly imprecise. Indeed,
because almost all action would seem to be deliberative and consistent, this
informal definition does not seem to allow us to distinguish rational from
irrational action. Everything confirms the definition and nothing refutes it.
The second sense in which the profession uses rational choice is more
formal: consumers have transitive preferences and seek to maximize the
utility that they derive from those preferences, subject to various constraints.
Transitive preferences are those for which, if some good or bundle of goods
denoted A is preferred to another good or bundle of goods denoted B and B
is preferred to a third good or bundle of goods denoted C, then it must be the
case that A is preferred to C. By contrast, if it were the case that A were
preferred to B, B were preferred to C and C were preferred to A, we would
find that distinctly odd - indeed, irrational. Similarly unobjectionable is the
assumption that the decision maker seeks to maximize utility subject to
various constraints (such as those imposed by income, time, cognitive
resources and the like). Most economists find this more formal sense of
rational choice to be so obvious that they never doubt it and are puzzled by
those who do. (For a discussion of other formal conditions on rational
choice, see Plous, 1993, pp. 80-82.)
However obvious the formal sense of rational choice may be to
economists and to those in other disciplines who have adopted it as their
model of human decision making, the formal sense has not been without its
critics. Two such criticisms are worth noting here. First, some have said that
the formal notion of rational choice is as tautological as the informal sense.
That is, there is no, or almost no, behavior that refutes the formal sense of
rationality. All behavior may be said to be directed at utility maximization
(who would ever do otherwise?) and all preferences can be said to be
transitive. For instance, one might explain many instances of seemingly
intransitive preferences as being the result of a change in preferences over
time. Second, one can show some inconsistencies or puzzles in the notion of
transitive preferences. Suppose that we have asked a subject how he feels
about a teaspoonful of sugar. Now we add a grain of sugar to that spoonful.
If the subject likes sugar, he should presumably prefer the augmented
spoonful to the original on the theory that more is better. (If he does not like
sugar, then he should prefer the original spoonful.) However, it is likely to
be the case that the subject cannot distinguish the spoonful with one more
grain of sugar from the original spoonful. If so, he may say that he is
indifferent between the two. (This confusion between more is better and
indifference is itself puzzling, but set that puzzle to one side.) If we continue
to add grains of sugar to the original spoonful and ask the subject each time
we do so how he compares the augmented with the previous spoonful, he
will probably continue to say that he cannot distinguish and is, therefore,
0710 Rational Choice Theory in Law and Economics 793
indifferent. But ultimately the grains of sugar will add up to something
substantially greater than the original spoonful. So, even though the subject
will have contended that each successive spoonful was just as good as the
original so that, by transitivity, the final heaping spoonful should be
indifferent to the first, the subject is almost certain to prefer the heaping
spoonful to the original teaspoonful.
3. The Uses of Rational Choice Theory in Economics
These problems notwithstanding, economists have found rational choice
theory to be a very useful model for forming hypotheses about market
behavior. There are five principal reasons for this. First, the theory allows
economists to make predictions about economic behavior and, by and large,
those predictions are borne out by the empirical evidence. For example,
rational choice theory predicts and empirical work confirms, that when the
wage rate rises, all other things held equal, the supply of labor increases and
the demand for labor decreases; when the price of alcohol rises, relative to
that of other goods and services, the quantity demanded goes down (if not by
much); when the price of a good or service rises, again, relative to that of
other goods and services, productive effort tends to shift into the supply of
that good or service; and when the price of an input rises relative to that of
its substitutes, producers tend to use less of that input and relatively more of
the substitutes. These sorts of results are so widespread, so familiar to
professional economists and so central to the tenability of modern
microeconomic theory that it is not surprising that rational choice theory
forms such an important part of the canon of modern microeconomics.
Second, whenever there are seeming deviations from the predictions of
price theory, economists can usually explain those deviations without having
to assume that the decision makers involved are irrational. If the deviations
are a matter of degree (for example, an increase in the tax rate on incomes
above $250,000 was followed by a much smaller increase in government
revenues than predicted), there are a large number of hypotheses that can
explain this deviation that are well short of questioning the rationality of the
parties involved. To take just one such hypothesis, there may have been
means by which those with incomes over $250,000 could shelter income
from the tax authorities that had not been worth pursuing until the tax rate
increased. Alternatively, one might argue that the deviation from the
prediction of rational choice theory is a statistical fluke, due to some oddity
of the data set, that the seeming anomaly is the result of the decision
makers not having had the appropriate information to reach the result
predicted by the theory, that there was some theretofore unnoticed market
794 Rational Choice Theory in Law and Economics 0710
failure, such as monopoly or monopsony, external costs or benefits, public
goods, or informational asymmetry, that accounts for the discrepancy
between the theorys predictions and the observed behavior. These statistical
and structural problems are real and common, so that economists are not
themselves being irrational in clinging fiercely to rational choice theory in
the face of seeming anomalies in the theorys predictions.
Third, an economist may explain behavior that seems anomalous to
rational choice theory by appeal to a slight emendation of the theory.
Suppose, by way of example, that someone demonstrates that for a particular
good, when the price rises, all other things held equal, the quantity
demanded increases. Is this sufficient evidence on which to abandon the
rational choice theory? Typically not. For instance, in the case of a good
whose quantity demanded rises rather than falls when the price of the good
increases, one might propose a new phenomenon called a snob effect,
which arises when consumers take an increased price for a good as a sign of
its desirability, not as a sign to switch to cheaper alternatives. As a
consequence, the demand curve for a good subject to a snob effect may slope
upward, to indicate that an increase in the price of that good leads to an
increase in the quantity demanded (Liebenstein, 1950).
Fourth, there is a strong presumption among economists in the
evolutionary fitness of rational behavior - at least in the economic realm.
That is, rational consumers will prosper, while irrational consumers will
squander their resources and, perhaps, become money pumps for rational
calculators. More importantly, rational profit-maximizing businesses will
dominate those businesses that do not operate according to a rational plan.
Fifth and finally, Professor Gary Becker has shown that even if there
were consumers who behaved irrationality, in the sense of having
intransitive preferences, the standard predictions of price theory (such as
that an increase in the relative price of a good will lead to a decline in the
quantity of that good demanded) would still hold (Becker, 1962). Since that
article appeared, there have been more formal demonstrations that the
conclusions of price theory and of welfare economics are not much affected
by the presence of even a large number of consumers with intransitive
preferences. Therefore, while irrationality might still be an issue with
respect to the behavior of certain individuals, it is not an issue with respect
to aggregate behavior in markets and may, as a result, be ignored.
The point of all this is to suggest that there are plausible reasons why
economists cling tenaciously to rational choice theory. The theory is
extremely useful and powerful. Its predictions are frequently accurate and a
valuable guide to the formulation of public policy. And it is facile enough to
explain phenomena that seem anomalous without necessitating an
abandonment of the theory.
0710 Rational Choice Theory in Law and Economics 795
4. The Use of Rational Choice Theory in Other Disciplines
Criticisms abound when scholars seek to use rational choice theory to
describe non-market behavior, as has been the case in such oppressed
disciplines as demography, history, biology, political science, international
relations and law. None of these disciplines involves explicit market choices,
but all of them have been revolutionized by the importation and use of
rational choice theory.
Why has rational choice theory been so attractive to some scholars in
these contiguous disciplines? The principal reason is that the theory is the
most complete and coherent account of human decision making in the social
sciences. Moreover, the acknowledged success of economics in the public
policy arena in the past fifty years, which may be attributed in part to its
grounding in a coherent theory of rational behavior, may have inspired
emulation of the modeling aspect of economics by other disciplines in the
hope that this will lead to academic and policy successes similar to those of
economics.
But, as I noted, there have been sharp criticisms of rational choice theory
in the study of non-market behavior. Why should this be the case? One
possible answer is that traditional scholars are threatened by rational choice
theory: it is an unfamiliar technique, wielded principally by young scholars
and clearly threatens the academic standing of those who use traditional
methods. But there is more to the objections than mere self-interest. Put in a
light most favorable to the objectors, their query may be put this way:
Rational choice theory may be fine for the consideration of explicit market
decisions - such as which car to buy, whether to lease the car or to purchase
it with a loan, which job to take and what terms and conditions to accept and
how to invest ones savings. These are, after all, quantifiable decisions. They
all involve money and that currency allows comparison among different
economic courses of action. But what reason is there to believe that
non-market decisions - such as whom to marry or how many children to
have or how to care for each of them or whether to trust ones ally in foreign
affairs and so on - are made according to the same calculations? Put
someone succinctly, the question is Why is the rational choice model
suitable to market behavior but not to non-market behavior? The question is
a serious one and deserves an answer.
I can think of three factors that might make the rational choice model a
better general model for market choices than for non-market choices. First,
market choices are frequent and routine. Even if people make mistakes when
they make their first market choices, they have an opportunity to learn
through repeated transactions. Moreover, in those instances in which market
transactions are rare in an individuals life - as, for example, the purchase of
796 Rational Choice Theory in Law and Economics 0710
a house, there are many people who have made these purchases, so that
there is the possibility of learning from others about the pitfalls of those rare
transactions. Nonetheless, the general point bears making that market
choices are more problematic for individuals, the rarer they are. Related to
this matter is the fact that many non-market choices are so infrequent that
people do not have repeated opportunities to learn and to make corrections.
Love and marriage are examples. Even though one might consult others for
their experiences with these infrequent decisions, each individuals
circumstances with respect to many of these non-market choices are so
highly particularized that the others experiences may not be an appropriate
guide to ones own best course of action.
Second, as already noted, market choices are mediated through a
common medium - money - that makes commensurability easier. We do not
have problems of comparing apples and oranges in many market
transactions because the choices almost always involve the purchasers
giving up money. Because the purchaser knows or could know the market
price of other goods and services or can compute an opportunity cost, he or
she can make a fairly accurate estimate of the comparative worth of very
different courses of action, such as whether to purchase or lease a new car or
whether to spend another year in school or get a job. By contrast,
non-market choices usually do not involved a common measuring rod like
money. Therefore, making comparisons across non-market alternatives or
between a market and a non-market alternative may be very difficult. How
does one compare the profound experience of parenthood with the cost of an
exotic vacation?
Third, there are problems of transparency in non-market choices. Market
choices involve relatively straightforward comparisons, save when they are
complex and reserved for specialists, as in some complicated options
valuations. There is, frequently, a single best (an optimal) decision. But
many non-market choices are simply difficult to understand and have a
variety of suitable outcomes. Consider the decision of whether or not to
invite a friend to travel a long distance with one. There is no correct
answer to the question and there are lots of nuanced meanings, including
misunderstandings, that may be read into the question and its answer.
Taken together, these issues of frequency, commensurability and
transparency may suggest why rational choice theory is widely accepted as
an explanation of market choices but has difficulties in acceptance as a
model of non-market choices (Ulen, 1998).
0710 Rational Choice Theory in Law and Economics 797
B. The Application of Rational Choice Theory in the Law
The most important, but not the only, characteristic of law and economics is
its use of rational choice theory to examine legal decisions. In this section I
describe the general reasons why rational choice theory may be appropriate
for the description and prediction of legal decision making and give
examples of the use of the theory in the analysis of private law rules of
contract and tort law and in the analysis of criminal law.
5. Why Rational Choice Theory is an Appropriate Model of Legal
Decision Making
Rational choice theory is one of three distinguishing characteristics of law
and economics. In light of the general criticism of the applicability of
rational choice theory to non-market choices given above, one is entitled to
ask why rational choice is appropriate for the discussion of legal matters,
most of which are non-market choices.
The answer is that many legal decisions are indeed market-like choices.
They may be said to be so on the ground that legal rules create implicit
prices on different behaviors and that legal decision makers conform their
behavior to those prices in much the same way as they conform their market
behavior to the relative prices there. For example, the law imposes a
monetary sanction (called compensatory money damages) on those who
unjustifiably interfere with anothers property, breach a contract, or
accidentally injure another person or his property. These money amounts
may be taken to be the prices of engaging in certain kinds of behavior,
such as a failure to take due care or to perform a contractual obligation.
Presumably, rational decision makers will compare those legal prices with
those of the alternatives and will comply with the laws duties (that is, not
interfere with anothers property without their permission, perform a
contractual obligation, or take due care) if the price for doing so is greater
than the price of not doing so. For example, if the benefit of breaching a
contract is $10,000 and the money damages that the breacher can anticipate
paying to the innocent party are $5,000, then there is likely to be breach of
contract (Cooter and Ulen, 1997; Posner, 1998). It is the central innovation
of law and economics to have recognized that many legal decisions have this
market-choice-like quality and that, therefore, rational choice theory is an
appropriate model of much legal decision making.
798 Rational Choice Theory in Law and Economics 0710
6. Private Law Examples of Rational Choice Theory
I shall here give only a few broad examples of rational choice theory in
private law, rather than an exhaustive survey. One particular omission
deserves mention. I shall have nothing to say about the Coase Theorem, the
most famous example of the economic analysis of law and a superb example
of rational choice theory in private law decision making, on the grounds that
this Encyclopedia covers that theorem extensively elsewhere. Here I merely
note that the bargaining behavior that the Coase Theorem posits will occur
in the absence of transaction costs precisely because the parties are rational
calculators in the manner assumed by rational choice theory.
Notwithstanding the fact that I have not discussed the Coase Theorem, in
Part C below I shall describe some criticisms of the assumptions of that
theorem and then in Part D I shall some implications for the theorem of
those criticisms. Here I shall give examples of rational choice theory as it
informs the economic analysis of contract law and tort law.
6.1 Contract Law
In an economic analysis of contract law, the place to begin is with the
question, Why do rational parties need the laws help in concluding
consensual agreements? One might well argue that in the absence of
transaction costs, parties seeking to conclude agreements would not need
help from the law. They would costlessly conclude mutually beneficial
terms. It follows that contact law aids parties to conclude agreements when
transaction costs are positive.
What gives rise to positive transaction costs in contracting? There are
two general sorts of reasons. First, there may be problems in the
environment in which the parties negotiate and these problems can lead to
inefficiencies. For example, there could be third-party effects and in the
absence of legal intervention the contracting parties are not likely to pay
attention to those external effects. Additionally, one of the contracting
parties could be a monopolist and could, therefore, put the other party in a
situation in which consent would be meaningless. The law can correct for
this social cost by insisting that parties reach roughly competitive terms in
their agreement.
The second general source of transaction costs in contracting are
problems that individual contractors may have. For example, some parties
may have unstable or intransitive preferences because, say, they are very
young, insane, or suffering from Alzheimers disease. When people have
unstable or intransitive preferences, there is no guarantee that they are in a
position to gauge the benefit of bargaining and cannot, therefore, form
mutually beneficial agreements. Predictably, contract law does not enforce
agreements in which one of the parties has unstable preferences.
0710 Rational Choice Theory in Law and Economics 799
The transaction costs arising from factors of the contractual environment
and individual transactors may be so high as to preclude contracting or to
make it take place on inefficient terms. As a general corrective, contract law
can present a set of pre-determined contract terms that take account of these
transaction costs and save parties the costs of specifying these terms each
time they negotiate to enter an agreement.
6.2 Tort Law
According to economic analysis, the tort liability system seeks to minimize
the sum of prevention, accident and administrative costs. Potential injurers
and potential victims are rational calculators who compare the expected
costs and benefits of various states of the world (such as those arising from
taking different kinds or amounts of precaution) and, given their tastes,
maximize their utility subject to several constraints. By assumption, the
transaction costs between potential injurers and victims are so high that they
cannot form a contractual agreement regarding their obligations in the event
of an accident. That being so, the potential injurer has virtually no incentive
to take the expected costs of his failure to take adequate precaution into
account. As a result, there are too many or too severe accidents and potential
victims may inefficiently seek to protect themselves from uncompensated
injury. Economic analysis of tort law focuses on using legal rules to induce
the (rational) potential injurer to internalize these costs of failing to take
adequate care. Specifically, by holding out the possibility that the potential
injurer will be deemed liable for failure to take due care and, if liable, will
have to pay the victims damages arising from the accident, tort law induces
the rational potential injurer to take the social-cost-minimizing level of care.
As an example of the rational-choice aspect of this analysis, consider the
economic view of negligence versus strict liability. To be extremely terse
about a complex matter, economic analysis suggests that some form of
negligence is efficient when precaution is bilateral and that strict liability is
efficient when precaution is unilateral. The intriguing novelty in this view is
the implication that the negligence standard addresses itself to both potential
victims and potential injurers in order to induce both of them to take care.
Imagine the calculations that a rational person will make when faced
with some form of the negligence standard for determining liability. Assume
that this person does not know whether she will be injured or will injure; for
example, she could be an automobile driver. She knows that under the
negligence standard the injurer who complies with the legal duty of care will
not be held liable for the victims injuries. Therefore, if she were to be an
injurer, the best thing for her to do would be to comply with the legal duty of
care. That action will minimize her expected liability and, being rational,
she decides to comply with the legal duty of care. But suppose that she is the
800 Rational Choice Theory in Law and Economics 0710
victim in an automobile accident. In that case she will almost certainly be
injured by someone who has complied with the legal duty of care. (Why?
Because every potential injurer is, like her, rational and will have recognized
that his expected liability is zero if he complies with the legal duty of care.
Being rational, he will seek to minimize his expected liability by taking the
appropriate amount of care.) Having reasoned that she will be injured by a
rational injurer who will not be found liable, she recognizes that if there is
an accident in which she is the victim, she will have to bear her own
accident losses. She must, therefore, take action so as to minimize those
expected accident costs by taking the optimal amount of care (whose
marginal cost equals its marginal benefit - the expected reduction in
expected accident costs). Thus, negligence induces optimal care by both
potential injurers and potential victims.
7. Public Law: The Decision to Commit a Crime
As a final example of rational choice theory as applied to legal decision
making, consider the well-known Becker (1968) model of the decision to
commit a crime. Becker hypothesized that criminals are rational calculators
and that, therefore, they made their decisions about compliance with
criminal law on the basis of a comparison of the expected costs and benefits
of criminal and legal activity. The expected costs of crime result from
multiplying the probabilities of the activitys being detected and of the
perpetrators being apprehended and convicted by the monetary value of the
legal sanction and the value of any non-pecuniary losses he might suffer,
such as a loss in reputation from being branded a criminal. The expected
benefits of the crime result from multiplying the probability of success times
the monetary and non-pecuniary benefits of the particular crime. These latter
include both the value of the goods or the amount of money resulting
directly from crime and such intangible but potentially valuable outcomes as
being known in ones community as a law-breaker. According to the Becker
model, the rational criminal will commit the crime if these expected costs
are less than the expected benefits and will refrain from crime if the reverse
is true. (For a critique of the Becker models predictions, using the criticisms
of Part C of this entry, see Wilson and Abrahamse, 1992).
C. Criticisms of Rational Choice Theory
Recent scholarship by some cognitive psychologists and by economists
familiar with the cognitive psychological literature describes experimental
0710 Rational Choice Theory in Law and Economics 801
results that are difficult to reconcile with rational choice theory. The
experiments have questioned implications of that theory with regard to at
least four different areas. First, subjects in carefully-designed experiments
seem to reject mutually beneficial exchanges when they believe that the
proposed division of the cooperative surplus violates widely-accepted norms
of fairness. Rational choice theory predicts that this will not happen. Second,
subjects in another series of experiments in which there are several stages of
bargaining involved do not devise rational strategies. Third, most decision
makers have cognitive limitations that cause systematic deviations in their
behavior away from that predicted by the theory of rational choice. For
instance, those engaged in a common-value auction fall prey to the
winners curse; and people cling to the status quo, even though an
alternative likely has much greater value. Fourth, experiments have shown
that people do not make decisions about uncertain outcomes in the way that
the theory of rational choice predicts.
I shall briefly summarize some of these results in this section before
turning in Part D to a discussion of the important implications of this
literature for the rational-choice-based economic analysis of the law.
8. Rational Bargaining
Rational choice theory makes two broad claims about bargaining. One is that
whenever there is a cooperative surplus greater than the transactions costs of
splitting that surplus, parties will find a means of dividing the surplus. The
second is that there are certain situations in which people will not fully
participate in bargaining behavior, such as in the provision of and payment
for public goods. Experimental evidence questions both of these claims.
People apparently willingly cooperate in circumstances in which rational
choice theory predicts that they will not cooperate and they frequently do not
bargain in circumstances in which the theory predicts that they will.
8.1 Cooperation in the Production of Public Goods
Rational choice theory predicts that for public goods - that is, goods that
exhibit non-rivalrous consumption and for which the costs to private
profit-maximizing suppliers of excluding non-paying beneficiaries are
prohibitively high - rationally self-interested, utility-maximizing consumers
will not pay for the units of a public good from which they benefit. They
will, in the classic phrase, free ride, that is, consume the public good
without paying for it.
However, a series of experiments reveals that people do willingly and
voluntarily pay for their share of public goods (Thaler, 1992; Ulen, 1994).
802 Rational Choice Theory in Law and Economics 0710
The experiments are variations on the following general set of rules. A
group of people, usually college students, are brought together and each is
given the same sum of money. They are told that they can invest some, none,
or all of that money in something called a group exchange. (The decision
to invest in the group exchange is a secret one. That is, one does not know
whether or not the other players have contributed. All one knows is that they
have all been given the same amount of money and are all subject to the
same rules.) The group is also told that the game operator will multiply the
total sum invested by the group by a number that is larger than one but
smaller than the number of people in the group and will then divide the
resulting sum equally among all of the group members, whether they have
invested in the group exchange or not. These rules make the group exchange
into a public good. Presumably, the temptation on rational actors will be to
contribute nothing to the group exchange and then benefit with an equal
share of the sum generated by the game operator.
To see how this works, suppose that there are five people in the group
and that each of them is given $5. If no one contributes anything to the
group exchange, then there is nothing for the game operator to multiply and
nothing, therefore, for the group to divide. But suppose that only one person
contributes nothing and the other four people in our example contribute their
entire $5 to the group exchange. Further, suppose that the group operator
doubles the resulting $20 to $40 and then distributes that sum equally
among all five players. Each, therefore, receives $8. The incremental return
to the four players who contributed $5 is $3, but that of the player who
contributed nothing is $8. This logic should be clear to all the subjects, so
that none of them should contribute to the group exchange; all of them
should seek to free ride. Thus, the prediction of the theory of rational choice
is that no one will invest in the group exchange.
In laboratory experiments of this game, the predictions of rational choice
theory are not borne out. Although not everyone contributes to the group
exchange, a substantial number do. On average, subjects in the experiments
contributed between 40 and 60 percent of their initial sum to the public
good. When experimenters vary the conditions of the game - by, for
example, increasing the number of times the game is played, giving the
players some prior experience with the game, or increasing the size of the
stakes - the general outcome is the same: contributions to the public good are
well above what the theory of rational choice would predict. The only
exception to the 40-60 percent contribution rate was when the subjects were
graduate students in economics at the University of Wisconsin. The
contribution rate for that group was only 20 percent (Marwell and Ames,
1981).
One variation of the experiment is particularly interesting: that of the
players repeating the game several times. Rational choice theory would
0710 Rational Choice Theory in Law and Economics 803
predict that with repeated plays the rate of contribution to the group
exchange would decline (perhaps because the players would come to
understand the disadvantages of contribution and the advantages of free
riding). And that is what the experimenters found. (There is some
controversy about whether the decline is rapid or gradual, but there is
agreement that there is decline.) Were the reasons for the decline those
given by rational choice theory? Plausible as the theorys conjecture sounds,
it is not supported by the experimental results. The 40-60 percent
cooperation rate of the earlier experiment is found to hold on the first trial of
the game even for experienced players - that is, even for those players who
have participated in other multiple-play public-goods experiments in which
the contribution rate fell with repeated plays. Andreoni confirmed this
surprising result in the following way. He assembled a group to play the
public-goods experiment and announced the usual rules of the game and,
further, that the game would be played for ten trials. He found, as expected,
that the contribution rate declined over the course of those trials. At the end
of the ten trials, he announced that the same players would play the game for
an additional ten trials. When the game was re-started for the second run of
ten trials, the participation rate rose back to the 40-60 percent range before
declining again. (Andreoni, 1988)
These experimental results present a puzzle for rational choice theory:
why do people cooperate when there appears to be a rational basis for not
cooperating? One possibility is that people start any given interaction from
the presumption that it is better to cooperate than not; they continue to
cooperate until the evidence shows this to be ill-advised; and then they quit
cooperating.
8.2 Rational Bargaining over a Cooperative Surplus
Rational choice theory offers no prediction about the particular proportions
in which voluntary traders will divide a cooperative surplus; it merely
suggests that if such a cooperative surplus exists and, very importantly, if
there are no serious impediments to exchange (that is, no transaction costs),
traders will find a way to divide that cooperative surplus so that both of them
are better off than they would have been if they had not traded. The theory
provides a complete explanation for exchanges that do take place and those
that do not: if a voluntary exchange takes place, then there must have been a
cooperative surplus to be divided and the impediments to exchange must
have been trivial; if an exchange does not take place, then there was either
no cooperative surplus to be divided (that is, the minimum price for which
the seller was prepared to sell was greater than the maximum price the buyer
was prepared to pay) or the costs of concluding an exchange were greater
than the cooperative surplus. Rational choice theory offers no other reasons
804 Rational Choice Theory in Law and Economics 0710
for a failure to exchange. Clearly, what would be troubling for rational
choice theory would be exchanges that failed to materialize even though
there was a cooperative surplus to be divided and there were no impediments
to exchange.
Experimenters have probed these possibilities in a very wide-ranging
series of experiments regarding the ultimatum bargaining game. (Guth,
Schmittberger and Schwarze, 1982). The game works as follows. There are
two participants, call them Player 1 and Player 2. They do not know one
another and are not allowed to communicate. The object is to divide a fixed
sum of money, say, $20. Player 1 makes an offer to divide the sum; Player 2
then either accepts the division, in which case the players receive the actual
division proposed by Player 1, or rejects it, in which case they each receive
nothing. Thus, if Player 1 proposes that they each receive $10 and Player 2
accepts that proposal, that is what they actually receive. If Player 1 proposes
that he receive $19 and Player 2 receive $1 and if Player 2 accepts that, that
is what they each receive; if Player 2 rejects that division, they each receive
nothing.
The prediction of rational choice theory is that Player 1 will recognize
that the best thing for her to do is to propose a one-sided division of the
fixed sum in her favor. This is because Player 2 will then be in the position
of accepting whatever Player 1 proposes or getting nothing and the clearly
rational thing for Player 2 to do is to accept something rather than nothing.
The experimental results do not confirm the prediction of rational choice
theory. Those in the position to make the initial proposed division generally
do not propose a one-sided division in their favor. Rather, in a wide-ranging
number of experiments over many years and in many different countries, the
modal (that is, most common) proposal is for a 50-50 split and the mean
proposal has been for a 37-73 split. Nor was the prediction for the sheepish
acquiescence of Players 2 to the proposed division confirmed. Most of them
accepted the split (presumably because the modal proposal was an even
split), but, interestingly, almost 25 percent of the proposals were rejected
(with the most one-sided proposals being almost uniformly rejected)
(Kahneman, Knetsch and Thaler, 1986).
There have been numerous variations on these basic versions of the
ultimatum game. In every instance, no matter how complex the
experimenters make the game, the results offer little support for rational
choice theorys account of how people do or ought to behave.
8.3 The Endowment Effect or Status Quo Bias
Recall that rational choice theory predicts that in the absence of transaction
costs and in the presence of a cooperative surplus, there will be an exchange.
One of the most important discoveries in the experimental literature is an
0710 Rational Choice Theory in Law and Economics 805
effect that suggests that bargains will not necessarily take place under the
ideal conditions posited by rational choice theory. The reason is the presence
of what is called an endowment effect or status quo bias. Thaler defines
that effect as the fact that people often demand much more to give up an
object than they would be willing to pay to acquire it. (Thaler, 1992, p. 63).
The closely related status quo bias may be defined as a general preference
for the current state of holdings over any alternative (Korobkin, 1994;
Samuelson and Zeckhauser, 1988).
The endowment effect surfaced in laboratory experiments (Thaler, 1992;
Korobkin, 1998). Experimenters intent on testing propositions about
bargaining typically gave half the subjects something of value (for example,
a lottery ticket, ballpoint pens, or a coffee mug) and the other half a sum of
money. One member of each group was paired with a member of the other
group. The pairs were then given an opportunity to exchange; the roles were
then re-assigned and the participants again had an opportunity to exchange.
This reversal of roles was done a number of times with the understanding
that only one of the attempted exchanges would actually be executed by the
experimenters. The subjects were given ample opportunity to learn the rules
of the game.
The purpose of the experiments was to test two propositions about
exchange suggested by rational choice theory. First was the proposition that
when there are no impediments to exchange, goods and services will move
to those who value them the most. Because there were no impediments in
the experiments, the tickets, ballpoint pens and coffee mugs should end up
in the hands of those who valued them the most. Sometimes that would be
the subject to whom the items had been originally given and sometimes it
would be to the person to whom cash had been given. Because the
investigators did not know beforehand what the tastes and preferences of the
subjects were, their prediction was that approximately half of the pairs
would engage in an exchange.
Second was a proposition about the prices at which the exchanges would
take place. Because of the role reversals and the repetition of the possible
exchanges, each subject found herself alternately in the role of seller and
buyer of the same object. The prediction of the experimenters was that the
prices asked by subjects in their role as sellers ought to be roughly the same
as the prices bid by them in their role as buyers.
The experiments confirmed neither of these propositions. First, far fewer
transactions took place than the theory predicted - approximately half those
anticipated. Second, the prices asked by those who were willing to sell and
those bid by those who were willing to buy were not in equilibrium. The
ratio of the median selling price and the median buying price was
806 Rational Choice Theory in Law and Economics 0710
approximately 2 to 1. These results were invariant to the objects being
exchanged and to other important factors.
9. Choice under Uncertainty
The rational choice theory of decision making under uncertainty posits that
decision makers attempt to maximize their expected utility by combining
three elements: their attitudes toward risk (risk neutrality, risk preferring, or,
the most commonly-assumed attitude, risk aversion); their stable,
well-ordered preferences for the possible outcomes; and estimates of the
likelihood of the various possible outcomes. But some recent experimental
results suggest that this is not an accurate description of how many people
make decisions about uncertain outcomes.
9.1 Preference Reversals
Consider the following choice under uncertainty. There are two gambles,
call them H and L. H entails a high probability of winning a small prize,
say, a 90 percent chance of winning $4. L entails a low probability of
winning a larger sum, say, a 10 percent chance of winning $40. When
presented with these alternatives, most people choose H. The subjects were
then asked to say for what price they would be willing to sell each gamble if
they owned it (as, say, a lottery ticket). Surprisingly, most subjects put a
higher price on L than on H (Lichtenstein and Slovic, 1971). This is
surprising because the expected value (the product of the probability of
winning and the value of winning) is almost identical in the examples given.
What is curious about this is that although when put to a choice between H
and L most people choose H, when asked to price the two gambles, most
people attribute a higher selling price to L than to H, which indicates that
they find L more valuable than H. The figures are dramatic. One scholar
reports that in a recent replication of the experiment that used the values
given above, 71 percent of the subjects preferred H but 67 percent priced L
above H (Thaler, 1992, p. 84). If one had predicted an outcome on the basis
of expected utility maximization, one would have confidently predicted that
these choices would have been consistent. That is, if H were preferred to L,
then the imputed selling price of H would have been higher than that of L
and vice versa. But that consistency is not at all what the experimenters have
found.
This curious phenomenon is called preference reversal. In so far as
there is a simple explanation for these reversals, it is that people apparently
use the payoffs rather than the expected values of gambles in pricing them.
What is troubling about this explanation for rational choice theory is that if
it is true, it can lead people to the sort of inconsistent and seemingly
0710 Rational Choice Theory in Law and Economics 807
irrational choices shown in the experiments. In the extreme, of course, one
can make sport of people who behave in this fashion by getting them to
make preposterous offers for very low probability gambles that have huge
monetary payoffs, a fact that may be evident to the organizers of
state-operated lotteries (Grether and Plott, 1979).
Three possible explanations have been given for preference reversals:
intransitive preferences, procedure invariance and violations of the
independence axiom. Let us take these possibilities up in turn.
As we have already seen, one of the common definitions of rationality in
economics is that preference orderings exhibit transitivity. It is easy to see
that the preference-reversal phenomenon might imply intransitive
preferences. A rational person ought to be roughly indifferent between the
imputed cash value of H and H itself. Similarly, a rational person ought to
be roughly indifferent between the imputed cash value of L and L itself. If,
therefore, one prefers H to L, then she ought, by transitivity, to prefer the
cash value of H to the cash value of L. But preference reversal means that
when H is preferred to L, the cash value of L is preferred to the cash value of
H. It turns out that this pattern of preferences is intransitive only if
something called procedural invariance does not hold.
Procedural invariance refers to a results being invariant to the
particular procedure designed to measure it. And most scientific
investigation presumes procedural invariance to hold. The distance from
Berlin to Munich should be the same whether we start our measurement in
Berlin and go south or in Munich and go north. In the context of choice
under uncertainty, the phrase refers to the invariance of preference rankings
when the investigator uses different means of eliciting the subjects
preferences. It is standard in modern economics to say that A is preferred to
B if A is selected when both A and B are available or if the subject has a
higher reservation price for A than for B. That is, we can determine the
preference ranking by two different procedures: either presenting the subject
with the choice and seeing which she chooses or by asking the subject which
good has the higher reservation price per unit. It is almost never stated as an
axiom in microeconomics (but probably should be) that these different
procedures must yield the same result. The notion is that the preference
ranking of A and B is (or ought to be) independent of the procedure by
which the investigator determines that ranking. As a result, the preference
equivalence of the cash value of H and H itself and that of the cash value of
L and L itself is the result of an assumption of procedural invariance.
The third possibility is that the subjects violate the independence axiom
of expected-utility theory. That axiom says, in essence, that if you prefer X to
Y, then you should also prefer the chance to win X with probability p to the
chance to win Y with probability p. This seems as straightforwardly
808 Rational Choice Theory in Law and Economics 0710
appealing as does the axiom of transitivity, but it turns out that the
independence axiom is sometimes violated in decision making under
uncertainty (Machina, 1990). The preference-reversal phenomenon would
clearly be a violation of this axiom.
9.2 Intertemporal Choice
Decision making over uncertain outcomes frequently involves choosing
between a current and a future outcome or between two future outcomes.
There is a standard, rational-choice-based theory of this allocation of
resources over time, but there is now experimental evidence that contradicts
this theory. People seem not to be fully aware of the special problems and
opportunities that the passage of time raises. As a result, they frequently
make decisions about the allocation of resources over time that seem to be
difficult to square with rational choice theory. Take the example of paying
income taxes. Many taxpayers routinely have too much income tax withheld
during the year so that they can receive a refund from the Internal Revenue
Service after filing their tax returns in the Spring of the following year. This
over-withholding constitutes an interest-free loan to the federal government.
The taxpayers who currently do this would be better off (according to
rational choice theory) if they were to reduce the amount withheld so that at
the end of the year they neither owed money to nor were owed money by the
IRS.
At the other extreme are examples of absurdly high discount rates. For
example, people routinely ignore the warnings of dermatologists that
over-exposure to the sun can cause skin cancer later in life, apparently
preferring the current benefits of a suntan. But they may pay attention if the
dermatologist tells them that the sun may cause large pores or blackheads in
the near future. Most homeowners do not have nearly enough insulation in
their attics and walls, even though the cost of installing more would lead to
significant savings on energy use within one year. Nor do they buy more
expensive energy-efficient appliances, even though the energy-use savings
will more than make up for the increased purchase price within a year.
Economists have calculated that the purchase of the lower-priced, less
efficient appliances implies a discount rate of between 45 percent and 130
percent at low energy costs and between 120 percent and 300 percent at
higher energy costs. Either set of discount rates is absurdly high.
Why do people make such anomalous decisions where intertemporal
choice is involved? One of the most robust findings in the experimental
literature is that discount rates decline sharply with the length of time that
the subject must wait for her reward and with the size of the reward. These
experimental results are not consistent with rational choice theory, which
holds that discount rates should generally equal the market rate of interest,
that the discount rates should be constant (that is, invariant to the period of
0710 Rational Choice Theory in Law and Economics 809
time considered) and certainly invariant with respect to the amount of
money involved. The difficulty posed by the declining discount rate as the
date of the reward recedes further into the future is that it implies an
anomalous preference reversal. This is because the individuals preference as
between, say, Project A and Project B could initially be in favor of A
(because it is, let us assume, the nearer in time) and then switch to B, all
other things remaining equal, if the time at which B will be realized is
brought forward (but is still realized after A is realized). If discount rates are
constant, this sort of switching, all other things equal, cannot occur
(Loewenstein and Elster, 1992).
The effect of the size of the reward on the discount rate is as strong as
the effect of time delay. The general problem is that people perceive the
difference between $100 today and $150 in a year as greater than the
difference between $10 today and $15 in a year. As a result, many people are
willing to wait for the extra $50 in the first instance but not for the extra $5
in the second instance. Rational choice theory cannot explain this robust
experimental result. Shefrin and Thaler have proposed that the explanation
lies in how people take mental account of small and large windfalls. They
hypothesize that small windfall gains are put into a mental account that
allows for immediate consumption, while large windfall amounts are put
into a separate mental account for which there is a much lower propensity
for immediate consumption. Thus, the opportunity cost of waiting for a
small windfall may be perceived to be foregone consumption. But the
opportunity cost of waiting for a large windfall will be foregone interest or
investment. If foregone consumption is more difficult to resist than foregone
interest or investment, that would explain the observed effect of the size of
the award causing a decline in the discount rate (Shefrin and Thaler, 1988).
D. Implications of the Criticisms of Rational Choice Theory for the
Economic Analysis of Law
As we have seen, law and economics has premised much of its scholarship
on rational choice theory. Therefore, the implications of the literature
critical of that theory for law and economics are profound. In this part I want
to focus on four of those implications - on the relationship between
transactions costs and the law, on the choice between mandatory and default
rules in the law, on the best means of dealing with risky decisions by
consumers and on some issues in tort law.
810 Rational Choice Theory in Law and Economics 0710
10. The Coase Theorem and Criticisms of Rational Choice Theory
The most famous piece of scholarship in law and economics is The Problem
of Social Cost by Professor Ronald Coase (1960). The broad inquiry to
which that article is addressed is this: when may society rely upon
bargaining to achieve the efficient use of resources and when may it not?
That inquiry then leads to a discussion of how the law should be structured
so as to encourage efficient resource use in those circumstances in which it
is inappropriate to rely upon bargaining. The Coase Theorem says that when
there are no impediments to exchange (that is, when transaction costs are
zero), the efficient use of resources will result, regardless of the assignment
of property rights. Appropriate legal policy depends on being able to identify
impediments to exchange and to specify correctives when those impediments
are significant. Law and economics scholarship has concentrated on search,
bargaining and enforcement costs as the elements of transaction costs and
has sought to identify the objective characteristics of transactions (for
example, the number of people involved, whether the transaction is for a
fungible or a unique item and so on) that cause these three elements of the
costs of exchange to be high.
The literature reported in Section 8 has two important implications for
the standard view of the Coase Theorem. First, the reported results on
cooperation and fairness suggest that people are far more ready to cooperate
and that they have a much stronger sense of what is an equitable outcome
than rational choice theory predicts. These conclusions point in two very
different directions on the Coase Theorem. On the one hand, the broad
willingness to cooperate (as revealed in the public goods experiments)
suggests that voluntary exchange may be able to achieve an efficient
allocation in a broader range of circumstances than those of zero transaction
costs and, further, that the need to intervene in private decision making to
enhance efficiency, even when transaction costs are positive and significant,
may be less than previously thought. For example, if people appear to be
more willing to contribute to the provision of public goods than rational
choice theory predicts, then there may be less need for the compulsory public
subsidization of those goods or the level of subsidization can be less
extensive. There are implications, too, regarding the need for or the most
appropriate structure of environmental regulations - for example, people
may be more willing to bestow the external benefits of
environmentally-conscious activity than previously supposed.
On the other hand, the finding of the experimental literature that people
appear to be extremely sensitive to the equitable distribution of resources
suggests that more intervention in private decision making may be justifiable
than previously thought. This is because the experiments suggest that people
0710 Rational Choice Theory in Law and Economics 811
may be so sensitive to fairness issues that they would rather not cooperate
than cooperate on terms that they consider to be excessively one-sided. This
is a cause for the failure of bargaining that has not heretofore been given
much weight. Even when transaction costs are very low, some otherwise
efficient exchanges will not take place because some of the participants do
not like the proposed division of the cooperative surplus. The experimental
findings provide an efficiency justification for legal intervention in private
decision making in order to prevent over-reaching by one of the parties that
might forestall an otherwise efficiency-enhancing exchange.
The second major implication for the Coase Theorem of the criticisms
reported in Section 8 arises from the endowment effect (or status quo bias).
Recall that that effect suggested two anomalies in bargaining behavior: first,
when transaction costs were very low, people were far more reluctant to
transact than rational choice theory predicted and, second, subjects typically
demanded twice as much to sell something they owned as they were willing
to pay in order to acquire it. The troubling implication of those findings is
that there may be cases in which there is no such thing as a uniquely
efficient assignment of rights. Where society initially assigns an entitlement
is where it is likely to remain; we should be far less sanguine about
entitlements moving to their highest-valued use, even when transaction costs
are zero, than we have been heretofore. (Indeed, status quo bias makes the
notion of highest valuing use less clear.)
11. Default and Mandatory Rules and the Criticisms of Rational Choice
Theory
If one assumes, as does law and economics, that the law can increase the
efficient use of resources by creating rules of conduct that correct for market
failures, two issues that must be resolved are, first, the specification of a rule
or standard and, second, whether that rule or standard is mandatory or may
be waived by those affected. One of the areas of the law in which this issue
has been central is corporation law. There the debate has been between those
who favor non-waivable mandatory rules of corporate conduct and those
who favor allowing corporations to opt out of some rules. Consider, for
example, insider trading. Everyone admits that there are potential
inefficiencies from allowing insider trading, although there are
disagreements about the extent and likelihood of these inefficiencies. Most
commentators, therefore, agree that there ought to be some legal regulation
of the practice. However, there is disagreement about whether this regulation
should take the form of a prohibition or merely a default rule from which
those corporations that so choose might wish to opt out. Those who favor
812 Rational Choice Theory in Law and Economics 0710
making the prohibition waivable argue that some corporations might wish to
offer their managers partial compensation in the form of allowing them to
trade on the basis of the inside information that they acquire in the course of
working for the corporation. If that method of compensation is more
efficient than the alternatives, then, the argument goes, those corporations
and their managers ought to be allowed to opt out of the default rule. The
other side argues that both private and public difficulties in policing the
behavior of managers make the realization of those efficiencies illusory.
Thus, they argue, the prohibition of insider trading should be non-waivable.
How are the findings of Part C relevant to this issue? Status-quo bias
suggests that people will not make changes away from a default position
unless the expected benefits from so doing substantially exceed the expected
costs. That is, the default position has a strong anchoring effect. With
respect to insider trading rules, the presence of status-quo bias might
indicate that even if the prohibition on insider trading was waivable, very
few corporations would take advantage of that waivability.
There is another relevant implication of status-quo bias. If most people
are reluctant to leave the status quo, whatever that is, then the law ought to
establish the starting position (that is, establish the status quo) at an efficient
point. In the case of insider trading that might suggest that the appropriate
starting point is a prohibition of the practice, not the freedom to engage in
the practice unless ones employer has forbidden it. This sort of
consideration no doubt has other applications in the law well beyond
corporation law. For instance, it may say something about whether society
should make the status quo one in which addictive drugs are legal or one in
which they are illegal but one may (explicitly or implicitly) opt out of this
illegality. (For the implications of status quo bias for a broad range of
contract issues, see Korobkin, 1998.)
12. Risk Regulation and the Criticisms of Rational Choice Theory
The regulation of risk is a topic upon which there is very large and growing
literature and about which there is a surprising lack of consensus. Many are
convinced that the panoply of regulations dealing with risky behavior is not
well conceived and the criticisms of rational choice under uncertainty
contribute to an understanding of this position. Recall that, broadly
speaking, people do not seem to do a very good job of appraising risky
outcomes. For example, they tend to overestimate the value of
low-probability, high-payoff gambles. And because of status-quo bias, they
prefer a known, high risk to an unknown, low risk. These imperfections in
the way people deal with risk may motivate them to demand legislative
regulation of risk that reflects their own, not entirely coherent, views. For
0710 Rational Choice Theory in Law and Economics 813
example, on an average day in the United States 30 people are killed on the
job, 56 are killed in accidents in the home, 133 die in automobile accidents
and 4,000 die from cancer. Of those who die each day from cancer, 30
percent of those deaths are attributable to tobacco; 4 percent are attributable
to cancers arising from occupational hazards; 1 percent to medical
treatment; and 2 percent to air and water pollution (Breyer, 1993). All other
things equal, these figures would suggest two predictions about current
regulations designed to minimize the harms from risky activities: first, that a
large amount of effort ought to be directed at reducing the risk of cancer and
second, that a large portion of the cancer-reducing effort ought to be directed
at tobacco-related cancers. Neither prediction is correct. Rather, the risk
regulation of the United States government has a willy-nilly aspect with
little rational regard for the value of the good it might be doing. For
instance, there is no single implicit value of a life saved that is used by the
federal government in regulating risk. Rather, the governments regulations
imply that the value of a life saved ranges from $10,000 to $1 billion
(Viscusi, 1992).
Just bringing coherence to risk regulation would be a substantial
improvement in the efficient allocation of governmental resources. But the
experiments on decision making under uncertainty described in Section 8
suggest an important new way of looking at the regulation of risk.
Heretofore, much government risk regulation has been premised on the
belief that individuals make errors in dealing with risk because they do not
have correct information. If they had that information, they would make the
appropriate maximizing decision. Thus, the governments role ought
principally to be to disseminate accurate information to assist individuals
and organizations in their decision making. But the material on
intertemporal choice in Part C suggests that even if they had the appropriate
information, some people would not make the right decision about risky
activities.
How these insights should translate into a reform of risk regulation is a
very broad issue. Here I want only to suggest that they might lead to
principled justifications for far more paternalistic policies than those that
rational choice theory typically recommends. For instance, where rational
choice theory might suggest that the comparison of the costs and benefits of
wearing motorcycle helmets ought to be left to motorcyclists so long as they
are well-informed about the true costs and benefits, the findings about
mistakes in intertemporal choice and in the assessment of risk imply that
motorcyclists will always underestimate the benefits of wearing helmets and
that, therefore, the best regulation for minimizing head injuries among
motorcyclists may be one mandating helmet-wearing. These are significant
differences in policy and we must wait on further empirical work to clarify
the extent of the cognitive errors and the various policy choices before us.
814 Rational Choice Theory in Law and Economics 0710
13. Tort Law and the Criticisms of Rational Choice Theory
Finally, I come to the issue of whether the anomalies discussed in Part C
affect the economic analysis of tort law. The connection between those
anomalies and the economic analysis turns, I think, on this central issue: the
economic analysis perceives that potential victims and potential injurers are
capable of understanding and acting rationally in response to the
implications of the tort liability system for their choices about which
activities to pursue, how and when to pursue those activities, how cautious
they should be, how much they should spend on warnings of danger to
others and the like. If those whose behavior we seek to affect by imposing
tort liability do not have the cognitive abilities to understand and act in
accord with the laws desires, then we should not be surprised to learn that
the tort liability system is not achieving its desired efficiency ends. For
example, if decision makers make systematic errors when faced with
uncertain outcomes or if they are systematically overconfident about their
abilities to avoid an accident or injury, then they may behave in ways that
are contrary to those anticipated by rational choice theory. The next sections
seek to clarify how these imperfections might influence several issues in the
economic analysis of tort liability.
13.1 The Choice Between Statutory Regulation and the Risk-Utility Test
There are two important points to be made about the efficiency of negligence
and of strict liability. First, within negligence there are two very different
means of determining whether someone had complied with a legal duty of
care. In one set of circumstances compliance is determined by comparing the
victims or injurers actions with a clear rule - for example, a speed limit or
manufacturing standard proposed by an administrative agency (or possibly
by some respected private standard-setting group). This sort of negligence
(negligence per se) is relatively easy for the court to determine and easy for
potential injurers and victims to perceive and to follow. No sophisticated
calculations are required and, therefore, the demands on the cognitive
abilities of the potential victim and injurer are not large.
The other, more common form of negligence delegates to potential
injurers and potential victims the determination of the appropriate amount of
care to take. There is no hard-and-fast rule specifying the suitable amount of
precaution; rather, each potential victim and potential injurer calculates
what is appropriate in the understanding that, in the event of an accident, a
court may check those calculations to see if they have been done reasonably.
This standard of due care is frequently determined according to a
risk-utility test or the Hand Test. The court assumes that the parties who
may injure or be injured compare the costs of precaution with the benefits of
0710 Rational Choice Theory in Law and Economics 815
taking precaution (the reduction in the probability and severity of an
accident) and that they will take all cost-justified precaution - that is,
precaution that confers greater (expected) benefits than it costs.
The cognitive demands of the risk-utility test are substantial. In order to
comply with the legal duties imposed by negligence, potential injurers and
victims must independently form an estimate of the probability of an
accidents occurring as a function of the amount of precaution they take and
an estimate of the size of the accident losses that will result from various
levels of precaution. An implication of the experiments noted in Part C
above is that potential injurers and victims may make systematic errors in
these calculations.
The potential shortcomings of human decision making with regard to
risk may be the key to understanding when it is socially efficient to use the
rule-like negligence per se and the due-care standard. Put simply, if one
believes that those likely to be involved in a particular kind of accident are
prone to cognitive errors and limitations, then the more appropriate method
of achieving social efficiency (in the sense of minimizing the social costs of
accidents) would be to state rules with which it is relatively easy to comply.
13.2 Strict Liability and Negligence
Recall that the law and economics literature has identified one principal
factor that should figure in the efficient choice between negligence and strict
liability: whether precaution is unilateral or bilateral. The presence of
cognitive errors and limitations in the ability to perceive and act rationally
upon risk complicates this distinction between unilateral and bilateral
precaution. It is not unlikely that situations arise in which both the potential
injurer and the potential victim could have taken precaution that would
reduce the expected social costs of accidents but in which one of the two
parties was very much less likely to have experience with the sort of
calculations of risk and expectation that the economic theory supposes that
both parties have. That is, a cognitive limitation in dealing with uncertain
outcomes may be an independent factor in determining whether precaution
was unilateral or bilateral and, therefore, in choosing between negligence
and strict liability.
Consider, for example, product-related accidents. Suppose that we were
free to decide for the first time which form of liability to use in those
accidents and suppose further that we intend to use the economic theory
exclusively in reaching our decision. Which form of liability - negligence or
strict liability - ought we to use in order to minimize the social cost of
product-related accidents? We might conclude that precaution is bilateral:
producers can reduce the likelihood and severity of accidents by taking care
in the design and manufacture of their goods and by warning consumers of
816 Rational Choice Theory in Law and Economics 0710
any non-obvious dangers; consumers can reduce the expected social costs of
accidents by taking care in the use of the product, by following the
manufacturers instructions, by using the product in a manner that it was
intended that it be used and so on. But suppose that we make one more
assumption - namely, that producers have much greater facility in making
decisions about uncertain outcomes than do consumer because consumers
are prone to the sort of miscalculations that we noted in Part C. We might
now doubt that precaution is truly bilateral. Perfectly rational consumers
might be able to calculate the appropriate level of risk and the expected level
of accident costs, given different levels of precaution, but these are not, by
assumption, perfectly rational consumers. They will make errors;
importantly, they will make more and more costly errors than will
producers. If so, then a situation that assumed the affected parties to be
rational and that precaution was bilateral becomes one in which only one of
the parties is reliably rational and there is, therefore, unilateral precaution.
This makes out an argument for treating at least some product-related
accidents under the strict liability rule. To put the point more generally, I am
suggesting that the recognition that there may be cognitive limitations
among potential victims and injurers should alter the search for the
appropriate liability standard from one in which the law looks for the
least-cost avoider to one in which the law looks for the least-cost decision
maker or least irrational party.
14. Conclusion
We have seen how important rational choice theory is to law and economics.
But we have also seen that there is an increasing body of experimental work
that questions some of the assumptions of that theory. We must amend the
rational-choice model, but precisely how we should amend the model is not
yet clear. I want to conclude with a cautionary statement about the crucial
questions that must be addressed in undertaking these emendations in
rational choice theory and in drawing conclusions about law on the basis of
these emendations.
Some may mistakenly think that we are put to a stark choice between, on
the one hand, rational choice theory and, on the other hand, the extreme
position that no coherent theory of human decision making is possible. That
is a dangerous illusion. A synthesis is possible and is, I believe, coming. But
it is not yet here and until it is, we must remain uncomfortably in the middle
- somewhat skeptical about rational choice theory but not so skeptical that
we abandon that theory. To see the dangers of moving too far, too fast in the
application of Part Cs findings, consider the experiments that suggest that
cooperation in the provision of a public good is much more likely than
0710 Rational Choice Theory in Law and Economics 817
rational choice theory predicts. This is, so far, merely suggestive; it is not a
complete guide to behavior. Therefore, no one could responsibly use these
experiments as a warrant for cutting the public subsidies for basic research
and public television or for laxer enforcement of the intellectual property
laws. Before we make policy pronouncements on the basis of these
anomalies, we need to know much more. The implication of some of the
experimenters is that their findings apply to all decision makers in all
circumstances. But that seems highly unlikely. Surely there are important
differences among circumstances and among people. There may be some
people who always obey the predictions of rational choice theory; there may
be some circumstances in which no one obeys those predictions. And there
may be more subtle differences. For example, are there systematic
differences in the dispensation to cooperate by age and gender? Are there
objective circumstances about the manner in which the cooperation is
solicited (for example, how long the people have known each other and
whether they are allowed to communicate) that lead to a greater likelihood
of cooperation? How robust is the finding that repeated playing leads to a
diminution of the propensity to cooperate? These and many more questions
need to be addressed.
Some day, perhaps soon, we shall have a complete account of human
decision making than that provided by rational choice theory. And when we
do, that account will greatly enhance our understanding of the law and our
ability to draft the law for desirable ends.
Acknowledgements
The author would like to thank an anonymous referee for helpful comments.
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38 Journal of Public Economics, 291-305.
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Economy, 1-13.
Becker, Gary (1968) Crime and Punishment: an Economic Approach, 76 Journal of Political
Economy, 169-217.
Breyer, Stephen (1993), Breaking the Vicious Circle, Cambridge, MA, Harvard University Press.
Coase, Ronald A. (1960), The Problem of Social Cost, 3 Journal of Law and Economics, 1-28.
818 Rational Choice Theory in Law and Economics 0710
Cooter, Robert D. and Ulen, Thomas S. (1997), Law and Economics, (2nd edn), Reading, MA,
Addison-Wesley-Longman.
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Co.
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Guth, Werner, Schmittberger, Rolf and Schwarze, Bernd (1982), An Experimental Analysis of
Ultimatum Bargaining, 3 Journal of Economic Behavior and Organization, 367- 383.
Kahneman, Daniel, Knetsch, Jack and Thaler, Richard (1986), Fairness as a Constraint on Profit
Seeking: Entitlements in the Market, 76 American Economic Review, 728-741.
Korobkin, Russell (1994), Policymaking and the Offer/Ask Price Gap: Toward a Theory of
Efficient Entitlement Allocation, 46 Stanford Law Review, 663-708.
Korobkin, Russell (1998), The Status Quo Bias and Contract Default Rules, 83 Cornell Law
Review, 608-687.
Lichtenstein, Sarah and Slovic, Paul (1971), Reversals of Preference between Bids and Choices in
Gambling Decisions, 89 Journal of Experimental Psychology, 46-61.
Liebenstein, Harvey (1950), Bandwagon, Snob and Veblen Effects in the Theory of Consumers
Demand, 64 Quarterly Journal of Economics, 183-201.
Loewenstein, George and Elster, John (eds) (1992), Choice Over Time, New York, Russell Sage
Foundation.
Machina, Mark (1990), Expected Utility Hypothesis, in John Eatwell, Milgate, Murray and
Newman, Peter (eds), The New Palgrave: Utility and Probability, London, Macmillan
Publishing.
Marwell, Gerald and Ames, Ruth (1981), Economists Free Ride, Does Anyone Else?, 15 Journal
of Public Economics, 295-310.
Nozick, Robert (1993), The Nature of Rationality, Princeton, Princeton University Press.
Plous, Scott (1993), The Psychology of Judgment and Decision Making, New York,
McGraw-Hill.
Posner, Richard A. (1998), Economic Analysis of Law, (4th edn), Boston, MA, Aspen Publishing
Co.
Samuelson, William and Zeckhauser, Richard (1988), Status Quo Bias in Decision Making, 1
Journal of Risk and Uncertainty, 7-17.
Shefrin, Hersh and Thaler, Richard (1988), The Behavioral Life-cycle Hypothesis, 26 Economic
Inquiry, 609-643.
Thaler, Richard (1992), The Winners Curse, New York, W.W. Norton & Co.
Ulen, Thomas S. (1994), Rational Choice Theory and the Economic Analysis of Law, 19 Law and
Social Inquiry, 487-522.
Ulen, Thomas S. (1998), The Growing Pains of Behavioral Law and Economics, Vanderbilt Law
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Viscusi, W. Kip (1992), Fatal Tradeoffs: Public and Private Responsibilities for Risk, New York,
Oxford University Press.
Wilson, James Q. and Abrahamse, Alan (1992), Does Crime Pay?, 9 Justice Quarterly, 359-377.
0720
THE ENDOWMENT EFFECT
Christopher Curran
Associate Professor, Emory University
Copyright 1999 Christopher Curran
Abstract
This chapter reviews the literature on the endowment effect that challenges the
validity of using neoclassical economic theory to evaluate legal issues. While
a consensus does not yet exist, much of the research suggests that the
endowment effect phenomena does not offer as much of a challenge to
neoclassical economic theory as was once thought.
JEL classification: D0, D6
Keywords: Endowment Effect, Experimental Economics
1. Introduction
This essay discusses the issue of whether the results of recent experimental
research on consumer behavior undermines the conclusions of neoclassical
economics enough to render arguments based on that theory incorrect. This
entry is not a thorough review of the rich experimental economics literature
(see Kahneman, Knetsch and Thaler, 1991) for summary of much of this
research and Conlisk, 1996, for a statement of the case for using the notion of
bounded rationality in economics). Instead, we focus on the possibility that the
phenomena known as the endowment effect may provide evidence that
questions the applicability of some of the basic assumptions made by
economists about consumer rationality. After describing the endowment effect
and some of the theories used to take account of this effect, we recount how
some law and economics scholars use the endowment effect in their analyses.
2. The Endowment Effect
The endowment effect arises when consumers willingness to accept (WTA) for
a good is greater than their willingness to pay (WTP) for it. While economists
have long recognized that an income effect may make cause the WTA to be
819
820 The Endowment Effect 0720
greater than the WTP, they accepted the conclusion by Willig (1976) that these
differences should be small. While psychologists had noted a difference
between the WTP and WTA as early as the 1960s (see Coombs, Bezembinder,
and Goode, 1967, and Slovic and Lichtenstein, 1968), economists only began
to focus on the issue after observing this difference when using surveys to
measure the value of environmental projects. When the economists asked
consumers about both their WTP and their WTA in these surveys, they found
that the reported WTA is much larger than the reported WTP - much larger
than Willigs predictions suggest. Using students as subjects and goods such as
coffee mugs, candy bars and trees as the commodities, experimental economists
have been able to find evidence that their subjects often have a WTA that is
substantially greater than their WTP (see, for example, Bishop, Heberlein and
Kealy, 1983; Knetsch, 1984; Knetsch and Borcherding, 1979; Knetsch and
Sinden, 1984; Brookshire and Coursey, 1987; Samuelson and Zeckhauser,
1988; Quattrone and Tversky, 1988; Donohue, 1989; Harless, 1989; Knetsch,
1989; Kahneman, Knetsch and Thaler, 1990; Ortona and Scacciati, 1992;
Boyce et al., 1992; Shogren et al., 1994; Loewenstein and Adler, 1995; Sileo,
1995; Pratt and Zeckhauser, 1996, for evidence about, explanations of and
implications of the endowment effect; Hoffman and Spitzer, 1993, offer an
excellent summary of the results of both the empirical and theoretical research).
3. Format of the Experiments
The formats used these experiments follow a regular pattern. The experimental
researchers randomly split the subjects into two groups. They give each of the
members of one group some object - say a coffee mug or a candy bar - and then
offer to buy the object back from them using some truth-revealing mechanism.
The researchers then give the members of the other group money and then
allow the subjects to purchase the object offered to the first group, again using
a truth-revealing mechanism. (There are a large number of variations on the
structure of the various experiments; see these studies or Hoffman and Spitzer,
1993, for more details of the different experiments.) The researchers report
potentially conflicting evidence indicating (1) that the endowment effect is
persistent and substantive, (2) that the endowment effect, while evident
initially, tends to disappear over time and (3) that there is no difference in the
WTP and the WTA.
0720 The Endowment Effect 821
4. Preference for the Status Quo
Studies that find evidence of the endowment effect suggest that consumers may
have a greater preference for the status quo than what the assumption of
rationality implies. Several criticisms have been leveled at the studies that find
evidence of an endowment effect. For instance, some authors reject the use of
hypothetical questions and experiments involving small amounts of money as
revealing little about a subjects actual behavior in the market place (see
Hoffman and Spitzer, 1993, p. 69, n. 23). Other authors question whether the
subjects really understand what they are being asked and whether the effect will
remain after repeated experiments. Unfortunately, the evidence on these points
is mixed; while some studies find evidence that the WTP is equal to the WTA
in experiments involving simple securities (see Kahneman, Knetsch and
Thaler, 1990, pp. 1329-1330; Harless, 1989), other studies reach the opposite
conclusion for simple securities (see, for instance, Knez, Smith and Williams,
1985) and for more complicated securities involving risk (see, for instance,
McClelland and Schulze, 1991).
5. Prospect Theory
The experimental evidence has generated several attempts to provide a
theoretical explanation of the endowment effect. We briefly review two
contrasting explanations here, referring the reader to Hoffman and Spitzer
(1993, pp. 85-96), Radin (1982), Heiner (1983) and Thaler (1980) for examples
of and a fuller discussion of the theoretical literature generated by the
endowment effect. The first of these explanations - usually identified as a
version of prospect theory - assumes that individuals have a preference for the
status quo. Originally, Kahneman and Tversky (1979) suggested this model to
describe human behavior in risky circumstances. (Also, see Tversky and
Kahneman, 1991; Tversky and Wakker, 1995.) Later, Thaler (1980) and
Kahneman, Knetsch and Thaler (1990) use elements from prospect theory to
explain the endowment effect. Kahneman and Tversky (1979) assume that
consumers have a value function that is positively sloped, concave for gains and
convex for losses, implying that individuals are risk-averse with respect to
gains and risk-loving with respect to losses. Figure 1 illustrates the value
function suggested by Kahneman and Tversky (1979).
822 The Endowment Effect 0720
Figure 1
The Value Function Proposed in Prospect Theory
6. Prospect Theory and the Endowment Effect
Figure 2 illustrates how prospect theory might explain the endowment effect.
We start with an individual owning quantity A of some good and ask how
much he would be willing to pay to acquire the larger quantity B. Thus, the
vertical distance between points D and C represents the WTP of this individual
to acquire (B - A) units of the good. Now we compare this situation with the
case where the individual already owns B units of the goods and is offered the
opportunity to sell (B - A) units of the good. Since the individual actually owns
B units of the good, we begin at point E (shown in this case to be valued higher
than when the individual did not actually own the good, though it is not
necessarily of higher value) and move to point F. Thus, the vertical distance
between E and F is the individuals WTA, which in this case is greater than his
WTP. The key point is that potential losses have a greater impact on the
individuals value than do potential gains.
7. A Neoclassical Explanation for the Endowment Effect
The second explanation of the endowment effect, developed by Hanemann
(1991), implies that we do not need to scrap neoclassical economic theory to
generate large gaps between an individuals WTP and his WTA. Figure 3,
which illustrates Hanemanns contribution, shows two indifference curves for
0720 The Endowment Effect 823
some good X and wealth. Consider an individuals WTP to move from point
A where he has X0 of good X to point B where he has the same wealth and X1
of good X.
Figure 2
A Prospect Theory Explanation of the Endowment Effect
Since the individual is indifferent between being at point A and point C, the
vertical distance between points B and C measures how much this individual
is willing to pay to move to point B. Now consider how much this individual
is willing to accept to move from point B to point A. Since the individual is
indifferent between being at points B and D, the vertical distance between A
and D measures his willingness to accept the move from point B to A. Figure
3 shows the case where the individuals WTA is greater than his WTP. As
Hanemann (1991) proves, the size of this difference depends on the elasticity
of substitution of the indifference curves - the more inelastic the indifference
curves are, the larger is the spread between the WTA and the WTP. Put another
way, the less substitutable a good is with money, the larger will be the
endowment effect. More importantly, if Hanemanns hypothesis is correct, the
endowment effect observed by experimental economists does not imply that the
neoclassical analysis of welfare economics is fatally flawed. Shogren et al.
(1994) report the results of experiments that lend support to Hanemanns
hypothesis.
824 The Endowment Effect 0720
8. Reception of the Endowment Effect in Law and Economics Scholarship
Scholars in law and economics have given the endowment effect a mixed
reception. Some authors such as Knetsch and Borcherding (1979), Hovenkamp
(1991), Hoffman and Spitzer (1993) and Fischel (1995) accept the endowment
effect as a real phenomena with serious implications for the study of legal
issues while others such as Curran and Rubin (1995), while analyzing the
implications of the endowment effect, seem to doubt its existence. A majority
of legal scholars ignore the existence of an endowment effect.
9. The Hovenkamp Critique
Hovenkamp (1991) claims that the endowment effect has very significant
implications for the study of law and economics because it potentially
undermines the validity of traditional results from welfare economics. As
Hovenkamp argues, the equality of WTP and WTA is central to the
construction
of demand curves, the estimation of consumers surplus, the use of cost-benefits
analyses and the use of indifference curves. He carries the argument further
when he suggests that, when the endowment effect exists, the person has no
indifference curve. (Hovenkamp, 1991, p. 226). Thus, he concludes that an
endowment effect that is substantial and ubiquitous could make [the tools of
welfare economics] virtually useless. (Hovenkamp, 1991, p. 227).
Figure 3
Hanemanns Explanation of the Endowment Effect
0720 The Endowment Effect 825
10. On Using WTP or WTA Measures of Value
Having rejected the traditional tools of neoclassical welfare analysis as virtually
useless, Hovenkamp tackles the problem of whether courts should continue use
the market price, which is equal to the WTP, as a measure of the value of
property in cases involving eminent domain, environmental regulation and
torts. While Hovenkamps reasoning differs from that used in earlier studies by
Knetsch and Sinden (1984) and Kennedy (1981), he reaches the similar
conclusion that courts should use WTA as a measure of value. Moreover,
Hovenkamp argues that in the presence of a large endowment effect, the
wealth-maximizing state may find it appropriate to intervene on behalf of the
poor more often than under traditional efficiency models. Hovenkamp (1991,
p. 228)
11. The Superiority of the WTA Measure of Value
It is useful to review Hovenkamps reasoning. Consider an entitlement in a
world with significant differences in individuals WTP and WTA. There is an
individual who has the largest WTA if he owns the entitlement - say individual
A. Additionally, there is an individual - say individual P - who has the largest
WTP for this entitlement. In a competitive world with transacting being
costless, ownership of the entitlement will end up with individual P unless it
originally belongs to some individual with a WTA that is higher than the WTP
of individual P. Hovenkamp argues that, while this outcome is Pareto optimal,
there exist other arrangements where the total wealth of society is higher. In
particular, social wealth is maximized if entitlements begin in the hands of
those who have the largest WTA - person A in our example. Thus, Hovenkamp
concludes that entitlements should be assigned to those with the highest WTA.
12. The WTA Measure of Value and the Distribution of Income
Hovenkamp connects his analysis to income redistribution by arguing that,
while there are no systematic differences in individuals WTA associated with
income differences, there is good reason to believe that an individuals WTP is
a positive function of income. Moreover, Hovenkamp argues that the
WTA-to-WTP ratio is much higher for the poor than it is for the rich, a point
that Curran and Rubin (1995) implicitly do not accept in their criticism of
Hovenkamp. By Hovenkamps logic, transferring endowments to the poor from
the rich will increase the total amount of social value.
826 The Endowment Effect 0720
13. Overcoming Practical Problems
One of the practical difficulties of using WTA as a measure of value when the
WTA and WTP measures differ is the fact that no one ever observes WTA.
Clearly, market prices are an accurate measure of the WTP of the purchaser
and the WTA of the seller; they provide little information about the buyers
WTA once he is the owner. This measurement problem is especially important
in thin markets where there are few substitutes for the good or where a good
cannot be bought and sold. A piece of land that has sentimental value for the
current owner is an example of a good with few substitutes while environmental
goods like clear air and water are examples of goods that have no recognizable
markets. Hovenkamp (1991, pp. 238-243) recognizes this difficulty with using
WTA as a measure of value. He suggests, however, the fact that economic
theory offers policymakers little aid in measuring WTA does not mean that they
cannot use the concept. He suggests that policymakers should turn to
psychologists and sociologists for aid in measuring WTA. Researchers in these
fields, Hovenkamp contends, have many tools - surveys, questionnaires,
interviews and tests - that would help in the measurement of WTA. Gathering
this information is costly. When costs become prohibitive, Hovenkamp suggests
that policymakers resort to generalizations. As an example of such a
generalization, Hovenkamp (1991, p. 243) suggests the fact that biological
organisms have a common set of survival needs and perhaps a common set of
minimal needs for social productivity implies that policymakers can assume
that goods such as these have a WTA that is systematically greater than their
WTP. Economists aware of the problems of rent-seeking common to
governments - and well-documented in the public choice literature - probably
will not share Hovenkamps faith in the ability of policymakers to correctly
identify what goods belong to the common set of survival needs.
14. A Logical Problem
The fact that Hovenkamp rejects neoclassical economic theory presents him
with a logical problem - what, if any, parts of the economic model can he use
in his analysis? Clearly, Hovenkamp offers a theory that purports to
differentiate among the various Pareto optimal points. However, Hovenkamp
(1991, p. 230) does not explain what he means by Pareto optimality in a
world where indifference curves do not exist. Hovenkamp does not resolve this
logical problem by constructing a completely new model of human behavior to
replace the neoclassical economic model. Instead, he assumes that consumers
WTA is larger than their WTP and then borrows concepts from the neoclassical
model when he needs them. While Curran and Rubin (1995) temper their
0720 The Endowment Effect 827
analysis with expressions of concern, they also mix the results of neoclassical
welfare economics in their criticism of Hovenkamp (for which Fischel, 1995,
p. 200, criticizes them).
15. A Constitutional Solution to the WTP/WTA Disparity
Fischel attempts to skirt this problem by substituting constitutionalism for
welfare economics. Fischel argues that the participants at the Federal and the
many state constitutional conventions knew about the endowment effect when
they specified that the market price (WTP) and not the WTA was to be the
measure of just compensation for eminent domain cases. Fischel argues that the
participants of these constitutional conventions understood that using WTP as
a measure of value would increase the ability of the government to exercise its
eminent domain powers. Fischel suggests that one reason these individuals
consistently choose to use the WTP measure of value is that they understood
that using WTA as a measure of value would deter the development of the
nations infrastructure that is so important for economic growth. Moreover, he
suggests that individuals may have an endowment effect when it comes to their
earnings. Fischel posits that in resolving how to measure just compensation
in eminent domain constitution designers considered both (1) the public gain
to society from the taking versus the private loss to the property owner and (2)
the impact of the endowment effect on the property owner (of his land) and on
the taxpayer (on his earnings). The resolution was to use WTP as a measure of
value. Thus, since this resolution of the issue was by the conscience choice of
the members of constitutional conventions, Fischel concludes that the offer/ask
disparity may undermine welfare economics less than is usually supposed.
(Fischel, 1995, p. 187)
16. The Policymakers Problem
Many may not find Fischels assurances that the members of the various
constitutional conventions considered and correctly solved the WTP/WTA
disparity issue satisfactorily. The dilemma facing society is that in deciding
whether to pursue a project, policymakers need to determine if the project is
potentially Pareto improving. To make this determination, they have to estimate
the costs of the project where these costs include the losses in value sustained
by property owners affected by the project. Currently, in the United States
courts use the market value of the property - that is, the WTP - plus some
amount to cover any losses to the owner due to inconvenience. The advantage
of using the WTP is that it is generally inexpensive to measure and avoids the
828 The Endowment Effect 0720
strategic problems inherent in convincing an individual to reveal his true WTA.
As long as the property is a close substitute for wealth, using WTP has the
additional advantage of closely approximating WTA. However, in cases where
the property involved has a great deal of sentimental value - for instance, when
ones ancestors are buried on the land that is to be flooded in order to build a
dam - the use of WTP may substantially underestimate WTA and may lead to
the completion of projects that are not Pareto improving.
17. Reflections from Public Choice Research
Public choice research suggests further complications in restricting government
project to those that are Pareto improving. (For examples of public choice
research on income distribution see Hochman and Peterson, 1974; Gaertner and
Pattanaik, 1988; Lee and McKenzie, 1990; Olson, 1987; Rowley and Peacock,
1975; Stigler, 1970; Tullock, 1971, 1983, 1986.) Interest groups and politicians
often have incentives to engage in rent-seeking activities that would cause them
to systematically ignore WTA measures in favor of the lower WTP measures.
For instance, de Alessi (1960) recounts the many distortions created by
government officials in an effort to use cost-benefit analysis to justify public
projects. Thus, the fact that the members of the federal and various state
constitutional conventions generally were politicians who either were members
of various interest groups or may have been readily influenced by
representatives of these interest groups undermines Fischels constitutional
justification for measuring value with market prices. On the other hand, it
would be surprising if economic scholars find Hovenkamps conclusion that
sociologists and psychologist have tools for accurately measuring WTA to be
very convincing.
18. Conclusion
The obituary for neoclassical economics surely is premature. As Hanemann
(1991), Shogren et al. (1994) and Calfee and Rubin (1992) demonstrate,
neoclassical economic theory predicts that the ratio of WTA to WTP can take
on any value, depending of the elasticity of substitution between a good and
wealth: the lower the elasticity of substitution, the larger the ratio of WTA to
WTP will be. Moreover, as the leading proponent of experimental economics,
Smith (1991, p. 894), observes, for all its deficiencies standard models of
economic behavior based on individual rational choice are excellent predictors
of actual behavior observed in the social context of exchange institutions. It
0720 The Endowment Effect 829
would seem rash to toss out all of neoclassical economic theory based solely on
the evidence offered by the endowment effect.
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Armentano, Dominick T. (1987), Comment: Efficiency, Liberty and Antitrust Policy, in Dorn, James
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0730
THE COASE THEOREM
Steven G. Medema
Associate Professor of Economics, University of Colorado at Denver
Richard O. Zerbe, Jr
University of Washington, Graduate School of Public Affairs
Copyright 1999 Steven G. Medema and Richard O. Zerbe, Jr
Abstract
The Coase theorem has evolved from an illustrative argument in Ronald
Coases The Problem of Social Cost to a centerpiece of the modern law and
economics movement. Along the way, the theorem has generated an enormous
amount of controversy and discussion, including numerous theoretical attempts
at proof and disproof and empirical and experimental analyses of the theorems
applicability. This chapter surveys the literature surrounding the Coase theorem
and presents an outline of the major issues within the Coase theorem debate.
In doing so, it attempts to assess the validity of the various challenges to the
theorems correctness and the implications of those challenges for the
theorems applicability, which is a separate issue. The analysis presented here
illustrates the importance of transaction costs and property rights within the
Coasean bargaining process and the need for further research along these lines
to flesh out their implications law and economics.
JEL classification: K00
Keywords: Efficiency, Externalities, Invariance, Property Rights
1. Introduction
Ronald Coases seminal essay, The Problem of Social Cost (1960), is one of
the most cited articles in the economics and legal literatures, and much of this
attention is owed to a proposition that has come to be known as the Coase
Theorem. While the Coase Theorem is by no means the only idea contained
within that essay, it has captured the attention and interest of economists and
legal scholars as have few other ideas. (For useful treatments of The Problem
of Social Cost as a whole, see Zerbe, 1976; Schlag, 1986; and Medema,
1996a; for context, see Coase, 1937, 1959.) Coase argued that, from an
economic perspective, the goal of the legal system should be to establish a
pattern of rights such that economic efficiency is attained. The legal system
836
0730 The Coase Theorem 837
affects transactions costs and the goal of such a system is to minimize harm or
costs, broadly conceived (Coase, 1960, p. 2). With this in mind Coase (1960,
pp. 2-15) demonstrates the importance of transaction costs by considering the
nature of bargaining or of contracts that could be struck by using an example
of crop damage caused by straying cattle. He noted that negotiations among
affected parties would result in an efficient and invariant outcome under the
standard assumptions of competitive markets (especially, that the costs of
transacting are zero), as long as rights are well-defined. Specifically, it is
necessary to know whether the damaging business is liable or not for damage
caused since without the establishment of this initial delimitation of rights there
can be no market transactions to transfer and recombine them. But the ultimate
result (which maximizes the value of production) is independent of the legal
position if the pricing system is assumed to work without cost (Coase, 1960, p.
8).
This is as close as Coase comes in his essay to stating what has come to be
known as the Coase Theorem.
A. Theorem(s) and Implications
2. Theorem(s)
Although Coase had set forth this idea already in The Federal
Communications Commission (Coase, 1959, p. 27), the first formal statement
of the Coase Theorem did not come until 1966, when George Stigler (1966, p.
113) offered that The Coase theorem ... asserts that under perfect competition
private and social costs will be equal. Subsequently, the Theorem has been
stated in numerous ways, including:
if one assumes rationality, no transaction costs, and no legal impediments to
bargaining, all misallocations of resources would be fully cured in the market by
bargains. (Calabresi, 1968, p. 68, emphasis in original)
in a world of perfect competition, perfect information, and zero transaction costs,
the allocation of resources in the economy will be efficient and will be unaffected
by legal rules regarding the initial impact of costs resulting from externalities.
(Regan, 1972, p. 427)
If transaction costs are zero the structure of the law does not matter because
efficiency will result in any case (Polinsky, 1974, p. 1665).
838 The Coase Theorem 0730
if there were (a) no wealth effects on demand, (b) no transaction costs and (c) rights
to pollute or control pollution, the allocative solution would be invariant and
optimal, regardless of the initial assignment of rights. (Frech, 1979, p. 254)
In a world of zero transaction costs, the allocation of resources will be efficient, and
invariant with respect to legal rules of liability, income effects aside (Zerbe, 1980,
p. 84).
a change in a liability rule will leave the agents production and consumption
decisions both unchanged and economically efficient within the following (implicit)
framework: (a) two agents to each externality bargain, (b) perfect knowledge of one
anothers (convex) production and profit or utility functions, (c) competitive
markets, (d) zero transactions costs, (e) costless court system, (f) profit-maximizing
producers and expected utility-maximizing consumers, (g) no wealth effects, (h)
agents will strike mutually advantageous bargains in the absence of transactions
costs. (Hoffman and Spitzer, 1982, p. 73)
when parties can bargain together and settle their disagreements by cooperation,
their behavior will be efficient regardless of the underlying rule of law. (Cooter and
Ulen, 1988, p. 105)
a change in [law] affects neither the efficiency of contracts nor the distribution of
wealth between the parties. (Schwab, 1988, p. 242)
While in many ways similar to one another, these statements of the
Theorem contain important differences, many of which are at the heart of the
theoretical debates over the Theorem.
Nonetheless, a casual reading of these statements reveals two general claims
about the outcomes. The first is that, regardless of how rights are initially
assigned, the resulting allocation of resources will be efficient. This proposition
- the efficiency hypothesis - is reflected in all statements of the Theorem. The
second claim, which is not reflected in all statements of the Theorem, is that
the final allocation of resources will be invariant under alternative assignments
of rights. This is the so-called invariance hypothesis. The debates over the
correctness of the Coase Theorem, and/or its proper form, have turned on both
of these hypotheses, and this struggle has been manifest in the current tendency
to appeal to two different versions of the Theorem - the strong version, which
encompasses both the efficiency and the invariance propositions (reflected in
the statements of the Theorem by Regan, Frech, Zerbe, and Hoffman and
Spitzer, quoted above), and the weak version, which encompasses the
efficiency proposition alone (reflected in the statements of the Theorem by
Calabresi, Polinsky, and Cooter and Ulen, quoted above).
0730 The Coase Theorem 839
3. Implications
For economists - Coases target audience (Coase, 1988a, 1993) - the
implication of the Theorem is that if remedies are considered in the unrealistic
world in which competitive markets are normally considered, a world of zero
transactions costs, the Pigouvian remedies said to be necessary for an efficient
resolution of externality problems are not, in fact, necessary. All that is needed
is a common law or statutory rule which assigns rights over the externality to
one party or another. The market/pricing mechanism will then function in the
same way as it does for ordinary goods and services over which rights are
clearly defined. Furthermore, if rights are well-defined, the observed situation
will be efficient (the parties having taken all Pareto-improving steps) and any
further intervention (for example, Pigouvian remedies) will make matters worse
rather than better.
If the implications for the economics of externalities are heretical, those for
law are downright perverse, for the Theorem tells us that the form of legal rules
does not matter - only their presence or absence. Thus, we will have the same
amount of pollution (and thus clean air or water) and of outputs associated with
the generation of pollution regardless of whether polluters or the victims of
pollution are made liable for pollution damage. The same amount of effort will
be devoted to precaution against causing torteous injury regardless of whether
injurers or victims are liable for harm caused. The structure of law pertaining
to breach of contract will have no impact on the allocation of resources through
the contracting process. Attempts by judges to engage in social engineering
from the bench will be fruitless, apart from distributional (as opposed to
allocational) effects. Assuming that rights are alienable, the allocation of
resources will be the same regardless of the rule of the law, and that allocation
will be efficient. More generally, it is a matter of indifference whether courts
impose property rules or liability rules (Calabresi and Melamed, 1972), and the
entire issue of adherence to precedent becomes a moot point in terms of its
effect on the allocation of resources.
B. Is the Coase Theorem Correct?
The Theorem has never been formally proved. Arguments regarding its
correctness or incorrectness generally consist of attempts to demonstrate that
it does or does not hold in a particular context or under a certain set of
assumptions. Of particular import here is the framework within which the
reallocations of rights contemplated by the Theorem are assumed to take place.
Two basic frameworks can be identified: the quasi-competitive framework,
within which all relevant markets are assumed to be perfectly competitive and
840 The Coase Theorem 0730
agents operate more or less along competitive lines in externality negotiations,
and the game-theoretic framework, within which there exists the potential for
strategic behavior among affected parties. We examine each of these in turn.
4. The Quasi-Competitive Framework
Most of the analysis of the Theorem has taken place within the
quasi-competitive framework, under which are two different types of treatment.
First, there are discussions of small numbers externality negotiations within a
more broad competitive context of full information, no strategic behavior,
agents operating within competitive markets, and so on, with the result that
parties strike mutually-beneficial bargains when they are available. This is
analogous to the standard Edgeworth box analysis and is the environment
contemplated by Coase in The Problem of Social Cost. The second type of
treatment actually assumes competitive markets in externality rights and
analyzes the Theorem on that basis. In the latter case, the first optimality
theorem of welfare economics suggests that the Coase Theorem is correct
(Arrow, 1969).
4.1 Rents
One of the earliest but merely technical arguments raised against the Theorem
is that it cannot hold under perfectly competitive conditions in the long run
because it presupposes rents that may not exist. To consider the objection
suppose that both the polluter and the victim are in a zero-profit, long-run
equilibrium position. (For expositional simplicity, in the following discussion
we will refer to the parties as polluters and victims. The analysis, of course,
generalizes to all manner of externalities.) Then, the assignment of liability to
the polluter will force the polluter to cease operations, since it lacks the
resources with which to make liability payments to the victim. Similarly, if the
victim is made liable, it will exit the market because it lacks the resources to
bribe the polluter to reduce its harmful activity. Thus, it is argued, the Coase
Theorem will only hold in the presence of non-transferable resources giving
rise to Ricardian rents (Wellisz, 1964, p. 351). It has been further argued that
even the prior existence of rents would not ensure the validity of the Coase
Theorem: the rents must be sufficient to support the externality - that is,
sufficient to allow the polluter to pay damages (if he is liable) or the victim to
pay the bribe (if the victim is liable); otherwise, a change in the direction of
liability will cause the party bearing the cost of the externality to exit the
industry (Tybout, 1972; Shapiro, 1974). Let us analyze these claims.
Suppose that the polluter is not earning rents and that he is liable for
damage caused. Then, the polluter will be forced to go out of business in the
long run, as he does not have the resources necessary to pay damages. This
0730 The Coase Theorem 841
result is efficient since the externality existed inefficiently in the first place: the
polluter was able to inflict damages on the victim only because he did not bear
the full social cost of his actions. If the polluter is not liable for damages, the
victims would be willing to offer a bribe up to the amount of damage to induce
the polluter to cease operations, a bribe which the polluter would be willing to
accept since it was not earning any rents in the first place. Thus, whether the
polluter or the victim is earning no rents, we get the same, efficient, result
regardless of the assignment of rights.
If neither party is earning rents sufficient to support the externality, the
externality would not exist in the first place; the appearance of the externality
would immediately drive the victim out of business and the externality would
cease to exist. (See Wellisz, 1964, p. 350; Crain, Saurman, and Tollison, 1978
and Zerbe, 1980, pp. 89-90; 99.) Thus rents must exist for negotiation over
rights to even be in the realm of possibility; that is, they are prior to the Coase
Theorem analysis. But once they are satisfied, an efficient and invariant result
will obtain.
The one case in which rents are not necessary is for externalities that are
industry-wide in their emission and public bads in their effects (so that all firms
in an industry are affected). Here, assuming that all firms are harmed equally
(in terms of the effect on marginal and average costs), the externality acts in a
manner analogous to an increase in input prices, causing an increase in
marginal and average cost, a reduction in supply, and an increase in market
price. The result will be invariant under alternative rules of liability.
4.2 Entry in the Long Run
One of the most discussed challenges to the Theorem concerns the effect of
liability or bribe payments on entry into markets. If polluters are made liable
for damages, the flow of liability payments into the victim industry will
increase the rate of return in that industry. If one assumes that firms entering
the market are also eligible for compensation, then entry will occur in the long
run, leading to an increase in the output of the victim industry. When victims
are liable, in contrast, the flow of bribe payments from victims to polluters
raises the rate of return in the polluting industry, leading to entry into that
industry and a corresponding increase in output. The arguments here are two:
first, that the invariance proposition fails to hold because of the disparate entry
effects of alternative legal rules; second, the efficiency proposition fails to hold
because when polluters are liable the bribe-induced entry will result in too
much victim output, relative to what is optimal, while when victims are liable
the bribe-induced entry will result in too much polluter output, relative to what
is optimal. (See Calabresi, 1965; Bramhall and Mills, 1966; Tybout, 1972;
Baumol, 1972; Schulze and dArge, 1974; and Frech, 1979.)
The inefficiency issue is easily disposed of. First, if transaction costs are
zero, agents are rational and there are no legal impediments to bargaining, then
842 The Coase Theorem 0730
the long-run inefficiency will be cured through the same type of bargaining
transactions that were employed to resolve the short-run inefficiencies caused
by the externality (Calabresi, 1968, p. 67). That is, available gains from
exchange will be exploited in the long run just as they are in the short run.
Second, following Nutter (1968), any long-run misallocation will be cured by
a single owner who will enter the market in order to exploit the potential for
gain. Third, the above argument assumes the existence of a single efficient
long-run equilibrium point (and thus that efficiency implies invariance), when,
in fact, such need not exist. Here, the long-run equilibria are both efficient and
thus the subsequent corrective negotiations or entrepreneurial actions are
unnecessary. That is, long-run entry effects do not invalidate the efficiency
argument.
The more difficult issue is that of invariance. While the above argument
against invariance would appear to be straightforward, consider the following
counter-argument. Suppose that ranchers are liable for damage done by their
cattle. The flow of liability payments will then be capitalized into the value of
farmland that adjoins ranching property and there will be no incentive for entry
into farming in order to secure the bribe. In analogous fashion, any bribes that
result from farmer liability will be capitalized into the value of ranchland that
adjoins farms and there will be no incentive to enter ranching. Given this, the
long-run entry effects that are said to invalidate the invariance proposition will
not occur (Demsetz, 1972a; Frech, 1979).
The key to distinguishing between these competing claims regarding
invariance has been provided by Holderness (1989), who pointed out that
invariance turns on the issue of whether rights are assigned to open or closed
classes of individuals or entities. An open class is defined as one into which
entry is unrestricted, while a closed class is one which can be entered only if the
right is purchased from a current class member (see also Demsetz, 1972b,
229-231). Consider first the assignment of rights within closed classes.
Landowners constitute a closed class since one can become a landowner only
by purchasing the land and the attendant bundle of rights from a current
landowner. The assignment of rights to one class of owners creates at once a
windfall gain for those having the right and a windfall loss for those not having
it. However, in a competitive system these windfall gains and losses are
immediately capitalized into the value of the land so that both types of land
yield a normal rate of return. Since the rate of return for each of these types of
land is unaffected by the assignment of rights, there are no incentives for entry
or exit. Thus, the invariance proposition holds for closed classes (Holderness,
1989, pp. 183-184).
The invariance claim does not hold for open classes, however.
Holdnernesss separation of open from closed classes calls attention since to a
broad category of spurious objections all based on incomplete property right
specification. Here, those who are not parties to the lawsuit through which the
0730 The Coase Theorem 843
initial assignment of rights is generated can acquire that right costlessly merely
by entering and this valuable right will not be capitalized into the price of any
resource. Entry will indeed result (Holderness, 1989, p. 185). Similarly, the
absence of a right reduces the returns to that activity, thereby inducing exit. The
asymmetric entry/exit effects across alternative assignments of rights will thus
result in different long-run outputs under alternative assignments of rights,
thereby negating the invariance proposition.
This distinction illuminates the divergent results obtained by many of those
offering support for or claiming to refute the invariance proposition. Those who
have found the invariance proposition to be valid in this (the entry issue)
context have either explicitly or implicitly assumed or worked with examples
constituting closed classes. On the other hand, those finding against invariance
have analyzed the problem in open-class contexts - primarily situations with
two industries where entry is possible. The invariance proposition is applicable
to closed class situations, such as externalities affecting land values, but is
inapplicable to tort situations, such as accident law, where there is free entry
into one or both classes and to assignments of rights which cover all (current
and future) entrants into an industry.
The open class case, however, would seem to violate an underlying
assumption of the Coase Theorem - fully-specified property rights. That is,
rights in open classes are not delimited to the extent necessary to make market
transactions possible; potential entrants are able to secure a valuable right
without paying for it. This is consistent with Barzels (1989, p. 2) definition of
property rights as the powers to consume, obtain income from and alienate ...
assets and Allens (1995, p. 2) definition of an economic property right as
ones ability, without penalty, to exercise a choice over a good, service, or
person (emphasis in original). In fact, the assumption of zero transaction costs
is said by some to mean that rights are fully specified (see Cheung, 1992; Allen,
1991, 1995) and the discussion in section 6, below). As such, the issue of
incompletely specified rights, or open classes, goes to the issue of relevance
rather than correctness.
4.3 Separable v. Non-separable Cost Functions
Another class of interesting objections is based on a failure to consider fully
contract or merger possibilities. It has been argued, for example, that the
validity of the efficiency (and invariance) proposition will turn on (in addition
to other previously-recognized problems) the form of the cost function of the
victim firm. It is well established that, if the victims cost function is additively
separable (that is, if CB = C(qA, qB) = C(qA) + C(qB)), then the Coase Theorem
holds - the outcome is both efficient and invariant under alternative
assignments of rights (see Gifford and Stone, 1973; Marchand and Russell,
1973). Suppose instead, however, that the victims (Bs) costs of production are
dependent upon both its own output and the output of the polluting firm (A),
844 The Coase Theorem 0730
so that CB = C(qA, qB), where the pollution damage owing to firm As output
increases the costs of firm B.
With a non-separable cost function there is neither efficiency nor
invariance. With a non-separable cost function, the level of pollution damage
to B is a function not just of As output, but of Bs output as well and thus a
given level of output by A causes B more harm (that is, causes a greater
increase in Bs costs) the more output B produces. In such a situation, the
victim can and does contribute to its own damage without having to bear the
cost, since it is fully compensated for all damage. As a result, the victim has no
incentive to mitigate damages and produces an inefficiently high level of
output. Moreover, the damage liability associated with this imposes a higher
than optimal cost on the polluter, causing it to restrict its output below the
optimal level (Marchand and Russell, 1973, pp. 613-615).
However, if both activities are controlled by a single owner, the result will
be efficient and invariant regardless of the initial assignment of rights and
irrespective of whether the victims cost function is separable or non-separable
(Marchand and Russell, 1973, pp. 614-616). Moreover, one can imagine a
contract between owners that mimics the effect of single ownership assuming
costs of monitoring and negotiation are zero. This demonstration is sufficient
to negate the nonseparability critique, since the inefficiency contemplated will
be exploited through merger, which can be achieved costlessly, or by an
entrepreneur (see, for example, Nutter, 1968; Coelho, 1975 and Zerbe, 1980,
pp. 87-88). Marchand and Russell (1975) have responded to this criticism by
invoking difficulties in carrying out a merger - that is, by introducing
transaction costs. But introducing transaction costs is no argument against the
correctness of the Coase Theorem. A further argument that can be raised
against the nonseparabilities critique is that it violates the assumption of
fully-specified property rights (at least in the sense of Allen, 1991, 1995), since
the victim is able to procure revenues from the polluter without giving up
anything in return.
4.4 Non-Convexities at the Negotiation Starting Point
Perhaps the one seemingly insurmountable criticism of the invariance
proposition comes from the recognition by Starrett (1972) that externalities will
cause nonconvexities to exist in the production sets of victim firms. (See also
Shapiro, 1974, 1977, 1978; Vogel, 1987.) The argument applies equally to
consumption sets and thus to externalities to which consumers are party. This
objection is similar to that of non-separable cost functions in calling attention
to a contacting problem. This is an interesting objection because it points to the
importance of information costs. In graphical terms, rather than generating a
convex production set, such as in Panel a of Figure 1, the externality causes
nonconvexities of the form illustrated in Panel b.
0730 The Coase Theorem 845
Figure 1
Panel A Panel B
Here, qB is the output of firm B, the victim and Z is the level of the
externality. The analysis turns on the effect of increasing pollution damage on
the victims output. Panel (b) illustrates a situation of increasing marginal
damage from pollution (given by the reduction in the victims output due to the
externality) with the recognition that, beyond some point (Z0), marginal damage
will be zero (Starrett, 1972, pp. 189-190).
The import of this for the Coase Theorem is as follows. Suppose that the
polluters (As) profit-maximizing level of pollution in the absence of the legal
rule is some level Z1 > Z0. With this level of pollution, B will produce no output.
If the A has the right to pollute, the point Z = Z1, qB = 0 is the starting point for
negotiation over the level of pollution. The minimum payment that the polluter
is willing to accept to reduce pollution is the reduction in profits that would
accompany the reduction in pollution. However, at (and around) Z1, there is no
benefit to the victim from a one unit reduction in pollution; the victims output
(qB) would remain at zero with this one unit reduction in pollution. Thus, the
victim would not be willing to offer a bribe payment to induce the polluter to
reduce its pollution by one unit (to Z1 ! 1 units) - it is a cost with no attending
benefit. Thus, the equilibrium when the polluter has the right to pollute will be
at a pollution level Z = Z1 and an output level for the victim of qB = 0, a result
which is due to the nonconvexity.
On the other hand, if the victim has the right to be free from pollution, the
baseline from which negotiation begins is Z = 0. The victim will be willing to
accept any bribe to allow positive levels of the pollution if the bribe is in excess
of the lost profits due to pollution damage (or reduction in q B). Thus, the parties
will be able to negotiate to an efficient result along standard Coasean lines, but
the final result will not (except by accident) be Z = Z1 and qB = 0. Thus, the
846 The Coase Theorem 0730
invariance proposition does not hold in the presence of nonconvexities if the
starting point for negotiation when the polluter has the right to pollute falls
within the non-convex region of the victims production set. However, if the
initial level of pollution is some level Z # Z0, the invariance proposition holds.
(See Cooter, 1980 for a discussion of how legal rules can be specified to
circumvent the nonconvexity problem).
The force of this critique is sufficiently powerful that the editors of the
Journal of Economic Theory said that Starretts demonstration that
nonconvexities are inherent in externality problems destroy[s] the validity of
the Coase Theorem (Shapiro, 1977, p. 222). However, this judgment fails to
understand the true nature of a fully transaction costs world. There is a
Pareto-better point available, but the nonconvexity means that the parties will
fail to reach it because the immediate marginal adjustments are not
Pareto-better. Essentially, the point is that the victim will not be able to spend
$15 for a change that will make it $20 better off because the first step along this
path would involve spending a dollar to get a zero improvement in welfare and
the victim, not being willing to take this first step, will never know that better
things are on the horizon. The problem here is one of information: it is
certainly the case that the victim would take this first, welfare-reducing step if
it was certain that, in the end, it would be better off. If both victim and polluter
knew of the existence of a superior position they could also merge to achieve
it. Thus, the nonconvexities argument introduces imperfect information into the
model. If, as most have maintained, information costs violate the zero
transaction costs assumption of the Coase Theorem, fundamental
non-convexities do not produce inefficiency. The non-convexity critique of the
Theorem points to the importance of information costs, but, if these are
considered as part of transactions costs, it does not point to the incorrectness
of the Theorem itself.
4.5 Income, Taste and Preference Effects
An additional complication first hinted at by Buchanan and Stubblebine (1962)
and Turvey (1963) and later more explicitly elaborated by Dolbear (1967) and
Mishan (1965, 1967, 1971), within the economics literature, and by Kelman
(1979) within the legal literature - is introduced when one or both parties to the
externality are consumers, for, at this point, we are forced to take into account
effects on demands that attend alternative assignments of rights. These effects
arise first, from differences in tastes between parties and, second, from
differences between the willingness to pay (WTP) and willingness to accept
(WTA).
Differences in Tastes If tastes are different (that is, as long as indifference
curves are not homothethic) a change in the income distribution will affect the
pattern of demand and therefore the pattern of resource allocation, though not
0730 The Coase Theorem 847
its efficiency. That is, alternative assignments of rights can have differential
effects on the structure of demands for consumer goods. Since different
assignments of rights result in different distributions of income, the
composition of demands - and hence equilibrium prices and quantities across
markets - will vary with alternative assignments of rights. For example,
suppose that an economy produces only beef and fish and that fertilizer runoff
used to produce grass, an input into beef production reduces fish production.
Those that produce beef prefer to eat beef and those that produce fish prefer
fish. A change in the liability rule from one in which beef producers are liable
to one in which they are not will increase the income of beef producers and
reduce the income of fish producers. This will then increase the demand for
beef and reduce the demand for fish; thus, the relative production of beef and
fish will not be invariant to the liability rule. This objection to the strong
version of the Theorem is well recognized. But, we shall see that even this
objection presupposes incomplete property rights.
Differences Between WTP and WTA A change in the law can change the sense
of ownership and thus change the measure of value from the WTP to WTA or
vice versa. Following Willig (1976), economists have tended to assume that any
differences between willingness to accept (WTA) and willingness to pay (WTP)
owing to a price change are small. This is now recognized as untrue in
important cases. For environmental goods, researchers have demonstrated
repeatedly that WTA questionnaires generate values from two to nineteen times
greater than those elicited by WTP questions (Levy and Friedman, 1994, p.
495, n. 6; Hoffman and Spitzer, 1993, pp. 69-85). There are three reasons for
the difference: income effects, substitution possibilities and loss aversion.
(Hoffman and Spitzer, 1993) present an excellent survey of the WTA v. WTP
issue, much of the evidence regarding which comes from the experimental
literature. The present discussion touches on what we believe to be the most
significant of these arguments.)
Let us first consider the implications of income effects. If most people
experience diminishing marginal utility of income, the utility loss resulting
from a reduction in income of a certain amount is greater than the utility gain
associated with an increase in income of the same amount. Thus, if individuals
bargain over utility, rather than over wealth per se, we would expect to see
differences between WTA and WTP and thus negotiated solutions that vary
with the initial assignment of rights (Hovenkamp, 1990). This is an income
effect. For example (and assuming that A, the polluter, is a firm, so that wealth
effects are irrelevant for it), if B (an individual) has the right to be free from
pollution, then the amount of pollution generated will be a function of the
payment that he is willing to accept to avoid pollution. If B does not have the
right to be free from pollution (that is, A has the right to pollute), then the
amount of pollution generated will be a function of the amount that B is willing
to pay to avoid pollution. Since the maximum amount a person is willing to pay
848 The Coase Theorem 0730
to avoid damages is a function of his budget constraint, while there is no such
constraint on the amount that the individual is willing to accept, we will see (as
long clean air is a normal good) a difference in the amount of pollution and
thus in pollution-related output, depending on the initial assignment of rights
(Mishan, 1971, p. 19). Thus, the invariance proposition will hold only when
income effects are not present or when all relevant income elasticities of
demand are zero.
The force of the income effects critique has been reflected in one of the few
major modifications of the standard structure of the Coase Theorem: the
addition of the assumption of no income effects or the qualifier income effects
aside, as reflected in several of the statements of the Coase Theorem set out
above. The use by some of the weak rather than the strong version of the
Theorem is also attributable largely to the role that income effects play in
negating invariance.
Consider next the issue of substitution possibilities. Recently, Hanemann
(1991) showed that the poorer the substitutes for the good, the greater the
divergence between the WTP and the WTA. Put another way, the divergence
will be greater the more unique the good. The substantial divergence between
WTP and WTA for unique goods arises in part from the fact that many of these
goods have no close substitutes. Thus, for most people, the WTA to allow
degradation of the Grand Canyon will be much greater than the WTP to
prevent degradation for most people. A change in the law that results in a
change from a WTP to a WTA criteria will have dramatic effects in the
measure of value for the good. Zerbe (1998a) and Cohen and Knetsch (1992)
have argued that the correct measure of damages as between the WTP and
WTA is, however, a function of the psychological reference point which may
not correspond with the legal reference point. For example, the Ellickson
(1986) study of the response to differing range laws shows such a difference.
In one half of Shasta County, California, open range was the legal rule and in
the other half closed range was the rule. Yet in both parts of the County, in
spite of opposite assignments of liability, people expected and provided similar
remedies. Cattle owners took responsibility for the damages in all cases and this
responsibility existed for many years and was enforced through social norms.
The reference state was one of crops not being damaged by straying cattle.
A further argument against the invariance proposition comes from the
influence that alternative assignments of rights may have on WTA v. WTP
through effects on consumer tastes and preferences. Here, the assertion is that
consumer tastes and preferences are not wholly exogenous to the structure of
legal rules but are influenced by them (Zerbe and McCurdy, 1996). Prospect
theory posits that individuals have a value (rather than utility) function which
is convex for gains and concave for losses and that the degree of concavity is
greater than the degree of convexity, so that losses of a given size are felt more
acutely than gains of that same size (Kahneman and Tversky, 1979). The link
between this idea and the WTA v. WTP argument is that the offer of money to
0730 The Coase Theorem 849
relinquish a right would be treated as a loss, whereas the purchase of a right
would be regarded as a gain. Since losses count more than gains, the minimum
amount that an individual would be willing to accept to relinquish a right will
exceed the amount that he is willing to pay to acquire it (Kahneman, Knetsch
and Thaler, 1990). One reason for this loss aversion is suggested by what
Thaler (1980) has called an endowment effect, owing to the fact that people
value received income more highly than opportunity income. Because of
this, people will be willing to forego more opportunity income to retain a right
than they would spend in received income to acquire it and thus WTA will
exceed WTP (Thaler, 1980; Kelman, 1979). Kelman attempts to apply this
argument to the producer side as well, arguing that producers may value
realized and opportunity income differently. However, doing so would
contradict the assumption of profit maximization. Moreover, as Spitzer and
Hoffman (1980, p. 1210) point out, a profit-maximizing entrepreneur could
(and, following Nutter, 1968, would) arbitrage this difference, thus generating
the outcome implied by the Coase theorem.
How important these forces are in creating a wedge between the WTP and
the WTA is as yet uncertain. At this point, however, it seems reasonable to say
that income and substitution effects and loss aversion are sufficient to invalidate
the invariance, although not the efficiency, claim of the theorem.
The above possible exceptions to the Coase Theorem represent important
cases, but do they really represent exceptions to the Coase Theorem? All of the
objections to the Coase Theorem that rest on consumer preferences rest on a
change in the distribution of wealth. Yet, these arguments at base reflect
property rights that are not fully specified or are inefficiently specified. These
conditions then violate the Coase Theorem assumptions that property rights are
fully specified.
Consider first a change in the rule of liability. If property rights are fully
defined (in the sense of complete ownership), this alteration of liability cannot
take place without compensation; if it does, the right was not fully defined in
the first place, in violation of the Theorems assumptions. Thus, owing to the
compensation, the distribution of wealth will be unaffected (Allen, 1995, p. 10).
Allens argument applies even to the income effects qualification. Of course,
this rebuttal does not go to the case where non-existent rights are subsequently
defined. However, in a world of zero transaction costs the definition of rights
would be perfectly anticipated and thus reflected in resource values (Allen,
1995, pp. 10-11). In sum, when alternative assignments of rights influence the
distribution of income and wealth, it must be the case that rights are less than
fully defined and/or that transaction costs are positive. Indeed, Allen (1991,
1995) has argued that fully-defined rights and zero transaction costs are really
the same thing (see the discussion in Section 6, below).
850 The Coase Theorem 0730
Perhaps the most intriguing case is one suggested by the recent literature in
which legal ownership is different from psychological ownership (Zerbe,
1998a, 1998b). Evidence suggests that a sense of ownership attends certain
environmental goods even if there is no individual ownership. A decision to cut
down the last remaining stand of privately owned redwood trees, the Headwater
Grove, may create a sense of loss among some that are non-owners of the
grove. This loss is correctly measured by the WTA. If, however, a decision to
measure the value of the grove is based on legal ownership the value to the
public will be based on the WTP for preservation. Since for a normal good the
WTP will be less than the WTA, the grove may be cut when it should not.
Property rights are fully specified in this example so that it would appear to
violate the strong version of the Theorem.
However, Zerbe (1998a, 1998b) has noted that, although property rights in
this case are fully specified, they are inefficiently specified. He argues that
efficiency requires that the legal measure of property and damage correspond
to psychological reference points. (Posners rule (1992, p. 52) for the
allocation of rights is a subsidiary of this theorem. This rule is that where one
class of claimants values the right more than other classes, efficiency requires
that the right should go to the claimants that value it the most.) If there is not
a correspondence between psychological and legal property rights, the use of
WTP and WTA based on legal criteria can impose net losses. Imagine that a
party, George, believes he owns a right or a property, M and that another party,
Ronald, also believes that George owns property M. They discover that the law,
however, holds that party George, not Ronald, owns M. Ronald suffers a loss
of M psychologically and therefore economically, while George gains M. Since
losses are, on the average, worth more than equivalent gains (due to income,
substitution effects and loss aversion), on the average George will gain less than
what Ronald loses. This is perfectly general, so that the application of law to
affect a legal ownership different from psychological ownership must, on
average, impose net losses. (This is true as long as Ronald and George may be
regarded as equivalent in the sense that on average one does not have a greater
income than the other or does not differ in some other relevant characteristic.
Underlying this proof is the notion that we cannot speak of it being efficient to
change preferences to be in accord with the law since this violates the proper
context for benefit cost analysis - which requires that preferences be taken as
they lie - and the very concept of efficiency. In any event benefit cost can not
evaluate the advantages of a change in preferences since this does not take
preferences as they lie.) Similarly, if one class of claimant psychologically
possesses property so that its removal is felt as a psychological loss, as
compared with a rival claimant who has a lesser psychological claim or no
claim, efficiency requires that the law grant the right to the psychological
possessor. But, in a zero transactions cost world this sort of inefficiency would
0730 The Coase Theorem 851
not arise since the law would be made to correspond with the psychological
sense of ownership.
5. The Game-Theoretic Framework
While the vast majority of the literature debating the validity of the Coase
Theorem employs the quasi-competitive framework, a number of commentators
have addressed the Theorem from a game-theoretic bargaining perspective,
arguing that that the quasi-competitive framework is not appropriate or relevant
for Coase Theorem-like bargains over rights owing to the small number of
parties contemplated and the potential for strategic behavior. (See, for example,
Davis and Whinston, 1962; Samuelson, 1966, p. 1141; Shoup 1971, p. 310;
Regan 1972, p. 428; Cooter, 1982, pp. 16-17.) By placing the Theorem in a
small numbers context but yet ignoring the potential for strategic behavior, it
is presumed that the contemplated agreements can and will be reached because
it is in the joint interest of the parties to do so (Samuelson, 1985, p. 322). Yet,
this fails to consider the possibility that what is rational for the group may not
be rational for the individual and constitutes, in essence, an a priori argument
for the Theorem (Regan, 1972, pp. 429-431).
Several commentators (for example, Davis and Whinston, 1965; Arrow,
1979; Aivazian and Callen, 1981; Samuelson, 1985 and Aivazian, Callen and
Lipnowski, 1987) have suggested that the Coase Theorem, as envisioned by its
proponents at least, lends itself quite naturally to the theory of cooperative
games. It can be demonstrated that the Coase Theorem will always hold in a
two-person cooperative game. However, this result is not particularly
comforting since, by setting the problem in the context of a two-person
cooperative game, efficiency is assured by definition (although there is no
guarantee of invariance), making this more along the lines of an illustration of
the Coase Theorem rather than a proof (Schweizer, 1988, pp. 246, 254). In fact,
much of the quasi-competitive literature (especially the two-person analysis)
can, without too much injustice, be described as cooperative game analysis. The
situation is complicated when the cooperative game involves more than two
players. While it has been suggested that the Theorem may not hold in such a
context (Aivazian and Callen, 1981), this claim has been shown to be incorrect
(Coase, 1981; De Bornier, 1986).
5.1 Noncooperative Game Theory
However, the most interesting and potentially most damaging, game-theoretic
analysis of the Theorem has involved the use of noncooperative game theory.
If parties have full information about each others utility (or profit or
production and cost) functions, the Coase Theorem will hold in a
852 The Coase Theorem 0730
noncooperative setting. The initial assignment of rights establishes the utility
level of each player in the absence of further reallocations of resources and
there are assumed to exist reallocations of resources which are efficiency
enhancing, in the sense that the utility of one player can be increased without
reducing the utility of the other player. However, neither party will agree to an
alteration in the allocation of resources unless that reallocation increases its
utility. The question, from the perspective of the noncooperative game, is
whether there exists a sequence of permitted moves which will generate an
efficient (Nash) equilibrium. Suppose that A is given the right to pollute. Then
the victim, B, has an incentive to offer an alternative allocation of resources
(for example, a combination of a bribe paid from B to A and a reduced level of
pollution by A) to A, but B knows that A will accept this offer only if As utility
is increased under the new allocation. Since B knows As utility function, he
can determine the range of allocations sufficient to garner As acceptance. And,
since Bs utility is higher with reallocation than without, he will not offer an
allocation that A would reject, choosing instead that allocation from the group
A will accept which maximizes his own utility. The resulting equilibrium is
Pareto efficient, since, given the utility level of one player, the other players
utility is maximized. As Arrow (1979, p. 29) points out, however, this is not the
competitive equilibrium. The same reasoning applies to the situation where the
victim is given the right to be free from pollution (Arrow, 1979, pp. 27-29;
Schweizer, 1988). In fact, it is not necessary for each party to enter the
bargaining process with full information, only that each party perceives that
there are net gains to it from providing full information during the negotiation
process and thus will reveal such information during that process (Saraydar,
1983, p. 603, n. 12).
The problem, numerous commentators have pointed out, is that it is unlikely
that the players will know each others respective utility (or profit, production
or cost) functions. This has a number of implications.
(a) Implication One: The Baseline Problem When victims are liable, the firm
can influence the level of the bribe that it receives by making an upward
adjustment in pollution emission at the time that the baseline level of pollution
(against which subsidized/bribe-induced pollution reductions will be measured)
is set or by choosing not to take cost-justified precautions. That is, the level of
pollution on which the bribe is based may differ from the level of pollution that
would have been emitted if the polluter was liable. The source of this incentive
is the inability of the victim to ascertain with certainty the true baseline level
of pollution. Moreover, disagreements over the baseline level of pollution may
result in the failure to consummate bargains when the victim is liable.
Conversely, if polluters are known to be liable for damages, then, in the absence
of full information about actual damages and measures taken by the victim to
0730 The Coase Theorem 853
mitigate damages, the victims moral hazard will result in too few resources
being devoted to precaution/mitigation by the victim and too many resources
being devoted to abatement by the polluter (Kamien, Schwartz and Dolbear,
1966; Tybout, 1972; Harris, 1990). With endogenous liability assignment,
however, the moral hazard problems disappear, since a party does not know
with certainty whether or not it will be forced to bear the costs of the
externality. Thus each party will act efficiently to minimize expected costs by
engaging in the appropriate level of precaution/preventive activity (Harris,
1990, pp. 701-702).
(b) Implication Two: Extortion Imperfect information raises the problem of
extortion, which can arise in a number of forms. First and related to (a), above,
polluters may threaten to emit higher levels of pollution in order to secure a
larger bribe (Mumey, 1971). Second, as Shoup (1971, pp. 310-312) has pointed
out, potential entrants may use extortion: if externality generators are not liable,
entrepreneurs may threaten to emit an externality in order to secure a bribe,
or, symmetrically, if externality generators are liable, potential victims may
threaten to come to the harm in order to secure a bribe. If these threats
necessitate the use of resources to establish credibility, the result will be
inefficient. However, investing resources to establish credibility violates the
zero transaction cost assumption of the Theorem. Jaffe (1975, p. 661) offers a
further counter to Mumeys result. The polluter will not wish to invest
resources in making a threat which will not be carried out and the mere
potential that it can carry out a threat will induce a more generous bribe.
Moreover, this extortion argument implicitly assumes both sufficient rents and
an open class situation and, on the latter ground, is subject to the rebuttal noted
above. Demsetz (1972a, p. 23) has also countered this criticism with the
argument that competition for these gains will drive the price of extortion to
zero, so that extortion is not a barrier to the attainment of the efficient
equilibrium. It should also be noted that Coase (1959, p. 27, n. 54) recognized
that the employment of resources solely to establish a claim could preclude
the attainment of the efficient result.
Third, since there are multiple ways to divide the gains from a bargain and
each individual is interested in both achieving the benefits from cooperation
and getting as large a share of the benefits as possible for himself, there will be
threats of noncooperation in order to increase ones share of the gains. For
these threats to be credible, however, they must occasionally be carried out and,
when this is done the result will be sub-optimal (Regan, 1972, p. 429). One can
see illustrations of what Regan (1972) has called the a priori argument for the
Theorem in the challenges to the extortion argument. For example, it is argued
that the limits of extortion are set by the size of the available rents: if one party
tries to extort from the other an amount greater than this, the other party could
simply transfer its resources into their next-best use. The extorting agent, being
unwilling to forego the potential gain, will thus agree to a solution which
854 The Coase Theorem 0730
garners for it an amount not in excess of the other partys rents. Thus, the only
differential impact of alternative legal rules will be on the distribution of rents;
the final allocation of resources will be unaffected (Boyd and Mohring, 1971;
Demsetz, 1972a; Feldman, 1974).
(c) Implication Three: Private Information While Davis and Whinston (1965,
p. 118) argued early on that information would be revealed through the
bargaining process, the application of more complex strategic thinking suggests
that private information, if revealed, may be used against ones self and thus
adversely affect ones payoff. Given this, agents have an incentive to conceal
information (through silence or lies) and to expend resources both to protect the
value of their own private information and to acquire information from/about
others. These costs and resultant delays and/or failures to consummate
mutually-beneficial bargains, are likely to preclude the attainment of efficient
negotiated solutions where information is asymmetrically distributed (Cooter,
1982; Sutton, 1986; Farrell, 1987). Cooter (1982, pp. 17-18) even goes so far
as to argue that an equally strong case can be made that parties will never agree
on the distribution of the surplus, even when transaction costs are zero, a
proposition that he labels the Hobbes Theorem. However, he maintains that
the ever-present strategic element is not as insurmountable as the Hobbes
Theorem implies, nor as inconsequential as the Coase Theorem implies; in
fact, he argues, gains from trade in bargaining situations are realized more
often than not (Cooter, 1982, p. 19). Cento Veljanovski (1982, p. 60) offers a
theorem similar to Cooters Hobbes Theorem - the Johansen theorem, which
holds that [d]irect bargaining has an inherent tendency to dissipate the
gains-from-trade through strategic behaviour (see Johansen, 1979, pp.
515-520). Unlike Cooter, however, Veljanovski maintains that in a world of
zero transaction costs the dissipation of gains is likely to be the more common
outcome.
A number of commentators have demonstrated the potential for both
agreement and non-agreement when information is imperfect. If neither partys
utility function is a function of the others private information, then an efficient
result will be reached. However, if either partys utility function is a function
of the others private information, then there is no guarantee that an efficient
result will be reached (Schweizer, 1988, pp. 259-263). (See also Arrow, 1979,
pp. 29-31; Cooter, 1982, pp. 20-24; Samuelson, 1985; Illing, 1992). Our
discussion here will draw primarily from Cooters analysis. Arrow and
Samuelson reach conclusions very similar to Cooter, using the assumption that
the parties are uncertain about each others utility functions. For example,
Cooter (1982, pp. 20-24) points out that uncertainty regarding the opponents
response causes each player to form a rational expectation of this response in
the sense of formulating a subjective probability distribution over his
opponents moves. Given this rational expectation regarding his opponents
strategy, each player chooses for himself the strategy that maximizes his
0730 The Coase Theorem 855
expected utility based on a comparison of the greater share of the gains from
taking a harder line in bargaining with the higher probability that this harder
line will prevent an agreement from being reached. The problem is that, while
each player will be playing the strategy that is optimal against the distribution
of his opponents possible strategies, this strategy is not necessarily optimal
against the particular strategy played by the opponent. The outcome will be
inefficient when players err in their predictions of the moves made by their
opponents (Cooter, 1982, pp. 20, 23; Arrow, 1979, p. 31). In fact, Cooter
contends that zero transaction (communication) costs actually decreases the
possibility of reaching an agreement, in that it facilitates the transmission of
threats and other strategic communications (Cooter, 1982, pp. 23), although,
as Arrow (1979) has demonstrated, it is possible to design a collective decision
rule that will induce a truthful revelation of preferences.
If the situation involves large bargaining groups, two more potential
difficulties arise. First, individuals will have an incentive to free ride and thus
the ability of the group to pay a bribe sufficient to induce the socially optimal
level of output/pollution will be greatly reduced. Second, if there are differential
damage effects across victims, we may observe the rise of coalitions within the
victim group (for example, by level of damage), each applying pressure to
encourage the result that best suits its interests. The greater is the number of
coalitions, the smaller is the likelihood that the optimal solution will be reached
(Wellisz, 1964, p. 354). However, as the number of parties approaches infinity
(with large numbers of right-holders and large numbers of rights-seekers), the
bargaining solution here will approach the efficient result of competitive
equilibrium (Samuelson, 1985, p. 338).
In sum, the likelihood of incomplete information gives us little reason to
believe that the Coase Theorem is correct when specified in a noncooperative
bargaining context. But while the game-theoretic critiques of the Coase
Theorem are suggestive of its demise, they have not gone unchallenged, largely
on the grounds that it is incorrect to place the Theorem in such a context. At
issue is what is meant by a world of zero transaction costs, to which we now
turn.
6. The Issue of Transaction Costs
Perhaps the most sticky issue in the debate over the Coase Theorem is the
meaning given to the assumption of zero transaction costs. Indeed, the very
concept of transaction costs has been so vague and ill-defined that Stanley
Fischer (1977, p. 322, n. 5) was once led to remark that almost anything can
be rationalized by invoking suitably specified transaction costs. Coases (1960,
p. 15) definition of transaction costs encompasses those costs associated with
search, negotiation, monitoring and enforcement, which, as Dahlman (1979,
856 The Coase Theorem 0730
p. 148) has noted, basically reduces to resource losses incurred due to
imperfect information. A bit more specificity (although even greater breadth)
is found in more recent definitions within the property rights literature such as
Barzels (1989, p. 2) contention that transaction costs are the costs associated
with the transfer, capture and protection of rights and Allens (1991, p. 3)
statement that they encompass the resources used to establish and maintain
property rights. Under these latter definitions, zero transaction costs implies
complete property rights (Allen, 1991, 1995; Cheung, 1992; see also Schlag,
1989).
If we take the Barzel/Allen definition as the basis upon which to evaluate
the Coase Theorem, three implications immediately follow. First, there is an
unspecified property right that lies at the heart of the private information
examples. For example, Farrell (1987) constructs a problem in which parties
A and B care about a time that is set. He notes that King Solomon would have
little trouble finding the optimum value since he charges each party an amount
equal to their effect on each other and that a bumbling bureaucrat can under
some circumstances find a superior (second best) result to that achieved under
zero cost negotiations. The showing that a centralized authority can achieve an
optimum is, however, equivalent to showing that there is an unspecified
property right. When A is allowed to set the time (about which both A and B
care), B will prefer to not participate in bargaining since his gain is greater
when A just sets the time unilaterally and B pays nothing. The advantage that
Solomon has is that he can force A and B to participate. Yet, in this example,
B gets to use the time that A sets. For example, the time may represent the time
for beginning a race. Farrells example assumes that B is nevertheless allowed
to participate in the race. But, if the race is owned the owner will in fact charge
both A and B, yielding the Solomon solution. Another analogy can be made to
ownership of a lake. The owner will charge each user at least the cost they
impose on other users. Farrell implicitly assumes that government is the only
owner of the lake. It is true that we can consider other examples in which the
ownership of the resource seems more foreign to our usual thinking, as when
the time represents a curfew or a time after which noise must be reduced-but
there is a lack of ownership none the less. These are simply examples in which
the absolute advantage of government with respect to certain sorts of
enforcement costs may support government ownership, but enforcement costs
are also transaction costs.
Second, nearly all of the challenges to the Theorems correctness are
invalidated under this conception of transaction costs, including entry,
nonseparabilities, nonconvexities and even wealth effects, as noted above. This
definition of transaction costs also invalidates other challenges to the Theorem
which were not discussed in the preceding sections - those based on rent
seeking (Jung et al., 1995; see Medema, 1996b) and the presence of risk (Posin,
1990; see Medema, 1995a and Posins, 1995, response). Of particular
0730 The Coase Theorem 857
importance here is the implication of the Barzel/Allen definition (and even
Dahlmans definition) for the game-theoretic challenges, which rely on the
existence of imperfect information. By any of these definitions, the presence of
imperfect information has the effect of introducing transaction costs into the
analysis through the behavior it induces and the game-theoretic challenges are
correspondingly invalidated. (On this point see also Allen, 1995, pp. 12-13;
Dahlman, 1979, pp. 158-159, n. 26; Hovenkamp, 1990, p. 787; Illing, 1992;
Samuelson, 1985, p. 323; Zerbe, 1980, pp. 85-86). Indeed, Saraydar (1983),
acknowledges that the imperfect information resulting from strategic behavior
violates the assumption of zero transaction costs, but argues that such costs are
virtually inevitable within a small numbers bargaining situation due to the
incentive to distort information. Further evidence for this line of reasoning may
be found within Coase (1960, pp. 31-33), who discusses the problem of moral
hazard (along the lines of Harris, 1990) in the context of positive transaction
costs.
Against these claims, defenders of the game-theoretic approach point out
that giving this type of content to the idea of zero transaction costs basically
renders the idea of bargaining meaningless and detaches the Theorem almost
completely from reality, making it, in the words of one commentator more in
common with astrology than with market analysis (Veljanovski, 1982, p. 60).
(See also Regan, 1972, pp. 429-430; Shoup, 1971, p. 310; Cooter, 1982, p. 17.)
In the end, then, whether the game-theoretic and other challenges to the Coase
Theorem go to its correctness or its relevance comes down to how one
interprets the almost mystical world of zero transactions costs (Zerbe, 1980,
p. 85).
This takes us directly to the third implication of the Barzel/Allen definition
- that [t]ransaction costs are ubiquitous (Allen, 1991, p. 4). The effect of this
is to make the Theorem per se completely devoid of applicability to the real
world. Coase (1981, p. 187) has made this point a bit more graphically,
contending that the analysis of a world of zero transaction costs is akin to
divining the future by the minute inspection of the entrails of a goose. Indeed,
by this definition the Theorems efficiency proposition must hold, since any
violation of it reflects a [cost] associated with the transfer, capture, or
protection of property rights. It may be argued with some justice that all of this
reduces the Coase Theorem to a mere tautology (Regan, 1972, pp. 429-30;
Cooter, 1989, p. 67). So be it. Coase (1960, p. 15) never claimed that it was
realistic, just that it follows logically from the same basic assumptions
underlying Pigouvian theory circa 1960. And indeed, based on the foregoing
analysis the correctness of the Theorem remains untouched, apart from the
potential for taste and preference-induced divergences between WTA and WTP
that may impact the invariance claim. The issue of relevance is a different
matter altogether and one to which we now turn.
858 The Coase Theorem 0730
C. Relevance
A further facet of the extensive debate over the Coase Theorem has been the
attempt to verify its predictions experimentally and empirically. Hovenkamp
(1990, p. 794) has recently pointed out that [c]onducting empirical tests of the
Coase theorem is like conducting empirical tests of the Pythagorean theorem.
Given the theorems assumptions, the results flow out as a matter of logical
necessity. This is true; as such and given the impossibility of satisfying the
zero transaction costs assumption in the world in which we live, the
experimental and empirical tests go to the issues of relevance and applicability,
rather than to the Theorems correctness. In doing so, they begin to address the
potential difficulties for the Theorem that are raised by the challenges discussed
above, such as the effects of imperfect information, the potential for strategic
behavior, nonconvexities and the presence of income or taste and preference
effects.
7. Experimental Tests
The experimental tests of the Coase Theorem are among the most interesting
of the various tests, since they offer the potential to mimic as closely as possible
the conditions of zero transaction costs. At the same time, they can begin to
capture the effects of factors such as imperfect information and isolate the
import of these effects vis--vis situations in which they are absent.
7.1 Experimental Framework and Results
The most extensive experimental tests of the Theorem are those undertaken by
Hoffman and Spitzer (at times with others - see Hoffman and Spitzer, 1982,
1985, 1986; Coursey, Hoffman and Spitzer, 1987; Harrison et al., 1987). The
experiments undertaken by Hoffman and Spitzer all involve the same basic
experimental framework. There is a range of possible outcomes, each with a
different associated payoff. One party (the controller) is given the property
right and thus can determine the outcome unilaterally. Consider the following
set of possible dollar payoffs (PA, PB) in the spirit of Hoffman and Spitzer: (5,0),
(4,4) and (0,5). If A is the controller, he will chose (5,0) unless B induces him
to choose a different outcome. The Coase Theorem predicts that (4,4) will be
chosen, with the actual distribution of the joint payoff ($8) being a function of
the negotiation process. And of course it is in Bs interest to offer A up to $4
to choose (4,4) and in As interest to accept any payment greater than $1 to do
so.
In well over 500 experiments with various sizes of bargaining groups
(including 1 1, 1 3, 2 2, 5 5, 1 9 and 1 19) conducted within this
framework, the results were quite favorable. In all, the parties bargained to the
efficient result 92 percent of the time, including 94 percent of the time under
0730 The Coase Theorem 859
conditions of full information and 90 percent of the time under imperfect
information. Moreover, the support for the Theorems prediction was actually
greatest in the 10 and 20 person situations - 98 percent, including 100 percent
in 20 person negotiations, where the 19 people devised their own informal
institutional arrangements (choosing representatives from the group as
bargaining agents) to overcome the large numbers problems. Given how little
the student subjects have at stake in these experiments, even those conducted
under conditions of imperfect information suggest very low transaction costs.
While this may seem quite unrealistic, these experiments do offer some fairly
substantial support for the applicability of the Theorem when transaction costs
are low.
One of the interesting issues raised by the early experiments came from the
nearly equal division of the payoffs ( $1) in the vast majority of the cases.
Individual rationality suggests, with respect to the above example, that the
controller would not settle for less than $5 and could potentially induce the
other party to agree to a $7.99 - $.01 split of the $8 payoff, as in, for example,
a one-shot game. The fact that so many controllers settle for less than what
should be their reservation price suggests either altruism - which contradicts
entirely the theory of externalities, Coase Theorem or otherwise, since, if agents
are altruistic, the individually rational behavior that is said to generate the
externality in the first place would not occur (Harrison and McKee, 1985, p.
655) - or a potential problem with the experimental environment.
One hypothesis offered to explain this result is that participants in these
experiments did not understand the full meaning and import of having a
unilateral property right as controllers (Harrison and McKee, 1985). Another
is that they did not feel a morally justified right to be the controller, since that
position was determined on the basis of a coin flip rather than being, in some
(for example, Lockean) sense, earned (Hoffman and Spitzer, 1985). Once
measures were implemented to control for this - educating subjects or having
subjects earn the position of controller by winning a preliminary game - the
extent of individually rational behavior increased dramatically and without a
significant drop-off in the rate at which efficient bargains were made -
approximately 90 percent (Harrison and McKee, 1985; Hoffman and Spitzer,
1985, 1986). Even then, however, 20-30 percent of the experiments generated
less than individually-rational outcomes, suggesting that the subjects behave
more like Lockeans than like utilitarians or egalitarians. Rather than taking this
as evidence against the Coase Theorem, Hoffman and Spitzer (1986, pp.
159-160) suggest that it speaks to the robustness of the Theorem across
alternative hypotheses regarding individual behavior.
860 The Coase Theorem 0730
7.2 Criticisms re: Externality Problems
One of the criticisms of these early experiments was that they did not account
for the possibility of affronts to dignity and other such factors to which people
would refuse to assign a monetary value or over which people would refuse to
bargain (Kelman, 1985, pp. 1038-1039). In an attempt to deal with the affront
to dignity issue, Coursey, Hoffman and Spitzer (1987) conducted experiments
that introduced a discomforting externality. This was accomplished by
introducing the possibility that the victim would have to hold one ounce of an
unpleasant-tasting liquid in his or her mouth for twenty seconds. These
experiments had two possible payoffs: (i) the polluter gets $0 and the victim
gets $10 and does not have to taste the liquid; (ii) the polluter gets $20 and
the victim gets $10 and does have to taste the liquid. The latter outcome, where
the victim is exposed to the externality, is, of course, the efficient one. Out of
40 experiments, the efficient outcome was chosen 38 times - 22 out of 22 times
when the polluter was the controller and 16 out of 18 times when the victim
was the controller. The results with the polluter as the controller may not be
surprising: when the polluter has the right to pollute, polluting is efficient and
there are substantial gains to the polluter from polluting, the polluter would be
expected to pollute.
What may be a bit surprising, however, is the propensity for victims to sell
their right to be free from the harm - here, for a 90 percent increase in payoff
(from $10, the payoff to the victim without tasting, to $19.06, the average
payoff to the victim when agreeing to taste), or roughly half of the gains to the
polluter. In spite of the authors claim to the contrary, these results further call
into question the assumption of individual rationality (or the inducement
thereof within the experimental environment), since, in half of the experiments,
the polluters paid the victims to taste the liquid even when the polluters had
a unilateral right to force them to do so. And while the authors do not jump
from a willingness to sell the right to avoid tasting bitter liquid to, say, the
legalization of prostitution or pornography (although they do not entirely close
the door on such matters, choosing instead to express no opinion as to
whether such activities should be allowed), they do suggest a presumption in
favor of allowing individuals to transfer moderate amounts of dignity and/or
moderate amounts of danger.
Based on their various findings, Hoffman and Spitzer (1986, p. 162,
emphasis added) assert that their results produce a presumption in favor of the
Coase Theorem, by which they mean that a judge or a legislator should start
his analysis by presuming that the parties can and will, in general, exhaust the
gains from trade available through private bargaining and that those who
would argue against this must bear the burden of the proof. Furthermore, they
argue, the strength of the evidence for the optimality of the bargaining
outcomes establishes a presumption in favor of injunctive over damages
0730 The Coase Theorem 861
remedies because of the high probability that the parties will bargain to the
efficient result (Hoffman and Spitzer, 1986, pp. 163-168). (See Calabresi and
Melamed, 1972. For discussions of the relative efficacy of property rules and
liability rules when transaction costs are positive, see also Polinsky, 1979;
1980; Ayres and Talley, 1995a, 1995b; Kaplow and Shavell, 1995, 1996.)
In making these claims, Hoffman and Spitzer clearly go too far. It is one
thing to show that the Coase Theorem is largely confirmed in a laboratory
setting that attempts more or less to mimic the zero transaction costs world, but
it is quite another to say that the results thus generated establish a presumption
in favor of the Coase Theorem for efficiently resolving real-world externality
problems with twenty or fewer parties. (It should be noted that the parties will
always reach an efficient point, in the Pareto sense. That is, even if transaction
costs are so large as to preclude rights transfers, that result is Pareto efficient,
given transaction costs. See, for example, Samuels (1974), Buchanan (1983)
and Calabresi (1991). However, the efficient result to which Hoffman and
Spitzers presumption refers is the Pigouvian social optimum, which is
equivalent to the Pareto optimal outcome when transaction costs are zero.)
What may be established is that up to twenty-party externalities will be resolved
efficiently through negotiations in many and perhaps even most, instances
where transaction costs are very low and the stakes are very small. But
transaction costs consist of far more than factors introduced by a twenty-second
tasting of a foul liquid or adding parties to a bargain, particularly when the
group consists of more-or-less homogeneous college students. The
emphysema-ridden residents of the neighborhood are likely to have a far
different view of pollution externalities than would others who are not so
affected; the light sleepers are likely to look far differently at the neighborhood
kennel than are the deep sleepers and so on. And how many groups are absent
one or two members who are likely to impede any negotiated settlement? All
of this is to say nothing of the information and coordination problems that may
attend complicated real-world bargains. In sum, Hoffman and Spitzer develop
some very nice results offering rather strong support for the Theorem when the
conditions it assumes are nearly met. However, to move from this to claims of
widespread applicability and presumptions in favor of the Theorem in
real-world cases is a somewhat different matter, one requiring far more caution
and future study than is implied by the authors.
7.3 Criticisms re: Invariance Proposition
Apart from transaction-cost-related issues of applicability, these experiments
also fail to get at the invariance proposition per se. For example, might effects
such as the normative sanction for rights, an affront to dignity, or wealth effects
cause a divergence between WTA and WTP? These issues are side-stepped
within the Hoffman and Spitzer experimental design that makes efficiency and
862 The Coase Theorem 0730
invariance go hand-in-hand. While the evidence regarding the existence of a
divergence between WTA and WTP is not uniform (see the survey by Hoffman
and Spitzer, 1993, and the references cited therein), it seems to weigh in favor
of the existence of a non-trivial divergence, one that is too large to be explained
solely in terms of wealth effects. Attempts to measure the relationship between
WTA and WTP have been done through surveys and through experiments. The
survey evidence shows a substantial difference between WTA and WTP,
although economists have been rather suspicious of these results because of
their several potential biases. However, as we have noted, recent experimental
treatments of this issue support the contention that WTA may be substantially
greater than WTP, often more than twice as great (Levy and Friedman, 1994;
Hoffman and Spitzer, 1993, pp. 69-85). While this literature is too vast to
survey here, one set of experiments, undertaken by Kahneman, Knetsch and
Thaler (1990), probes this issue in the context of the Coase Theorem and, in a
number of different types of experiments, finds significant endowment effects.
Using items such as mugs, pens, binoculars and chocolate bars, they find that
individuals, when given the opportunity to exchange these items for cash,
exhibit a strong reluctance to part with entitlements and thus that, contrary to
standard assumption of economic theory, preferences are apparently not
independent of entitlements (Kahneman, Knetsch and Thaler, 1990, p. 1339).
The value that the subjects place on these objects appears to increase
substantially as soon as the individual is given the object (Kahneman, Knetsch
and Thaler, 1990, p. 1342) and the resulting disparity between WTA and WTP
does not dissipate in repeated trials (that is, with market experience). They
suggest that this endowment effect is most likely to occur for items that are not
easily replaceable, which makes the endowment effect particularly important
for the Coase Theorem, since things like a nice view, or clean air or water, are
not easily replaced and it thus can be expected that people will refuse to sell
such goods even at prices somewhat greater than their reservation price for
buying them.
Two implications of these WTA versus WTP experiments are particularly
important. The most obvious is that the results provide strong evidence against
invariance in the outcomes of bargains even when transaction costs are zero.
Second, endowment effects reduce the gains from trade as compared with a
world in which preferences are independent of endowments. Since fewer
mutually advantageous exchanges are possible, the volume of trade is lower
than it otherwise would be (Kahneman, Knetsch and Thaler, 1990, p. 1344).
Given the size of the potential disparity between WTA and WTP, one can
conceive of situations where each partys WTA is greater than the other partys
WTP, so that no trade would occur, whereas if WTA were equal to WTP, we
would see bargains consummated. Experiments run to test this implication in
a Coase Theorem context revealed substantial under-trading relative to the
Theorems predictions (Kahneman, Knetsch and Thaler, 1990, pp. 1339-1341).
0730 The Coase Theorem 863
Even when transaction costs are negligible, then, there does not seem to be
much room for confidence in the generation of an invariant outcome when
consumers are party to an externality.
7.4 Criticisms re: Different Contexts
Even less favorable to the Theorems applicability are the results of an
experiment by Stewart Schwab (1988), who looked at the Theorem in the
context of labor law and labor-management negotiations. The graduate student
subjects in Schwabs experiments were asked to negotiate a union contract over
wages, vacation time and - the crucial aspect of the experiment - whether or not
the company had the right to transfer work to its nonunion plant over the
course of the three-year contract. The implications for the Coase Theorem lay
in the contract presumption that was said to govern labor relations in the
absence of a specific contract provision: in one group of experiments, subjects
were told that the legal presumption was that the company must continue to use
union workers unless the contract explicitly states otherwise (that is, includes
a go clause), while the other group was told that the presumption was that the
company could transfer work to the nonunion plant during the course of the
contract unless the contract explicitly stated otherwise (that is, includes a stay
clause). (These contract presumptions have actual counterparts in labor law B
the Milwaukee Spring cases.)
Analysis of the results of these experiments shows that only about 20
percent of the contracts were fully efficient when wage levels, vacation time
and the stay or go clause are accounted for, a vast difference from the roughly
90 percent efficiency of the Hoffman and Spitzer and the Harrison and McKee
experiments. Out of 108 contracts, all but two had efficient wage levels, but
only 31 percent had efficient vacation levels and only about 65 percent had a
stay clause where it was efficient or a go clause where it was efficient. Schwab
contends that three factors may account for these differences. First, parties in
these experiments were bargaining over multiple contractual terms under a
binding time constraint and thus may have found it difficult to make efficient
choices on all items. Second, unlike many of the other experiments, subjects
here were not given full and perfect information. This meant both that
information had to be communicated during the negotiation process and that
signaling and bluffing could occur, leading to inefficient agreements. Finally,
the subjects did not know what the best outcome was from the beginning and
thus had to find their way to it and do so over a rather large bargaining range
which, of course, could easily result in inefficient outcomes (Schwab, 1988, pp.
251-252).
Given these factors, the rather high rate of failure to reach efficient bargains
is not particularly surprising. The environment of these experiments
corresponds much more closely to a natural setting than do many of the other
experimental treatments and the factors that exist in these natural settings are
864 The Coase Theorem 0730
such as to weigh heavily against the attainment of efficient results. By the same
token, however, these experiments go much more to the application of the
insights of the Coase Theorem than to the testing of the Theorem per se, in that
they introduce a variety of factors that are assumed away by the Theorems
assumption of zero transaction costs. Thus, earlier work, such as that by
Hoffman and Spitzer, speaks favorably to the Coase Theorem on its own terms,
while Schwabs results are rather pessimistic about the ability of parties to
bargain to efficient results in more natural settings. However, Schwabs results
take on a better cast when evaluated in light of what he calls the weak
efficiency hypothesis, which says that the law will not affect the rate at which
efficient bargains are consummated. (This is not to be confused with the weak
version of the Coase Theorem, noted above, which asserts efficiency but not
invariance.) The form of the contract presumption does not have a significant
effect on the inclusion of stay clauses or go clauses, nor on the efficiency of the
contracts (Schwab, 1988, pp. 252-253).
8. Empirical Studies
There have been three studies that more or less take Coases farmer-rancher
example into the real world to look at the ability of parties to negotiate efficient
solutions to animal trespass problems.
8.1 California Animal Trespass Laws 1850-90
Kenneth Vogel (1987) examines the response of farmers and ranchers to
changes in California animal trespass laws between 1850 and 1890. At the time
when, in 1850, California joined the Union, its principal industries were
mining and cattle raising and, reflecting the importance of the cattle industry
to the state, California had what was, in essence, strict nonliability for cattle
trespass. This rule clearly favored the ranchers and the evidence strongly
suggests that the rule was designed with that in mind. At the same time,
however, it played a major role in hindering the development of agriculture in
the state (Vogel, 1987, pp. 163, 167).
However, between 1851 and 1890 there were no less than 150 different laws
enacted by the California legislature altering the rules that governed cattle
trespass in ways that benefited farmers (Vogel, 1987, pp. 163-164). The Coase
Theorem predicts that these alterations in the law will have no effect on the
allocation of resources; that is, ceteris paribus, these changes in the law should
have no effect on the level of resources devoted to ranching and farming, or on
ranching and farming outputs. And, according to Vogel, this situation is
particularly well-suited to testing the applicability of the Theorem to the real
world since the externality is visible, the parties are, at least post hoc, easily
0730 The Coase Theorem 865
identifiable and it is easy to measure, or use proxies to estimate, the damages
(Vogel, 1987, p. 181).
Contrary to the Theorems prediction, however, the enactment of the
various estray laws beginning in the 1860s was accompanied by an enormous
increase in farm output, particularly for wheat farming, which became common
in the valleys, while cattle were moved up into the foothills. Econometric
analysis undertaken by Vogel shows that a number of variables attempting to
capture the effects of legal change on crop outputs are significant and that these
are uniformly positive in sign, which supports the claim that these legal
changes did indeed influence the growth of agriculture (Vogel, 1987, p. 184).
Given the strength of the evidence, it remains to explain why the Coase
Theorem fails here. Vogel suggests two reasons. First, transaction costs may be
significant and, furthermore, are asymmetric across alternative assignments of
rights; specifically, they are lower when ranchers are liable (Vogel, 1987, pp.
176, 187). When ranchers are not liable for the damage done by their cattle, the
farmer wishing to keep the cattle off his land will have to negotiate with each
rancher whose cattle might potentially stray onto his land in order to
accomplish this. On the other hand, when farmers have the right to
compensation for damages, the onus is on the ranchers to initiate negotiations
and the rancher need only bargain with those farmers on whose land his cattle
may be expected to stray. Second, there are nonconvexities as a result of the
externality. If ranchers are not liable for trespass damages, the fact that each
farmer has to negotiate with all ranchers whose cattle might stray onto his land
in order to prevent damage means that [i]f a farmer fails to contract with the
rancher whose cattle actually use his land, all payments made to the other
ranchers are useless (Vogel, 1987, p. 176). The farmer will thus have little
incentive to initiate such negotiations, with the result that efficiency will obtain
only if it is efficient for cattle to be allowed to roam freely. This nonconvexity
is not present when farmers are given the right (Vogel, 1987, pp. 174-176,
187). Taken together, these two factors can explain why output was lower when
the ranchers were not liable.
In contrast to Hoffman and Spitzer, who use their experimental results to
claim a presumption in favor of the Coase Theorem, Vogel (1987, pp. 186-187)
argues that his results refute the general applicability of the Theorem. Yet,
Vogel has not refuted the Theorem but rather has shown the importance for the
case of straying cattle of transactions costs and pointed out the importance of
assigning the legal rule to minimize transactions costs as both Coase (1960, p.
19) and Posner (1983, p. 71) suggest should be done. Given the enormous
volume of legal change at the time, the nonconvexities present and the
difficulty of ascertaining the source of the damage, Vogels broad conclusion
may be premature. Some degree of support for a more moderate view can be
found in the study of contemporary trespass disputes undertaken by Robert
Ellickson.
866 The Coase Theorem 0730
8.2 Effects of Open- v. Closed-Range Laws
Ellickson (1986, 1991) examines, among other things, the effects of open-
versus closed-range laws on cattle trespass disputes in Shasta County,
California. Under open-range laws, cattlemen are not usually responsible for
accidental trespass damage, whereas they are strictly liable under closed range
laws. Ellickson finds that cattlemen and their neighbors do in fact behave in a
manner suggested by the Coase Theorem, cooperating to resolve their disputes
regardless of who is liable. However, the evidence also suggests that it is not
Coase Theorem-type mechanisms at work here; rather, individuals seem to rely
on community norms to determine their behavior. For example, while the
Theorem predicts that the cattleman would install a fence if he were liable
(closed range) and that the neighboring farmer would do so if he were liable
(open range), it is almost always the cattleman who installs the fence because
both cattlemen and their neighbors believe that the cattleman is morally
obligated to do so, since his cattle cause the damage. Moreover, the citizens
seem to be very ignorant of the relevant law and ignore those aspects of the law
that conflict with their view of the world. As such, they do not bargain in the
shadow of the law (see Mnookin and Kornhauser, 1979, and Cooter, Marks
and Mnookin, 1982), but beyond it; community norms seem to have much more
force than the legal rule in place. Ellickson suggests that this may be due to the
fact that relations among the neighbors are both complex and continuing,
because of which the transaction costs associated with acquiring information
and litigating disputes are high and reliance on norms offers a lower-cost way
of resolving these disputes. Ellickson (1989, 1991) also suggests that this
norm-based behavior points to the need to revise certain of the behavioral
concepts underlying law and economics.
8.3 Roaming Deer in Scottish Highlands
In a study that has interesting commonalities with that of Ellickson, Nick
Hanley and Charles Sumner (1995) examine an externality situation owing to
the roaming of red deer in the Scottish Highlands which cause damage to
growing trees and, in the process, impose substantial costs on the owners of
these forests, the value of the timber from which is diminished. In addition, the
wandering deer may destroy growing crops on farmland and, when they stray
onto sheep grazing land, reduce the forage for sheep, thus imposing costs on
both farmers and sheep ranchers. The beneficiaries of the red deer population
are estate owners, who derive substantial income and estate value from the
presence of red deer on their estates (Hanley and Sumner, 1995, pp. 88-91).
Given the level of damage, the small number of parties, the ease of
quantifying damage to forests and the relative ease with which estate owners
could reduce the size of their herds, the situation seems to reflect an
inefficiently-high deer population and a fertile ground for the working of Coase
0730 The Coase Theorem 867
Theorem-type mechanisms. Even so, an extensive study by Sumner (1993)
failed to turn up any instances of Coasean bargaining between owners of deer
estates and neighboring landowners. What one does observe, however, are Deer
Management Groups which neighboring landowners have established to
coordinate deer management across neighboring estates ... and forest/farmland,
in order to reduce the level of the externality. The advantage of such groups
is that they effectively [internalize] the externality across members of the
group, thereby avoiding the third-party effects that can result with bilateral
bargaining (Hanley and Sumner, 1995, p. 93). It is interesting to note the
parallel between the rise of the cooperative Deer Management Groups and the
behavior of neighbors revealed in Ellicksons study of cattle ranching in Shasta
County. While the law offers a low-cost option (free government culling) for
dealing with red deer damage, groups of neighboring landowners in essence
ignore the law and work out a solution amongst themselves, perhaps
presumably because it is the case that the transaction costs associated with the
cooperative efforts of the Deer Management Groups are lower than those that
would attend bilateral negotiations of the Coasean variety (Hanley and Sumner,
1995, p. 93).
8.4 Implications for other Legal Rules: Divorce
The Coase Theorem has implications for all manner of legal rules, including,
as Peters (1986, 1992) points out, the rules governing divorce. Since 1970,
there has been a progressive movement in the US from divorce by mutual
consent (requiring the agreement of both parties), to unilateral divorce, where
the marriage can be terminated at the demand of either party. Intuitively, the
rules governing divorce function to establish property rights with respect to
dissolution of the marriage. Under unilateral divorce law, the spouse seeking
divorce has property rights with respect to dissolution while, under mutual
consent, the right rests with the spouse who does not wish to see a divorce
occur (Peters, 1992, p. 690). The conventional wisdom was that unilateral
divorce laws would make divorce easier (in economic terms, reduce transaction
costs), thus increasing the divorce rates in states that adopted such laws. The
Coase Theorem predicts that if bargaining costs are minimal and information
is symmetric across parties, divorces will only be undertaken when they are
efficient (that is, joint benefits exceed joint costs), regardless of the law
governing divorce and that the legal rule will have no impact on the divorce
rate.
Peters (1986) tests a model corresponding to the Coase Theorem
environment against one that posits asymmetric information and thus predicts
that divorce rates will differ across alternative legal rules and finds that the data
support the predictions of the Theorem against the conventional wisdom: the
move to a unilateral divorce rule does not affect the probability that a woman
becomes divorced (Peters, 1986, pp. 446-448). Moreover, the level of alimony
and child-support payments are significantly lower in states with unilateral
868 The Coase Theorem 0730
divorce rules (Peters, 1986, p. 449) and the labor force participation rates of
married women in such states are higher, which, she argues, may represent an
attempt by married women to self-insure against the possibility of becoming
divorced without compensation (Peters, 1986, pp. 448-449, 451-452). Thus,
both the divorce rates and the distribution of compensation are consistent with
the Coase Theorem. However, a number of subsequent studies find that the
evidence tends to support the conclusion that divorce rates are in fact higher in
unilateral divorce states than in mutual consent states. (See, for example, Allen,
1992; Zelder, 1993a, 1993b; Brinig and Buckley, 1995; Friedberg, 1995,
which also contain numerous citations to literature on both sides of the
argument.) Within this debate, each side claims that the others empirical work
contains errors or biases that influence the results (see, for example, Peters,
1986, 1992; Allen, 1992).
Even if one is willing to accept the result that divorce rates are not impacted
by the legal rules governing divorce, it remains to ascertain whether these
results actually reflect the working of Coase Theorem-type mechanisms. There
is plenty of reason to suggest that the answer is no, or at least not
necessarily. First, there is no evidence to suggest that unilateral divorces are
undertaken only when they are efficient. Rather, Peters infers that the efficiency
proposition holds based on a questionable claim that transaction costs are low
and the fact that the data confirm the models invariance and distribution
predictions. (For contrasting views on the potential magnitude of transaction
costs here, see Peters (1992, p. 690) and Allen (1992, p. 684). Allen (1992,
1995) goes so far as to argue that, by working an uncompensated transfer of
wealth from wives to husbands, the move to no-fault divorce violates the zero
transaction costs/fully-specified rights condition assumed by the Theorem and
thus that the rise in the divorce rate does not constitute a legitimate argument
against the Theorem.) Furthermore, Peters fails to account for the fact that the
Theorem predicts not just an invariant divorce rate, but an invariant allocation
of household resources as well - just as the farmer-rancher example predicts an
invariant allocation of resources devoted to farming and ranching. The fact that
female labor force participation is higher in states with unilateral divorce rules
thus speaks loudly against the claim of invariance.
8.5 Implications for Other Legal Rules: Pre-Trial Settlements
A similar problem attends the claim that the high rate at which suits are settled
prior to trial supports the Coase Theorem (Hoffman and Spitzer, 1986, pp.
168-169). Glanter (1983, pp. 28-30) finds that roughly 90 percent of all
lawsuits are settled before they go to trial and that, when they do not settle, it
tends to be due to (i) cases that require a judicial decree to be settled; (ii) cases
that are not costly to litigate, which reduces the incentive to settle; (iii) the
placing by one or more parties of special value on having a judicial decree for
0730 The Coase Theorem 869
reasons including, inter alia, precedent and reputation; (iv) cases that involve
an issue that is not easily negotiated over, such as a fundamental value; and
(v) the high transaction costs associated with settlement as compared to going
to trial - factors that lie outside of the bounds of the Coase Theorem. However,
the high proportion of settlements does not imply that the parties have
bargained to the Pareto optimal result contemplated by the Coase Theorem.
There is no way to infer from the settlement data whether the parties have
bargained to the socially optimal result contemplated within a zero transaction
costs world, or if they simply have realized some of the potential gains from
negotiation but hit a point where the transaction costs from further negotiation
exceed the expected gains and choose to settle at a suboptimal outcome
because this settlement, although not optimal, is still better than going to trial.
8.6 Implications for Other Legal Rules: Unemployment
Perhaps the most unique empirical test of the Coase Theorem is Donohues
(1989a) analysis of the Illinois employment experiment (Spiegelman and
Woodbury, 1987), which attempted to determine whether the payment of
bonuses to unemployed workers for securing employment, or to employers for
hiring unemployed workers, would reduce the duration of unemployment and
the costs associated with the unemployment compensation system. While the
experiment was conducted to ascertain how such bonuses might affect the
duration of unemployment, its application to the Coase Theorem is
straightforward. The efficiency hypothesis predicts that mutually advantageous
bargains will be struck under either scheme and all workers and employers who
satisfy the eligibility requirements will collect bonuses. The allocative
invariance proposition suggests that members of the worker-payment group
(WPG) will find jobs and collect bonuses at the same rate as members of the
employer-payment group (EPG). The invariant distribution hypothesis predicts
that members of the WPG and EPG groups will have the same aggregate
compensation (wages plus bonus). The WPG workers would be expected to
have lower wages than EPG workers, reflecting a bargaining away of a share
of their bonus, as compared to EPG workers higher wages as employers
bargained away a share of their bonus.
Donohues inquiry into the results of the Illinois experiment reveals that
they contradict the predictions of the Coase Theorem on all counts. To begin
with, the number of bonuses paid to WPG workers was about five times that
paid to EPG employers. Furthermore, many workers and employers who met
the requirements for bonuses failed to submit a voucher to receive their bonus -
particularly employers. Given this, says Donohue, [t]he conclusion that a
number of individuals and employers acted inefficiently is hard to rebut
(Donohue, 1989a, p. 573). The experimental results also revealed that members
of the WPG had a significantly greater improvement in obtaining employment,
relative to the control group, than did members of the EPG, which, along with
870 The Coase Theorem 0730
the differential bonus collection rates among the groups violates the allocative
invariance prediction of the Theorem (Donohue, 1989a, pp. 569-577). Finally,
there was no significant difference in wages across the WPG and EPG hirees,
so that aggregate (wages plus bonus) compensation was higher for WPG
workers than for EPG workers, in violation of the invariant distribution
prediction of the Theorem. That is, it appears that workers did not bargain with
employers over the wage or the bonus as a result of this program (Donohue,
1989a, pp. 586-590).
Donohue (1989a, pp. 591-601) asserts that transaction costs are extremely
low here and thus that the Theorem fails in a case most favorable to its success.
He offers two possible explanations for why the experiment failed to satisfy the
predictions of the Coase Theorem, each of which goes to the issue of individual
behavior/decision making in the context of such bargains. One possibility, to
which Donohue lends a great deal of support, is ignorance on the part of
workers, who seemed not even to realize that bargaining was possible and may
not have understood that the bonuses could aid them in gaining employment.
Moreover, there may have been an authoritarian effect which caused the
workers to believe that the bonus was in effect inalienable - that the party
designated to receive the bonus was in fact entitled to its full value, an effect
that would also discourage the type of bargains envisioned by the Theorem
(Donohue, 1989a, pp. 600-602).
Donohues conclusions regarding the implications of the Illinois experiment
for the Coase Theorems applicability have been challenged by Ellickson
(1989) and Lindgren (1990), both of whom contend that Donohue greatly
underestimates the effect of transaction costs within this experiment. Acquiring
this so-called free money actually involves a substantial number of steps (and
even more for employers than for workers), the aggregate effect of which is to
make the process rather costly, relative to the size of the bonus. Lindgren
(1990, pp. 581-582, 585), for example, lists the steps that participants in the
WPG and EPG programs must go through in order to collect bonuses and offers
several reasons why one would not anticipate an invariant distribution of
income, or bargaining over the bonuses. In fact, Lindgren (1990, p. 583)
suggests that the results do in fact match the predictions of the Coase Theorem
(see also Ellickson, 1989, p. 625).
First, because costs are high relative to the bonuses, the insights underlying
the Coase Theorem would lead one to predict that many workers or employers
who are eligible for bonuses would not collect them. The Illinois study
confirmed this prediction. Second, because costs are higher for employers than
for workers, the insights of the Coase Theorem would lead one to predict that
more workers in the worker-bonus group would be influenced to participate in
the program, obtain work quickly and collect the bonuses. Again, the Illinois
study confirmed these predictions (Lindgren, 1990, p. 583).
0730 The Coase Theorem 871
Indeed, if transaction costs were zero, the entire premise of the experiment
would disappear, since job search is a positive transaction cost phenomenon
(Lindgren, 1990, p. 578). Finally, the presence of stigma and institutional
rigidity effects would lead one to predict minimal bargaining over wages and
bonuses (in an amount different from the control group), a result again
supported by the Illinois experiment. In fact, Ellickson finds the results of the
Illinois experiment very consistent with his own study of Shasta County - that
people often tend to rely on norms rather than legal rules to govern their
behavior, particularly when the stakes are low and there is an expectation of a
continuing relationship, as among neighbors in Shasta County and between
employers and employees in the Illinois experiment (Ellickson, 1989, pp.
627-628).
8.7 Implications for Other Legal Rules: Tenancy
The two earliest attempts to empirically validate the working of Coase
Theorem-type mechanisms in real-world environments were undertaken by
Cheung (1969a, 1973), who examined two of the classic illustrations of market
failure caused by externalities - share tenancy arrangements in agriculture and
the relationship between beekeepers and apple orchard owners. These studies
undertake to examine the Stigleresque version of the Theorem, which asserts
the efficient internalization of externalities under conditions of perfect
competition.
The standard view in the economics and tenancy literatures has long been
that share tenancy leads to an inefficient allocation of resources, owing to (i)
the short duration of the leases; (ii) the discouragement of effort on the part of
the tenant, since a portion of each unit of output must be paid to the landowner
as rent; and (iii) the disincentive for either party to make investments in the
land that will maximize the lands productivity (see Cheung, 1969a, pp. 3-4,
7-8 and the references cited therein). As a result, one would expect to observe
lower crop yields under share tenancy than under alternative cultivation
arrangements. However, the Coase Theorem predicts that, if transaction costs
are zero and there are well-defined and freely alienable private property rights
in land, the allocation of resources will be the same whether the landowner
cultivates the land himself, hires farm hands to do the tilling, leases his
holdings on a fixed rent basis, or shares the actual yield with his tenant. In
other words, different [observed] contractual arrangements do not imply
different efficiencies of resource use Y (Cheung, 1969a, p. 4).
An examination of share tenancy in China and Taiwan prior to the land
reforms of 1949 shows that there was a well-developed system of private
property rights in land in China and Taiwan at this time and that the market
by and large comported with the dictates of competition. Furthermore, Cheung
did not observe lower ratios of labor and other inputs, a lesser degree of
improvements, or lower yields on tenant farms than on owner-cultivated farms
872 The Coase Theorem 0730
or on farms employing wage labor, nor is there evidence that the market values
of land under tenant cultivation are lower than the values of land under owner
cultivation (Cheung, 1969a, pp. 56-61, 1980, p. 42). And, while it has been
argued that, under share tenancy, certain types of activities - such as
improvements to farms - would be contracted inadequately or not at all, Cheung
(1980, p. 43) finds that these are precisely the activities stated in every written
contract that I could find. All of this evidence suggests quite strongly that
charges that share tenancy is less efficient that other cultivation arrangements
cannot easily be sustained.
Even though the theory assumes zero transaction costs where transaction
costs are actually positive, it is able to explain much of the observed farming
behavior (Cheung, 1969a, p. 159). In this situation of well-defined property
rights, transaction costs are not so high as to affect resource use at the margin,
but, rather, affect the choice among alternative contractual arrangements - the
use of alternative methods of cultivation reflecting the tradeoff between
coordination costs and risk, each of which varies across alternative contractual
arrangements (Cheung, 1980, p. 44). (For a related discussion, see Cheung,
1969b.) While Cheungs evidence does not conclusively demonstrate the
optimality of share contracts, it certainly does lend strong support for the claim
that, at a minimum, share contracting is no less efficient than other available
contractual arrangements and thus that, under the appropriate (and not
unrealistic) conditions, the mechanisms of the Coase Theorem can lead to a
satisfactory resolution of externality problems through the market.
The other early study by Cheung of the working of Coase Theorem-type
mechanisms is The Fable of the Bees ... (1973), a study which responds to
Meades (1952) classic discussion of the positive reciprocal externalities that
exist between beekeepers and the owners of apple orchards: apple blossoms
provide valuable services to beekeepers, whose bees feed on them, while, at the
same time, bees provide valuable pollination services to the apple-orchard
owner. While Meade argued that a system of taxes and subsidies can and must,
be imposed in order to achieve efficiency, contractual arrangements between
farmers and beekeepers have long been routine in the US and the existence of
a market for nectar and for pollination services can be readily observed in the
state of Washington, the location of Cheungs study - in some cases merely by
consulting the yellow pages of the telephone directory (Cheung, 1973, p. 19).
The question, of course, is whether these markets generate an efficient
allocation of resources. Cheung (1973, pp. 24-28) argued that a presumption
can be established in the affirmative, since available data provides substantial
support for the competitive nature of the market.
How is it that in this externality situation the market avoids the failure
pointed to by Meade? To begin with, transaction costs are very low here. Since
the value of resources devoted to pollination and nectar extraction is
0730 The Coase Theorem 873
insignificant and farmers could easily and cheaply keep bees themselves (and
sometimes do so), the gains from contracting with beekeepers are extremely
small, which, in turn, suggests that contracting costs are minimal (Cheung,
1980, pp. 46-48). There is also a well-developed system of contractual relations
between beekeepers and farmers, so well-developed, in fact, that, while written
contracts (sometimes as simple as postcards) are used to secure an initial
arrangement among the parties, oral agreements are standard for subsequent
relations. Furthermore, these oral contracts are rarely breached, owing to the
presence of extra-legal constraints in the form of sanctions against those who
do not honor their contracts (Cheung, 1973, p. 29). Yet, in spite of the
informality of these contracts, they tend to be quite comprehensive, specifying
the number and strength of the [bee] colonies, the rental fee per hive, the terms
of delivery and removal of hives, the protection of bees from pesticide sprays
and the strategic placing of hives. And, where hives are placed merely for
honey-generating purposes (that is, no pollination is involved), prices (often
paid in honey) are not necessarily fixed - being allowed to vary with the honey
yield (Cheung, 1973, p. 29). All of these various pieces of evidence lead
Cheung to conclude that, contrary to Meades story, the allocation of hives and
nectar flows approximates that of a smoothly functioning market wherein
resources are efficiently allocated (Cheung, 1980, p. 50).
This having been said, Cheung notes that there are two factors which could
potentially complicate these arrangements (relative to standard lease contracts),
both of which relate to other levels of external effects. First, there are potential
spillovers from one farmer contracting for pollination services, which could
potentially lead neighbors to take strategic advantage by employing fewer hives
themselves. Second, the use of pesticide sprays by one farmer may result in
damage to the bees kept on nearby farms. But both of these issues are dealt with
through either custom or explicit contracting (such as the payment of risk
premiums for potential exposure to pesticides), depending on the
circumstances. The reliance on customs here is an interesting parallel to
Ellickson (1986, 1991), discussed above.
It should be obvious that it is not possible to confirm or refute the efficiency
claims made by Cheung and, given this, the results cannot be said to show the
applicability of the Theorem (here, the Stigler, 1966, version) per se. Yet, they
offer important evidence that markets can successfully (if not fully efficiently)
deal with potential externality problems under the appropriate conditions.
874 The Coase Theorem 0730
D. Importance
9. The Importance of the Coase Theorem
The importance of the Theorem lies not in whether it is correct, but in the
detailed nature of the assumptions required to make it correct-in that is the
nature of transactions costs. The interesting question about the Theorem then
is the nature of the transactions costs associated with those situations in which
the theorem is thought to not be correct. The legacy of the Theorem lies in the
subsequent work attempting to detail the nature of transaction costs and their
effect on the workings of the economic system. The richness and variety of
types of economic arrangements can now be seen in the richness and variety of
transaction costs and in mechanisms for reducing them.
In this sense the importance of the Coase Theorem lies not in its supposed
correctness or incorrectness and the corresponding policy relevance or lack
thereof, but, rather, in the positive transactions cost propositions that flow from
it. These include both normative and positive propositions. Examples are
Posners (1992, p. 52) normative suggestion that at law [s]ince transactions are
never costless in the real world, efficiency is promoted by assigning the legal
right to the party who would buy it ... if it were assigned initially to the other
party and the positive prediction of Lesser, Dobbs and Zerbe (1997) that suits
at law in situations where negotiation costs are low will involve considerations
of distribution not efficiency.
The Coase Theorem has helped to give rise to an extensive body of work,
much of it summarized by Eggertsson (1990), concerned with economic
behavior and institutions and to a more detailed and useful sense of what is
meant by property. The Coase Theorem has made clearer the relationship
between transactions cost and property rights and in doing so has begun to give
a much stronger basis for understanding how legal regimes change in response
to changes in constraints (North, 1981). One can now define the strength of
property rights in terms of lower transaction costs for the exclusion, exchange
and use of property.
In part of the economics literature at least (Eggertsson, 1990) the
transactions cost approach has replaced the market failure model of public
intervention that is expressed by Weimer and Vining (1992, p. 30):
When is it legitimate for government to intervene in private affairs? In the United
States, the normative answer to this question has usually been based on the concept
of market failure - a circumstance where the pursuit of private interest does not lead
to an efficient use of societys resources or a fair distribution of societys goods.
0730 The Coase Theorem 875
When the costs of transaction mechanisms are introduced there are
departures from perfect markets. These departures are in fact externalities
because they represent effects not taken into account in the decision making
process. Externalities, then, are found everywhere there are transaction costs
and are ubiquitous. Since the concept of market failure rests on externalities
that are defined by transactions costs, the concept of market failure (and the
concept of externality) does no work for us that is not already done by
transaction costs (Zerbe and McCurdy, 1996). Externalities are in fact an
unnecessary complication in the theory of government intervention.
Public goods represent a useful example of a situation in which the market
failure model can be and to some extent is being, replaced by a transaction cost
model. The older market failure approach is represented by Samuelson (1954),
who saw public goods as a class of market failures. For example, in writing
about the classic case of the lighthouse, Samuelson (1964, p. 45) writes:
Here is a later example of government service: lighthouses. These save lives and
cargoes; but lighthouse keepers cannot reach out to collect fees from skippers. So,
says the advanced treatise, we have a divergence between private advantage and
money cost ... and true social advantage and cost ... Philosophers and statesmen
have always recognized the necessary role of government in such cases of
external-economy divergence between private and social advantage.
The transaction cost-property rights approach appears to provide a richer
vehicle of analysis, as shown by Cheung, North and others. For example, Coase
(1974a) shows that the British lighthouse system was once a well-functioning
private system and that, in general, the system was more complex than that
suggested by the simplistic market failure diagnostic.
The triumph of the transaction cost approach shows that the true legacy of
the Coase Theorem lies not in its correctness, but in drawing attention to the
role played by transaction costs within the economic system.
10. Conclusion
In light of the foregoing discussion, three things can be said about the Coase
Theorem. First, it is correct, in the sense that it has withstood all of the
challenges mounted against it to date. Efficiency will obtain, regardless of the
initial assignment of rights and the result will be invariant keeping in mind that
even income effects are irrelevant if one accepts the Barzel/Allen definition of
zero transaction costs. Second, the Theorem, although correct, is unrealistic,
as Coase recognized (see Coase 1960, p. 15, 1981, p. 187, 1988a, pp. 174-179).
The latter point, of course, should have been obvious from the beginning, which
876 The Coase Theorem 0730
raises the question as to why the debate over the Theorem has been so intense.
A small part of the answer, within the economics profession at least, may lie
in the interesting theoretical puzzle that the Theorem poses. Dwarfing this,
however, is the normative debate that, implicitly or explicitly, pervades nearly
all aspects of the Theorems discussion.
Three prescriptions for legal-economic policy are said to flow from the
Coase Theorem.
1. Rights-cum-market solutions are said to be preferable to Pigouvian remedies
for the resolution of externality problems.
2. Property and contract are efficient; any interference with the outcomes so
generated will make matters worse rather than better. It is this implication
that makes the Coase Theorem, in the minds of some, the cornerstone of
a laissez-faire legal and economic policy regarding contract and property
law (Hoffman and Spitzer, 1986, p. 151).
3. When transaction costs are positive, rights should be assigned to those who
would possess them in the end-state if transaction costs were zero, as seen
in the prescriptions of wealth maximization, or mimic the market.
But the Coase Theorem says none of these things. The Theorem is a positive
statement with no normative implications; it is an is statement, not an ought
statement. Each of the above propositions rests on the assumption that
efficiency is the goal of legal-economic policy. But the Coase Theorem goes
merely to the presence of absence of efficiency; it does not tell us that it is all
that matters or even that it matters at all. It is this normative leap that seems
to underlie most of the hostility to the Coase Theorem - and, by extension, to
law and economics generally. (See, for example, Baker, 1975; Kelman, 1979;
the Symposium on Efficiency as a Legal Concern, 1980; A Response to the
Efficiency Symposium, 1980; Schlag, 1986; Gjerdingen, 1986; Johnston, 1990
and Crespi, 1991.) For a response to these types of criticisms see Zerbe (1998a).
Compounding the hostility to the normative use of the Coase Theorem are the
use of incorrect definitions of economic efficiency by proponents of law and
economics (Zerbe, 1998b).
Furthermore, even if one takes efficiency to be the goal of legal-economic
policy, the Coase Theorem does nothing to establish the sanctity of property
and contract or the superiority of the market over Pigouvian remedies, owing
to the ubiquitous nature of transaction costs. If coordination is costless, the
market will optimally allocate rights and resources, but so too will Pigouvian
remedies. On the other hand, the Pigouvians fare no better in this debate since,
after waving away the Coase Theorem on the grounds that transaction costs are
positive, they tend to immediately fall back on the demonstration that
Pigouvian remedies generate socially optimal outcomes, using models in which
0730 The Coase Theorem 877
government is assumed to operate with full information and without cost. (But
see Baumol, 1972, for a more judicious evaluation of Pigouvian remedies.)
Here, we come to the true import of the Coase Theorem. The Theorem is
not, in the end, about markets or about costless bargaining; rather, it is about
the costs of coordination. If coordination is costless, markets function perfectly;
but so does government. If coordination is costly, markets function imperfectly;
but so does government. The task for legal-economic policy thus becomes that
of ascertaining the magnitude and influence of these costs and the resulting
implications for alternative institutional-policy arrangements. The true and
valuable legacy of the Theorem is all of the subsequent work on transactions
costs that explore the costs of coordination under different regimes and in
different situations. Like the Coase Theorem itself, this, too, is without direct
normative implications. However, it has led to certain normative claims, as
noted above. One, from an analytical perspective, is that the received
conception of externalities should be abandoned. Another, this time from a
policy perspective, is that judgments as to the appropriate form of government
intervention should be made on the basis of what institutional arrangement
produces the lowest combination of coordination costs. In this regard, it is
interesting to note that much of the normative debate and the propositions we
noted above in that regard can be turned into a series of positive predictions
about which arrangements will promote economic efficiency. Where the
affected parties could reach a solution through negotiation but choose litigation
or regulation, the real issue is likely to be who is to be assigned property rights
rather than how to realize gains from trade (see, for example, Lesser, Dobbs
and Zerbe, 1997).
Finally, the meaningfulness of the Coase Theorem must be understood in
epistemological terms. The correctness of the Theorem is a matter of logical
validity; in general, the Theorem is a conclusion derived from premises and the
role of the assumptions constituting its premises is to rule out of consideration
all those variables which would prevent the derivation of the conclusion as a
matter of logic. The validity of the Theorem, therefore, is a function of the
assumptions defining away certain limiting conditions. The empirical truth of
the Theorem - its descriptive accuracy - is a separate matter from its logical
validity. The Theorem considered empirically is a tendency statement, a
statement that under certain conditions such and such behavior and allocative
and so on results can be expected; that is, a law in the Marshallian sense.
However, the logical and empirical aspects are closely related to one another
in that changing the assumptional conditions of the Theorem is tantamount to
changing the conditions in terms of which the Theorem is a tendency
statement. The Theorem is a tendency or probability statement in a further
empirical sense, to wit: the experimental literature indicates that the results
expected on the basis of certain specifications of the Theorem are realized
something less than one hundred percent of the time.
878 The Coase Theorem 0730
Given the foregoing, it becomes clear that much of the literature on the
Coase Theorem not only overreaches in terms of the normative implications
more or less improperly drawn from the Theorem, but fails to specify the
meaningfulness of the Theorem in such terms - readily leading to practices
which make claims for and take the Theorem far beyond what logicality and
empiricism permit.
Acknowledgments
The authors would like to thank Douglas Allen, James Buchanan, Robert
Cooter, Robert Ellickson, Elizabeth Hoffman, Richard Posner, Warren Samuels
and participants in the Workshop in the History of Economic Thought and
Methodology at Michigan State University for comments and suggestions on
previous drafts of this chapter and for helping to clarify our thinking on certain
points raised herein. The excellent research assistance of Mary Therese Cogeos
is also gratefully acknowledged. Of course, the authors are solely responsible
for any remaining errors.
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Cases
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0740
TRANSACTION COSTS
Douglas W. Allen
Associate Professor
Department of Economics - Simon Fraser University
Copyright 1999 Douglas W. Allen
Abstract
This chapter addresses the history, use and significance of the term transaction
costs. Few words in the economic language have been more abused or fought
over and this is shown to result from the emergence of two distinct definitions
and uses. The Neoclassical definition rests on the costs of trading across a
market, while the property rights definition centers on the costs of
establishing and enforcing property rights. In articulating these two separate
definitions and in demonstrating their relationship and separate uses, it is
hoped that more progress can be made in the field of transaction cost
economics.
JEL classification: K0, L0, L2, D0, D8
Keywords: Transaction Costs, Property Rights, Coase Theorem
1. Introduction
Transaction costs. Do another two words exist in the economic lexicon that
generate as much friction? Conceptually introduced in Coases 1937 paper The
Nature of the Firm as simply the cost of using the price mechanism (Coase,
1988, p. 38), the words transaction costs have evolved to the point where
some skeptics claim they include any cost that is convenient and elusive enough
to avoid critical examination (Niehans, 1987, p. 678). Advocates, on the other
hand, have hailed the recognition of these costs as revolutionary and as
important conceptually as marginalism and substitution (Cheung, 1983, p.
21).
The ambiguity that surrounds the concept of transaction costs stems, in
large part, from the existence of two literatures simultaneously claiming
ownership over the term. The property rights literature begins with Coase and
has consistently focused on the role transaction costs play in determining the
distribution of property rights, broadly defined as all laws, rules, social customs
and organizations that generate incentives for behavior. This literature has
called into question fundamental concepts like efficiency and the nature of
production. Though based in neoclassical economics, this literature has evolved
beyond the neoclassical model and has produced the new sub-fields of law and
economics, the new economic history and the new institutional economics.
893
894 Transaction Costs 0740
Though this field, through Coase, claims the discovery and rightful title to
transaction costs, ironically the words are conspicuously absent from many
of its titles. Indeed this literature is mostly responsible, though not solely, for
the plethora of terms that either substitute for or refine the notion of transaction
costs.
The neoclassical literature on transaction costs begins in the early 1950s,
although some might argue that it starts with Hicks (1935) or even Coase
(1937). This literature defines transaction costs more narrowly, generally
models them more explicitly and often analytically identical to transportation
charges or taxes. The correspondence with familiar costs carries over to the
types of issues examined, such as the effect of transaction costs on the volume
of trade, abilities to arbitrage, the bunching of transactions, intermediation and
the existence and efficiency of equilibrium - all standard neoclassical fare.
Sometimes this literature examines issues of property right determination, such
as the role of middlemen and the medium of exchange. In addition to the
different approach and definition, the conclusions are often opposite from the
property rights literature as well. This is especially true over questions of
efficiency and this has increased the level of belittling rhetoric between the two
camps. For example, it is common in the neoclassical literature, when reference
is made to the Coase Theorem - the cornerstone of the property rights literature
- to say the so-called Coase Theorem (See Niehans, 1987 p. 678, for an
example). The property rights literature is just as aggressive, claiming that the
neoclassical camp often wants their cake and eat it too. For example, early
criticisms over the monopoly model almost mocked the inconsistency of having
a monopolist know its demand curve at zero costs, yet find it prohibitively
costly to price discriminate (see Demsetz, 1969, or Barzel, 1977, for examples).
The likely cause of this dichotomous literature is twofold. First, there is the
early introduction of costly transacting by Coase (1937) in the explicit context
of institutional choice, at a time when the profession had little interest or ability
to grapple with the issue. As Coase (1972) noted, his 1937 paper on the firm
was often cited, but was little used. Second, there is Coases failure in 1937 to
define transaction costs with any precision, using instead the phrase the costs
of the price mechanism. At the same time, though Coase uses examples that
suggest more than just the market is involved in transaction costs, he ultimately
leaves the issue open for interpretation. As such, the property right literature
did not truly begin until 1960, with Coases publication of The Problem of
Social Cost. This latter article provided the necessary elaboration of Coases
1937 publication in order to tie many existing ideas together and to provide a
property rights research agenda (see Barzel and Kochin, 1992, or Medema,
forthcoming, for elaborations on this point). In the intervening years,
economists did what they could with the term transaction costs and the
neoclassical approach was born.
The purpose of this chapter is to provide a broad picture of transaction
costs: its history, definition, foundation, use, measurement and implications.
0740 Transaction Costs 895
As such, it is often necessary to sacrifice detail and the reader is directed to
explore the references for further treatment. A theme throughout the chapter
is the dichotomous use of the term transaction costs in the two streams of
literature already mentioned. It is ironic that a disagreement over ownership
should engulf a term so closely related to property rights. Unfortunately, as with
all cases of disputed ownership, useful output is lower for lack of definition.
2. A Tale of Two Histories, Part A: The Property Right Approach
In the beginning Coase created transaction costs. His critics might continue:
And the term was formless and void and darkness was over the surface of the
term. For the believers in the property right approach, however, Coase (1937)
is seminal. As an advanced undergraduate perplexed by economics ability to
conceptually organize the economy around prices, Coase was troubled that
there was no room for any form of direct cooperation or direction. In his words
we had a factor of production, management, whose function was to coordinate.
Why was it needed if the pricing system provided all the coordination
necessary? (1992, p. 715). His solution was to recognize that there are costs
of using the price mechanism. When prices allocate resources at a cost, then
they compete with other allocating mechanisms like firms and governments.
Coase argued that, at times, firms and direct management supersede the
market, while at other times market prices are used in directing goods and
services. Readers interested in the genesis and a detailed account of the history
of Coases first great work are directed to Williamson and Winter (1991).
In this simple argument a charitable reading finds some basic elements that
distinguish the property rights literature. First, all methods of allocating
resources have costs and benefits and no single mechanism works for free and
dominates all others - in modern language, all allocation mechanisms are
second best. Second, it is argued that rules, organizational forms and
methods of payments are subject to economic analysis. Although it has been
argued that Frank Knight (1921) indirectly made a similar case (see McManus,
1975; Barzel, 1987), Coase explicitly addressed this issue. And finally, Coase
implicitly argues that positive transaction costs were both necessary and
sufficient for an explanation of the firm.
Coase provides examples of what he meant by the costs of the price
mechanism: discovering what the prices are, negotiating and closing a contract;
and he hints at problems of enforcement, but he stops short of any definition.
In fact, throughout all of his writings, Coase never goes beyond providing
examples of transaction costs. Barzel and Kochin (1992, p. 25) have noted that
the discussion of transaction costs in that [1937] paper is brief and cryptic and
even the most sympathetic reader would have to agree. Though the words
896 Transaction Costs 0740
transaction costs are never used in his first work, Coase is still correct when,
in his Nobel address, he states that: What I think will be considered in the
future to have been the important contribution of this article is the explicit
introduction of transaction costs into economic analysis. (1992, p. 716).
It remains a strange fact of economic history that after the publication of
The Nature of the Firm, neither Coase, nor any other writer in the profession,
picked up the joint theme of transaction costs and property rights. Finally, in
The Federal Communications Commission, Coase (1959) returns to the theme
of the influence of transaction costs on property rights and this article provides
the motivation for The Problem of Social Cost (see Kitch (ed.), 1983, or
Stigler, 1988, for discussions of how Coase came to write his most famous
paper). Ironically, even Coase did not appreciate his accomplishment at the
time of writing:
I should add that in writing this article I had no such general aim in mind. I thought
that I was exposing the weaknesses of Pigous analysis of the divergence between
private and social products, an analysis generally accepted by economists and that
was all. It was only later and in part as a result of conversation with Steven Cheung
in the 1960s that I came to see the general significance for economic theory of what
I had written . . . (1992, p. 717)
A tremendous amount has been written regarding The Problem of Social
Cost and the literature it instigated. For friendly discussions of The Problem
of Social Cost see Cheung (1983), Barzel and Kochin (1992), Coase (1988,
1992) or Medema (1994, 1996a). For less friendly ones see Cooter (1982),
Donohue (1989), Kelman (1979) and Samuels (1974). Regardless, for the
purposes here, only two points require elaboration - namely, that Coase
explicitly makes a connection between transaction costs and property rights in
the context of the common law of liability and that Cheung (1969) generalized
this argument to the context of contracts and contract choice.
Cheung has made many contributions to the property rights literature on
transaction costs, but perhaps his most significant is generalizing Coases
original argument. The importance stems from the fact that Coase never
defined transaction costs and has often used examples that suggest transaction
costs arise only in market exchanges. Cheung, in analyzing share tenancy and
providing the first contractual example of the Coase theorem, explicitly argues
that contract choice depends on the transaction costs of the different contracts.
These transaction costs are clearly internal and not just market costs. Cheungs
work inspired Stiglitz (1974) and begins the principal agent literature, but it
also establishes the precedent of thinking of transaction costs across markets
and internal to the firm - a theme that is strongly articulated in Williamson
0740 Transaction Costs 897
(1975, 1979, 1985). This connection between transaction costs and property
rights is summarized in the Coase Theorem, which is defined as follows:
Coase Theorem: In the absence of transaction costs, the allocation of
resources is independent of the distribution of property rights.
There are many attacks and defenses of the Coase Theorem, none of which
are dealt with here (see Shapiro, 1974, for an example of an attack, Allen,
1997, for a defense and Zerbe, 1980, for a survey). The point is that for all
property right approaches to transaction costs, the two concepts of property
rights and transaction costs are fundamentally interlinked. In fact, it will be
shown that they are two sides of the same coin and that this linkage
distinguishes the property right approach from the neoclassical approach to the
study of transaction costs.
Property Rights and Transaction Costs
The delineation of ownership is as old as human written records. The Mosaic
laws as described in the Ten Commandments or the laws on takings in Exodus
22:1-15, as well as the host of other Levitical laws throughout the first five
books of the Old Testament, are all attempts to legally define ownership. From
the Hammurabi code to the English common law the notion of legal ownership,
or legal rights, to property is well defined. In the words of Blackstone: The
third absolute right; inherent in every Englishman, is that of property: which
consists in the free use, enjoyment and disposal of all his acquisitions, without
any control or diminution, save only by the laws of the land (1803, p. 138).
Though it is difficult to identify where one idea begins, the modern attempt
to go beyond a legal delineation of rights and begin talking about economic
rights seems to start with Alchian. Alchians early work on tenure (1958) and
the pursuit of individual utility within the context of regulated firms (Alchian
and Kessel, 1962) hinge on the property right structures of the institutions in
question. For example, managers and administrators of non-profit firms and
universities, he argues, face a lower relative cost of private consumption on the
job than their counterparts in the private sector. Because these firms are
constrained in their ability to show profit, they are able to survive with higher
costs. Alchians insight was that the set of rules (the distribution of property
rights) determined the level of output of the firm because they determined the
incentives of each individual. This theme is manifest throughout Alchians
work and culminates in his famous article with Demsetz (Alchian and
Demsetz, 1972). But perhaps Alchians most significant contribution,
articulated most clearly in Alchian (1965, 1979), is his emphasis on economic
rather than legal rights. For Alchian, property rights are the rights of
individuals to the use of resources (1965, p. 817) not just under the law, but
in reality. He makes clear that these rights are not solely dependent on the
898 Transaction Costs 0740
existence of the state, but that they depend on custom, reciprocity and voluntary
restraints. This notion is now commonplace in the modern property rights
literature and is explicitly found in Ellickson (1991) and Landa (1994).
Although economic property rights are enhanced by the law, they are ultimately
use rights and the greater extent one can exercise these uses and bear the
consequences the greater are the property rights, regardless of the law. Property
rights are therefore defined as:
Property Rights: the ability to freely exercise a choice over a good or
service.
The property rights literature argues there is a monotonic relationship
between property rights and wealth. Given that trade is the transfer of property
rights, there can be no trade (and hence no gains from trade) in the absence of
property rights. Also, when property rights are perfectly defined, the Coase
theorem states that the gains from trade are maximized. Assuming there is a
continuum between these two extremes, as property rights become better
defined, the gains from trade increase (see Anderson and Lueck, 1992 for an
empirical example). Other things equal, individuals prefer better defined
property rights to poorer defined ones because they prefer more wealth to less.
Increasing the ability to make choices of one individual can reduce the
ability to make choices for others. Generally speaking individuals increase their
property rights in three ways. First, the individual may steal the good in
question. Second, the individual may privatize a good that was previously in the
public domain. Finally, an individual may cooperate with other individuals
with an agreement to divide the new wealth in some fashion.
When property rights are perfect, by definition no theft can take place and
as a result, no effort is made to protect the rights (a point made in Cheung,
1974 and Barzel, 1985). However, when property rights are incomplete,
individuals attempt to increase their ownership in an effort to increase their
wealth. This attempt to capture property rights may be dissipating (as in the
case of theft), or may be wealth generating (as in the case of assets brought out
of the public domain). When there is an opportunity for theft, there is also an
opportunity for protection. Hence, when property rights are incomplete,
individuals are always in the process of maintaining their existing property
rights and attempting to establish new ones. This leads to the property right
definition of transaction costs.
Transaction Costs, #1: the costs establishing and maintaining property
rights.
This definition is first articulated in Allen (1991). Writers in the property
rights literature have seldom defined transaction costs, relying mostly on
0740 Transaction Costs 899
examples of inspection, enforcing, policing and measurement which all hint at
the protection of property rights and implicitly recognize the threat of
appropriation or theft. For similar, but informal, definitions, see Cheung (1969,
p. 16), McManus (1975, p. 336), Jensen and Meckling (1976, p. 308), Barzel
(1985, p. 8), Goldberg (1989, p. 22) and Alchian and Woodward (1988, p. 66).
Transaction costs include any direct costs, as well as any concomitant
inefficiencies in production or misallocation that resulted from them. For
example, consider the Klein and Leffler (1981) example of a firm investing in
a sunk asset as a guarantee of product quality. The firm does this to protect the
wealth of its customer and as such it is clearly an attempt to maintain property
rights. The transaction costs would include the cost of the investment and any
increases in costs of production that it may have caused.
The property rights definition of transaction costs respects no boundaries
between firms, markets, households, or any other theoretical constructs. When
property rights are protected and maintained in any context, transaction costs
exist. By explicitly recognizing this relationship it is clear that statements like
if we assume zero transaction costs and complete property rights are
redundant. To say that a situation has zero transaction costs is to say that
property rights are complete, according to this definition. Cheung (1992, p. 54)
agrees with this, stating: the dual specifications of clearly delimited rights and
zero transaction costs are redundant. If transaction costs are truly zero, the
delineation of rights can be ignored.
When it is costless to establish and maintain rights they are done so
perfectly. If transaction costs are prohibitively high then property rights will
neither be established nor maintained and property rights will be zero. The
reverse, however, is not necessarily true. If property rights are complete in some
situation, there are two possibilities, either transaction costs are zero, or costs
may have been incurred to guarantee the property rights simply because the
benefits of doing so exceed the costs - in which case transaction costs are
positive. Further, when property rights are zero, transaction costs could also be
zero. For example, if a property right could never be established, despite the
resources devoted towards such a goal, no one would bother making any
expenditures towards establishing property rights and the good would remain
unowned. For example, there are no property rights over the planet Venus and
no efforts have been made to establish any.
Transaction Cost Economics with the Property Rights Approach
An excellent survey of the property right literature is found in Eggertsson
(1990a), while an excellent textbook treatment of this approach is found in
Milgrom and Roberts (1992). Essentially the property rights literature is
characterized by several features related to the above definition. First, the
central question is always what explains the distribution of property rights?,
900 Transaction Costs 0740
where the distribution of property rights has a broad meaning and includes
all sets of rules, governance structures and organizations. Hence, families,
firms, governments, non-profit institutions, contracts, are all viewed as sets of
property rights. Lawyers forming a partnership to split the residuals, a farmer
renting land from a landowner, or a judge deciding on a case, are all examples
of different allocations of property rights. Every distribution of property rights
has with it a set of production costs and a set of transaction costs. The
distribution of property rights that maximizes the gains from trade net of all
costs is the optimal distribution. This, in fact, is the grand hypothesis of
transaction cost economics under the property rights approach. An account of
transaction cost methodology is beyond the scope of this paper, but see
Williamson (1979, 1985) for detailed accounts.
A second characterization is the reluctance to infer any policy implications
from the analysis and to stress explanation. As stated earlier, this goes back to
Coases original idea that no single allocation mechanism dominates. Notions
of market failure lose meaning when there is no reason for prices to allocate
everything. One might as well refer to government failure or firm failure in
cases where prices do allocate.
This transaction cost approach dominates what is now called the New
Institutional Economics, so named because it provides a theoretical framework
and emphasis of testability to the institutional traditions of Veblen and
Commons. Oliver Williamson is considered the founder of this literature, both
in terms of vocabulary and content and he is one of the strongest proponents of
applying the notion of transaction costs ubiquitously. His notion of a
governance structure as a distribution of property rights providing appropriate
incentives to govern a relationship, is intended to apply within and outside
firms. Williamson (1971) is the first to note the role sunk costs can play in
causing contracting problems and incentives to vertically integrate. This idea
is popularized in Klein, Crawford and Alchian (1978) and in Klein and Leffler
(1981). The role of asset specificity and idiosyncratic capital is so attached to
the name of Williamson that for many, transaction costs means little else.
Although Williamsons understanding of the relationship between transaction
costs and property rights is consistent with what is presented here, he also
distinguishes between the property rights approach and the transaction cost
approach to organizational problems. For Williamson, a property rights
approach deals with grand private environmental rules, while the transaction
cost approach deals with private incomplete contracts (see Williamson, 1990
for a discussion).
0740 Transaction Costs 901
3. The Tale of Two Histories, Part B: The Neoclassical Approach
Although, Coase (1937) provides mostly market exchange examples and could
be argued as the founder of the neoclassical approach to transaction costs, it
could be better argued that this approach begins with Hicks (1935) publication
A Suggestion of Simplifying the Theory of Money, which predates Coase by
two years. In his paper, Hicks begins what is known as a transaction demand
for money, although he never calls it as such. For him, there are frictions in the
economy and these apply to buying and selling capital assets yielding positive
returns. When the returns were small, at the margin, relative to the costs of
trading, individuals rationally hold cash balances yielding no return. In his
words:
The most obvious sort of friction and undoubtedly one of the most important, is the
cost of transferring assets from one form to another. This is of exactly the same
character as the cost of transfer which acts as a certain impediment to change in all
parts of the economic system; it doubtless comprises subjective elements as well as
elements directly priced. Thus a person is deterred from investing money for short
periods, partly because of brokerage charges and stamp duties, partly because it is
not worth the bother. (1935, p. 6)
Since money is used to facilitate exchange and since an exchange that needs
facilitating must be subject to transaction costs, it is not surprising that those
concerned with money dealt with these costs. Indeed, Baumol (1952) and Tobin
(1956) elaborate on the transaction demand for money and again treat
transaction costs as the costs of trading. The first explicit statement of
transaction costs as the cost of trading comes from Demsetz (1964) where he
states that Transaction cost may be defined as the cost of exchanging
ownership titles (1988, p. 64). Although this type of definition refers to
property rights, transaction costs only arise when an exchange of property
rights takes place. This leads to the neoclassical definition of transaction costs:
Transaction Costs #2: the costs resulting from the transfer of property
rights.
This is a shortened version of the definition later given in Niehans (1987).
The neoclassical approach to transaction costs dominates in finance and pure
theory. The following is a partial list of papers that utilize a neoclassical
approach: Brennan and Copeland (1988), Constantinides (1986), Dermody and
Prisman (1993), Dumas and Luciano (1991), Fisher (1994), Gennotte and Jung
(1994), George, Kaul and Nimalendran (1994), Guia-Abiad (1993), Hirshleifer
(1973), Huberman (1990), Jouini and Kallal (1995), Lund (1993), Pesaran and
902 Transaction Costs 0740
Timmermann (1994), Shaffer (1989), Stavins (1995), Wagner and Schulman
(1994), Wilcox (1993) and Young (1989). A typical definition of transaction
costs found in these papers would be as follows:
In general, transaction costs are ubiquitous in market economies and can arise from
the transfer of any property right because parties to exchanges must find one
another, communicate and exchange information. There may be a necessity to
inspect and measure goods to be transferred, draw up contracts, consult with
lawyers or other experts and transfer title. Depending upon who provides these
services, transaction costs can take one of two forms, inputs or resources - including
time - by a buyer and/or a seller or a margin between the buying and selling price
of a commodity in a given market. (Stavins 1995, p. 134)
In the neoclassical approach, enforcement-type costs within firms are not
transaction costs. Transaction costs consist of those costs that occur between
firms or individuals from the process of market exchange. Hence, an economy
made up of one giant firm, or a state run economy, would be a zero transaction
cost economy by this definition. Because these transaction costs are just the cost
of exchange, they are modeled in a more recognizable fashion, often in the
form of a transaction function (see Constantinides, 1979 for an example).
These functions are similar to other neoclassical production functions and are
usually assumed to depend on labor inputs. These functions may have
increasing, constant, or decreasing returns to scale. Further, the transaction cost
functions may have fixed or variable components. Although the analogy is not
complete, in many ways transaction costs play a role very similar to
transportation costs and taxes and, according to Niehans: transaction costs are
analytically analogous to transportation costs.
Being analytically similar means that many of the impacts of transaction
costs are similar as well. Consider, for example, the impact of transaction costs
on the volume of trade. If transaction costs increase with the quantity traded,
this has the impact of increasing the relative price of the commodity being
purchased. Since this holds for goods, in effect the budget constraint becomes
kinked at the endowment point and, as a result, individual demands become
less responsive to price changes and the volume of trade falls. These are often
called proportional transaction costs in the literature and their effect on
multiperiod investment and consumption has also been examined. (See Bensaid
et al., 1992; Boyle and Vorst, 1992; Constantinides, 1976; Davis and Norman,
1990; Eppen and Fama, 1969; Kamin, 1975; Leland, 1985; and Magill and
Constantinides, 1976). Other similar results follow as well. Like per unit taxes,
frictional per unit transaction costs drive a wedge between buying and selling
prices, although neoclassical transaction costs are not necessary to explain price
spreads. Glosten and Milgrom (1985), based on Copeland and Galai (1983),
0740 Transaction Costs 903
provide an adverse selection explanation for bid-ask spreads that assumes
traders have zero friction costs.
Fixed transaction costs tend to bunch transactions together and provide an
explanation for the demand for money (see Edirisinghe, Naik and Uppal, 1993,
for an example). Differences in transaction costs across individuals lead to
some specializing in the transaction function. Hence brokers and agents are
those individuals with low transaction costs. Alchian and Allen (1964) were
probably the first to note this (see also Niehans, 1969). Differences in the
transaction costs across commodities provide an explanation for why some
commodities are used as currencies of exchange (Niehans, 1969 and Alchian,
1977). In these last two cases, the question examined is close to the institutional
type of question addressed by the property rights school. Neoclassical
transaction costs have also been used to analyze the equity premium. The real
average returns on US Treasury Bills is less than 1 percent, while for stocks it
is closer to 7 percent. This difference is too large to explain with reasonable
Arrow-Debreu models. Mehra and Prescott (1985) began a literature explaining
this premium based on neoclassical trading costs. (See Aiyagari and Gertler,
1991, for an example and a survey of the literature.) Finally, all discussions of
the existence of equilibrium with transaction costs utilize a neoclassical
definition (See Bergstrom, 1976; Foley, 1970; Hahn, 1971; Hart and Kuhn,
1975; Heller and Starr, 1976; Kurz, 1974b; McKenzie, 1981; Radner, 1972;
and Repullo, 1988).
Definitional Squabbles
For the most part, these two streams of literatures - the property rights approach
and the neoclassical approach - flow independently. Those writing in the area
of property rights follow the line of reasoning laid by Coase, Cheung and
Williamson and use the broad notion of transaction costs. Those interested in
the neoclassical issues of volume of trade and equilibrium generally stick to an
Arrow-Debreu based general equilibrium model and use the narrow definition
of straight exchange costs.
The major exception is Harold Demsetz. Demsetz was an early contributor
to the theory of property rights and the role of enforcement costs in determining
the distribution of property rights (See Demsetz, 1964, 1967 and 1972).
Ironically though, he was also the first to articulate the neoclassical definition
of transaction costs (Demsetz, 1968). For Demsetz, transaction costs remain
the costs of coordinating resources through market arrangements (1995, p. 4)
and among property right economists he remains a staunch, though perhaps
lonely, proponent of this view. Demsetz (1964) is the first to deal with the
breadth of definition used for transaction costs. In Demsetz (1988) he
acknowledges that this is mostly a question of semantics, since his collection
of costs all fit under the rubric of governance costs or the property rights
definition. According to Demsetz, the clear meaning of transaction costs is the
904 Transaction Costs 0740
cost of transacting. To apply the term more broadly threatens to make the term
tautological and useless. This view is summarized by Schlag, an overly
expansive view of transaction costs threatens to make the Coase theorem
tautological. On the other hand, an overly restrictive view of transaction costs
can effectively invalidate the theorem (1989, p. 1675).
Demsetz (1988, pp. 144-150) argues that a broad definition of transaction
costs hinders any understanding of firms and markets. For example, Demsetz
(1995) argues that the definition of a firm and its internal organization are two
separate issues that have been confused since Coase. Demsetz defines the firm
as a production unit, created to exploit gains from specialization. Since markets
only transfer titles they complement firms and the Coasean notion of firms and
markets substituting for one another does not arise. This is exactly the opposite
way the property rights literature would define a firm (see Barzel, 1989, as an
example). Coase has always put emphasis on the formal relations within a firm
(for example, employer vs. employee) as a possible means of reducing
transaction costs. Alchian and Demsetz (1972), on the other hand, downplay
the role of authority within the firm. (See Medema, 1994 , for a discussion of
Coase vs. Alchian and Demsetz.)
Demsetz, de facto, takes a property rights approach to the internal
organization of the firm, however. Demsetz (1995) discusses several transaction
costs (definition #1) arguments for the firm without using the term, including:
shirking, Knightean uncertainty, reduction of coordination costs and the agency
problems from opportunism. Hence, in the end there is very little to quibble
over and the definition to be used depends on the problem being addressed.
Clearly, all of the costs mentioned by Demsetz fall under the umbrella of the
property right definition of transaction costs, where a broad transaction cost
definition is necessary in order to make clear that the Coase theorem does not
apply.
4. The Distribution of Property Rights vs. The Volume of Trade
The economics profession is littered with various assertions and theorems
stating that distributions of property rights do not matter. The Coase theorem
is the most famous of these, but there are many others. For example, the
Modigliani/Miller theorem (1958) is almost identical to the Coase theorem.
This proposition states that if capital markets are perfect and firms and
investors face the same rate of interest, then investors can unravel any corporate
structure chosen by the firm. This means that the ratio of debt to equity
financing, as well as the form of debt and equity within the firm, is irrelevant
to the firms value. A similar result is found in the Ricardian Equivalence
Theorem (1951). This theorem states that with perfect capital markets, the
governments choice over taxation and debt is irrelevant to the level of
0740 Transaction Costs 905
household wealth, because taxpayers are able to unravel any financing decisions
of governments.
In addition to these, there are a host of equivalence results regarding taxes,
the most famous being that it is irrelevant whether the consumer or the
producer is taxed, the result is the same in terms of both resource allocation and
incidence of tax paid. Furthermore, both ad valorem and per unit taxes are
equivalent in terms of resource allocation. Finally, in trade policy and again in
terms of resource allocation, it is well known that tariffs and quotas can have
identical effects.
All of these results are special cases of the Coase theorem because all taxes,
debt obligations, equity shares and other policy instruments are delineations of
property rights. A firm deciding on the optimal amount of debt versus equity
is essentially assigning property rights over the stream of expected profits,
including priority in case of unexpected shortfalls. A government deciding on
a choice between taxation and debt is simply transferring property rights over
time. In all of these cases, only a different distribution of property rights exists
and given the Coase theorem, this does not alter the allocation of resources -
when, as Coase stated, transaction costs are zero.
When transaction costs are not zero, these equivalence results do not occur.
For example, Barzel (1976) shows how the tax equivalent result is altered when
transaction costs are positive. When goods are complex bundles of commodities
they become difficult to define under tax legislation and some attributes are
possibly ignored. Under these conditions, taxes have the effect of altering the
relative price of the taxed and untaxed attributes and therefore alter the mix or
quality of the item that is produced. Lump sum taxes tend to increase the
quality of good, while per unit taxes tend to lower quality. The result is that
different forms of taxation can have vastly different effects on resource
allocation. Furthermore, differences in the ability to avoid taxation implies that
tax revenue is not neutral with respect to the location of the tax.
All these examples explain why the property rights approach requires a
broad definition of transaction costs. Given the Coase theorem and all of its
different manifestations, distributions of property rights are irrelevant. If we did
live in a world of zero transaction costs (definition # 1), then firms truly would
toss coins to decide debt levels, if indeed there were any firms, which would
also be decided by a coin toss. And so on for governments and all other
institutions. The importance of the Coase theorem then is that it points to
transaction costs as the necessary factor in any explanation of the distribution
of property rights. The definition of transaction costs, therefore, must be those
costs that cause the Coase theorem to not apply. This also seems to be the
reason why the neoclassical approach never analyzes questions of economic
organization outside of the choice of medium of exchange. They have selected
a definition of transaction costs that is too limited for this purpose. Many in the
906 Transaction Costs 0740
neoclassical literature have balked at this line of reasoning, suggesting that it
is tautological. The difference of opinion stems from the different objectives
each approach is interested in.
5. The Causes of Transaction Costs
Regardless of which stream of literature is examined, the underlying theme for
transaction costs is the notion of ignorance. Hence, even though its treatment
is different and the definition is narrower, the neoclassical approach still uses
examples of transaction costs that are similar to the property rights approach.
Niehans states that parties must
find each other, they have to communicate and to exchange information . . . goods
must be described, inspected, weighed and measured. Contracts are drawn up,
lawyers may be consulted, title is transferred and records have to be kept. In some
cases, compliance needs to be enforced through legal action and breach of contract
may lead to litigation. (1987, p. 676)
Negotiation, fraud, communication and contract stipulation all come about
because knowledge is incomplete and not common. Though its importance is
recognized by everyone, the role of information leads to a great deal of
confusion in the discussion of transaction costs. Information costs are a
prerequisite to transaction costs and are a necessary condition for their
existence. Information costs, however, are not always transaction costs. Steven
Cheung once remarked that transaction costs are costs that do not exist in a
Robinson Crusoe world (a definition consistent with definition #1). Clearly
Crusoe faced many information problems, but until Friday showed up, he had
no transaction cost problems.
Barzel has been a strong proponent of the distinction between information
and transaction costs. Barzel (1977) states that transaction costs include those
(costs) required to formulate and to police contracts (p. 292), but goes on to
point out that it is possible to have information problems resulting in
speculation, sorting and signalling, which may appear to yield decreases in
social value, but that these reductions are impossible when transaction costs are
zero. With zero transaction costs, contracting is a perfect substitute for
information because contracts can always be made over all contingencies.
Barzel (1982, 1985) stresses that information costs are at the heart of
transaction costs because they lead to measurement. Barzel (1977) notes that
when the distinction between information costs and transaction costs is made,
several other points follow rather obviously: costless information implies
perfect property rights; individual honesty does not necessarily eliminate
transaction costs; costly information means transaction costs can explain
0740 Transaction Costs 907
self-imposed constraints; and total costs, not just transaction costs or
information costs, are required to be minimized.
It is not always appreciated that information costs are not sufficient for
transaction costs. The mere presence of information costs lead to risky events
which can be eliminated through contingent claim contracts. In addition to
costly information a factor is required to eliminate the ability to write complete
contingent claim contracts. There are several examples of what this factor
might be. Knight was the first to suggest this with his distinction between risk
and uncertainty; uncertainty arising in situations where moral hazard prevented
individuals from assigning accurate probabilities to events and thereby
eliminating the ability to contract over the risk. Barzel (1989) and Allen (1991)
have stressed the idea that goods are complicated bundles of attributes that both
are variable in nature and alterable by individuals. The inability to separate the
contributions to quality by nature and man allows for cheating to take place in
equilibrium. Other attempts to add to information costs include the notion of
asymmetric information and opportunism (see Ackerlof, 1970, and Williamson,
1975, 1985).
6. Modelling Transaction Costs, Part A: Neoclassical Modelling
As may be expected, the two literatures have different methods by which
transaction costs are modelled. In both cases, transaction costs considerably
complicate the neoclassical model and the level of mathematical sophistication
is quite demanding. The major point made here, however, is that neoclassical
modeling is a direct extension of the Arrow-Debreu model, while property
rights modeling involves some fundamental differences.
In an Arrow-Debreu world with complete contingent markets, trades only
take place once. An early application of transaction costs in neoclassical models
explained why markets had a sequence over time - the general idea being that
at any given time, a specific market may be too expensive to trade in and thus
trade is postponed until some future date.
There are two general types of approaches in modeling neoclassical
transaction costs. The first, used by Foley (1970), Hahn (1971, 1973) and
Starrett (1973), involves a central transactor who takes buy and sell orders from
each household and carries them out. In order to pay for his services, the
broker charges a margin between the buying and selling price for his efforts.
The second approach requires households and firms to directly use resources
in the purchase and sale of goods. Here the firms and households use some type
of transfer technology. (For early treatments, see Kurz, 1974a; Niehans, 1971;
or Ulph and Ulph, 1977. See Repullo, 1988, for a later treatment using this
908 Transaction Costs 0740
style.) Although the specific technologies are generally simple, they are usually
sufficient to complicate the analysis greatly.
Three general approaches are taken to model the transaction technology.
The first simply assumes that some general transaction function T(x) exists (see
Brennan and Copeland, 1988, for example). This function is often assumed to
depend on the volume of trade, cash flows, number of traders and other such
variables that reflect the size of the transaction. The second assumes that
transaction costs are fixed (see Leland, 1974; Mukherjee and Zabel, 1974;
Brennan, 1975; Goldsmith, 1976; Levy, 1978; or Mayshar, 1979, 1981; for
examples). Finally, proportional (or iceberg) transaction costs k(x) are
assumed, where k is a constant fraction and x again is a measure of the size of
transaction (see Gennotte and Jung, 1994, or Constantinides, 1986, for
examples). All of these technologies make their way into standard objective
functions for firms and households. Though the subsequent analysis is usually
complicated, the results are most often exactly analogous to the effects of
transportation charges. Typically, these analyses show that the presence of
transaction costs reduces the frequency and volume of trade.
7. Modelling Transaction Costs, Part B: Property Rights Modeling
The property rights approach to modeling is a vast, diverse and technically
complex literature, well beyond the scope of this survey to treat it in any detail
(see Holmstrom and Milgrom, 1994, or Hart and Moore, 1990). Unlike the
neoclassical literature, where transaction costs enter and yield results which are
somewhat predictable, modeling the distribution of property rights is
fundamentally different. Rather than entering through a transaction technology,
transaction costs arise through changes in incentives and manifest in changes
in values in different property right distributions, with often surprising results.
For example, Coase (1960) is perhaps the first surprising result, despite the
lack of formalization. Cheung (1969) is another and perhaps the first case of
a formal treatment of transaction costs from a property rights approach. Here
two examples of property rights modeling are provided to highlight some
differences.
The simple example of insurance, first discussed in Rothschild and Stiglitz
(1976), demonstrates some differences. Consider a world where there are two
types of behavior: careful and uncareful and all else equal, individuals prefer
being uncareful. Furthermore, there is the chance that a fire may occur and the
probability of this event depends on the behavior of the individual. If insurance
companies can fully observe behavior they offer a full insurance contract and
everyone takes it - no one has an incentive to be careless.
0740 Transaction Costs 909
Thus far, we have a standard neoclassical problem and the introduction of
risky events has changed little. Recall that the marginal rate of substitution of
the individual for wealth in both states of the world is:
a U (Wa )
1 a U (Wb )
where pa is the probability of fire in state a, U the individuals affine utility
function and W the wealth level in the two states. In the case of pure
uncertainty the probabilities are determined by nature.
However, if the behavior of the individual is not observable, the
probabilities are alterable by the individual and a transaction cost problem
arises. As has been noted above the transaction cost problem requires: (1) the
presence of uncertainty (here the probability of a fire) and (2) the ability of the
individual to change his behavior without costless detection. Since the firm
cannot observe behavior, this implies individuals all become careless, which
alters the marginal rate of substitution! The introduction of costly information
leads to preferences no longer being fixed and exogenous and this is an
example of a fundamental difference between the two types of models. (Arnott
and Stiglitz, 1988) explore the implications of shifting marginal rates of
substitution.)
The solution to this particular problem has the insurance company offering
an incomplete contract (an insurance contract with a deductible), which points
to a second difference. Namely the possible non-existence of explicit
transaction costs in equilibrium. The insurance company, by offering an
incentive compatible contract, does not engage in any form of direct
monitoring. Such monitoring is not necessary and many property right models
have no actual resources used to establish and maintain property rights in
equilibrium. In this case, the transaction costs are simply the lost gains from
trade that result from the incomplete contract.
As a second example, consider a variation on the principal-agent model first
introduced by Stiglitz (1974). In this model the effort of a risk-averse agent is
unobservable and so a contract is reached that trades off incentives for risk
avoidance. For example, consider the case of cropshare contracts, where a risk-
averse farmer contracts with a risk-neutral landowner (Allen and Lueck, 1995).
For a plot of land, output is q=(e + ?), where e is the unobservable labor effort
and ? is a random variable with mean 0 and variance s . Furthermore, assume
that the farmers income is Y = aq + and his utility is U=E(Y) + (r/2)Var(Y),
where r is a measure of risk aversion, a is the share of output and is a fixed
side payment. Finally, assume that the cost of effort to the farmer is c0 + c1e +
(c2/2)e2.
910 Transaction Costs 0740
For a given outputshare the effort which maximizes farmer utility is:
c1
e$ ( ) = ,
c2
which represents the behavior of the farmer and becomes a constraint to the
landowner designing the optimal contract. This incentive compatibility
constraint represents another example of a fundamental distinction in modeling
property right distributions - namely, the constraints often involve optimization
problems. The next stage in this particular problem involves the landowner
maximizing his expected income E ((1 ! a) ( + ) + ) subject to the incentive
constraint and a participation constraint.
Although the principal-agent model has been extended and broadly applied,
(see Dewatripont, 1989; Freixas, Guesnerie and Tirole, 1985; Holmstrom,
1979, 1982; or Shavell, 1979, for examples), it has recently fallen out of favor
for models where all parties are risk neutral (see Eswaran and Kotwal, 1985;
Grossman and Hart, 1986; Leffler and Rucker, 1991; and Allen and Lueck,
1992a, for examples). Holmstrom and Milgrom (1991) develop an explicit
principal-agent model where risk aversion is not required. The great advantage
of risk neutrality is that it allows for several margins over which transaction
cost behavior can take place. However, though there remains no single way to
model transaction costs in the property rights approach, the bottom line
remains that it does involve some fundamental differences from putting a T
in a cost function.
8. Direct Empirical Work
The empirical work in transaction cost economics is very large. On the property
rights side, studies have examined vertical integration (Anderson, 1988;
Fishback, 1986, 1992; Globerman, 1980; Globerman and Schwindt, 1986;
Joskow, 1985; Levy, 1985; Mahoney, 1992; Masten, 1984; Masten, Meehan
and Snyder, 1989, 1991; and Monteverde and Teece, 1982), long-term
contracts (Crocker and Masten, 1988; Joskow, 1985, 1987; Leffler and Rucker,
1991; Masten and Crocker, 1985), franchising and share contracts (Allen and
Lueck, 1992a, 1992b, 1993; Alston and Higgs, 1982; Alston, Datta and
Nugent, 1984; Datta, OHara and Nugent, 1986; Lafontaine, 1993; Williamson,
1976; Zupan, 1989a, 1989b), marriage (Allen, 1990, 1991; Brinig, 1990;
Brinig and Alexeev, 1993; Parkman, 1992), wildlife (Lueck, 1991), horse
racing (Hall, 1986), price adjustments (Crocker and Masten, 1991; Goldberg
and Erickson, 1987; Joskow, 1988b, 1990), economic history (North, 1981;
North and Weingast, 1989; and North, 1990), rate of return regulation (Crew
and Kleindorfer, 1985) and a host of other organizational issues (see Shelanski
0740 Transaction Costs 911
and Klein, 1995, for a more complete listing of references to the empirical
literature).
Studies in the neoclassical approach are also numerous and mostly focus on
asset arbitrage, the volume of trade, risk adjusted returns and the bundling of
transactions (see Demsetz, 1968; Fisher, 1994; Frenkel and Levich, 1975;
Litzenberger and Rolfo, 1984; Malkiel, 1966; Pesaran and Timmermann, 1994;
Phillips and Smith, 1980; Protopapadakis and Stoll, 1983; Schultz, 1983;
Smiley, 1976). It should be stressed that the empirical transaction cost literature
seriously tests hypotheses and therefore by its existence refutes the assertion
that transaction cost economics is tautological. However, most of property right
and neoclassical empirical studies are of the comparative static variety and
attempt to test transaction cost hypotheses using various proxies for asset
specificity, uncertainty, measurement costs, friction and other transaction cost
variables in reduced form equations. There are only two studies that have
attempted to measure the level of transaction costs.
The first and perhaps most ambitious of these is Wallis and North (1986),
who attempt to measure the entire transaction sector of the economy over 100
years. Understandably, the first problem they face is how to define transaction
costs. Their property rights background leads them to define transaction costs
as the resource costs of maintaining and operating the institutional framework
associated with capturing the gains from trade. In the end, however, they
simply separate resources devoted to transacting as their measure and in doing
so ironically come closer to a neoclassical definition. Although they
acknowledge the conceptual problems this definition has with respect to firms,
they settle for the following compromise:
We divide occupations into those that provide primarily transaction services to the
firm and, by elimination, those that provide primarily transformation services. The
wages of employees in these transaction occupations constitute our measure of the
transaction sector within firms. (1986, p. 100)
This compromise would require all protective services (police, courts and
so on) included in the non-transaction sector of the economy, which makes
Wallis and North so uncomfortable, they switch its classification (pp. 102-103).
The analysis of Wallis and North concludes that the transaction sector accounts
for a significant part of the economy and that this has grown from 25 percent
to 40 percent over the years 1870 to 1970.
Davis (1986), however, has pointed out that this estimate is not robust for
even small changes in the line that separates transactions from production.
In the end, the problem of definition seems overwhelming. Is a farmer a
manager/marketing agent, or a grain-growing field hand? All jobs have
elements of production and transaction in them and it seems an impossible task
912 Transaction Costs 0740
to separate them. This perhaps best explains why Wallis and North were both
the first and the last to tackle transaction costs on such a grand scale.
A more sophisticated treatment of measuring the costs of organization is
found in Masten, Meehan and Snyder (1991). They note that much of the
empirical literature proxies only the hazards of market exchange and ignores
the internal costs of governance. Reduced form estimates are unable to
distinguish between internal and external transaction costs.
Furthermore, attempts to directly measure transaction costs are subject to
the problems faced by Wallis and North. Finally, Masten, Meehan and Snyder
recognize the selection bias that occurs since the efficient organization structure
is chosen and the other choices are not observed. Their solution is to utilize
switching regression techniques and to adopt censured regression models used
in labor economics. From this technique they obtain actual dollar estimates of
organization costs and therefore can estimate the magnitude of individual
coefficients and not just their relative impact. Masten, Meehan and Snyder
apply this methodology to naval shipyard contracts and find that overall
organization costs amount to 14 percent of total costs. They estimate that if an
incorrect contractual agreements is chosen that this would lead to increases in
organizational costs of up to 70 percent.
9. Conclusion
The essential element of transaction costs, that property rights must be
protected, is found in most fields of economics and throughout the disciplines
history. Adam Smith, in discussing foreign trade, endowments, corporate
ownership structure and non-profit organizations repeatedly exploits concepts
of costly information and the ability of individuals to exploit others ignorance
to their own advantage (see West, 1990, for an account of Smiths anticipation
of modern economic ideas like principal-agent relations). In macroeconomics
the notion of costly information lead to the rational expectations revolution and
subsequent real business cycle models based on search and the disincentives
found in unemployment insurance programs. Public choice models are founded
on the premise that individuals can use the state as a mechanism to transfer
wealth to themselves. In game theory, the prisoners dilemma and other
non-cooperative games are essentially transaction cost problems. And other
fields like industrial organization, international trade, development and labor,
all contain ideas that hinge on the protection of property rights.
Given its long history and prevalence, it is ironic that the definition of
transaction costs would be so difficult to agree on. This paper has argued that
two definitions prevail in the literatures: one that defines transaction costs as
only occurring when a market transaction takes place; the other defining
0740 Transaction Costs 913
transaction costs as occurring whenever any property right is established or
requires protection. I have called these the neoclassical and property rights
definitions and have argued that which definition is useful depends on what
question is being examined. Recognizing the distinction, though, is important
for removing ambiguity and animosity.
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0750
PUBLIC GOODS AND CLUB GOODS
Patrick McNutt
Chairperson, Competition Authority, Dublin and Research Associate,
Department of Political Science, University of Dublin
Copyright 1999 Patrick McNutt
Abstract
Public goods contrast with private goods. Pure public goods have the unique
characteristics of non-excludability and non-rivalry in consumption while
private goods are sold to those who can afford to pay the market price. The
under-supply equilibrium of a public goods provision is an important aspect of
the provision of public goods. The economic theory of clubs represents an
attempt to explain the under-supply equilibrium of a public goods provision. It
raises many different and controversial issues which impinge on government
policy in the public sector. In many respects, a club provision proffers an
alternative to a central government provision of local public goods. The salient
characteristic of a club, the excludability factor, may militate against an equal
and democratic distribution of the club good. At the level of voluntary clubs,
with which Buchanan was originally concerned, club theory can critically
appraise the efforts at achieving optimal membership of the club and the
maximum utility of club members. As the literature introduces increasing
problems with cooperation then it behoves law and economics scholars to
research and develop non-market and/or non-cooperative solutions to an
optimal provision of public goods.
JEL classification: D60, D71, K00.
Keywords: Free Rider, Pareto Optimality, Club Goods, Excludability and
Non-rivalry, Coase Theorem, Homogeneity
1. Introduction
Pure public goods as originally defined by Samuelson (1954) have the unique
characteristics of non-excludability and non-rivalry in consumption. Public
goods contrast with private goods; public goods are non-excludable and
non-rivalrous in consumption while private goods are sold to those who can
afford to pay the market price. The market price excludes some consumers
while the property of rivalrous consumption ensures that not all consumers who
can afford to pay the price, actually purchase the private good. The public
goods property of non-rivalry ensures that a provision of the good for consumer
A entails a provision for consumer B. Likewise, the property of
927
928 Public Goods and Club Goods 0750
non-excludability ensures that one cannot exclude consumer B from securing
the benefits of the public good, consequently there is no incentive for consumer
B to pay the costs of providing the public good. Therefore a consumer may free
ride (Kim and Walker, 1984) on the provision of the public good, securing the
benefits but not paying the costs of provision.
A lighthouse signal is a classic example of a pure public good, where the
provision is both non-rival and non-excludable. Local radio or community
radio, theatre performances and untelevised sports events are interesting
examples of a local public good, where the provision is non-rival but
excludable. The market is not the only mechanism through which goods and
services are provided in a modern economy (Coase, 1974); public goods and
club goods are characterised by their provision wholly through a political
process since by their very nature they are unmarketable.
A primary reason why market failure persists is reflected in the inability of
citizens to act cooperatively and it is this lack of cooperation which mandates
an allocative role for government in the economy. A public good that becomes
excludable is a club good (McNutt, 1996). The economic analysis of clubs
pioneered by Buchanan (1965) can be applied to the provision of local public
goods, ranging from the supply of decentralised regional public goods (local
health boards) to community projects and neighbourhood schemes, such as
community sports clubs and residents associations.
In the theory of clubs, however, there is collective consumption but with an
exclusion principle, for example, a membership fee. One can think of club
goods as public goods sans non-excludability. There are economies of scale in
that additional members reduce the average cost of the club good. But
additional members also lead to crowding which in the long run could be
regarded as the introduction of rivalrous consumption. Indeed the club goods
have polar extremes as noted by Mueller (1989, p. 131): for a pure public good
the addition of one more member to the club never detracts from benefits of
club membership ... [for] a pure private good, say an apple, crowding begins to
take place on the first unit.
2. Excludability and Non-Rivalry
There are, therefore, two salient properties pertaining to the provision of public
goods, namely, non-excludability in supply and non-rivalry in consumption.
The latter implies that inter-citizen consumption is mutually exclusive, that is,
the consumption by one citizen of the public good will not affect the
consumption level of any other citizen. Radio broadcasts, clean air or defence
spring to mind as examples of a non-rivalrous public good. Non-excludability
is the hallmark of a political system where the central government funding
0750 Public Goods and Club Goods 929
emanates directly from citizen taxation. However, in the provision of some
public goods, either local public goods or club goods, the citizens often prefer
to act independently of government. The property of excludability in the supply
of the public good is the sine qua non of club goods.
A prisoners dilemma characterisation of the market failure problem would
indicate a Pareto inferior outcome as long as a dominant strategy existed for the
individual citizen. The incentive to cheat on collective decisions, otherwise
known as the free rider problem, illustrates one dominant strategy which
undermines the optimal provision of public goods. In the classic tradition of
public choice, government intervention per se would represent an externality.
It is the increasing trend towards local public goods in the provision of public
sector output that has facilitated the application of club theory which exhibits
a cooperative response to the resolution of a local or regional issue.
Buchanan (1965), who was one of the first scholars to consider the
efficiency properties of voluntary clubs, derived the economic conditions under
which an optimal provision of a local public good could be attained. This early
work outlined a justification for club analysis in the explanation of why clubs
would organise. Both Buchanan and Olson (1965) recognised independently
that clubs enable members to exploit economies of scale in the provision of the
public good and to share in the cost of its provision. They each addressed the
issue of membership restrictions, with Olson distinguishing between exclusive
clubs and inclusive clubs with no membership constraints.
Likewise, Tiebout (1956) had much earlier addressed a club-related issue
in his work on population mobility and size of local government. His voting
with the feet hypothesis has many direct applications in the area of local public
goods. Other scholars, notably Schelling (1969) and McGuire (1974) justified
club formation on the basis of a taste for association. This has since been
translated in the club literature as the assumption of homogeneity (identical
tastes), an assumption which has raised the policy issue as to whether or not
mixed clubs are optimal. For example, if mixed clubs are not optimal then the
policy of group segregation is optimal whereas the policy of busing, as practised
in some US states, is suboptimal. The issue of optimality, however, is not
completely resolved across the club literature.
3. Public Goods Paradox
To what extent the theory of clubs enables policymakers to escape the
under-supply equilibrium in the optimal provision of public goods remains a
challenging issue. In other words, the optimal provision of public goods
generally is constrained by what can broadly be defined as the public goods
paradox, that is, unless the spoils of the public good are divisible there is no
930 Public Goods and Club Goods 0750
incentive for the individual to participate in its provision. Club theory
overcomes the problem of non-excludability in so far as members of the club
use the club good. The non-excludability characteristic of a pure public good
may constrain the realisation of economies of scale in any interest-group
provision of the good unless the gains are divisible.
Table 1
An Economics Typology
Excludable Non-Excludable
Rival Private good Public good
Non-Rival Local public good Pure public good
The public good in Table 1 is characterised as non-excludable and rival. In
other words, rivalness in consumption is the distinguishing feature between a
public good and a pure public good. The good could be described as a common
good in the absence of any rival behaviour between citizens; some examples
include air quality, frontier land and outer space. Rivalrous behaviour,
however, converts the common good into a public good as frontier land is
zoned, air quality control becomes necessary and space stations are constructed.
Once property rights are established the good eventually becomes an
excludable and rival private good. For example, if a toll-free congested bridge,
a rival and non-excludable good, becomes a congested bridge with
Pigou-Knight tolls, the good therefore becomes a rival and excludable private
good. There are increasingly few examples remaining (Hummel, 1990) of a
pure public good otherwise defined as a public externality. Medical knowledge
is one example but the classic examples of national defence, the environment,
outer space and unpolluted air are no longer regarded as pure public goods.
Table 2
An Economics A Law and Economics Typology
Excludable Non-Excludable
Rival Private good Private externality
Non-Rival Club good Public externality
To what extent they represent McNutts (1996) collective good thus
warranting a citizen tax, depends upon how acceptable the good is to the
citizens and the citizens effective demand for that good. For example, should
peaceniks who may regard defence as an unacceptable public good or Gaelic
0750 Public Goods and Club Goods 931
speakers who may regard the English-language public radio broadcasts as an
unacceptable public good, be obliged to pay the requisite fee or charge to have
the good supplied? While pollution represents the classic example of an
externality, may we suggest pollution control as a modern example of a pure
public good. This would include anti-smoking legislation, catalytic converters
in car exhausts and CFC legislation. Albeit, the classic lesson from the
literature (Van Zandt, 1993) is that an optimal provision of pure public goods
may escape the policymaker.
The property of excludability, as noted in Table 2, is the essence of a club
theory approach to the provision of public goods. If consumption of the public
good is not contingent on payment, individuals have no incentive to reveal their
true preferences. The individual becomes a free rider and if all individuals
behave likewise the net result is an absence of effective demand for the good.
Where consumption is non-rival, for example, exclusion could be easily
applied. However, because the marginal cost to previous consumers of adding
one extra consumer is zero, the price should be zero. In this case there is no
need to exclude. However the administrative costs of the public good provision
must be covered somehow and with non-rival consumption in the absence of
exclusion, the usual market method cannot determine price.
Musgrave and Musgrave (1980) have argued in favour of the
non-excludability characteristic; they have argued that with excludability,
non-rivalrous goods can be effectively provided by private production. In a
different context Ng (1979, p. 190) emphasised the non-rivalrous characteristic,
particularly if we do not regard public production as a necessary and sufficient
condition for a public good. Since free riders impact on these conditions it is
rather difficult to compute exactly the individuals valuation of a public good.
And this is particularly difficult if payment is not contingent to a particular
preference revealation. Preference revelation mechanisms (Kormendi, 1980) for
example, where individuals pay a price that equates with their revealed
preference for the good, are presented as experimental attempts to minimise the
problem. Another alternative to the market failure result in the provision of
public goods is to be found in the general theory of clubs. Tanzi (1972) had
shown that welfare costs may be involved in providing public goods which
differ with respect to how individuals are excluded from consuming the good.
4. The Coase Theorem and Property Rights
In standard public goods analysis it is assumed that consumption of the public
good can be extended to all consumers at a zero marginal cost. It is also
assumed that a free rider problem exists or that individuals (Cohen, 1991) can
only be excluded at some positive cost. Loehr and Sandler (1978, p. 27)
consider the issue of a forced rider in which people are forced to consume,
932 Public Goods and Club Goods 0750
whether they like them or not a range of public goods, for example defence.
They further comment that it is entirely possible that the welfare of some
individuals might fall when a marginal unit of the public good is provided.
The Pareto optimality conditions would have to allow for subsidies for these
individuals to ensure that the marginal utility to tax price ratios for all
individuals are equal. The forced rider may influence the provision of the
public good. This could be extended to local goods and services where forced
riders may be involved in decision making.
Pigou (1920) had suggested that government intervention was necessary in
order to abate the externality problem. The transactions costs of grouping
concerned citizens together in order to resolve the externality problem was
prohibitive. Coase (1960) argued that in the absence of transaction costs,
concerned citizens could resolve the problem, independent of government.
Theorem 1, the Coase Theorem and the liability rules amend the public choice
analysis of the externality problem.
Theorem 1: In the absence of transactions costs and bargaining costs, concerned
citizens will agree to resolve an externality problem and arrive at a Pareto optimal
allocation of resources, independent of government.
The apportionment of blame and the allocation of property rights, that is,
the right to clean air, the right to pollute, proffer an alternative, indeed a
complement, to the introduction of Pigovian taxes. The idea behind liability
rules was to apportion blame; an alternative to this procedure in tort law is to
establish optimal conditions which may prevent the accident or property rights
dispute occuring. The traditional response in public finance was either to
compensate the offended party or tax the offending party. This required an
apportionment of blame which may have induced unnecessary government
expenditure and rent-seeking activity. The costs incurred must be weighted
against an inter-citizen or club resolution of the initial dispute.
The costs of providing the public good must include the bargaining costs
attributable to the resolution of the ensuing debate on the amount of public
good supplied, if at all. The treatment of these bargaining costs are a cental
feature in Buchanan and Tullock (1962) whose framework was used by Loehr
and Sandler (1978) in considering the impact of bargaining costs in the
provision of public goods. They illustrate the net indirect costs imposed on
forced riders and the number of individuals required to reach agreement on
public provision. They further represents costs imposed upon a person who
bears some burden under all decision rules with the exception of unanimity.
In this case if the individual was a forced rider he would agree to the
decision only when adequately compensated, that is when net costs are zero
where the entire population is in agreement. Loehr and Sandler further
0750 Public Goods and Club Goods 933
comment that their cost function is downward sloping since the greater the
proportion of the population needed for agreement, the more likely persons
similiar to himself (but not identical to him) will be wooed by the early
proponents of the public action. A point may be reached where the need to
form larger and larger coalitions would force bargains between free riders and
forced riders. A particularly interesting point in Loehr and Sandler (p. 31) is
their comment that the cost curve need not end at zero when unanimity is
reached.
In other words, some free riders, they argue, may still exist, even where
everyone is in agreement on the policy. Summation of all individual cost
curves in their presentation creates a community cost curve which indicates that
more and more decisive groups would imply a higher cost in terms of effort and
bargaining. If the decisions have to be made at the point where community
costs are at a minimum then we are abandoning Pareto optimality. The solution
presented represents a second best solution. McNutt (1996) considered an
inter-citizen resolution by adapting an earlier argument in Turvey (1968, p.
310) who had argued that the traditional interpretation of an externality is
rather restrictive. How much group B suffers from As externality depends not
only on the scale of As diseconomy but also on the precise nature of As
activity and Bs reaction to it. For example, the victim in Pigous chimney
example could reduce the disutility by installing an indoor clothes-line.
The Pigouvian solution of reducing the amount of smoke contrasts with the
alternative solution of either building a higher chimney or using different
smokeless fuel. McNutt (1996) shows that by allowing an inter-citizen
resolution to a dispute, the cost may be less than the government cost. If
citizens can agree on the resolution of an externality problem, the cost to the
government of financing the inter-citizen solution may be less than a central
government solution. An inter-citizen resolution like the Coase theorem offers
an alternative to government action in the resolution of an externality problem.
One policy implication of this result applies to traffic congestion in large cities.
Rather than impose a tax on car owners who persist in driving to the city at
rush hour, car-users should be encouraged to resolve the externalities of long
tailbacks, car emissions and queues by acting collectively. Car pools with
special motorway lane access, such as the HOV (heavy occupancy lanes with
at least three passengers per vehicle) lanes in the US, would be socially more
efficient than allowing as many fee paying cars to enter the city limits; citizens
would prefer to incur the lower garage parking fee for the pooled car.
5. Tiebout-Oates World
It is useful to re-examine the conditions which independently underpin the
Tiebout (1956) and Oates (1972) models of local public goods and adapt the
934 Public Goods and Club Goods 0750
Loehr-Sandler model in a search for some common ground in a Tiebout-Oates
type world. Forced riders, can leave the local neighbourhood; this assumes no
relocation constraints; crucial to the question posed here is the failure of
individuals to reveal their true preference for local public goods. In his analysis,
Tiebout recognised the efficiency in the supply of public goods and further
acknowledged that voting process was the only recourse to reveal the
preferences of the sharing group. The optimal allocation is determined by a
voting with the feet exercise.
Tiebout had presented an earlier framework for the theory of clubs in
assuming an infinite number of individuals who form themselves into many
clubs of different sizes. Under certain conditions the infinity assumption allows
each club to maximise its own benefit without violating Pareto optimality. The
Buchanan-Ng framework may be preferable to the Tiebout framework in the
case where location of consumers is exogenous, transport is costly and where
there are few clubs. In the Tiebout model individuals can vote with their feet,
moving to regions according to their preferences for public goods.
Nevertheless, in order to examine this model further we note two
assumptions of the Tiebout model, namely (i) consumer-voters are fully mobile
and (ii) they have full information on the differences on revenue and
expenditure in the local areas. These two assumptions depend on the absence
of relocation constraints such as employment, house purchase and school
availability. It also presupposes a large number of alternative communities with
which the consumer can effectively rank order each community. The remaining
assumptions include the following: (iii) there are no external economies or
diseconomies of scale in the supply of the public services; (iv) there is an
optimal community size for every community service; and finally (v)
communities below the optimal size attract the new residents.
This set of assumptions establish the classic Tiebout model and ensure the
global optimality of excludable public goods provision. Mueller (1989, p. 157)
outlines an illustrative proof of this global property. However the new residents
can produce congestion in the new area and the resulting congestion costs and
possible negative externalities if the community has grown beyond the optimal
size, forces Mueller to conclude that in general the Tiebout model will not
produce a Pareto optimal outcome. In his illustration he shows quite clearly
how a non-Pareto though stable equilibrium can emerge. Empirical evidence
to support the hypothesis has been forthcoming, for example, Cebula (1979)
showed that inter-area differences in welfare benefits influenced migration
decisions while Aronson and Schwartz (1973) in an earlier and original
analysis showed that those towns likely to gain in relative population are those
that offer residents equal or better services at an equal or lower tax rate.
0750 Public Goods and Club Goods 935
6. A Marginal Decision Curve
McNutt (1996) offered an alternative interpretation to the global condition in
a Tiebout-Oates world by considering the idea of a marginal decision (MD)
curve. This differs from the average benefit curve employed initially by Mueller
(1979); while both curves represent benefit, Muellers curve assumes that
benefit is a function of community size whereas McNutts curve is a function
of the number of internal members (who form an internal group) in the sharing
group. The concept of an internal group is used to explain the formation of
alliances in the provision of public goods. In many instances, for example, the
alliance may expressly form to prohibit the supply of public goods as with
defence or environmental quality. As illustrated by McNutt (pp. 198-199), the
group MD schedules are mirror images of each other which reinforces the point
that utility in the club is maximised by dividing the club good equally between
each group.
Let us take the example of tulips in a public square; tulips represent a public
good, planted in the public square by the local authority. Assume that the
tulips, for whatever reason, offend a sub-group of the individuals who spend the
day in the square. For this sub-group the tulips represent an externality. The
square itself is a public good, but the presence of tulips reduces the utility of
this sub-group. Next we introduce the concept of internal member:
Definition: define the sub-group S of citizens such that there is an issue i which
at least one member j of the group regards as an externality, then j 0 S is
defined as an internal member of the set S. The set S is a proper subset of the
set, C, of all individuals in the square.
If the committee responsible for planting tulips decides against planting
tulips in the square, the internal group is defined as decisive. The significance
of an internal group is in its ability to rank local public goods in descending
order of preference. The important characteristic of an alliance supplied public
good is jointness in supply, that is, the supply includes private benefits as well
as public goods. The private good may include cultural or educational benefits
but may also include private externalities as with the tulips example.
Club theorists may have underestimated how members of a sharing group
become associated. Apart from similiar tastes, there is the possibility of an
association by alliance, that is an alliance of internal citizens who expressly
object to the supply of a public good. How this manifests itself in theory, is as
follows: the sharing group, that is the group of all citizens who consume the
good, is subdivided into group A which derives exactly half as much utility as
group B, the internal group, in any provision of a local public good. Group B,
an internal group, has a negative impact on the remaining members, (MDA) =
1/2 (MDB).
936 Public Goods and Club Goods 0750
If the rule is to maximise the utility of the sharing group then emphasis will
be in the directon of group B. Ironically the utility of the A group will decrease.
The dominance of the internal group secures a reduction in the amount of local
public good in order to maximise the utility of the sharing group, B. McNutt
(1996, pp. 198-199) called this the tulips paradox, that is, in the local
provision of a public good the presence of a decisive internal heterogeneous
group with identical tastes may reduce the supply of the local public good in
order to maximise the utility of the larger citizenry group.
7. A Buchanan-Ng Framework
There are two basic models across the literature on club theory, the Buchanan
(1965) within-club model and the more general Oakland (1972) total economy
model which will be developed in a later section. Buchanans model is the
classic treatment of clubs while the Oakland model is more general in
extending club theory to include heterogeneous members, discrimination,
variations in the utilisation of the public good and exclusion costs. Neither
model, however, guarantees Pareto optimality in the provision of local goods,
which ironically is the raison dtre of club theory as a methodological study
of the allocative efficiency of (impure) public goods.
The assumptions underpinning the Buchanan model include the following:
(i) individuals have identical tastes for both private and public goods; (ii) the
size of the club good (a swimming pool), hence its total cost, is fixed; and (iii)
equal sharing of costs. Mueller (1979) has argued that (iii) follows as an
assumption from (i). In a simple model Buchanan determines the optimal size
of the club membership. Mueller shows that with some algebraic manipulation,
by deducting each individuals share (equal shares) of the cost of providing the
good from private income to obtain net of public good income and
substituting this into an objective function with the amount of public good and
club size as explanatory variables, the Buchanan model obtains the Samuelson
condition for the efficient consumption of a public good.
The crucial assumption in the Buchanan model, and in club theory
generally, is the assumption of identical tastes and incomes. The Tiebout model
shows that it is inefficient to have individuals of differing tastes in the same
club. Intuitively, think of ten women golfers in a golf club of 25 players. The
result here is akin to Paulys (1967) result, obtained much earlier, that no stable
equilibrium will exist if the women golfers form a winning majority. This is
particularly the case if the number of women golfers increased and the threat
of exit by the male golfers becomes credible - they could leave and form an
alternative club. The dynamics of the situation would suggest that a small
membership size is optimal - in other words, there has to be a limited degree
0750 Public Goods and Club Goods 937
of publicness (an excludability factor) as additional members beyond the
optimal membership size will impose a cost on existing members. Congestion
may arise on the golf course, reducing the utility of existing members.
According to Ng the relevant Pareto optimality condition requires that any
individual in the club must derive a total benefit in excess of the aggregate
marginal cost imposed on all other consumers in the club. So the Buchanan-Ng
theory is to optimise the membership; alternatively Oakland considers the
degree of congestion or overcrowding to be important. Club theory has many
interesting applications in the analysis of congestion and in establishing the
optimal group size for (say) a local golf club to a local community. Buchanans
economic theory of clubs builds on three rather important assumptions: (i) that
the benefits and costs are divisible amongst the club members. As more
members join, average costs for the provision of the club declines, but marginal
benefits begin to fall as more members contribute to congested levels of
membership; (ii) it is costless to the club to exclude members. This
conveneintly removes any distortion should exclusion be deemed necessary in
order to attain an optimal (MC = MB) membership. Finally it is assumed that
(iii) there is no discrimination across members. This is a rather difficult
assumption to defend in practice, as in the case of golf clubs and swimming
pools where there is evidence of sex discrimination. However, with these three
fundamental assumptions, an individual quasi-concave utility function is
maximised in order to find the optimal club size and the optimal quantity of the
good.
The public good is not a pure public good, but rather there is an element of
congestion as individuals consume the good up to its capacity constraint. What
arises then is some exclusion mechanism in order to charge consumers a price
for the provision and use of the good. Brown and Jackson (1990, p. 80) had
commented that the purpose of a club is to exploit economies of scale, to share
the costs of providing an indivisible commodity, to satisfy a taste for association
with other individuals who have similar preference orderings. For Buchanan
and Ng the main club characteristic is membership or numbers of consumers
and it is this variable that has to be optimised. For Tiebout an assumption of
infinity of individual consumers presupposes costless exit from one region to
another and the formation of many clubs. Oakland considered the degree of
congestion as an important characteristic in the provision of a club good. There
is room for all of the characteristics in a general theory of clubs that seeks to
determine a Pareto-optimal distribution of public goods.
What appears not to have been examined in this context is the interpretation
of an individuals income elasticity of demand as a proxy for tastes for a public
good. In the Tiebout world high-income individuals may migrate to the same
area which leaves relatively poorer individuals consuming only the public
goods which they themselves can afford to provide. No one really objects to
club membership when the public good is tennis courts, squash courts or golf
938 Public Goods and Club Goods 0750
clubs. To avoid congestion in the club and to achieve economies of scale, a
Pareto efficient outcome is arrived at by introducing an exclusion principle. But
in a Tiebout world of clubs, right-handed golfers exiting to form an alternative
club, is quite different to the world in which high-income individuals migrate
to one area and low-income individuals to another area.
As Mueller (1979, p. 144) pointed out the voluntary association approach
is likely to affect the distribution of income. If individuals can vote with their
feet and have positive income elasticities of demand for public goods they can
benefit from living in a community with incomes higher on average than their
own. But for the poorer individuals transport and mobility is costly and for the
higher-income individuals the formation of interest groups (for example,
regional or local environmental lobby) is a concomitant to the provision of the
public good. Each militate against an egalitarian distribution of the public
good. Any attempt to transfer across from rich to poor runs directly into the
issue of the proper bounds of the polity and the rights of citizenship according
to Mueller. However, in order to reach levels of efficient voluntary provision in
Paretian terms, cooperation is necessary.
8. Precis on General Models
The presumption is that a voluntary provision of the public good will lead to a
suboptimal outcome. The general model further assumes the existence of a
private good and an impure public good, with the private good acting as a
numeraire. The members are heterogeneous, non-members are costlessly
excluded and club members determine their utilisation rate of the club good by
varying the number of visits (to the public park) and time spent at the club.
Optimal provision in this general model, within which both members and
non-members are considered in deriving the optimal conditions for a single
club, requires, according to Sandler and Tschirhart (1980, p. 1489) that the
marginal benefits from crowding reduction, resulting from increased provision,
equal the marginal costs of provision (MRT). This is analogous to the earlier
Pareto optimal condition (MRS = MRT) for public goods provision and not
unlike the conclusion extracted by Buchanan. The utilisation condition in the
general Oakland model requires an equal rate of utilisation for all members,
although total toll payments (for utilisation) vary between heterogeneous
members.
Oaklands model is identical to the Buchanan model under the following
conditions: (i) all members are homogeneous and each consumes the available
quantity (say) X of the public good, such that Xi = Xj; (ii) for the members S the
crowding function must be an identity mapping, that is C(S) = S, this reduces
the general Oakland utility function to the Buchanan function U(Y1,X1,S),
where S substitutes for C(S). The insertion of a crowding function into the
0750 Public Goods and Club Goods 939
utility function is one major difference between the models in club theory.
Sandler (1978) argued that by including a crowding function, crowding
externalities such as poor view can be considered, (a) increases in the provision
of the public good reduces crowding (dc/dc < 0) and (b) increases in member
use of the good increases crowding, that is (dc/dxi > 0). It has been argued that
the general model implicitly assumes cardinality of the utility function. Sandler
and Tschirhart (1980, p. 1490) in their review of club theory comment that
since the general model requires an ordering of the population based upon club
preferences, cardinality is implicit.
Cardinality may rule out particular functional forms of the utility function,
that may be otherwise appropriate for club analysis, for example the
transformation W = LogU. In practice, however, populations cannot be ordered;
this applied weakness in the Oakland model has been overcome by Hillman and
Swan (1979) who proposed an ordinal representation that does not require an
ordering of the population. Their model, a ceteris paribus type model,
maximises an arbitrary members utility subject to the constancy of other
members utility levels. Recall that Buchanans model maximised individual
utility U(Y, X, S) subject to a production:cost constraint F(Y, X, S) = O. The
Hillman and Swan (1979) result is akin to this basic Buchanan model when (i)
C(S) = S and (ii) F = U[Y, X, C(S)]. The (ii) condition is the Buchanan
constraint in the optimization procedure; an analogy requires that the Hillman
and Swan constraint be rewritten as F = U[Y1, X, C(S)] = O. This may be
unlikely but worthy of further research.
Both Tiebout (1956) and Oakland (1972) represent alternative frameworks
to the approach adopted by Buchanan (1965) in accounting for the
under-supply of public goods. Oakland looked at the degree of congestion while
the Tiebout model is an application of club theory to community size. A
Tiebout-Oakland public goods problem would manifest itself for those public
goods for which congestion begins at a certain size of community. As the
community gets larger, residential density increases (community congestion),
reducing the utility of everyone living in the community. Two factors which are
important in the context are: (i) that the total number of people may not be an
integral multiple of N, the number of workers, that is there may be a fixed
population as identified by Pauly (1967); and (ii) the number of communities
may be fixed. The one exception, alluded to by Atkinson and Stiglitz (1980),
is a frontier society.
If the communities are fixed, say, to two, an optimal provision of the public
good may involve an equal treatment, a result which in Atkinson and Stiglitz
(1980) yields a local minimum (maximum) solution with population shortage
(excess), hence social welfare could be increased by moving to an unequal
treatment. A similiar point was alluded to earlier in the discussion of the
marginal decision curve. However, the general theory of clubs with the property
of no discrimination of members assumes a group of homogeneous individuals.
940 Public Goods and Club Goods 0750
The Tiebout world has heterogeneous individuals sorting themselves out into
homogeneous populations with homogeneous tastes. Hence doctors and lawyers
live in the same neighbourhood and there are golfers in the golf club and
swimmers in the swimming club. Health and sports clubs have to acquire an
optimal mix of members in order to minimise crowding and queues. A sorting
mechanism has to be introduced such as a rota or a time schedule based on
membership age. But is the sorting optimal? In answering this question we
have to refer to the concept of homogeneity.
9. Homogeneity
In the literature there are at least two interpretations of homogeneity in the club
literature; first (i) Tiebouts (1956, p. 419) homogeneity as captured in his work
where he commented on restrictions due to employment opportunities are not
considered. In mixed communities doctors and lawyers do not have equal
incomes since the respective income depends on labour supply. Consequently
they are not perfect substitutes and the community needs both; the community
is better off if they have the same tastes. Secondly, an Atkinson-Stiglitz (1980,
p. 531) type homogeneity, which is a weaker version of the Tiebout
homogeneity and argues that individuals are [not] always better off forming
homogeneous communities with people of identical tastes. In their argument,
they consider a third public good produced as a compromise to a merged
community forming from the separate communities. In the merged case the
individual can enjoy the benefits of the economies of scale associated with three
public goods (equivalent to our average cost reductions in the Buchanan
model), but when these benefits are weighted against diminishing returns to
labour N (equivalent to the declining benefits in a Buchanan model), the
individual is better off.
An interesting dimension arises in the context of a heterogeneous
population which can be translated into different marginal valuations. If, for
example, the local authority does not tax the individuals according to their
respective valuations, by imposing an equal tax, there may not be an optimal
provision of the local public good in the merged community. Those who value
the public good less, are essentially subsidised by the high-value individuals
and receive a windfall gain in the provision of the good. The movement from
separate communities to a merged community is not a Pareto improvement.
Atkinson and Stiglitz (1980) arrive at a similar result, assuming no
diminishing returns to labour, in looking at positive benefits, that is everyones
taxes [are] cut. Whether the sorting is optimal or not depends clearly on the
assumptions of diminishing returns to labour, the existence of a windfall
provision to individuals with lower valuations and on the assumption of
homogeneity.
0750 Public Goods and Club Goods 941
Pauly (1970b) and McGuire (1974) in their generalisation of the earlier
work of Tiebout assume an indefinitely large number of individuals, forming
clubs of different sizes. Pareto optimality is not violated with the assumption
of infinity (uncountable infinity according to Ng, 1979) as each individual can
join a club that suits his or her preference, thus maximising the individual
(average) benefit or the benefit of the club. The applicability of this infinity
framework is, according to Ng (1979, p. 212), suitable for the cases where the
number of clubs for the same good is large and the population is mobile; he
suggests group segregation in housing the nomadic life and sports clubs.
In the typology of public goods presented in Table 2 earlier, the club good
is defined as a non-rival excludable public good. A different usage of rivalry
has been discussed in the literature by Starrett (1988, p. 58) in the context of
club theory and local communities. The spatial element in local communities,
with competing use for a limited (same) space, generates club rivalry that is
independent from the rivalries we have been discussing. In what he refers to
as a bare bones model, Starrett concludes with an optimality condition which
suggests that efficient size will require that average provision cost equal the
sum of the various marginal rivalry costs. In the model transport costs play the
role of rivalry costs, as Starrett (1988, p. 59) argues transportation has no
value to the members per se but must be incurred if they want to share the
collective good.
That each individual in the club is equal distance from Starretts collective
good, the assumption of radical symmetry, is dropped in an alternative model
which allows for choice in the number of trips to the collective good (for
example, the public park) and in the amount of residential land held by each
individual. The first-best solution is an unequal division of land as individuals
closer to the public good represent an externality to these further out in the
residential area. The latter residents have larger tracks of land. Starretts
unsurprising conclusion is a formulation that treats equals equally (p. 60); the
reason, apart from the formal rigour of his model, is that in the real world the
political system will impose this constraint on society. Of the Lagrangean
optimisation results presented by him the one that is of interest is the condition
for optimal club size.
Theorem 2: The Henry George Theorem states that if public expenditure is fixed and
population varies, the population that maximises consumption per capita is such that
rents equal the public good expenditure.
The Starrett (1988, p. 62) result which states that the supply of the public
good should equal the pseudo-land rent in the optimal spatial club is in many
respects similiar to the Henry George Theorem as derived by Atkinson and
942 Public Goods and Club Goods 0750
Stiglitz (1980, p. 525). Optimization on club size leads to the Starrett result. In
a Henry George world, each citizen had identical tastes, an assumption which
is imported by Buchanan into his original club model. Since club rivalry
involves spatial separation the marginal cost of rivalry is reflected in the
marginal premia on limited space. Starrett concludes that in our bare-bones
model this premia could be measured in terms of transport costs, [but]
differential land rents turns out to be the right measure in broader contexts (p.
62). The measure is right, relatively speaking, in that it secures an optimal club
size. The different approaches within the general theory of clubs highlight the
many different characteristics of a club and of a club good. The general theory
of clubs offer a solution to the optimal provision of public goods.
10. Future Research and Controversies
In this final section we look at some of the more interesting areas of research
within the public and club goods literature, areas of recent controversies indeed
which have arisen across the literature. Many of the issues have an important
bearing on the optimal provision of local public goods and consequently on
local public finance.
10.1 Membership Homogeneity
Membership homogeneity has to be one of the more controversial issues within
the club literature, particularly from a public policy perspective. For example,
if mixed clubs with heterogeneous membership are found to be non-optimal, as
outlined in our earlier discussion, serious policy implications for group housing
or education schemes may arise. The literature is divided on the optimality of
mixed clubs, with Ng (1973b) and Oakland (1972) arguing for the optimality
of clubs and Berglas and Pines (1978), Helpman (1979), McGuire (1974) and
Stiglitz (1977) arguing in favour of homogeneous clubs. The latter group,
according to Sandler and Tschirhart (1980, p. 1492), have recognised that
mixed clubs may be desirable when strong scale economies require a larger
membership than possible with homogeneity.
Mixed clubs, however, are not Pareto optimal due to an important
assumption: the equal cost sharing assumption which states that in a mixed
club, albeit all members pay the same membership fee, those members with
higher valuations of the public good have a higher total payment as they use
(visit the park) the good more frequently. Conversely mixed clubs are shown
to be efficient when there are no second-best constraints imposed. Hence, by
invoking second-best constraints requiring all members to share club costs
equally, as alluded to in our argument on windfall gains or requiring all
members to use the club equally irrespective of tastes as in McGuire (1974) and
0750 Public Goods and Club Goods 943
Porter (1977), mixed clubs can always be shown to be less desirable than
homogeneous clubs. It is the set of second best constraints that relegates the
mixed clubs to second place in the efficiency comparisons. A scale of
membership fees may (paradoxically) encourage the intense user of the good
to use it less and while her less frequent user revisits frequently.
10.2 Pareto Optimality
Neither the within-club Buchanan model nor the Oakland economy model,
ensure Pareto optimality. As Sandler and Tschirhart (1980, p. 1493) conclude
[within-club] may fail when the membership size is large relative to the entire
population, [general model] will fail when multiple clubs are desirable. The
multiple clubs translates into a variable number of clubs and this requires that
both the optimal number and optimal size of clubs be determined
simultaneously. A rather different slant on the optimality controversy is
whether or not Buchanan, in his original article, failed to consider Pareto
optimality. Ng (1973b,
p. 294) has argued that Buchanan did fail to give Pareto optimal conditions in
maximising the average net benefits instead of total net benefits; Ng (1979,
p. 212) in defending his position has reiterated that his analysis aims at Pareto
optimality or maximising total benefits of the whole population. Both Berglas
(1976) and Helpman and Hillman (1977) criticised Ngs (1973b) attack on
Buchanan and questioned whether or not Ng had maximised total benefits of
one club, which in general is non-Pareto optimal.
The Buchanan-Ng framework on clubs which concentrates on each
particular club, is preferable, according to Ng (1979, p. 212), to the more
general model (wherein) these conditions are not satisfied (our italics). The
conditions referred to are generally the infinity conditions outlined in our
discussion. In contrast Berglas (1976) defended Buchanan on optimality and
Helpman and Hillman (1977, p. 295) suggested that the issue is very much
dependent on a recognition of the different types of club problems analysed
and a realisation of the difference between maximizing average net benefits (for
the members) and maximising total net benefits for the club. Buchanan
proceeded with the former, whereas Ng proceeded with the latter in
maximising total net benefits for the entire economy (p. 1493) according to
Sandler and Tschirhart (1980). Other scholars have considered the issues
arising from exclusion costs, member discrimination and the analysis of an
efficient membership fee or toll for optimal club provisions. The interested
reader is directed to the review by Sandler and Tschirhart (1980) and Mueller
(1989) and the bibliographies contained therein.
Game theory has helped to shed some light on the issues raised in the club
literature and in particular Pauly (1967) to whom we referred earlier, defined
the optimum club size as that size for which average net benefits are
maximised. This is at variance with the non-game arguments by Ng (1973b),
Helpman and Hillman (1977) and the Oakland general model. A direct
944 Public Goods and Club Goods 0750
comparison between the game and non-game outcomes is complicated by the
different assumptions used. In particular the game approach does not admit the
interdependency between the membership and the provisions which
characterises the classic Buchanan type model; nor does it consider a
simultaneous solution to membership, provision of the good and finance. In
many cases the club fee is decided ex-post. The approaches do converge on the
optimum number of clubs in the homogeneous case.
Pauly (1970a, p. 60) divided a mixed population into homogeneous groups,
with each group divided into multiple clubs where average net benefits are
maximised. He proved that the core was non-empty and existed if the clubs
consist of identical members with equal payoffs and that clubs with higher
average pay-offs have fewer members. There has been an increase in game
theoretic contributions, for example, Cornes and Sandler (1986), Sandler and
Posnett (1991) and notaby Sugden (1981, p. 118) who has argued that where
there is a consistent theory of non-Nash, utility-maximising behaviours, even
less of the public good would be supplied than in a Nash equilibrium. The
conclusion is that public goods would never be supplied at all.
10.3 Profit-Maximising Clubs
However there are two more recent controversial developments to which we
would like to turn our attention. The first concerns the issue of profit-
maximising clubs, alluded to in the classic survey by Sandler and Tschirhart
(1980). Berglas and Pines (1978) have demonstrated that a perfectly
competitive industry with identical firms (each firm acts as a club) supplying
the shared club good would achieve the same efficiency conditions as those of
a private co-operative.
Hillman (1978) found that the non-discriminating monopolist provided
smaller output and charged a higher price and operated more crowded facilities
than the non-profit cooperative. In contrast Hillman and Swan (1979) have
shown that a discriminating monopolist will always achieve an effecient
outcome. Ng (1973a) argued that a government was necessary in order to
achieve the efficient outcome, defined as maximising total benefits. He
continued to argue, in the spirit of our earlier discussion, that since members
under a monopolist will maximise net benefit rather than total benefit an
efficient outcome is not attained in the absence of a centralised government.
Ng apparently underestimated the impact of short-run political objectives
in guiding a government-run club, as later outlined by Sandler (1978).
Scotchmer (1985, p. 39) has argued that with a homogeneous population,
profit-maximising clubs will achieve an equilibrium that is within epsilon of
being efficient. There is entry in response to profits and with incumbent clubs
making a conjectural variation on the price and facility response in other clubs
when it changes its strategy, the number of clubs will be too large. The
strategy space is defined by facility X and price P, not facility X and the
member N. With the strategy space (X, P) each club believes that it can get
0750 Public Goods and Club Goods 945
more clients at the expense of other clubs. The set of strategies is a Nash
equilibrium if no club can charge (X, P) such as to make more profit, with the
zero conjectural variation assumptions. The strategy space (X, N) is abandoned
because the Nash equilibrium requires the assumption, deemed unlikely by
Scotchmer (1985, p. 27), that the other [clubs] will change their prices in
whatever manner necessary to maintain the clientiele.
The earlier profit-maximising club literature explored by Berglas (1976)
and Wooders (1980) had assumed that there was an efficient size sharing group
and the conclusion has been that provided entry forces profits to zero, a club
equilibrium will be efficient. However, these firms are competitive in the sense
of being a utility-taker, whereas Scotchmer (1985) departs from this in
arguing that firms take as fixed the strategies of other firms. It is essentially a
non-cooperative game and the equilibrium is cast as a Nash equilibrium. For
members the utility available in other clubs will change as membership
changes.
10.4 Multi-Product Clubs
A further area of research which was introduced in the wake of new material
on contestability theory is the idea of a multi-product club, footnoted initially
by Sandler and Tschirhart (1980, p. 1513). In particular, they had suggested a
role for the concept of economies of scope defined simply as complementarity
in production. Within the literature, however, some scholars have considered
this issue already, although the joint products include a private good and an
impure (or indeed pure) public good. Examples would include the Samuelson
constraint and the Henry George Theorem. However, in the area of local
government, where communities and cities share multiple club goods, this
application may prove to be useful. Berglas and Pines (1978) did, however,
present a multiproduct club model, but did not consider the concept of
economies of scope.
The essence of this assumption in any industry-type analysis is that the two
products cannot independently be provided at a cheaper cost than joint
production. It is important to recall that the relationship in the club literature
between the average cost curve and the number of clubs is related to the
definition of a single product monopoly. The condition of sub-additivity in the
cost function had already been used in the club literature by Pauly (1970a, p.
55) in his argument that club characteristic functions may be sub-additive.
The many variants to the economic analysis implicit in Buchanans original
model have advanced our understanding of club theory and have helped to
incorporate club theory into the economic analysis of local public finance.
946 Public Goods and Club Goods 0750
11. Concluding Comment
The economic theory of clubs represents an attempt to explain the under-supply
equilibrium of a public goods provision. It raises many different and
controversial issues which impinge on government policy in the public sector.
In many respects, a club provision proffers an alternative to a central
government provision of local public goods. The salient characteristic of a club,
the excludability factor, may militate against an equal and democratic
distribution of the club good. At the level of voluntary clubs, with which
Buchanan was originally concerned, club theory can critically appraise the
efforts at achieving optimal membership of the club and the maximum utility
of club members.
Game-theoretic approaches to public goods provision may give scholars the
latitude within which they could abandon the conventional postulate of
individual utility maximisation and critically evaluate how rational behaviour
can be encouraged in the individual for the voluntary provision of the public
good. Arguably, it is in the arena of an interchange between club provision and
an interest group provision of a local public good that the contestable issue of
sub-additivity may arise. The externalities, both private and public, to a certain
degree may discourage rational individuals from contributing more in order to
attain a Paretian outcome.
If the literature identifies increasing problems with cooperation then it
behoves law and economics scholars to adopt an approach which will research
and develop non-market and/or non-cooperative solutions to an optimal
provision of public goods. This approach will contribute positively to an
evaluation of the economics of the provision of excludable club goods. The
approach will also precipitate a much wider debate on the policy issues of local
neighbourhood supply and provision of public services; it may also impact on
the theory of public goods provision generally by focusing more on the
(intra-interest group) economies of organisation per se in an attempt to explain
the under-supply equilibrium of a public goods provision.
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0760
NETWORK EXTERNALITIES
William H. Page
Mississippi College, School of Law
John E. Lopatka
University of South Carolina, School of Law
Copyright 1999 William H. Page and John E. Lopatka
Abstract
A network exists when a products value to the user increases as the number of
users of the product grows. Each new user of the product derives private
benefits, but also confers external benefits (network externalities) on existing
users. Network externalities may cause markets to fail. Networks may not reach
optimal size, because users fail to take account of external benefits. Markets in
which incompatible standards compete may tip in the direction of a standard
that gains an early advantage, even if that standard is objectively inferior.
Suppliers of network goods may compete to become the de facto standard or
may attempt to make their products compatible. The theory of network
externalities has been applied in numerous legal areas including antitrust
(monopolization and cooperative standard-setting); intellectual property (the
scope of protection for dominant software programs); and corporate law (the
selection of contract terms).
JEL classification: K00
Keywords: Increasing Returns, Positive Feedback, Lock-In, Standardization
1. Introduction
The subject of network externalities has become popular in the economic and
legal literature since the mid-1980s. The fundamental idea is that the act of
joining a network confers a benefit on all other participants in the network.
According to proponents, this seemingly simple phenomenon strongly
influences competitive strategies and market outcomes in network markets.
Network externalities can, for example, influence consumers decisions whether
to adopt a new technology and producers decisions whether to standardize
their products. Ultimately, the literature suggests, network externalities can
cause markets to fail: equilibrium may not exist, or multiple equilibria may
exist and the fundamental theorems of welfare economics may not apply
952
0760 Network Externalities 953
(Katz and Shapiro, 1994, p. 94). Networks may not reach optimal size, because
purchasers do not take account of social benefits of their purchases, and
markets may converge on an inferior standard that effectively excludes better
products.
The theory of network externalities is well developed, especially for such a
new field of inquiry. Its policy implications are less clear. Some economists
claim that the inefficiencies associated with network externalities are common
in some important markets, including computer hardware and software,
transportation and telecommunications. And some argue that network
externalities justify changes in the law of antitrust, corporations, economic
regulation and intellectual property. Some of the proposed policy changes
would involve greater government intervention in the market, some would
involve less. Other scholars suggest that courts and policymakers should be
cautious in relying on network externalities. They argue that the theoretical
market failures associated with network externalities would only occur under
rare conditions. They also challenge the empirical evidence that network
externalities have actually thwarted the adoption of better technologies. Any
real market failures in network markets, they argue, probably stem from
familiar economic phenomena (like natural monopoly) that are better analyzed
using conventional tools. Even if the market has failed, government
intervention is inappropriate because network externalities cannot be identified
in practice or government action is likely to be more costly than any benefits
it may produce. In the following discussion, we will address both theoretical
and policy issues, trying wherever possible to keep them distinct.
A. Types of Network Externality
The users of certain products can be thought of as forming networks, either
because they are physically connected or because they have close market
relationships. A network externality is a benefit conferred on users of such a
product by anothers purchase of the product. (A purchase may also impose
external costs, but the literature focusses primarily on the sources and
consequences of external benefits, or positive consumption externalities.) Some
analysts distinguish between direct externalities, exemplified by
communications networks, and indirect externalities, exemplified by the
hardware/software paradigm (Katz and Shapiro, 1985, 1994; Church and
Gandal, 1992b). Note that the distinction between direct and indirect
externalities refers to the source of benefit to participants in the network, not
necessarily to the magnitude of the network effect.
954 Network Externalities 0760
2. Direct Externalities
Direct externalities typically occur in a physical, two-way communications
network (Rohlfs, 1974). My purchase of a fax machine, for example, directly
benefits existing fax machine owners, who now have an additional person with
whom they may communicate. If there are n fax machines in the network, each
owner has n(n-1) potential interlocutors; an additional fax machine adds 2n
(total) potential communications within the system, and thus enhances the
value of membership, assuming that each owner may at some point wish to
communicate with every other owner (Economides, 1996). Similar reasoning
applies to telephones and internet access software, each of which expands the
number of people who can communicate over a physical network. Users of the
network thus receive increasing returns in consumption. (Notice that direct
benefits do not accrue to users of a one-way physical network, like paging or
electric power transmission, because the existing users of the networked goods
may not interact with new users any more easily than those who are not on the
network (Economides and White, 1994; Economides, 1996).) Producers of
network goods may also receive increasing returns to scale in production, at
least up to some critical mass.
The positive feedback effect (Arthur, 1989, 1990) of increased network
size makes the larger network that much more attractive to new purchasers, and
the goods that permit access to the network that much more valuable. The value
of the good to the purchaser also depends on the purchasers expectations about
the future size of the network. The demand for a fax machine is thus a function
not only of the price of the product, but also of the expected size of the network
to which the fax machine will be connected. This last point resolves the
apparent paradox that, despite the downward slope of the demand curve, the
marginal purchase of a good can yield a higher value than inframarginal goods:
the value contributed by the expected size of the network offsets the reduction
in value from the purchase of a marginal unit (Economides, 1996).
Direct network externalities might arise even in the absence of a physical
network. Those who speak a language, for example, constitute a network. The
value of knowing a language depends in part on how many others speak it. A
students decision to learn a language is influenced by the expected size of the
network of speakers; and the students learning the language directly benefits
other speakers. Similarly, the value to an individual of a particular word
processing program, say WordPerfect, likely will depend in part on the number
of others who select WordPerfect and with whom the individual expects to
exchange files. This effect is diminished to the extent that conversion between
programs is possible, but, so long as conversion is imperfect or costly, the effect
persists.
0760 Network Externalities 955
3. Indirect Externalities
Economists have also identified indirect externalities in the network of users
of systems of compatible devices, even if the devices owned by different users
are not physically connected. A system can be any combination of a durable
good and associated goods or services that perform some desired function. Katz
and Shapiro (1994) illustrate this type of system with the hardware/software
paradigm, which includes not only computer hardware and software, but many
other product combinations, including cameras and film, phonographs and
records, and television sets and programming. More broadly, a typewriter
keyboard could be considered hardware, and the capability and experience of
using that keyboard could be considered software. Owners of compatible
hardware and software systems constitute a virtual network (Katz and
Shapiro, 1985, 1994; Arthur, 1989, 1990). At the extreme, any combination of
complementary products can be described as a system, and those who purchase
the system can be said to form a virtual network. Thus, a cappuccino machine,
a coffee grinder, espresso coffee beans and milk form a system, and those who
drink home-made cappuccino form a network.
Indirect externalities can arise in these markets only when, as is typical, the
components are purchased at different times. For example, applications
software programs are often purchased at various times over the useful life of
a computer. In these circumstances, adoption of the hardware by one purchaser
confers external benefits on other users of the same hardware, because it
expands the installed base of the hardware, stimulating demand for compatible
software. Suppliers may therefore take advantage of scale economies and
provide more varieties of software. The availability of more diverse and
inexpensive software enhances the value of the existing users hardware. These
indirect benefits stemming from strong complementarities are said to cause
positive feedback in much the same way as direct benefits of expanded
communication in physical networks.
Indirect network externalities may arise in many contexts. Participants in
physical networks, both one-way and two-way, may receive indirect external
benefits, if the increased size of the network results in more options and better
service. Traders on a financial exchange may also receive indirect benefits from
the array of services provided by the exchange (Economides, 1993a, 1996). And
users of Discover cards benefit when more people carry Discover cards, because
more merchants will accept a widely-adopted card (Evans and Schmalensee,
1996).
956 Network Externalities 0760
4. Network Effects versus Network Externalities
Liebowitz and Margolis (1994, 1995a) distinguish network externalities from
network effects. A network effect exists when the net value of an action ... is
affected by the number of agents taking equivalent actions (Liebowitz and
Margolis, 1994, p. 135). Network effects, so defined, are ubiquitous in the
economy. Purchases of a good by one group of consumers may bid up its price
and thereby affect other consumers of that good as well as consumers of
complementary and substitute products. Liebowitz and Margolis point out that
economists at one time misinterpreted these interactions as inefficiencies, but
now recognize them to be pecuniary external economies and diseconomies,
which the price system internalizes as wealth transfers between, say, purchasers
and suppliers. Liebowitz and Margolis (1994, p. 135) would limit the term
network externality to those specific network effects in which the equilibrium
exhibits unexploited gains from trade regarding network participation.
Network externalities, so defined, do cause market failure, but are far less
common than network effects generally.
Liebowitz and Margolis (1995a) accept the distinction between direct and
indirect network effects, but argue that they are fundamentally different in their
consequences for efficiency. They recognize that direct network effects in
physical networks may (in limited circumstances) be true externalities. But they
challenge the notion that indirect network externalities arise whenever
complementary goods become more plentiful and cheaper as the number of
users of the related product increases. They contend that much of what the
literature calls indirect network externalities are merely positive pecuniary
externalities that result in wealth transfers.
These theoretical points lead to very different policy conclusions. If the
price of complementary goods decreases as a network grows because rents are
transferred from input suppliers or producers to consumers, the market does not
fail, and no state-sponsored remediation is necessary. If instead price falls due
to positive technological externalities, remediation may be required, but only
because of a conventional market failure in an upstream or downstream market,
not network externalities.
Katz and Shapiro (1994), leading scholars in the field, have adopted the
distinction between network effects and network externalities in theory, though
they disagree in its application, and generally argue that true network
externalities are more common than Liebowitz and Margolis suggest. Other
scholars continue to use the term network externalities to encompass all
network effects. (Economides, 1996; Klausner, 1995).
0760 Network Externalities 957
B. Effect of Externalities on Network Size
5. Physical Networks/Direct Externalities
The existence of positive network externalities in adoption of a technology in
a physical network implies that the private marginal benefit of acquiring a
network technology is lower than the social benefit. In deciding whether to buy
a network good, the individual compares the price only with his private benefit,
not the benefit that his purchase confers on other users. Consequently, the
equilibrium size of a physical network under perfect competition, with direct
network externalities, may be smaller than the social optimum (Katz and
Shapiro 1994; Economides, 1996).
The size of a physical network is also affected by consumer expectations.
Because information about other potential purchasers future actions is always
imperfect, consumers expectations may result in a nonoptimal network size.
For example, if all consumers expect no one else to purchase, then the network
size will be zero, even if all consumers would benefit by joining the network;
if all expect everyone to purchase, the size will be large (Katz and Shapiro,
1994). The importance of consumer expectations gives producers an incentive
to convince consumers through a variety of practices that their networks will
attract many users.
Some physical networks may be owned by a single firm. Firms that own a
network may use their property rights to internalize consumption externalities.
This result is most apparent in entirely internal networks. Fax machines, for
example, faced an initial externality problem in that purchasers had no
incentive to buy one unless others did also. If there were a high enough degree
of uncertainty, the market might not have developed at all. But large firms
apparently had enough incentives to purchase fax machines for purely internal
communications to create a critical mass (Katz and Shapiro, 1994, p. 97, n. 4).
A single firms ownership or sponsorship of a physical network with
individual subscribers can also internalize network externalities. Consumer
surplus is maximized if the sum of marginal private and social benefits of a
purchaser equals marginal cost (Liebowitz and Margolis 1994; Katz and
Shapiro, 1994). Liebowitz and Margolis argue that ownership of such a
network can usually solve the problem of a suboptimal network size that flows
from direct network externalities. The owner will set access prices that reflect
the fact that additional users provide benefits to all other users. If marginal
costs are assumed to increase, a network can reach an optimal size. Liebowitz
and Margolis believe that the assumption of increasing marginal cost, typical
to economic models, is appropriate here because economies of scale are
exhaustible for many network commodities. In these circumstances, more than
one network can coexist, so competition is possible. If, on the other hand,
958 Network Externalities 0760
economies of scale are inexhaustible, the market is a natural monopoly, which
may be inefficient but not because of something unique to the network character
of the good.
Suppose that ownership of the network does imply a monopoly. Economides
and Himmelberg (1995) argue that the incentive of the monopolist to restrict
output overwhelms its incentive in increase consumer demand by influencing
expectations about network size. The resulting monopoly equilibrium is at a
lower network size than under competition. Katz and Shapiro (1994) argue
that, if a monopolist charges a single access fee above marginal cost, external
benefits will not be internalized. But price discrimination may well allow the
network to internalize the adoption externalities: for example by setting access
fees at or below cost and earning profits on usage fees (p. 101). The network
owner thus addresses the problem of buyer expectations about the future size
of the network.
Liebowitz and Margolis (1994) recognize that not all networks that generate
direct network externalities can be owned. For example, the network of
speakers of Esperanto is not ownable and so may fail due to direct network
externalities. But other market mechanisms may minimize any social cost in
such cases. Intermediary organizations may, for example, facilitate
communication among groups within the population. Network effects can also
be internalized by the direct interaction of participants. For example, computer
programmers working on a common project can agree to adopt the same
language. These interactions will tend to internalize potential externalities
when transactions are easy. Liebowitz and Margolis believe, therefore, that
network externalities will not often result in a suboptimal size of a network, and
to the extent that a network is inefficiently small, the reason can be traced to
the conventional market failure associated with natural monopoly.
6. Virtual Networks/Indirect Externalities
The analysis of the effect of indirect externalities on the size of virtual networks
is somewhat different. In these markets, externalities may arise because of the
durable nature of the hardware component in the system. The purchaser of
hardware knows he will be locked in to the product for a time, because the
cost of switching to different hardware will be substantial. (On the effects of
switching costs, see Klemperer, 1987a, 1987b, 1989). Consumers then may be
uncertain about the future availability and price of software for the product. If
this uncertainty can be addressed, then the network externality problem
disappears. If, for example, all of the components of the system are
competitively supplied by firms with U-shaped average costs, the market will
reach an efficient competitive equilibrium. The market is indistinguishable
from any competitive market with complementary products (Katz and Shapiro,
0760 Network Externalities 959
1994). Note that this outcome differs from the inefficient outcome in physical
network markets under competition discussed in the previous section.
Katz and Shapiro (1994) argue that network externalities can arise if
hardware is supplied competitively at marginal cost, but differentiated software
is provided at a price above marginal cost by firms subject to scale economies.
Apparently responding to Liebowitz and Margolis, Katz and Shapiro (p. 100)
state that if all goods were priced at marginal cost, these network externalities
would be merely be pecuniary externalities, and market equilibrium in
hardware/software markets would be efficient. If, however, software is not
priced at marginal cost, a suboptimal variety of software may result or software
may be produced at an inefficiently high cost, and the resulting networks may
be smaller than optimal because the marginal social benefit of additional sales
is greater than the private benefit to the purchaser. In such circumstances, Katz
and Shapiro argue, a subsidy to hardware suppliers (or software suppliers) can
increase consumer welfare by expanding the supply and variety of software.
Liebowitz and Margolis presumably would respond that the subsidy in this case
is (theoretically) justified because of imperfect competition in software, rather
than because of any indirect network externality.
If a monopolist supplies both hardware and software, consumers may fear
that, once they are locked in to the durable good, the monopolist will exploit
them by increasing prices of the software. (Farrell and Shapiro, 1988; Katz and
Shapiro, 1994; Shapiro and Teece, 1994). Sponsorship arrangements by the
monopolist may provide a solution. Thus, network externalities can be avoided
if the seller can somehow commit to software prices in advance of purchase. If
such commitment is possible, consumers would have no reason to fear lock-in
specifically. They would, of course, be subject to monopoly pricing (either
single-price or discriminatory), but any inefficiency would then be attributable
to the monopoly, not to network externalities. (Katz and Shapiro, 1985, 1994).
The monopolist may attempt in various ways to approximate a commitment
to future supply of compatible goods at prices consumers expect to pay. It may,
for example, attempt to guarantee a competitive supply of compatible software,
even inviting competitive firms to enter the market (Economides, 1996; Farrell
and Gallini, 1988; Katz and Shapiro, 1994). It may also adopt a policy of
leasing hardware, thereby assuring that customers would not be locked in, were
it to raise software prices. Or it might engage in penetration pricing of
hardware, which would mean that, although consumers may pay high software
prices, they will be compensated by lower hardware prices. Finally, it may rely
on its reputation as a bond securing purchasers against exploitation (Katz and
Shapiro, 1994). If it were to exploit purchasers, it would damage its ability to
sell later generations of its hardware.
960 Network Externalities 0760
C. Competition Among Networks
7. Tipping and Lock-In
One of the most striking consequences of network externalities is their effect
on the nature of competition between sellers of products embodying different,
incompatible standards. The literature cites many examples: VHS and Beta
standards for VCRs; phonographs and compact disc players; conventional
versus high-definition television; and so forth. In such markets, network
externalities may favor the markets adoption of a single sellers product as the
de facto standard, such as VHS rather than Beta as a videotaping format. In
corresponding theoretical models, one technology gets an early advantage (for
whatever reason), and positive feedback of the larger network size leads new
users to adopt that technology. It is suggested that the first mover in markets
for information-based software receive continuously increasing returns to scale,
reinforcing early successes and aggravating early defeats (Arthur, 1989, 1990,
1994, 1996). Ultimately, competing technology leaves the market. A market
that settles on a single standard is said to have tipped.
In other markets, network externalities and scale economies may be
exhausted at a smaller network size, so that the market can accommodate more
than one network. Moreover, consumers heterogeneous preferences can result
in multiple standards, such as the IBM-PC and the MacIntosh computer
(Liebowitz and Margolis, 1995a; Katz and Shapiro, 1994, p. 106). Firms,
therefore, might prefer to promote their own incompatible networks regardless
of the resulting size. Or each firm might prefer its own standard, yet prefer
compatibility with a rivals standard if only one standard can prevail.
The tendency of network markets to tip leads to particularly intense
competition early in the markets existence (Farrell and Shapiro 1988).
Competitors may employ aggressive strategies like penetration pricing - in
some instances giving the product away - in order to become the de facto
standard. Katz and Shapiro (1994, p. 107) observe that in such cases firms are
bidding for future monopoly profits. After achieving dominance, the firm may
recoup some or all of the expenses it incurred in the early competition. In such
cases, what appears to be monopoly profit earned by the firm in later stages of
production is actually recovery of the earlier expenditures. Another possibility
is that a firm with an early lead may have an incentive to deter new entry by
low pricing in order to build on its advantage (Farrell and Saloner, 1986a).
One implication of the network externalities literature is that the market
may settle on a good with a lower social valuation. The literature cites
numerous examples: the QWERTY typewriter keyboard (David, 1985); VHS
and Beta videocassette formats (Arthur, 1990); and AM stereo (Besen and
Johnson, 1986). Proponents of network externalities point out that a goods
0760 Network Externalities 961
value to the user depends upon its inherent benefit (the value of the good to the
purchaser even if no one else adopted it) plus its network benefit. The network
benefits increase with the size of the network. Initial adopters will primarily
take account of the goods (apparent) inherent benefit to them. If that inherent
benefit is greater for good A than for good B, the initial adopters will choose
A. As the size of network increases, it becomes still more advantageous to
choose A over B, and all subsequent adopters will do so. But suppose that,
although B offers lower inherent benefits, its network benefits increase at a
higher rate than those of good A, and at some network size actually exceed
those of A. In theory, B would offer greater social benefits if it were adopted by
the market as a whole; but the market nevertheless chooses A (Farrell and
Saloner, 1986b; Klausner, 1995). Katz and Shapiro (1994, p. 106) state that
standardizing on a single system can be very costly if the system turns out to
be inferior to another system. This type of standardization may also affect
innovation incentives in the market.
Once the market tips toward a single standard, it may remain on that
standard and its successors for a long time. Markets may exhibit excess
inertia and remain locked into a standard, even though an objectively better
standard is available (Katz and Shapiro, 1985; Farrell and Saloner, 1986a).
Present users face substantial switching costs; even though all users would be
better off with the new standard, those benefits do not accrue to the present
users who must pay for switching. New purchasers also may opt for the
established standard because of the immediate benefit that the established
network offers; they do not take account of the benefit that purchasing the new
technology would confer on later purchasers. Even if they anticipate the new
technology would be widely adopted, the benefits of that adoption to the
purchaser may be so far in the future that they are substantially discounted
(Farrell and Saloner, 1986b, p. 947, n. 14).
Theoretical models, however, demonstrate no inevitable tendency of
markets to lock-in on inferior products. Changes in the assumptions underlying
the models (for example, concerning communication and information in the
market) may eliminate the outcome of excess inertia (Farrell and Saloner, 1985,
1986a; Liebowitz and Margolis, 1990). Moreover, markets may actually exhibit
insufficient friction (Katz and Shapiro, 1986b, 1994) or excess momentu
(Farrell and Saloner, 1986b), tipping suddenly and inefficiently to new
technologies. Insufficient friction may be inefficient because consumers do not
take account of the network benefits their purchase of the established product
would confer on existing users. Given this external benefit, it may be socially
preferable to stay with the established technology. Nevertheless, consumers,
fearing that they will be stranded with an obsolete, unsupported technology (the
penguin effect, Farrell and Saloner 1987), may jump to the new technology.
Katz and Shapiro (1986b, 1992) suggest that sponsorship of proprietary
962 Network Externalities 0760
technologies may lead to inefficient adoption of one technology over another
through excess momentum. For example, if the incumbent technology is
supplied competitively under a shared standard, a new, proprietary technology
might be offered at penetration prices in order to attract an installed base. The
incumbent competitive suppliers would be unable to price below their marginal
cost, because they can have no expectation of recoupment.
8. Criticism of the Tipping Scenario
Liebowitz and Margolis (1995a) dispute the suggestion that increasing returns
to scale in high-technology markets lead to market failure. They point out that
the frequently-observed relationship between increasing participation in a
market with indirect network effects and falling prices is ambiguous. Such a
relationship may result from scale economies, but it may also reflect
technological progress. In the latter case, prices drop because advances in
technology reduce industry costs, not because of a network effect.
Liebowitz and Margolis (1994) also criticize the suggestion that markets fail
because the wrong network is chosen, so that total net benefits are lower that
they would have been under the losing technology. This kind of asserted failure
is a function of models that assume inexhaustible scale economies, for only then
does a single network survive. Liebowitz and Margolis argue that the marginal
gains of network size are often exhausted at sizes above a critical mass that is
small relative to the total market. If the benefits of size are exhausted, multiple
networks can exist. In that event, not only are monopoly problems lessened, but
the theoretical question shifts to whether the best set of networks emerge. And
the inframarginal externality that may affect the discrete choice of a network
is not different from other coordination problems that exist in many other
market choices (Liebowitz and Margolis, 1994, p. 141).
Liebowitz and Margolis are especially critical of claims that network
externalities lead consumers to make discrete choices among networks, choices
that do not maximize social welfare. Such externalities cannot be addressed by
taxes and subsidies, because those policies can only affect the scale of a
network. Rather, the assumed market failures occur because network
externalities supposedly prevent value-increasing transitions from one
technology to a superior one. At the extreme, the literature seems to suggest
that economic actors may easily become forever stuck in technologies that are
widely recognized as inferior to available alternatives. Liebowitz and Margolis
(1994, p. 145) colorfully call this the Chicken Little view of market
transitions. They contend that economics has generally not done well in
explaining transition, which affects all components of the economy, not just
networks. Nevertheless, value-increasing transitions do occur, even if the
0760 Network Externalities 963
process is not well understood. Evans and Schmalensee (1996) note that, for
example, the computer software market exemplifies Schumpeters (1942) view
of modern competition - one in which firms and industries are constantly
created and destroyed through the process of innovation.
Whatever the theoretical possibility of market failure brought about by
network externalities, critics complain that empirical support has not been
adduced. Proponents of network externalities, for example, have often pointed
to the conventional QWERTY keyboard as an illustration of lock-in. The
keyboard arrangement was chosen, it is said, to slow down the typist to avoid
mechanical jamming; other arrangements permit faster typing. Even though
technological improvements have eliminated the mechanical problems, users
are locked-in to the inferior QWERTY arrangement - consumers wish to avoid
the costs of learning a different arrangement, and producers will not supply
alternative products because not enough consumers would purchase them.
Liebowitz and Margolis (1990) argue forcefully, however, that the story is
factually incorrect, for the QWERTY keyboard is not demonstrably inferior to
the leading alternative. Similarly, Liebowitz and Margolis (1994) find evidence
that the Beta videotaping format is no better than VHS. In all, Liebowitz and
Margolis believe that real indirect network externalities are of limited
theoretical importance and have not been established empirically. For a similar
discussion of the complexity of the issue of objective superiority of one
technology to another, see Van Vleck (1995).
D. Compatibility and Standardization Among Network Goods
9. Compatibility and Standardization Among Network Goods
Many of the private and social consequences of network externalities depend
upon whether products competing in a network market are compatible in a
relevant sense. The term compatibility is used in the literature to refer to
different relationships depending upon the context. For example, physical
networks are said to be compatible if they allow direct interconnection; virtual
networks are said to be compatible if various components of the system are
interoperable, that is, they can work together; and various products, such as
computer software, may be said to be compatible if consumers can use them
without significant retraining (Lemley and OBrien, 1997). For useful surveys
of the issues surrounding compatibility and standardization in markets with
network externalities, see Cohen (1996) and Katz and Shapiro (1994).
Whether systems are made compatible depends on a host of factors that may
influence decisions of firms on questions of design and contracting with other
producers. Compatibility may arise as a result of a single firms product
964 Network Externalities 0760
becoming the de facto standard in the market; or it may arise through collective
standard-setting mechanisms. In addition, converters or adapters may make
products compatible to varying degrees (Farrell and Saloner, 1992). In some
instances, it may be to a firms advantage to try to prevent compatibility with
existing systems and compete with them to become the de facto standard for at
least a part of the market. In other instances, firms may choose to make their
products compatible with other products by licensing or by participation in
coalitions or standard-setting organizations (Katz and Shapiro, 1994).
Compatibility, by expanding the size of networks, offers both private
benefits and private costs to producers and consumers of network goods.
Participants in compatible physical networks receive the direct external benefits
of communicating with a larger number of consumers, and save the costs of
owning two sets of hardware. Participants in compatible virtual networks
receive the indirect benefits of a larger network, including a greater variety of
components that may be mixed and matched to achieve an optimal system
(Matutes and Regibeau, 1988), and a reduced risk of being stranded with
obsolete technology. Producers receive the benefits associated with larger scale.
Compatibility may impose costs, however, depending upon how it is achieved.
If it is achieved by standardization, then there may be a reduction in the variety
of systems and products available to first-time consumers (Gilbert, 1992). If it
is achieved by adapters, the adapters themselves impose costs (Katz and
Shapiro, 1994).
Whether firms have an incentive to create compatibility depends upon how
the resulting changes in the terms of competition affect them. Compatibility
reduces the risk that the market will tip to a rivals sponsored standard, and so
may reduce the intensity of competition, at least in early stages when
incompatible systems would be competing to become the markets de facto
standard (Katz and Shapiro, 1986b). This tendency suggests that some firms
(or coalitions of firms) may have an incentive to agree to adopt a compatible
standard (Besen and Farrell 1994; Katz and Shapiro, 1994). But if systems are
compatible, then the market may accommodate more firms, and so
compatibility may actually increase competition over the long term (Katz and
Shapiro, 1994). Firms that standardize reduce their chances of becoming the
dominant firm.
When networks are incompatible, then competition is between physical
networks or between systems of goods that comprise virtual networks. When
virtual networks are compatible, however, competition is among the
components of the system (Matutes and Regibeau, 1988; Economides 1988,
1996; Katz and Shapiro, 1994). In such situations, the firms preference for
compatibility depends upon the tradeoff between the increased demand that
compatibility creates and the increased competition that it entails. Firms that
believe they offer a better overall system (like Apple Computer in its earlier
years, perhaps) may opt for incompatibility; firms that believe they offer a
better individual component may opt for compatibility. In general, the winner
0760 Network Externalities 965
take most nature of competition between incompatible systems may lead firms
with very promising (or highly regarded) technology to oppose compatibility,
even when compatibility is socially preferable (Katz and Shapiro, 1994). The
social optimum is not achieved because firms individually do not take account
of the effects of compatibility on others.
E. Policy Implications
10. Policy Implications: General Remark
The many inefficiencies identified in the network externalities literature have
led some to propose changes in government policies to accommodate the
theory. But most economists have counselled caution in using the network
externalities literature to justify greater government intervention. Katz and
Shapiro (1994), for example, note that private market responses may correct
any inefficiency. Furthermore, they point out that interest group pressures make
government responses less likely to favor efficiency than powerful incumbent
producers. And there is little reason to think the government has the ability to
identify the correct market outcome better than market mechanisms (Arrow,
1995; Vita and Wellford, 1994; Lopatka and Page, 1995a, 1995b). Liebowitz
and Margolis (1994) are even more insistent that the network externalities
literature is far too limited in its theoretical implications and its empirical
support to justify a more interventionist government policy.
Nevertheless, legal literature and to a lesser extent the case law have begun
to take account of network externalities. A search of the WESTLAW Journals
and Law Reviews database reveals over references to network externalities
in diverse areas of law. And the concept has begun to be accepted by some
policymakers and courts. The following sections will address some of these
issues.
11. Antitrust: Monopolization
Because it predicts that a single firm may dominate a market, network
externalities theory has been recruited to support claims of monopolization. It
implies that a firm may have an incentive to make its network incompatible, to
achieve higher sales volumes than its competitors during early stages of
production, and to convince potential users that its standard eventually will
prevail. The practices that a firm uses to influence the direction in which the
market tips are likely to be attacked as exclusionary. For example, in Eastman
Kodak Co. v. Image Technical Services, Inc. (1992), the Supreme Court held
966 Network Externalities 0760
that an equipment manufacturer (without monopoly power in the equipment
market) could have monopolized by requiring consumers to purchase its repair
services as a condition of obtaining its replacement parts. The Court did not
mention network externalities explicitly, but did treat the equipment, services,
and parts as a sort of system. Recall that Katz and Shapiro (1994) specifically
refer to durable equipment and repair services as an example of the
hardware/software paradigm, or an indirect network. The Courts reasoning
closely resembles a network externalities analysis. It stated that purchasers were
locked-in to Kodak equipment and would find it costly to predict the prices of
aftermarket services and products at the time of equipment purchase. High
switching costs and imperfect information are important features of network
externalities theory.
The United States, in its amicus brief in Kodak, appeared to reject network
externalities theory by arguing that Kodak could not extract monopoly profits
in aftermarkets because it lacked monopoly power in the equipment market.
But the Antitrust Division under the Clinton administration explicitly invoked
network externalities theory in suing Microsoft for monopolizing the market
in personal computer operating systems, although it limited the scope of its
complaint to restraints in Microsofts distribution contracts (United States v.
Microsoft, 1995). In the litigation challenging the consent decree in that case,
all sides (and the District Court) agreed that network externalities in the
hardware and software markets had important antitrust implications and might
justify stricter application of monopolization standards. A group of anonymous
amici curiae filed a brief that was co-authored by Brian Arthur and Garth
Saloner, both prominent theorists of network externalities. For a full analysis
of the brief and the district courts opinion, see Lopatka and Page (1995a).
Network externalities theory has limitations as a policy guide in
monopolization cases. (Lopatka and Page, 1995a, 1995b; Evans and
Schmalensee, 1996; Gifford, 1996). It does not, for example, support breakup
of a firm that achieves dominance. The theory predicts that networks will often
grow large for efficiency reasons. Tipping does not necessarily imply that a
producer is forever locked in, because new technology (and creative new
producers) can benefit from the same phenomenon to leapfrog the old dominant
firm. The very possibility of tipping is an important incentive to innovation and
novel marketing strategies. And history contains enough examples of
technological change sweeping away previously dominant firms to caution
against government action to break up a market leader.
Lock-in may not even signal market failure. A firm may dominate because
it in fact offers the best product. An antitrust court could not confidently declare
that the wrong technology had triumphed (Vita and Wellford, 1994). While
excess inertia is possible, theory does not tell us when it is present. Thus there
is no justification for encouraging displacement of a dominant firm by
weakening its locked-in position. Nor is there justification for detailed
0760 Network Externalities 967
supervision of the dominant firms practices. If the market is a natural
monopoly, it is not well suited to antitrust regulation, regardless of network
externalities.
For similar reasons, network externalities theory does not offer much
assistance in identifying exclusionary conduct that creates monopoly power.
Some models suggest that markets can be tipped by trivial events or an early
advantage, so that the development of the market is path dependent (Arthur,
1989; David, 1985). Microsofts MS-DOS operating system may have achieved
dominance because IBM selected it long ago for the IBM PC (Besen and
Farrell, 1994). If historic accident determines market outcomes, however, none
of Microsofts subsequent competitive acts can be blamed for its dominant
position. Some practices may be theoretically inefficient, but courts lack the
knowledge to identify when they are so. Firms may, for example, use
advertising to manipulate consumers expectations about which standard will
prevail (Besen and Farrell, 1994; Katz and Shapiro, 1994). Or they may use
product preannouncements to discourage existing customers from switching to
another supplier and to encourage prospective purchasers to wait (Farrell and
Saloner, 1986b). But there is no effective way to distinguish these practices
from efficient dissemination of information (Ordover and Willig, 1981).
Network externalities theory may actually provide efficiency explanations
for apparently exclusionary practices. For example, vertical integration or
exclusive contracts may allow a producer to establish a credible commitment
to provide a supply of complementary goods. Similarly, a lease-only policy
(sometimes suspect in antitrust law) may be an effort to assure consumers that
they will not be locked in to a dying network.
Predatory pricing issues may also be influenced by network externalities.
Katz and Shapiro (1994, p. 104), describe penetration pricing: by selling
hardware below cost early on, the network sponsor is stimulating the demand
for software, which may lead to a lower price of software if software is
produced according to economies of scale or if the elasticity of demand for
software is higher for marginal consumers than for the average hardware
consumer (see also Besen and Farrell, 1994). This pricing strategy may
resemble predatory pricing; but its goal is to overcome network externalities in
building an installed base. Below-cost pricing or even giveaways of some
products, like computer software, may be a rational means of establishing an
installed base of complementary product sold by the same firm. Farrell (1989)
suggests that this sort of competitive below-cost pricing by sponsors of
proprietary technologies will typically lead to the better technology being
adopted. Thus, Lemley (1996) concludes that such a price war raises concerns
only if it is asymmetric, that is, if one of the combatants has greater staying
power.
Although network externality theory is susceptible to misuse in the analysis
of monopolization, it may sometimes provide a helpful context for examining
allegedly exclusionary conduct. For example, Lemley (1996) suggests that
968 Network Externalities 0760
concealment of a proprietary claim to a market standard during a period in
which that standard is being promoted for acceptance in the market or by
standard-setting organizations may be monopolistic.
12. Antitrust: Horizontal and Vertical Agreements
Antitrusts traditional hostility to horizontal agreements may cast suspicion on
some agreements in network industries. But antitrust has also recognized that
some industries require cooperation in order to exist. (See, for example,
National Collegiate Athletic Assn v. Board of Regents, 1984). Network
industries often fall in this category (Carlton and Klamer, 1983; Evans and
Schmalensee, 1996). Perfect competition may be inefficient (in physical
networks) or entirely impractical (in virtual networks). Network externalities
can often be internalized only by contract or joint ownership. Bank credit cards
require cooperation among banks in order to compete with cards issued by a
single firm (Carlton and Frankel, 1995). Telecommunications networks require
agreements on interconnection and sharing of joint costs and revenues.
Producers of both hardware and software must settle on standards to assure
compatibility (Brown, 1993). Lemley (1996) mentions the Internet Engineering
Task Force as an example of a necessary standard-setting organization. While
these points suggest procompetitive explanations for some types of agreements,
they do not exclude the possibility of such an organization being used as a
cartel or an exclusionary device. Some network joint ventures may thus require
continuing antitrust controls. Real estate multilisting services offer network
benefits, but do not justify price fixing by participating realtors. And network
externalities do not imply that standard-setting joint ventures should be
permitted to exclude competitors (Anton and Yao, 1995).
Mergers and joint ventures have become common in network industries.
Network externality theory offers a number of efficiency justifications for these
arrangements. Physical networks may offer greater value to subscribers by
merging, and may benefit from scale economies and greater information.
Research and development joint ventures may permit firms to pool information
and resources to create more advanced technology. These considerations do not,
however, imply that antitrust scrutiny is inappropriate. A merger creating a
network that is larger than is justified by scale economies may create an
unnecessary danger of monopoly. In Money Station, Inc. v. Board of Governors
of Federal Reserve System, the Board argued to the court that an acquisition
of a small ATM network by a bank controlling the dominant ATM network was
less likely to lead to anticompetitive effects because (p. 1133):
0760 Network Externalities 969
Network externalities, such as the economies of ubiquity, tend to promote the
consolidation of regional ATM networks. As a result, in various geographic areas,
like the Mideast region, dominant ATM networks have been emerging throughout
the EFT industry. One recent study indicates that the ten largest regional networks
now account for 80 percent of all regional ATM transactions in the United States.
In this light, the Board believes that, as a result of economic and market structure
conditions, regions are likely to have one dominant ATM network.
The court properly questioned this reasoning as a way of avoiding competitive
concerns about the merger. It is not clear that network externalities require
dominance of a single firm.
13. Intellectual Protection for Proprietary Standards
The theory of network externalities suggests that a single product may emerge
as the de facto standard in the market. Should the presence of network
externalites, and the consequent danger of lock-in, affect the intellectual
property protection given to a proprietary de facto standard? Menell (1987,
1989), relying in part on an analogy to the QWERTY story, has argued that
network externalities justify limiting copyright protection to computer software
that has become the industry standard. In Lotus Development Corp. v. Borland
International (1995), the court adopted this reasoning, holding that Lotus
1-2-3s user interface was a method of operation, like the buttons on a VCR,
and therefore not protectable expression under copyright law. One of the
reasons the court offered was the need for compatibility. The court found it
absurd to suggest that if a user uses several different programs, he or she
must learn how to perform the same operation in a different way for each
program used. A concurring judge added that if Lotus is granted a monopoly
on this pattern, users who have learned the command structure of Lotus 1-2-3
or devised their own macros are locked into Lotus ... Consequently, a
competitor (Borland) should be allowed to copy Lotuss menu command
structure.
This decision adopts a network externality theory raised by Borland and
amici curiae in their briefs on appeal. It has been questioned by Dam (1995),
who points out that compatibility in this case is not the interoperability that
allows use of competitive software or the inteconnection that allows
communication across a physical network. Rather, compatibility in this case
means only that a user may costlessly adopt a competing product. The
argument is that the menu structure has become the de facto industry standard,
and so free copying should be allowed to assure adequate competition. But it is
questionable whether network externalities are at issue here. The users of Lotus
970 Network Externalities 0760
1-2-3 do not constitute a physical network, so there are no direct external
benefits from expansion of the installed base. Furthermore, the case does not
involve complementary products, so there are no apparent indirect network
externalities from greater availability of compatible goods. There are at best
so-called convenience externalities. There are switching costs between
spreadsheets, but not evidently more than between products generally.
One difficulty with the use of network externalities to limit copyright
protection is that it is difficult to limit the principle to computer software. It has
been suggested that many popular copyrighted works, such as Gone With the
Wind, create a network of users that may be exploited in spinoffs and sequels.
Thus, the case of computer software does not appear to be unique among
copyrighted products (Lunney, 1996). More generally, the application of the
network externalities concept to negate copyright protection for popular
software is similar to the antitrust argument that the successful firm has
monopolized, and is questionable for the same reasons. Weakening copyright
protection allows greater competition by clones, but reduces the payoff for
innovators, by threatening loss of protection for successful firms.
14. Contract Terms and Other Norms
Some scholars have argued that social norms have network aspects.
Conventional rules like those governing right of way for drivers at an
intersection have greater value the more people adopt them. This extension of
the concept of network externalities has been most fully developed by Klausner
and Kahan (Klausner, 1995; Kahan and Klausner, 1996), who have argued that
the adoption of corporate contract terms can create indirect network
externalities. Common use and judicial interpretation of contract terms benefit
the network of firms adopting those terms by, for example, clarifying the
meaning of the set of legal rules governing the firm. Larger network size
generates positive feedback because it increases the stock of judicial precedent
and the common understanding of the relevant rules. Network externalities thus
modify the conception of the firm as a nexus of contracts. They imply that
contract terms that maximize the value of the individual firm may not
maximize social wealth. State corporation laws, by providing default rules for
contractual provisions, are analogous to industry standards in physical networks
like telecommunications, because they can facilitate the creation of networks.
Their goal should be to promote the creation of an optimal mix of uniformity
and diversity by providing open-ended default rules menus of alternative
provisions. Network externalities may also account for the dominance of
Delaware corporation law. Some scholars have suggested that states compete
in a race to the top for corporate charters by offering statutes that maximize
firm value. But Delawares dominance (despite the prevalence of similar laws)
0760 Network Externalities 971
may reflect the positive feedback effect of its large network of incorporated
firms. This result implies that Delaware law has become popular not because
it offers optimal terms, but because it has become locked in.
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0760 Network Externalities 977
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0770
PATH DEPENDENCE
Stan J. Liebowitz
Professor of Economics and Associate Dean
School of Management, University of Texas at Dallas
Stephen E. Margolis
North Carolina State University
Copyright 1999 Stan J. Liebowitz and Stephen E. Margolis
Abstract
What role does the past play in current economic conditions? Economic models
usually determine equilibrium ending points without concern for intermediate
disequilibrium conditions or the prior history of the system. That the past does
play some role is obvious, but the nature of its impact requires careful
delineation. Some path dependence theorists have argued that past decisions
might have locked-in certain inferior outcomes. In making sense of this claim
particular attention needs to be paid to the meaning of inferior. Upon
investigation, such claims have been found to be without empirical support (in
private markets) and based on fairly narrow theoretical assumptions. In
nonmarket contexts less is known.
JEL classification: K0, K2, L5.O3, L0
Keywords: Path Dependence, Network Externality, Network Effect, Lock-In
1. Introduction
Most generally, path dependence means that where we go next depends not
only on where we are now, but also upon where we have been. History matters.
Stochastic processes are path dependent if they exhibit memory: The probability
distribution for the process at time t+1 depends upon more of the history of the
system than just its state at time t.
As it has recently been applied in economics, path dependence means that
equilibrium allocations depend on history. Economic allocations that are path
dependent could not be predicted by knowledge of the efficient allocations, or
the conditions that determine the efficient allocation, alone (Arthur, 1989). An
expectation of path dependence accordingly is in conflict with economic models
981
982 Path Dependence 0770
that derive an equilibrium without taking account of the process leading to
equilibrium.
Path dependence has a natural appeal. How could an outcome not depend
upon the events that occur in the process of adjustment to equilibrium? The
usual answer is that small variations in adjustments are averaged out, or
countered, under the influence of the forces tending toward some determinate
equilibrium. To take a familiar example, we expect price and quantity to adjust
toward the supply-demand intersection, even if price adjustment were
momentarily misdirected. Path dependence arguments introduce conditions
under which correcting adjustments are not inevitable and they appeal for
attention to the peculiarities that may unravel the predictability suggested by
conventional equilibrium models. As we discuss below, however, this appeal
must be countered by the recognition that any theory is a simplification of
reality. So it remains a crucial question whether theories that ignore the
sequence of events leading to equilibrium are ignoring something important.
The phrase lock-in by historical events, (Arthur, 1989) offers what is
perhaps the best expression of the alleged importance of path dependence for
economics. Lock-in has special meaning here. In some sense, of course, we are
always locked in to a number of things; to eating, breathing, and remaining in
our solar system to name three. But this is not what lock-in means in this
literature. The lock-in in path dependence is a lock-in to something bad, or at
least a lock-out of something better. It constitutes an inferior economic outcome
such as an inferior standard or product where superior alternatives exist, are
known, and where the costs of switching are not high.
These historical events of interest, in Brian Arthurs terminology, are
small or insignificant. The insignificance of these historical events is not
their effects - for their consequences are alleged to be large - but rather that
they may seem inconsequential at the time they occur. There is an implicit
allegation that such events are neither inevitable, in which case they might be
taken as instances of the stinginess of nature, nor the product of significant
conflict or deliberation, in which case they are the avoidable consequence of
human folly. As we will elaborate below, a part of the appeal of the path
dependence literature is the implicit allegation that these lock-ins, these bad
economic outcomes, are avoidable by small but prudent interventions.
Path dependence is an idea that spilled over to economics from intellectual
movements that arose elsewhere. In physics and mathematics the related ideas
come from chaos theory. One potential of the non-linear models of chaos theory
is sensitive dependence on initial conditions: determination, and perhaps
lock-in, by small, insignificant events. In biology, the related idea is called
contingency - the irreversible character of natural selection. Contingency
implies that fitness is only a relative notion: it is not survival of the fittest
possible, but only of the fittest that happen to be around at the time. Scientific
0770 Path Dependence 983
popularizations like James Gleicks book Chaos, Mitchell Waldrops
Complexity and Stephen J. Goulds Wonderful Life have moved these ideas into
the public view.
While the warm reception given to path dependence in the social science is
due in part to the attention given to these related ideas in the physical sciences,
the analogy is incomplete. If, for example, turtles become extinct, they will not
reappear suddenly when circumstances change to make it advantageous to have
a shell. But if people stop using large gas guzzling engines because gasoline
has become expensive, or extend patent protection to the look and feel of
software, they can always revert to their old ways if they came to regret the
switch. Stephen J. Gould, who has made the affirmative case for contingency
in biological evolution, nevertheless has noted the limitations of the analogy to
social evolution. What may have also been lost in social sciences borrowing
of this concept are the active debates in the real sciences about the generality
or applicability of chaos and contingency. Christian de Duve (1995), for
example, argues that contingency applies only within important constraints in
biological evolution.
Similarly, path dependence and chaos have an apparent unity that may be
misleading. In chaos theory, small events or perturbations do tend to cause a
system to evolve in very different ways but the system never settles down in any
repeatable path or fixed equilibrium. The essence of the chaos theory is that
this seemingly endless pattern, which never finds an equilibrium, is not random
but rather has a determinate structure. Path dependence in economics has
imported the view that minor initial perturbations are important, but has
grafted this on to a theory where there are a finite number of perfectly stable
alternative states, one of which will arise based on the particular initial
conditions. The potential for never-ending disequilibrium that seems the
essence of chaos theory is thus missing from the economic analysis of path
dependence.
Path dependence challenges some parts of the law and economics literature.
Some of the influence of economics on legal reasoning comes through
efficiency results, or at least expectations of efficiency. To take one example,
support for privity in contract can be found in economists arguments that
individuals maximizing actions have the effect, under certain conditions, of
maximizing total wealth. Path dependence (in its strong forms) is a challenge
to these arguments. For the law itself, path dependence may seem self evident,
given the role of precedent. In fact, those who have put forward the view that
the law may tend toward efficiency have borne the burden of proof that
precedent - or path dependence - would not overwhelm other factors. So for the
law, what has seemed to require special argument is the absence of path
dependence, not its presence. For this reason, the empirical issue of path
dependence in market-based choices may be of particular importance for law
and economics. If path dependence can interfere with efficiency even where
984 Path Dependence 0770
precedent does not play an explicit role and where we might expect evolution
toward efficiency, such influence would appear magnified in the law, where
precedent has such an explicit role.
In the remainder of this entry, we examine the theoretical and empirical
claims of the economic literature on path dependence. We start with a simple
example of path dependence, offered to help fix ideas. Following that, we offer
a taxonomy of path dependence claims that draws on our article in the Journal
of Law, Economics and Organization. In our view, some of the confusion
around path dependence has resulted from a failure to distinguish among types
of path dependence claims. We offer a remedy here. Following that, we present
a discussion of the means by which market behaviors would tend to unravel
instances of path dependence that constitute inefficiencies. The possibility that
profit-seeking activities may be able to undo harmful path dependence reduces
the issue to an empirical one: Are there documented instances of harmful path
dependence? We close on that issue.
2. The Allegation: The Inefficiency of Path Dependence
The allegation of path dependence, as it addresses the workings of laissez-faire
markets, is that market choices can stick us on undesirable paths. Once we are
stuck in such a rut, individual decisions are the best we can manage only from
the rut in which we find ourselves. Accordingly, for any allocation decision that
might be susceptible to path dependence, we lose the usual presumption that
individual choices lead to an optimal outcome. Consider the following example
of a choice that could be subject to path dependence. Suppose that it is
important that we all drive on the right side of the road, unless we all drive on
the left. Assume also that it matters fairly little which convention we adopt but
that most of us would prefer a convention of right-hand-side driving. Suppose
further that one early driver is observed driving on the left-hand-side of the
road. (Perhaps he was avoiding a puddle from a leaking horse trough.) Others
who were planning to drive make a quick determination that left-hand-side
driving, though mildly objectionable, will be the safe way to go. Those drivers
are also observed driving on the left, which causes still more left-hand-side
driving, and so on. Notice then that it could happen that we each prefer to drive
on the right, but that each of us ends up driving on the left. Each agent behaves
in a privately optimal way, given his circumstances, but the aggregate outcome
is inferior to a seemingly feasible alternative.
As we will see when we examine these issues in detail, the phrase it could
happen that is a crucial one. That something could happen does not mean that
it does happen. Before we can get to that, some definitions.
0770 Path Dependence 985
3. Definitions of Path Dependence
There are three possible efficiency outcomes where past conditions or decisions
exhibit a persistent influence on a dynamic process. First, such persistence
might do no harm. That is to say, an initial action does put us on a path that
cannot be left without some cost, but that path happens to be optimal (although
not necessarily uniquely optimal). For example, a capricious decision to part
ones hair on the left may lead to a lifetime of left-side parting, but the initial
urge to part on the left might capture all there is to be taken into account. On
a grander scale, our decision to use a particular system for powering the
machinery in a plant may be a controlling influence for decades, but the
long-term effects of the decision may be fully appreciated by the initial decision
maker and fully taken into account. We have used the term first-degree path
dependence to indicate instances in which persistence of prior conditions or
decisions exists, but with no implied inefficiency. This taxonomy of path
dependence claims appears in our 1995 paper in the Journal of Law,
Economics and Organization. Mark Roes 1996 Harvard Law Review paper
also offers a related categorization of path dependence. In Roe, path
dependence can be weak (the efficiency of the chosen path is tied with some
alternatives), semi strong, (the chosen path is not the best but not worth fixing,
or strong (the chosen path is highly inefficient, but we are unable to correct it).
Since information is always imperfect, a second possibility arises. When
individuals fail to predict the future perfectly, it is possible, even likely, that
decisions appearing efficient ex ante may not always appear to be efficient ex
post. Here the inferiority of a chosen path is unknowable at the time a choice
is made, but we later recognize that some alternative path would have yielded
greater wealth. In such a situation, which we have termed second-degree path
dependence, persistence of prior conditions or decisions leads to outcomes that
are regrettable and costly to change. They are not, however, inefficient in any
meaningful sense, given the assumed limitations on knowledge.
Related to this second type of path dependence is third-degree path
dependence. In third-degree path dependence, persistence leads to an outcome
that is inefficient - but in this case the outcome is remediable. That is, there
exists some feasible arrangement for recognizing and achieving a preferred
outcome, but that outcome is not obtained. Williamson (1993b, p. 140) offers
the term remediability to describe the condition that such feasible alternatives
exist, and urges remediability as the appropriate standard for public policy
discussion. Similar positions have been argued by Demsetz, Coase, Calabresi
and Dahlman, among others. In the framework that these authors have
advocated, market failure is not demonstrated unless a specific policy
recommendation can be shown in which the benefits exceed the costs, including
all of the administrative costs of the policy. For actual policy purposes, it of
986 Path Dependence 0770
course makes a difference whether the remediation remains possible: lost
opportunities in the past are of not interest. But for the consideration of market
failure, an opportunity for remediation in the past is of at least academic
interest.
The three types of path dependence make progressively stronger claims.
First-degree path dependence is a simple assertion of an intertemporal
relationship, with no implied claim of inefficiency. Second-degree path
dependence stipulates that intertemporal effects propagate error. Third-degree
path dependence requires not only that the intertemporal effects propagate
error, but also that the error was avoidable.
The essence of the distinction between third-degree path dependence and
the weaker forms is the availability of feasible, wealth-increasing alternatives
to actual allocations, now or at some time in the past. The paths taken under
first- and second-degree path dependence cannot be improved upon, given the
available alternatives and the state of knowledge. Third-degree path
dependence, on the other hand, supposes the feasibility, in principle, of
improvements in the path taken.
The existence of first- and second-degree path dependence is not in dispute.
Clearly, this form of path dependence is very common. They are a reflection of
ordinary durability and they have long been reflected in economic modeling.
First-degree path dependence is recognized, for example, when we
acknowledge that Robinson Crusoe and Friday may choose to make provision
for the future. Ordinary durability installs (at least) this kind of persistence.
Economists consider second-degree path dependence when we study decision
making under uncertainty. While it may be of interest to identify these
instances of persistence, first- and second-degree path dependence do not
constitute a challenge to standing efficiency claims.
For these reasons, it is not surprising that the main focus of this literature
rests on third-degree path dependence. The claim that the predictions of
efficiency in standard economic methodology are likely to be wrong is a bold
claim. Naturally, it is an empirical issue whether the path dependence literature
acknowledges something important that neoclassical economics neglects by
focusing on equilibrium positions rather than on the path toward equilibria.
Some of the most prominent examples in this literature feature specific claims
of inefficiency. For example, listen to Paul David: The accretion of
technological innovations inherited from the past therefore cannot legitimately
be presumed to constitute socially optimal solutions provided for us - either by
heroic enterprises or herds of rational managers operating in efficient markets
(1992, p. 137).
Since it is only this third form of path dependence that can be understood
as market failure, it is important to maintain the distinctions among these
various forms. One must take care not to extend the plausibility of instances of
ordinary durability - first- and second-degree path dependence - to third degree
claims.
0770 Path Dependence 987
4. What forms of path dependence appear in the literature?
Brian Arthurs (1989) consideration of path dependence gives us the phrase of
lock-in by historical events. In his examples of the workings of
positive-feedback models, which we examine in detail below, he finds that path
inefficiency is possible where there are increasing returns. Arthurs version of
path dependence is the third-degree form - so long as the information regarding
the returns to each choice is available to relevant decision makers.
Thomas Schelling anticipated some of the kinds of problems that are
considered in the path dependence literature. He discusses as interactive
behaviors problems in which outcomes depend heavily on the order in which
actions occur. Inferior outcomes may prevail in these cases, even in the face of
known preferred alternatives, illustrating the third-degree form (1978, pp.
36-8). Shelling offers these cases, however, as examples of nonmarket behavior,
and he also notes that market institutions often arise as remedies for these
problems (p. 33). Elsewhere he acknowledges the unfeasibility of some
hypothetical improvements (p. 132).
The archetypal allegation of path dependence is the configuration of the
typewriter keyboard. Davids (1985) presentation is largely responsible for
introducing this story to economists. According to this story, the standard
QWERTY keyboard arrangement, introduced in the 1870s, is dramatically
inferior to an arrangement offered by August Dvorak in the 1930s. We are,
however, regrettably locked into the inferior arrangement by a coordination
failure: no one trains on the Dvorak keyboard because Dvorak machines are
hard to find, and Dvorak machines are hard to find because no one trains on
Dvorak keyboards. The process is said to be path dependent in that the timing
of the adoption of QWERTY, and not its efficiency, explains its survival.
Some of Davids claims for this case do not go beyond first-degree path
dependence. Most readers will not question the observation repeated in David
that One damn thing leads to another (David, 1985, p. 332), because it asserts
no more than first-degree path dependence. But David makes stronger claims.
In accepting and repeating the claim that the cost of retraining in Dvorak is
recovered ten days after the end of training (p. 332), for example, he positions
the QWERTY case as an active example of third-degree path dependence.
Davids 1985 paper concludes: Competition in the absence of perfect futures
markets drove the industry prematurely into standardization on the wrong
system where decentralized decision making subsequently has sufficed to hold
it (emphasis in original). We stay with the wrong keyboard, according to
David, not because sunk investments in QWERTY make the switch to the
Dvorak arrangement an inferior choice, but because of decentralized decision
making. This attribution of the error to decentralized decision making clearly
suggests that alternative, presumably centralized, decision mechanisms would
988 Path Dependence 0770
correct this error. This is a third-degree claim. Davids reader is likely to find
the claim of path dependence in the third-degree form to be more palatable
because of his earlier establishment of weaker forms of path dependence.
Paul Krugman has offered industrial location as an example of inefficient
path dependence. If there were economies of having several firms in the same
industry produce at a single location, we would expect firms to congregate
somewhere. It could happen that firms simply congregate around the first
location at which a plant is established. In such a circumstance, there would be
no reason to think that the location chosen by such an industry is efficient.
Krugman uses the example of the accumulation of carpet manufacturing firms
around Dalton, Georgia (this city is the center of carpet production in the
United States; Krugman offers it as an example of path dependence and as an
example of the defects of traditional economic models). In such cases, it is
argued, economics does not tell us which location would be chosen for an
industry, and that it would only be by the sheerest of coincidences that the
choice of location for a single plant would turn out to be the efficient location
for an entire industry. There are several problems with this argument. First,
there are some reasons to think that the first firm at a particular location would
have chosen a location that is congenial to its industry. Second, most industries
have multiple production sites, and therefore there would be competition among
these candidate sites as a focus for industrial agglomeration. (For example,
many carpet plants operate successfully in locations outside of Georgia, both in
the Southeast and elsewhere.) Finally, locational choices may often involve a
choice among a number of equally efficient alternatives. The fact that
economics cannot explain the choice of a particular location over equivalently
attractive alternatives is no evidence against the efficiency of the chosen
outcome.
Path dependence along with the QWERTY story have moved out of
academic writing and into the arena of public policy. In the Los Angeles Times
(October 5, 1995), Steve Steinburg writes, regarding the adoption of an internet
standard, [I]ts all too likely to be the wrong standard. From Qwerty to Dvorak
keyboards, to Beta vs. VHS cassettes, history shows that market share and
technical superiority are rarely related. In The Independent (September 5,
1995) Hamish McRae discusses the likelihood of lock-in to inferior standards.
He notes the Beta and VHS competition as well as some others, then adds,
Another example is MS-DOS, but perhaps the best of all is the QWERTY
keyboard. This was designed to slow down typists ... . In Fortune (May 15,
1995) Tim Smith reports that QWERTY was intended to slow down typists,
and then notes, Perhaps the stern test of the marketplace produces results more
capricious than we like to think. In a long feature series in the Washington
Post (November 13, 1995), Steve Pearlstein argues that modern markets,
particularly those linked to networks, are likely to be dominated by just a few
firms. After introducing readers to Brian Arthur, he states, The Arthurian
0770 Path Dependence 989
discussion of networks usually begins at the typewriter keyboard. The
QWERTY story has also been published in the New York Times, The Sunday
Observer, and The Boston Globe, The Encyclopedia Britannica, and broadcast
on PBSs Lehrer news hour. The story can be found in two very successful
economics books written for laymen; Robert Franks and Philip Cooks Winner
Take All Society and Paul Krugmans Peddling Prosperity, where an entire
chapter is devoted to the economics of QWERTY. It also figures prominently
in Dixit and Nalebuffs Thinking Strategically and appears in some of Stephen
J. Goulds writings.
These popularizations generally constitute the third-degree form. For the
academic writings as well, the simple observation of durability conveys little
surprise. These are interesting tales precisely because they are tales of things
gone wrong.
5. Market Actions and Path Dependence
We start with a simple numerical example of path dependence as an illustration
of the basic case. Table 1 is reproduced from a 1989 paper by Brian Arthur that
is often credited with starting the whole discussion. The table is the basis for
an exercise by which Arthur seemingly demonstrates the likelihood of
unsatisfactory lock-in where there are increasing returns.
Table 1
Adoption Payoffs
Number of 0 10 20 30 40 50 60 70 80 90 100
Previous
Adoptions
Technology 10 11 12 13 14 15 16 17 18 19 20
A
Technology 4 7 10 13 16 19 22 25 28 31 34
B
The story that goes with the table is that there are two technologies that are in
competition with each other. A would-be adopter arrives on the scene and
chooses between technologies A and B. Assume for now that an adopter
receives a payoff (value), as shown in the table, that is determined by the total
number of adopters of a given technology. So, for example, if there are 21
adopters of technology A, each would enjoy a payoff of 12. The payoffs increase
with the number of adopters, which incorporates the increasing returns
assumption. These increasing returns might be due to either economies in
990 Path Dependence 0770
production, or network effects. (Network effects occur where the value of a
product to a user increases as more consumers use the product.)
Arthur uses the table to illustrate the likelihood of undesirable lock-in. The
first adopter on the scene, choosing between a payoff of 10 with technology A
and a payoff of 4 with technology B, would be expected to choose technology
A. The arrival of subsequent adopters will only serve to reinforce the advantage
of choosing A. But notice that if the eventual number of adopters is large
enough, technology B would yield greater returns. But the choices of individual
adopters will lock us in to technology A.
Arthurs story of lock-in is simple - deceptively so. If we look at the table
alone, it seems unavoidable that individuals choices will lead to an irreversible
choice of technology A and it seems undeniable that A is an unfortunate choice
where the number of eventual adopters is large. The first adopter would rather
have 10 than 4, and so would anyone else. We are locked in; the market fails.
Each agent acts rationally, given the payoffs in the table, but as a group we end
up with less than we might have had. Perhaps, the argument goes, some
government action is needed to enforce a coordinated decision.
What is lacking from the table and is also lacking in the great outpouring
of abstract modeling of path dependency, is an appreciation of both the variety
of steps that people take to avoid such harms, and the restrictive conditions
assumed in the table. These analyses make the common mistake of assuming
that market organization and perfect decentralization are, or ought to be, the
same thing.
Imagine for a moment that each of these technologies is owned, perhaps
through patent or copyright. In that case, if the number of potential adopters is
large, the owner of technology B would have a significant incentive to establish
B as the technology of choice. Just as the owner of especially productive land
is expected to capture the value of its advantages, the owner of a technology
would be expected to capture the advantages that it offers over the next best
alternatives. Given that, it is worthwhile for the owner of technology B to cut
prices for early adopters or provide other incentives to induce adoptions of B.
While the owner of A will have similar incentives, the total wealth potential of
technology B is greater, so B would be able to offer greater incentives to
become the technology of choice, under the assumption that B is the technology
capable of yielding greater total benefits. Alternatively, if the technology is not
owned, it would pay all would-be adopters to enter agreements to adopt the
preferred technology.
More generally, the inefficiency that seems inescapable in the table is a
profit opportunity for someone who can figure out the means to move the
outcome from A to B and appropriate the difference. Such entrepreneurship can
take various forms, some of which are familiar. Where a technology is not
patentable or otherwise ownable, a firm may be able to create a format or a
0770 Path Dependence 991
variant of the technology that is. Firms can advertise, they can lease out the
goods that implement the technology, they can enter strategic alliances. On the
consumer side, a large user of a technology may be able to profit from adopting
technology B regardless of the choices of other users. For example, large firms
with numerous typists would have switched to Dvorak if Dvorak really did offer
significant advantages.
The model that gives us lock-in from the numbers in the table not only
reduces producers to the role of mere spectators, but it also assumes that
consumers have no foresight. For if consumers were aware of the entire table,
all that is required to prevent lock-in to an inferior alternative is that adopters
can make reasonable forecasts of the number of eventual adopters. If, for
example, early adopters know that they will be joined by 100 more, they will
see that everyone will be better off with technology B. The latecomers will see
it that way too, and the early-comers know it. (For a more complete discussion
of this example, including an alternative interpretation of the table, see our
1995 paper.)
The kind of foresight that we are talking about here is not the domain of
gifted visionaries. It is the kind of foresight that led consumers to buy an FM
radio (as opposed to AM) in the early 1960s, cassette players in the 1970s (as
opposed to eight-track), and CD players in the 1980s (as opposed to analog
phonograph recordings). It leads newlyweds to buy a service for eight even
when they do not yet know three other couples in town. And in 1990, it led
consumers to buy Windows-based computers even when most machines were
still DOS-based .
Finally, this model of lock-in also imposes certain other theoretical
restrictions that may or may not commonly occur in the world. For example,
to obtain the lock-in that Arthur demonstrates, the technology that offers
smaller benefits at low levels of use must enjoy greater economies of scale. That
is, the returns functions must cross, or initial consumer decisions will not put
us on wrong paths. Since changes in payoffs must be due to economies of scale
or network effects, it must be presumed that these influences differ across
technologies. While it is certainly possible that this could occur, the
requirements for lock-in are far more stringent than might appear upon a casual
reading. In particular, it would seem that network effects would most likely
exert the same influence on either of two rival standards or technologies.
6. Cases
The extensive theoretical literature on path dependence formalizes the
following type of claim: it is possible to specify models in which right-hand-
side driving is widely preferred, but nevertheless we all end up driving on the
left. Such models must always include assumptions, explicit or not, about
992 Path Dependence 0770
expectations, ownership, information, network effects, production economies,
communication, the possibility of side payments, the presence of large users
and, more generally, entrepreneurship. Many of these are simply ignored,
which is to say they are implicitly assumed away. The question then becomes
whether this particular abstraction of reality captures what is important about
the kinds of choices that path dependence is said to address. We are left then
with an empirical question.
For empirical support, the literature of path dependence draws repeatedly
on the same handful of stylized cases based on the popular histories of some
well-known competitions between competing technological developments. First
and foremost is the aforementioned story of the typewriter keyboard. In second
place in this cannon is the competition between the Beta and VHS videotaping
formats. After that is the eclipse of the Macintosh operating system by
Microsofts Windows.
Our paper The Fable of the Keys (Liebowitz and Margolis, 1990) presents
evidence on the typewriter keyboard story. In short, the received history is that
the now-standard QWERTY keyboard arrangement is inefficient (some argue
deliberately so) and that the Dvorak keyboard is known to be better. Our
research shows that most of the claims for the superiority of the Dvorak
keyboard can be traced to Dvoraks own writings. An often mentioned Navy
Study, purporting to demonstrate the superiority of Dvorak, turns out to have
been supervised by a Lieutenant Commander August Dvorak. A reading of the
Navy study reveals that it was transparently rigged in favor of the Dvorak
arrangement. In addition, a number of studies, using various methodologies,
indicate that Dvorak offers little or no advantage over the QWERTY
arrangement.
The allegation regarding the Beta and VHS competition is that the Beta
format was superior, but that an early lead for VHS, strong producer alliances
and better marketing led consumers to forsake their preferred alternative in
order to be compatible with the majority of users. Simple versions of this
history often ignore the fact that Beta had a two-year head start on VHS. Also
overlooked is the fact that Sony, the creator of the Beta format, took great pains
to try to forge a producer alliance, first offering its machine to the creators of
VHS and then offering its machines to other Japanese and American producers,
well before VHS had any significant market share. Betas early adoption by
Sanyo, Toshiba and Zenith runs counter to the claims that Sony was not
interested in partners. Sonys failure to attract RCA to its coalition, however,
gets to the true heart of the matter. Beta and VHS had almost identical
performance, owing to common technological roots including the joint
production of a previous generation of machines. Sony chose a small cassette
for Beta, limiting the recording time, while Matsushita (the owner of JVC, the
nominal creator of VHS) chose a larger cassette and a longer taping time. In
negotiations, RCA told Sony that it preferred VHS since at that time Beta
allowed recording time of only one hour, insufficient for movies or football
0770 Path Dependence 993
games. Sony slowed down the tape, allowing the taping of two hour programs,
albeit at lower quality. Matsushita in turn slowed down VHS to get four hours
of taping time, and RCA entered an agreement to market the four-hour VHS
machine. RCAs judgement that longer taping time was more important to
consumers than smaller cassettes appears in retrospect to be correct.
Everywhere that consumers had a choice they overwhelmingly chose VHS even
though the price differential was negligible (RCA came in with a startlingly
low $1000 price, but this was matched by Zeniths $996 price within the week).
Picture quality seems not to have been the issue either. Consumer Reports
product testing at the time indicated no clear advantage in picture quality for
either format, finding VHS better in two tests, Beta better in one, and a tie in
another (Klopfenstein, 1989, p. 28).
What this case actually demonstrates is not lock-in but rather the ability of
markets to facilitate a switch from one path or standard to another. In spite of
Betas two-year head start, the market shifted very quickly to a format that
offered an advantage to consumers. It is noteworthy that broadcasters
eventually standardized on the Beta format. The main difference between the
formats, other than the size of the cassette, is the way the cassette is threaded.
The Beta method, although more complicated, offers some advantages in
editing videotape and in special effects. This advantage is unimportant to most
home users, but is important to broadcasters. Broadcasters and home users
rarely exchange video tapes, so there is little benefit for compatibility between
the two. It is interesting, therefore, that professional broadcast users
standardized on Beta, which is advantageous to them, and home users adopted
VHS, which, with its longer taping time, is preferable to them.
The third of these path dependence stories is computer operating systems.
It is sometimes claimed that although Microsoft operating systems are inferior
to the Macintosh operating system, Macintosh failed because consumers were
so locked-in to DOS that they would not make the switch to the better system.
This claim requires close examination along several dimensions. First, the
superior operating system is not the one that is theoretically ideal, but the one
that is most efficient given the cost of the hardware required to run it. That is,
economic efficiency is what counts, not some form of engineering efficiency.
When DOS was king, computer memory was expensive and processors were
slow. The graphical interface of the Macintosh required far more computing
power to update than the DOS interface, on the order of fifteen to one. To take
advantage of graphical documents required much processing and storage
capacity, making it more expensive to get reasonable performance from a
Macintosh machine. As the price of memory fell and processors became faster,
the DOS operating system took on the features of the Macintosh, until at the
present time they (Windows95 and the Macintosh) are almost identical in
functionality for the typical consumer. Often overlooked is the fact that the
994 Path Dependence 0770
better operating system, the graphical operating system, did win, when it was
justified by the cost. Again, it is worth noting that graphics professionals, for
whom graphical processing was critical even at very high prices, moved to the
Macintosh early on, when there was no good DOS alternative. That continues
to be the market where the Macintosh has its greatest market share.
Van Vleck (1997) digs deeply into the claim, longstanding in the literature
of economic history, that the British use of a small coal car (compared to the
US and Germany) was an example of persistence of technological
backwardness; a kind of path dependence. Van Vleck shows rather
convincingly that the small coal car was an efficient response to differences in
prevailing conditions in Great Britian.
Of particular relevance for law and economics is work by Bruce Kobayashi
and Larry Ribstein on the adoption of uniform laws by states. For certain areas
of the law, particularly where laws effect dealings with outsiders,
standardization of statutes is efficient. Kobayashi and Ribstein (1996) studies
the adoption of statutes that allow limited liability companies and find that
while there are strong tendencies toward uniformity, the first form of a
provision is not particularly to become the standard form. Again this is contrary
to an expected influence from path dependence. In a related paper, Ribstein and
Kobayashi (1996) do find evidence of an influence of efficiency in states
tendencies regarding uniformity of statutes. They show that uniformity is much
more likely to be found in those areas of the law in which uniformity is
particularly advantageous.
7. Path Dependence Outside of Markets
Our attention has been largely limited to the role of path dependence in market
choices. Our observation is that where feasible improvements to an allocation
can be identified, private actors will attempt to engage in exchanges that will
allow them to profit from accomplishing these improvements. We do note,
however, that many social choices do not take place in markets, and in fact may
not even be recognized explicitly as choices.
The choice of religious and social institutions does not take place in an
explicit market. The choice of government, for much of history, has not even
been a choice for individual citizens. The institution of slavery was not a
voluntary transaction. In these cases, the forces that would normally promote
an efficient solution in the market do not necessarily come to the fore. A lack
of ownership of alternative institutions is one problem, but a more important
and fundamental problem is the absence of voluntary, feasible transactions. If
the state or military controls the proceeds from productive activities, there may
not be a feasible way to wealth-increasing improvements, since the beneficiaries
can not write enforceable contracts to pay off the despots who control the
0770 Path Dependence 995
system. Where there is no ownership of assets, or where coerced transactions
are possible, the usual efficiency implications of market transactions can not be
presumed. In such a world suboptimal solutions might have considerable
permanence. For two differing analyses of path dependence for institutions, see
North (1990) and Kiwit (1996). Norths influential book, unfortunately, seems
to accept at face value the claims of the path dependence literature that are
based on false empirics.
These considerations have special importance with regard to path
dependence and the law. For some aspects of the law, such as Antitrust, our
finding that lock-ins are rare or nonexistent has fairly obvious implications.
One of the concerns that has arisen in recent years, for example, is that high
technology industries are particularly prone to path dependence because of
network effects, and that therefore society might become ensnared in an inferior
technology or standard. This argument has been made, both in the press and in
arguments to the court, in connection with the many antitrust actions regarding
Microsoft. Since these concerns can also be voiced for many technological
standards, they might also made in connection with other antitrust cases,
including the case that is currently being made against Intel. Our writing
cautions that lock-in problems with choices of technologies or standards do not
follow reliably, or even with much likelihood, from the simple presence of
network effects.
The role of path dependence and lock-in is murkier in other areas of the
law. With regard to statutory law, one might refer to legal institutions as a kind
of market where suppliers of legal rules (legislators, judges) interact with
demanders of these rules (constituents, plaintiffs). Yet even under this
public-choice view of legal institutions, they are not the same as markets. The
role of entrepreneur, of someone who can become rich by selling a better
solution, does not have a complete analogy. Perhaps politicians do fill this role
to some extent, but dollars and votes do not necessarily translate one to one.
Nevertheless, the work of Kobayashi and Ribstein, cited above, shows that for
several legal developments where path dependence might be expected to
appear, it is not found.
Other writers, most prominently Richard Posner, have said much more
regarding efficiency in the common law. Judges certainly could, where their
decisions were not thoroughly circumscribed by precedent, seek out the global
optima that are allegedly locked-out under theories of lock-in. But where legal
efficiency is said to be the product of evolution to efficiency, the mechanisms
for avoiding lock-in are less readily apparent. Indeed, litigators proposing novel
legal theories may play the entrepreneurial role. Nevertheless, we are less
sanguine that problems of path dependence are reliably avoided where law
evolves from law and accordingly is less able to make the kinds of systematic
jumps that allow markets to avoid lock-in.
996 Path Dependence 0770
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0780
NON-LEGAL SANCTIONS
Stephan Panther
Institute of Economics, AWM, Universitt Hamburg
Copyright 1999 Stephan Panther
Abstract
The study of non-legal sanctions is a comparatively new area in law and
economics, which is developing fast. Little universally agreed upon stock of
knowledge exists and relevant contributions are spread in diverse fields.
Therefore, the main aim of this review is to provide a systematic and integrated
view of the topic. It is placed firmly in a New Institutionalist framework and a
clear classificatory structure is developed. Non-legal sanctions are seen to flow
from informal social norms, which are systematized using a game theoretic
perspective. From this departure, the host of applications to diverse substantive
areas of law can be presented clearly. Outstanding contributions are
highlighted.
JEL classification: A12, A13, C70, K00
Keywords: Non-Legal Sanctions, Social Norms, Incomplete Contracts,
Reputation, Relationship-Specific Assets, Informal Insurance
A. Introduction
1. The Limits of Legal Rules
Law and economics has focused on the analysis of the (efficiency) effects of
formal legal rules, which are enforced by a specialized central agency, the
state, employing legal sanctions. However, even in fully developed market
economies with a high degree of division of labor, formal legal rules do not
comprise the total picture. They would do so only if it were possible to specify
and enforce a comprehensive set of property rights perfectly, and, building on
this, perfectly specify and enforce contracts. In such a world, actors would only
interact through voluntary contracts, not influencing each other in any other
way. It is a perfectly secure world. Even if it is not characterized by perfect and
complete information for every actor, actors expectations concerning each
others behavior are sure to be fulfilled since an omniscient, omnipotent and
benevolent government guarantees perfect enforcement. This world, of course,
is utopian.
The world we live in knows only incompletely specified and enforced
property rights and contracts. The arm of the law does not reach everywhere.
Crimes remain unsolved, courts err and using them is costly, and hence some
999
1000 Non-legal Sanctions 0780
cases are simply never filed. Contracts do not contain provisions for all possible
contingencies that might arise. Rulers, politicians and government officials are
self-interested and hard to control and it actually might be a blessing that they
are not omniscient and omnipotent. In our world, formal legal rules and legal
sanctions no longer determine behavior with certainty. Other factors
co-determine actions. Especially non-legal rules (social norms) and non-legal
sanctions play prominent roles.
Before turning our attention to these (see also the comments on Lindenberg,
1990, and Schlicht, 1997, in Section 6 below), it should be noted that the other
important factors shaping action are cognitive rules and schemata. After all, it
is the subjective perception of rules and sanctions which matters for individual
behavior, a point stressed by Opp (1985). Denzau and North (1994) discuss this
issue in a neo-institutionalist framework. Lessig (1996) and Sunstein (1996)
raise some cognitive issues in relation to law, the latter especially suggesting
that the mere declaration of a rule as a law may influence the prevailing social
norms.
2. A Framework for Classification
Since the term sanction is somewhat ambiguous, a note of clarification is
necessary right at the start. Sociologists usually use it to describe both
punishments and rewards, while legal scholars frequently only consider
punishments (but see Ellikson, 1991, pp. 124-126). Fortunately, little in the
following depends on this distinction in a fundamental way. I will generally
follow the legal usage here, explicitly noting deviations.
Any system of sanctions faces the same issues. At a first level these are: who
decides about the sanction, how, And who administers the sanction? All of
these may be examined in greater detail. Ellikson (1991) (see also Ellikson,
1987), probably the seminal contribution on non-legal rules and enforcement,
distinguishes five types of rules applicable to sanctioning systems (pp.
132-136). Constitutive rules answer the first of the who questions above,
relating especially to the structural aspects of the question (for example, which
court is in charge?). Controller-selection rules give an answer to the second
who question in a systematic fashion (for example, first vs. second party
control, see below). Procedural, remedial and substantive rules relate to the
how question above. Procedural rules refer to the way information has to be
obtained, weighted, interpreted, and so on by those who impose sanctions.
Substantive rules define the kind of behavior to be sanctioned, remedial
rules regulate the type and severity of the sanction. Together the latter two
describe the criteria used in imposing sanctions.
I see the distinction between non-legal and legal sanctions as drawing on
the last two types of rules only; a legal sanction is administered in accordance
0780 Non-legal Sanctions 1001
with criteria laid down in a legal rule. Of course, the law frequently delegates
the decision over the precise content of the required behavior to other, possibly
private, actors. Contract law is centered on this idea. It nevertheless remains
clear when conduct is law abiding and when not. In modern western societies
the law also regularly contains binding constitutive, procedural and controller
selection rules, the existence of which is, however, not taken as part of the
definition of a legal sanction here.
Social norms are to non-legal sanctions what laws are to legal sanctions.
Coleman (1990), Elster (1989a) and Hechter (1987) are monographs containing
comprehensive treatments of social norms from a methodological
individualistic perspective. Coleman is the prime reference. Elsters treatment,
while full of insight, is hampered by his non-consequentialist definition of
norms. Opp (1985) is a systematic account in the form of an article, Opp (1979)
provides a systematic comparison of sociological and economic accounts of
norms as far as available at the date of publication.
All of the aspects of a sanctioning system just discussed may be regulated
by a system of social norms. The main debate has, however, been on the issue
of whether a mere substantial rule, a prescription or prohibition of an action,
constitutes a social norm, or whether an attached remedial rule, the
specification of a sanction in case of deviation, has to be present, too. The latter
view is taken here, which is argued, for example, in Weise (1996). It is also
implied by Coleman (1990, pp. 241-249), while Elster (1989a, pp. 98-100)
favors the former. See Crawford and Ostrom (1995) for a comprehensive
discussion.
Given the primary focus of this review on non-legal sanctions, we will
classify social norms by the way they are enforced. While the following is one
common classification, it is by no means universally accepted. It follows largely
Ellikson (1991, pp. 123-136) and Kiwit and Voigt (1995). (See also James
Coleman, 1990, pp. 241-249 for a somewhat different view.)
External norms are enforced through sanctions by non-specialized members
of a society. Ellikson (1991) further distinguishes situations where sanctions are
administered by those against whom a norm has been transgressed (second
party control) from those where originally nonaffected parties are involved in
sanctioning (third party control). Decisions about and enforcement of the
sanction may lie with the same actor or may be separated. The non-specialized
nature of enforcement does not imply anything about the severity of the
sanction, which may range from expression of disapproval to ostracism to
physical violence.
Internal norms have been internalized to such a degree that their
transgression, while benefiting narrow self-interest, causes discomfort, psychic
costs. In contrast to external norms, issues of policing do not arise here. The
very actor who deliberates a deviation from a rule also sanctions himself (first
party control). Cooter (1996) (Cooter, 1994, is an earlier version) contains a
1002 Non-legal Sanctions 0780
systematic treatment as a foundation for his public policy recommendations (see
Section 13).
Borderline cases, where the term social norm for the basis of a sanctioning
system is somewhat stretched, are those where the relevant rules are codified
and sanctions are decided about and possibly even enforced in an organized
fashion by specially designed agents (Third party control by organizations in
the terminology of Ellikson, 1991, formal private rules for Kiwit and Voigt,
1995). As long as the rules are not given legal status, this is still a case of
non-legal sanctions.
Recently, the term convention (dating back as least as far as Weber,
1921[1978]) has reappeared in economic and New Institutionalist theory as a
rival to the term social norm, as for example, in Sugden (1986) and Young
(1996). The latter define convention in game theoretic terms as a particular
equilibrium in games with multiple equilibria. If external norms are modeled
as games (see Sections 4 and 5), they constitute conventions in this sense too.
By way of contrast, I suggest limiting the use of the term convention to norms
which are self-enforcing in a narrow sense: self-enforcing even in the absence
of any sanctioning action. This implies that deviating from equilibrium
strategies is not profitable even if everybody else merely continues the behavior
prescribed on the equilibrium path in the absence of deviation. The typical
example is an equilibrium in a coordination game, driving on the prescribed
side of the road being the notorious real world case. By this very definition,
conventions lie outside the scope of this paper.
3. Basic Relationships between Legal and Non-Legal Sanctions
A non-legal sanction may be complementary to a legal sanction, both requiring
the same action in a certain situation. In this case, non-legal sanctions add to
the effect of legal sanctions. Obviously it is also possible for legal and non-legal
norms/sanctions to work in opposite directions, making them conflicting, just
as a neutral case may arise.
When the non-legal and legal norms conflict, the question of the dynamic
development of the two arises. No generally accepted theory exists.
Taxonomically, one may distinguish three cases. First, social norms may
regularly adapt to legal rules. In this vein, in an article also interesting because
of its substantial focus (see Section 12), Ramseyer (1987) seems to suggest that
norms follow legal incentives, making them effectively an appendix to formal
institutions. The reverse position, social norms regularly forcing legal rules to
adapt, is rarely taken in New Institutionalist thinking. The third position, the
two influencing each other with the one or the other being dominant from time
to time, seems to dominate. North (1990) offers a comprehensive treatment in
0780 Non-legal Sanctions 1003
a general New Institutionalist framework. He suggests the possibility of
path-dependency in the institutional development caused by the persistence of
non-legal rules. Kiwit and Voigt (1995) discuss this critically. Cooter (1996)
discusses the development of internal norms using arguments from evolutionary
game theory, also emphasizing the reciprocal interaction of external and
internal norms. He sees the existence of network externalities in
norm-adherence as a possible cause for path-dependency in their development.
Adams (1996) adds the dependency of a norm on the context of other existing
norms as another important reason for path-dependency: informal norms come
in hierarchically connected systems, meta-norms helping to interpret more
specific ones. All in all, social norms are likely to be interlinked with legal
rules and with each other, making change a slow, gradual process occasionally
interrupted by big jumps.
A special and particularly strong case of conflict occurs when non-legal
sanctions involve actions prohibited by law, that is, the infringement of legal
rights. This subcategory can be referred to as extra-legal sanctions. They are
dominant in organized crime, and I refer the reader to Chapter 8400
(Organized Crime and Illegal Markets) in this encyclopedia. I will speak of
non-legal sanctions, whenever the above conflict is not present. It is in this
narrow definition that we will use the term from now on.
The last distinction draws our attention to an important final point. If
non-legal sanctions do not violate legal rights, how are they possible? For a
sanction to exist, the sanctioner needs to be able to act in a way that diminishes
the utility of the wrongdoer. Thus, non-legal sanctions are only possible in a
world where not all assets of an actor consist of legally protected rights. In the
terminology of Charny (1990, p. 392), the sanctioned party of the interaction
has posted a bond which can be confiscated by the sanctioning party.
Bhm-Bawerk (1881), in an early treatment of related issues, termed these
non-legal assets Verhltnisse (relationships). In a world where property
rights are perfectly specified and enforced, no such non-legal assets, and
hence no non-legal sanctions, would be available.
We have now come full circle and will in the following Sections 4 to 6 turn
to a survey of the theoretical literature on non-legal sanctions which tries to
clarify the mechanisms involved in non-legal sanctioning systems. The
following sections then survey the applications in several substantive fields.
1004 Non-legal Sanctions 0780
B. Theory
4. External Norms: Second Party Control
If only the parties involved in an exchange are able to impose non-legal
sanctions on each other, the non-legal assets used in the process may be termed
relation-specific prospective advantages (Charny, 1990, p. 392). The
sanctioning action usually consists in the termination of the exchange, at least
for long enough periods to deter deviations in the first place. Eger (1995,
Chapter 4) contains a systematic treatment of second party control, as do E.
Posner (1995) (see also Section 13), Rubin (1993) and Kronman (1985)
(discussed also in Section 11).
The most straightforward way to conceptualize relation-specific prospective
advantages can be traced back to Williamson (1983) (but see the earlier work
by Schelling, 1960, p. 135; see also Williamson 1985, Chapters 7 and 8). The
central idea is the posting of hostages. The exchange partner A, prone to
undertake an opportunistic breach of agreement, takes an action which gives
the trading partner B control over an asset which is valuable to A (but not
necessarily to B). A prime example is relation-specific investment, which pays
considerably less outside the present relation. By leaving the relationship after
being cheated, a partner can thus sanction the cheater. The emphasis here lies
in the direct, possibly deliberate, creation of relation-specific advantages by the
parties to the exchange themselves.
The dominant conceptualization of a sanctioning system involving
relation-specific prospective advantages is the idea of a repeated game. Taylor
(1976) and Ullmann-Margalit (1977) are early exemplary versions which are
often cited outside economics and game theory. The theory covers both bilateral
and multilateral games. It relies on the game never definitely ending in any
particular period. A deviator is punished by all others in the game, who are all
second parties, since they are all hurt by his deviation. Here the relation-
specific advantage consists in the value of repeating the exchange/cooperation
with the established partner in comparison with the value of the next best
alternative, given by the non-cooperation payoff. Besides the payoff difference
between cooperation and outside-option, the time horizon determines the
severity of the sanction possible. The latter is caught in the discount factor
which determines the weight of future payoffs. In the context of repeated games
it may also be interpreted as reflecting the exogenous chance that an actor
dies, that is, leaves the game which leads to the separation of the partners.
A notorious problem with the idea of cooperation being sustained by
repetition of exchange is the multiplicity of equilibria in repeated games, which
in fact regularly have an infinite number of equilibria. No universally accepted
theory of choosing among them exists, even though the idea that people
0780 Non-legal Sanctions 1005
eventually manage to coordinate on pareto optimal ones (that is, cooperative
ones in this context) has intuitive appeal. We sidestep this issue and continue
the discussion focusing on the cooperative equilibria made possible in the game
structures under review.
Note that important additional questions arise in the multilateral case: How
is information about deviations disseminated? Can it be trusted to be correct?
How can actors be motivated to administer a sanction? The information issues
are usually dealt with by choosing appropriate assumptions, most frequently
by the public observability of deviations. Before elaborating on the motivation
question it should be noted that its relevance is not absolutely obvious. After all,
in the situations treated in this section, everybody is a second party, that is,
directly affected by a deviation. The main issue, however, is whether an action
other than delivering the required sanction exists which is more advantageous
to the actor in question. This will not be the case when the actions required for
sanctioning constitute an equilibrium in the stage game (the one-period game
which is repeated over time). Otherwise an actor is tempted to deviate from the
punishment path. A host of formal contributions have dealt with this problem,
Abreu (1988) being a central one. The idea of the formal solution is to punish
the deviator from a punishment path (forgiving the original deviator) and
anybody deviating from that punishment path, and so on.
Models of repeated interaction become more interesting if the factors
determining the severity of the sanction, that is, determining the relative gain
from cooperation, are explained endogenously. Klein and Leffler (1981) and
Telser (1980) are early contributions in this vein. They center on the idea that
raising the price paid to the supplier in an exchange, and thus ceteris paribus
raising his profit, will make the exchange opportunity more valuable to him.
If the supplier can manipulate the quality of the good and the buyer can detect
this only ex post and if a high price is paid only if customers expect high
quality, increased profit from the sales of high quality constitutes a
relation-specific advantage. The underlying basic idea is fairly general and has
been applied widely especially in the theory of efficiency wages. Within that
body of theory the contributions by Akerlof (1982) and Shapiro and Stiglitz
(1984) contain explicit formulations of the kind of non-legal sanction
mechanism considered here.
Recently a closely related mechanism has been studied by Kranton (1996a)
and Ghosh and Ray (1996) in the context of random matching games. A
bilateral cooperation game (a kind of prisoners dilemma in continuous
strategies) is played between two actors, who can decide to continue the
cooperation next period or leave the relationship. If they do leave, they are
randomly matched with another unmatched player. What stops players from
always trying to cheat each other and quit the relationship immediately
afterwards? There exists an equilibrium where two newly matched players do
not cooperate fully right from the start, but rather build up cooperation slowly.
1006 Non-legal Sanctions 0780
Leaving an exchange partner in such a situation is costly since a renewed
buildup of cooperation is necessary. In this way, an existing relationship again
offers relation-specific advantages.
Kranton (1996b) provides a different endogenous explanation of the
possible size of non-legal sanctions in a relationship conceptualized as a
repeated game. She considers a model where relational exchange and
anonymous search markets are mutually exclusive alternatives for any
particular actor. If actors cheat in an ongoing relationship they have to
withdraw into the market forever. Payoffs in the search markets determine the
severity of this sanction. The proportion of actors engaged in relational
exchange also feeds back to the market, however, due to search externalities
(thick market externality: more people on the market make search easier). The
reciprocal influence of the two institutions may lead to either of them prevailing
even if the other one is efficient. A related model is Kultti (1995). Pairwise
lifelong credit contracts between agents are enforced by the threat of trading on
a barter market. Agents come in two types and asymmetries in production
possibilities and numbers of actors per type determine the result.
The related but distinct idea of the reputation of an actor has been
introduced into the formal game-theoretic literature by Kreps et al. (1982).
They consider a repeated prisoners dilemma with a definite end known in
advance. If for all agents non-cooperation were the equilibrium in a one shot
game (non-cooperative actors), cooperation would not be possible.
Non-cooperation would always result in the last period, since no sanction for
deviation from the norm would be available in the future. This being so,
non-cooperation would result in the second to last period, and hence in the
third to last period, and so on. In the model of Kreps et al. (1982), cooperation
is nevertheless sustainable, since actors come in two types, one of which will
cooperate as long as the exchange partner has done so up to now, even in the
last period (cooperative actors). Actors do not know each others type.
Non-cooperative actors find it worthwhile to camouflage themselves as
cooperative actors almost up to the end of the game. If non-cooperative actors
deviate, their exchange partner learns their true type immediately. In that sense
they lose their reputation, which constitutes the relation-specific prospective
advantage in this model.
However, this clearly does not transport all that there is to the common
sense notion of reputation. The latter is centered on the idea of public
information about an actor: the past behavior of an actor towards exchange
partners becomes known to other actors who, when they deliberate a
transaction, will take this information into account (see also Charny, 1990, for
this definition of the concept). This usually includes the above notion of
reputation as an estimate of the characteristics of an actor, but does not
logically have to. A reputation for cheating simply means that an actor is
publicly known to have cheated before (a qualified number of times?), whether
0780 Non-legal Sanctions 1007
this is due to special personal traits or not. When I want to clearly distinguish
between the two notions of reputation, I will use the term g-reputation if I want
to refer to the game theoretic usage of the term, and cs-reputation for the
common sense notion. This common sense notion of reputation leads us to the
next section.
5. External Norms: Third Party Control
When third parties administer sanctions, the information and motivation issues
already relevant for multilateral second party control gain considerably in
importance. In particular the motivation problem becomes more pointed: why
should an actor sanction another, usually at least foregoing cooperation benefits
in doing so, when the other has not deviated against him? The theoretical
answers to these issues are as yet more exploratory than comprehensive.
Consider the contribution of Klein and Leffler (1981) mentioned in Section
4. In its simplest version, all demanders are identical in all respects and the
behavior of the supplier is identical towards them. If the supplier cheats, he
cheats all demanders and only second-party sanctions occur as a consequence.
Nevertheless, it can and has been interpreted as a model of cs-reputation in the
sense just introduced.
Suppose quality were stochastic (for example, reliability) and consequently
not every buyer could observe quality in the period after purchase. Assume that
the information transmission problem is solved. Upon receiving the information
that quality is poor, a reputational equilibrium of the following kind is
self-enforcing, needing no threats to would-be deviators from the punishment
path: every demander expects poor quality and is only willing to pay the
correspondingly lower price, and the supplier, knowing this, will actually
provide poor quality at the lower cost. Since punishment strategies constitute
an equilibrium, there is no motivation problem for sanctions to be administered.
Bendor and Mookherjee (1990) also assume that the information problem
is solved. They model a multitude of actors engaged in simultaneous repeated
bilateral exchanges. The motivation problem is dealt with by assuming a
prisoners dilemma structure on payoffs and calling for the equilibrium of the
single shot stage game (the non-cooperative action) to be played as a
punishment. Two of their results are worth mentioning: referring to the
interpretation of discount factors as reflecting separation probabilities, they
state that non-legal sanctions by second parties are sufficient in very stable
societies, third-party sanctions are effective at intermediate levels of stability,
and in a society with very unstable relationship only legal enforcement can
sustain cooperation. Furthermore, for third-party control to be effective, either
the payoffs from exchanges with different actors have to influence each other
1008 Non-legal Sanctions 0780
or they have to differ. If payoffs from exchanges are separable and symmetric,
third-party enforcement is ineffective.
Kandori (1992) has tackled the information problem by trying to find
minimal requirements for third-party sanctions to be effective. He looks at this
question in a random matching game with bilateral exchange: every period,
actors are reshuffled into new pairs. Kandori basically confirms the intuition
about the role cs-reputation may play in such a situation: he finds conditions
under which a label, determined by the past actions of an actor and known to
the player he is matched with at the start of their trading period, is sufficient
for cooperation to be sustained. The motivation problem reappears, since
Kandori considers general payoff structures. Hirshleifer and Rasmusen (1989)
discuss the somewhat related issue of ostracism.
Kandori (1992) and especially Ellison (1994) have analyzed another kind
of equilibrium, which does not require any information transmission. Whenever
a player has been cheated, he will cheat any other player in the game. In a
contagious process, cooperation will eventually break down. This becomes
interesting if one assumes a public randomization device (a public signal, for
example, a campaign for moral renewal). Using this idea, Ellison shows that
such a contagious process can be of finite length. This is shown for prisoners
dilemma games and random matching of pairs. In addition, the result does not
require too patient players and equilibrium can even be stable in situations
where deviations may occur by mistake. We may then find periods of
widespread deviation alternating with periods of cooperation in a population.
6. Internal Norms
Internal norms provide first party sanctions. The actor deliberating a deviation
from a rule foresees at the same time an internal non-legal sanction in the form
of reduced utility. The potential importance of internal norms is fairly obvious.
Nevertheless, they have been somewhat disreputable in mainstream economic
theory, since their use amounts to explanation via preferences. Economists have
been very skeptical about any direct way of obtaining data about preferences
and in the absence of data, postulating a preference for something can explain
virtually any behavior. However, as survey techniques have become more and
more sophisticated in other social sciences and experiments have gained
general approval in economics, evidence on preferences can be obtained and
tested far more reliably. This has put internal norms back on the research
agenda of methodological individualistic theoreticians.
Despite their temporary disrepute, internal norms have very reputable
ancestors. No one less than the founding father of modern economics, Adam
Smith, has been counted among those who have developed a full blown theory
0780 Non-legal Sanctions 1009
of internal norms. Elsner (1989) traces Smiths parsimonious theory which
builds on the human faculty of being able to put oneself into another persons
shoes and on the human desire for approbation from those around him. Along
the same lines, McAdams (1995) introduces a theory of status closely connected
to internal norms. He argues that the esteem of others as an end in itself is an
important motivating force of actors, working both in groups which are close
knit and in groups which only share a common observable trait.
Internal norms are closely tied to emotions, the relevant non-legal sanctions
being regret, remorse, shame, guilt, embarrassment and the like (see, for
example, Frank 1987, 1988; Huang and Wu, 1994; and Elster, 1996). Their
role is straightforward if emotions are conceived as a direct sanction for breach
of a substantive rule in the sense of Ellikson (1991). Their role, however, may
also be important in enforcing second- and third-party non-legal sanctions, if
an actor feels guilty, and so on if he does not sanction a deviator. In this context
feelings of hatred, vengeance and anger also are important, a subject especially
studied by Frank (1988).
Internal norms are also connected to cognitive issues. A comprehensive
modern methodologically individualistic approach of human action -
recognizing Smithian antecedents - is formulated by Lindenberg (1990). He
stresses the role of socially learned framing effects: the preferences and the
action space available to an actor depend on the way a situation is perceived,
framed. This may, for example, explain why opportunities for opportunistic
behavior are used differentially in two situations even though objective
incentives are the same. Framing effects thus emphasize the conditionality of
internal norms (see Section 11 for an application). Even closer to modern social
psychology is Schlicht (1997) (Schlicht, 1993 is an earlier condensed version),
which also goes well beyond a theory of internal norms, giving an explanation
of various forms of rule-guided behavior broadly compatible with the theory of
Lindenberg. Based on a fundamental cognitive propensity to perceive the world
as governed by regularities, human actors are equipped with a preference for
rule-guided behavior, deviation causing discomfort (cognitive dissonance),
which requires corrective action. This may serve as a foundation for moralistic
agression, the increased likelihood and severity of defense, if a subjectively
established moral right has been infringed upon.
Another line of research has focused on the genesis of internal norms. Here
evolutionary approaches dominate. Landes and Posner (1978) draw on
sociobiological reasoning, while Witt (1986) provides an account combining
results from the psychology of learning with elements of evolutionary game
theory. The latter is also the base of the recent endeavor of Gth and Kliemt
(1994).
1010 Non-legal Sanctions 0780
C. Applications
7. Family
Comprehensive treatments of the role of non-legal sanctions in stabilizing the
family as an institution are Ben-Porath (1980) and Pollak (1985). They
integrate both external and internal norms in their analysis, Pollak emphasizing
the insuring role of families. Both discuss the pros and cons of the organization
of economic activities in families, but Ben-Porath discusses the role of other
informal social relationships, especially friendship, too.
Becker, Landes and Michael (1977) consider the idea of relation-specific
investments and the costs of finding a new partner in the context of marriage
and its dissolution. Note that this application predates the work of Williamson
on relation-specific investments and could be regarded as the first application
of these ideas. Weitzman (1981a, 1981b), without explicit reference to Becker
et al., contain nevertheless the same argument as an important building block
of her comprehensive discussion of the social and economic implications of the
marriage contract.
Several papers center around the idea of bequests and their manipulation by
parents as a non-legal sanction against children. The Rotten Kid Theorem
(Becker, 1974, 1981, Chapter 8) shows under which conditions altruistic
parents can assure family wealth maximizing behavior by selfish children.
Becker and Murphy (1988) analyze public policies on education, old age
security, divorce, marriage age, and so on as attempts to correct for defects in
the sanctioning mechanism via bequests. Bernheim, Shleifer and Summers
(1985) provide a general discussion of non-altruistically motivated parents
leaving bequests. Pauly (1990), Zweifel and Strwe (1994) and Richter (1995)
include discussions of the demand for long-term-care insurance if parents
desire to manipulate the behavior of children via bequests. Parents may decide
rationally not to buy such insurance in order to leave intact the incentives of
children to care for them in their old age.
8. Informal Insurance beyond the Family
As already noted, while the family is an important informal insurance
institution it is by no means the only one. Other close-knit relationships also
provide the basis for such arrangements. In particular, informal insurance in
developing economies has attracted considerable attention in recent years. The
articles are written in a fairly analytical style without losing sight of the
underlying institutional setup. Most of them explicitly discuss non-legal
sanctions. Fafchamps (1992), taking up many of the issues raised by Posner
0780 Non-legal Sanctions 1011
(1980), discusses the institutions of rural areas of developing countries with
reference to the formal game-theoretic literature of repeated games
emphasizing problems of asymmetric information. The article is nevertheless
written in a very accessible style and remains largely informal.
Extending the partly empirical, partly theoretical study by Kimball (1988),
Coate and Ravallion (1993) discuss informal insurance as a problem of second
party sanctions in a repeated game framework. They discuss the maximum
amount of risk-sharing possible in such an arrangement and compare with first
best risk-sharing. Both Udry (1994) and Besley and Coate (1995) extend the
analysis in the direction of community credit. Udry emphasizes the role played
by sanctions imposed by village or family elders, serving a function very much
like the formal arbitration procedures in Bernstein (1992) (see Section 11).
Empirical results are given from a field study in Nigeria. Besley and Coate
emphasize the role of third party sanctions in enforcing repayment in group
lending. Again comparisons are made with first best arrangements. Finally
Arnott and Stiglitz (1991) began the task of analyzing formal and informal
institutions that exist side by side (see also Kranton, 1996b, discussed on
p.1171) in the case of insurance arrangements. Their noteworthy result sees
informal institutions surviving even if their existence is inefficient.
9. Pre-Legal Societies
Several contributions purport to study the entire system of rules governing a
pre-legal society. Posner (1980) is an early and in many ways seminal
contribution. He argues that many features of primitive societies can be
understood as the consequence of two factors: first, high uncertainty leading to
a great need for insurance; and second, the absence of formal insurance due to
high information and other transaction costs. The article derives an
exceptionally rich picture from this basic argument, discussing a host of
institutions and comparing them with modern legal rules. The argument
reappears in Posner (1981) Chapters 6 and 7 and is applied to Homeric Greece
in Chapter 5. The latter attempt is criticized in Versteeg (1989). Commenting
on a historical case study on a New Guinean tribe, Benson (1988) emphasizes
the ability of pre-legal societies to marshal change. Friedman (1979) provides
a lively account of historical institutions in early medieval Iceland. Pointing out
the conditions leading to their gradual decomposition, he also takes a less
sanguine view than Benson on the potential of such a system today. Iannaccone
(1992) may be useful in understanding the way religious communities close
their ranks. Finally, Miller (1993) points out the role that sacred scriptures may
play in regulating rituals.
1012 Non-legal Sanctions 0780
10. Property
Several contributions inquire into the policing and sanctioning of property
rights by informal sanctions. Here the well-known study by Ellikson (1991),
already heavily referred to in Section 2, provides a prime example. The case
study which forms the major part of this monograph studies the norms on cattle
trespass in a small, close-knit community, enforced by first-, second- and third-
party sanctions. Legal provisions concerning trespass have even been overruled
by informal rules. The use of the legal system for regulating motorway
accidents involving cattle shows that the legal system is relied upon more
frequently if the social distance between the parties of a conflict becomes larger,
if the stakes increase, or if costs can be shifted to third parties. Ellikson (1986)
and Ellikson (1989) are separate publications based on this material. Also in
the field of tort law, Ramseyer (1996) describes the working of the strict
liability regime privately operated by some firms in Japan prior to 1995.
Ostrom (1990), a modern classic by any standard, deals with the non-legal,
either semi-formal or informal enforcement of property rights in common pool
situations. Her account is full of empirical material in field studies from
different parts of the world, both successes and failures from the point of view
of efficiency. As conditions for success, she identifies among other elements
(see pp. 88-104) the involvement of appropriators in monitoring as well as
graded sanctions, conditional on the severity and frequency of deviation from
the rule. These are mentioned here because they are connected with two
noteworthy effects not described so far. Monitoring has a direct private benefit
to those involved: they gain information on the state of compliance in the
system, which allows them to adopt a strategy of compliance conditional on the
state of compliance in the system. In the same vein, sanctioning provides the
information to the violator that the sanctioning system is well-functioning. This
work has been extended through experimental research published in Ostrom,
Gardner and Walker (1992, 1994).
Further work on aspects of non-legal enforcement of property rights are
Anderson and Hill (1975), an early analysis of issues related to Ellikson (1991),
as well as Benson (1986, 1989b). Finally, Anderson and Swimmer (1997)
deliver an empirical analysis of the transaction cost determinants of the
property rights regimes of about 40 North American Indian nations.
11. Contract
Both Charny (1990) and Rubin (1993) are comprehensive treatments of the
issue of non-legal sanctions in relation to contracts (see also Kronman, 1985
for a somewhat earlier and more limited account). Both are written in an
0780 Non-legal Sanctions 1013
informal style, the latter being more of a systematization of the contributions
up to the time of publication while the former offers more an original synthesis.
Charny identifies three systems of non-legal sanctions: third party decision
making with reputational enforcement (external norms with formal decision
making processes and third-party sanctions); reputational monitoring by market
participants (external norms and third-party sanctions); and unilateral decision
making (second-party sanctions). Internal norms play a minor but
non-negligible role.
The role of formal decision making in non-legal sanctioning is explored in
detail in Bernstein (1992) in a case study of the New York diamond trade. Her
rich material includes a view on the development of non-legal enforcement
embedded in an ethnic group into a more formal structure. The article by
Matsumura and Ryser (1995) presents a case study and a model for the
Japanese institution of public announcement of default on notes and the
sanctioning system built around it. Their contribution is especially noteworthy
for analytic consideration of incentive issues concerning the revelation of
information. The role of clearing houses, which is central in this system, is also
the topic of the historical study by Gorton and Mullineaux (1987) on
nineteenth-century commercial banks. Taking a property rights perspective,
Pirrong (1995) studies the limits of formal private enforcement in the light of
a historical case study on the Chicago Board of Trade. He concludes that
unequal distribution of gains may lead to the non-development of
efficiency-enhancing institutions. Greif, Milgrom and Weingast (1994) and
Milgrom, North and Weingast (1990) are other highly interesting historical
case studies on formal medieval institutions backing up non-legal sanctioning
mechanisms. The mix of authors makes for good history and good theory. The
latter article concentrates on the growth of the Law Merchant, the
autonomous, international merchant law system which is also studied in
Benson (1989a). Benson argues in favor of the efficiency-promoting role of
spontaneously evolved systems of rules. The analysis of Schwartz and Scott
(1995) provides an antidote to the efficiency view on formal private
rulemaking. In an analysis of the American Law Institute and the National
Conference of Commissioners on Uniform State Laws, two US institutions,
they discover evidence of the capture of these institutions by interest groups.
The purely informal norm backed by third-party sanctions has also been
dealt with in the area of contracts. Such reputational mechanisms requiring
information transmission are most effective in closely knit (business)
communities. The seminal paper in this area is Macaulay (1963), which goes
well beyond analyzing bilateral relationships, for which it is usually credited.
A very early economic study is Cheung (1973), discussing the pricing of the
pollination services of bees, explicitly noting the relevance of social norms (p.
30). Allen and Lueck (1992) report on a modern field study concentrating on
agricultural contracts. Ramseyer (1991), in an analysis of the Japanese banking
industry, cautions against overestimation of the role of reputation and repeated
1014 Non-legal Sanctions 0780
deals. Basically, business partners do not know whether the opposing party will
defect and quit the market or whether it is there to stay. Legal rules,
information gathering and formal private policing are used as remedies.
In a brilliant historical study, Greif (1994) has compared the community-
and reputation-based enforcement mechanism of a medieval Jewish trader
community in Islamic North Africa with the individualistic enforcement
mechanism of their Genuese contemporaries combining analytical clarity with
a host of interesting institutional issues. A notable result is the likely superiority
of the communal system at any moment in time combined with its inferiority
in the opening up of new trading areas.
The literature on second-party sanctions based on external norms is large.
Concerning contract law, however, as may have become clear already in
Section 4, it is largely identical with the literature on relational/long-term
contracts which is dealt with in a chapter section in this encyclopedia. The
relatively new models of the endogenous determination of the severity of the
sanction via exit from and re-formation of relationships have, however, not yet
found their way into this literature.
When we leave the framework of purely external norms and take internal
sanctions into account, the theory of relational contracts developed by Macneil
over the course of the last twenty years is a prime reference. Macneil can take
credit for being the first to formulate a theory covering relational contract
(which has been acknowledged by writers like Williamson). It has been
changing considerably over time. A good, concise statement of its latest stage
of development is Macneil (1987), along with Macneil (1983, 1985). The
theory stresses the relevance of internalized solidarity and reciprocity norms in
ongoing contractual relationships, apart from the disciplining role of other
sanctions. His theory is not developed in close contact with economic reasoning
and therefore is not always easy to understand from this frame of mind.
Lindenberg and de Vos (1985) criticize it from a revisionist rational choice
perspective, to which Macneil (1987) replies. Lindenberg (1988) presents a
theoretical design of his own applying his framing theory (see Section 6). The
approach centers on the idea of weak solidarity in long-lasting contract
relationships. While selfish gain-maximization is the main aim, solidarity
norms enter the decision as a secondary factor. By way of contrast, the strong
solidarity present in close-knit social units like families is characterized by the
fulfillment of normative duties as the main aim and selfish aims as a secondary,
distracting, factor. Lindenberg argues that strong solidarity frequently is
detrimental to contractual relationships.
Several other publications dealing with non-legal sanctions in relation to
contracts also implicitly or explicitly refer to both internal and external norms.
Experimental work supporting the importance of internal norms in contracts
is presented by Hackett (1994). Very interesting work based on anthropological
0780 Non-legal Sanctions 1015
field studies on trading networks by South-East Asian Chinese is presented in
Landa (1979, 1981). (See also Landa, 1983, on the Kula Ring, a classic
anthropological example of gift exchange). An onion-like structure of
relatedness is described, ranging from the nuclear family to the ethnic group
of Hokkien-Chinese to Non-Chinese, associated with declining levels of
trustworthiness. The trading practices embedded in these relationships are
discussed using information economics and the theory of money. Of particular
interest is the borderline between credit and cash transactions. The argument
is generalized in Carr and Landa (1983) where religious groups are included
and a club-theoretic framework is used. Cooter and Landa (1984) deepen the
analysis with respect to the question of the socially vs. privately optimal size of
trading groups. They conclude that the socially optimal trading group is smaller
than under free entry, but larger than a monopolistic trading group maximizing
only the welfare of its members. This and other work has recently been
republished in book form (Landa, 1994). While using the early analytical
apparatus common at the time, it is nevertheless full of insights. La Croix
(1989) builds upon the above work and, using the line of argument of
Williamson (1983), discusses the kind of (ethnic, religious, and so on) bond
posted in a middleman group.
12. Corporations
Ramseyer (1987) provides an excellent discussion of the role of non-legal
sanctions in explaining the relative rareness of hostile takeovers in Japan,
embedded in a good general discussion of the role of culture and norms. He
argues that the existing norms persist largely due to the fact that they are in line
with the underlying economic incentives. Hostile takeovers are relatively
unprofitable in Japan since the firms are highly leveraged. Hence banks have
a good bargaining position for appropriating any efficiency gains the takeover
might produce.
Black and Kraakman (1996) provide an excellent analysis of the possibility
to design a self-enforcing corporate law. The aim of the effort is to protect the
interests of minority shareholders in the absence of non-legal norms and
effective legal enforcement, a situation prevailing especially in some of the
former socialist countries. The approach centers on the idea of giving the
parties concerned as much direct leverage as possible, minimizing the need for
third-party involvement (courts, lawyers, officials, and so on). Core elements
are reliance on procedural protection - like transaction approval by outside
directors - bright line rules and strong legal remedies on paper which to some
extent compensate for weak remedies in fact.
1016 Non-legal Sanctions 0780
13. Crime and Criminal Enforcement
Felson (1986) provides a detailed account of how non-legal sanctions may
support law enforcement. Combining elements of social control, routine activity
and rational choice theory, he provides a minimal set-up for non-legal
sanctions. A potential offender has to have at least one social contact, the
intimate handler, whose disapproval affects the potential offender, be it
intrinsically or instrumentally. Close kin are usually a case in point. This
person has to be contactable by a person who might observe any potential
offence, the guardian. Felson then describes how the density of social ties in
closely knit, locally concentrated communities provides a multitude of social
relationships which can be turned into handler and guardian at any time,
significantly lowering crime rates. The more sparsely knit or the more spatially
dispersed the web of social contacts is, it is argued, the less effective are
non-legal sanctions, causing crime rates to be higher in urban areas. The most
recent exercise in tracing social influences on criminality, Glaeser, Sacerdote
and Scheinkman (1996), can also be interpreted as modeling the effects of
non-legal sanctions on crime rates.
Kunz (1976, 1993) emphasize somewhat different issues. It is asserted that
a criminal subculture is stabilized by three elements which serve to reduce the
probability and severity of official sanctions in such a subculture: a norm of
mutual protection by non-cooperation with official authorities, enforced by
non-legal, frequently extra-legal sanctions, and the promise of mutual support
in case a member of the subculture has been exposed to legal sanctions
Opp (1989), reconstructing central sociological theories of crime in a
rational choice framework, suggests further potential pathways for effects of
non-legal sanctions, when discussing the theory of differential association.
Day-to-day interactions may influence the kind of norms internalized and
thereby alter the subjective costs of committing a crime. Cognitive aspects are
also stressed. Systematic differences in the day to day interactions of people
may influence their knowledge about opportunities for criminal action or about
ways to escape formal sanctions.
When discussing the labeling approach, Opp also treats the effects of
stigma, non-legal disadvantages (that is, sanctions) suffered as a consequence
of being convicted, on crime. The criminal career hypothesis maintains that
rather than deterring, criminal punishment condones further crime by labeling
the actor who committed the crime a criminal, stigmatizing him and thus
pushing him into a criminal career. Opp points out that this hypothesis could
be reconstructed in terms of an economic analysis if one assumes that the
stigma accompanying criminal sanctions reduces post-punishment legal
opportunities, that is, stigma reduces the opportunity cost of further offences.
If stigma leads to more additional crimes due to criminal careers than it deters
0780 Non-legal Sanctions 1017
by raising the disutility of an offence in the first place, it may actually reduce
the deterrent effect rather than increase it. Rasmusen (1996) considers other
models of stigma. The models analyze self-enforcing third-party sanctions,
are adverse selection and moral hazard driven, and give rise to multiple
equilibria. Karpoff and Lott (1993) include an empirical study of the interaction
between criminal sanctions and the loss of reputation caused by these sanctions
in the case of corporate fraud.
14. Non-Legal Sanctions and Public Policies
Several publications contain discussions of public policies and regulation from
a non-legal sanctions perspective. Two questions are central: first, is a
particular social norm enforced by non-legal sanctions likely to be efficient?
Second, does the state have the means to improve upon a social norm?
The first question has two aspects, which are not always clearly
distinguished: it is necessary for an efficient norm to prescribe an efficient
behavior, that is, to contain an efficient substantive rule. However, this is not
sufficient. In addition the informal enforcement of that behavior via informal
first-, second-, or third-party control has to be efficient. If both aspects can be
answered affirmatively, no public policy is required. This is the position taken
in a public policy centered article by Rock and Wachter (1996). They discuss
what they term a norm of no-dismissal-without-cause in the non-union sector
of the US economy overriding the legal status of employment at will (Kamiat,
1996 is a critical comment.). In the same vein, Benson (1994), referring to
external norms, argues that a large amount of the public activities considered
as the provision of public goods could be, and historically have been, privately
provided. He presents historical case studies for policing and road maintenance
in Britain.
The deviation from efficiency that provides the most straightforward a priori
case for state intervention is inefficient informal enforcement of an efficient
substantive rule, calling for enforcement by the state. Along this line, Cooter
(1996) is probably the most ambitious and systematic attempt to formulate a
program of incorporating non-legal norms in law. He proposes to judge the
efficiency of non-legal norms by evaluating the structure generating it, using
the term structural approach for this endeavor. Rubin (1994), building on his
systematic exposition of private enforcement mechanisms (see also Section 11),
discusses how governments of the Eastern European transition countries can
build upon and support the autonomous development of non-legal sanctioning
mechanisms. He favors legal enforcement of arbitration and the adoption of
privately generated rules into the law. Giving this view an explanatory twist,
Hgg (1994) sees firms demanding regulation and supervision in order to
1018 Non-legal Sanctions 0780
overcome problems remaining after the various forms of non-legal enforcement
elaborated above in Sections 4 and 5 have been exhausted. A technical analysis
is combined with some historical evidence.
Besides these rather general treatments, more specific analyses exist.
Johnston (1996) analyzes a specific legal question. He discusses the influence
of the US merchant law on business norms. Specifically, he looks at the
requirement of a written contract for court enforcement of contracts worth more
than $500. He finds evidence that the writing requirement is not complied with
in contracts within repeated relationships, where non-legal enforcement is
expected to be sufficient. He identifies requirement of written contract
whenever this is the relevant business norm as a reasonable reform of the law.
E. Posner (1996b) is a critical comment. Epstein (1992a) discusses the use of
business customs as evidence of due care in tort cases, arguing in favor of such
a presumption in cases where the tort occurs between parties of a voluntary
agreement. Epstein (1992b) presents an essentially identical argument in the
area of intellectual property. Finally, the discussion of public policy responses
to non-legal sanctions in Charny (1990), centered around the problem of
information costs and possibly unsophisticated actors in the market, argues in
favor of enforcement of the norm that well-informed rational actors would have
agreed upon. The general principles derived are applied to detailed problems
of US contract law, however, this reviewer feels that the policy discussion is
somewhat disconnected from the earlier comprehensive discussion of non-legal
sanctions (see Section 11).
Social norms may, however, not always prescribe efficient behavior. If they
do not, this calls for corrective interventions rather than enforcement of the
norm. Cooter (1996) expects norms to require inefficient conduct if it is
possible to externalize costs to third parties or if heavy network externalities are
present in norm use. E. Posner (1996a) argues for more general skepticism
concerning the efficiency of norms, inefficiencies being especially due to
information problems and strategic behavior in norm creation and enforcement.
McAdams (1995) proposes an interesting and original theory of racial
discrimination based on his status-oriented theory of norms (see Section 6) and
looks at the US anti-discrimination laws from this perspective. Epstein (1995)
is a critical comment.
Let us now turn to the second fundamental issue. The above contributions
are mute on the question of whether beneficial intervention is possible.
Intervention, however, may be problematic for several reasons. Striking a
classic note, Charny (1996) is skeptical as to whether the evaluation of the
efficiency of norms can be undertaken with reasonable accuracy at all given the
numerous factors at stake. More fundamentally, state intervention may cause
counterproductive changes in the content or enforcement of social norms. In
highly original research drawing on psychological material and self-conducted
0780 Non-legal Sanctions 1019
experiments, Frey (1993a) produces evidence showing that formal incentives
may adversely affect internal norms. When a certain kind of behavior which
has been sustained by internal norms becomes rational from the point of view
of external incentives, for instance because of formal legal sanctions, the
internal motivation to act might be crowded out under certain conditions.
Whenever this is the case, internal norms and external incentives cannot simply
be added, rather they substitute for each other over an initial range. Frey
(1993b, 1993c) are applications in the field of the employment relation. Frey
(1997) summarizes the entire research project. Chong (1996) provides a related
survey of the interactions between incentives stemming from internal norms
and other sources.
Concentrating on external norms, E. Posner (1995) is a well written,
insightful and comprehensive informal discussion of the various channels
through which public policy may influence non-legal sanctioning systems based
on game theoretic reasoning. He especially emphasizes the effects of policies
on the ability of groups to continue to enforce external norms encouraging
cooperation. Various specific policy areas are discussed. Pildes (1996) also
discusses various ways in which public policies can undermine efficiency
enhancing norms, taking recourse to the concept of social capital developed
by Coleman (1990). In a similar vein, Bernstein (1996), in a detailed case study
on US merchant law, shows that the policy of adopting business norms into
law can change those very norms adversely. Finally, Lindbeck (1995) discusses
the effect of the welfare state in the presence of (external and internal) social
norms. He argues that the disincentives of the welfare state will be cushioned
temporarily by contrary social norms which will, however, be shaped over time
by those very disincentives. Both multiple equilibria and vicious circles may
result (see also Arnott and Stiglitz, 1991, discussed on p. 14).
More generally, in the presence of social norms stipulating non-legal
sanctions, formal legal rules interact with those norms in a complex manner.
Levmore (1996) and McAdams (1996) contain comprehensive and
well-reasoned discussions of the role and interaction of norms and law in the
area of communication. The former discusses the use of anonymous
communication as a means to further the frankness of comments, a solution
which is frequently dominated by the use of intermediaries. The latter discusses
the prohibition of blackmail by criminal law, arguing that the ban is likely to
reach a second-best optimum when combined with privacy laws, the benefit of
a blackmail ban being essentially the use of information otherwise used for
blackmail for public dissemination, leading to non-legal sanctions. Hasen
(1996) discusses the relationship between social norms encouraging people to
vote in a general election and state laws trying to enforce mandatory voting.
An interesting treatment of the interaction of legal and non-legal rules and
sanctions concerning the use of the legal enforcement system, the courts, is
1020 Non-legal Sanctions 0780
included in Ramseyer and Nakazato (1989) (see also McAdams, 1996).
Japanese are frequently said to be reluctant in using the modern legal system
since it contradicts traditional norms both in form (publicity of conflict vs.
traditional desire for harmony) and substance (universalism vs. traditional
particularism). Their empirical findings of Japanese litigation rates related to
automobile accidents contradict this by showing behavior in line with
maximization of short-term gain. This reviewer, however, finds the
identification of cultural influences with irrationality in the early parts of the
paper unfortunate. The beginnings of an explanation of the results which is in
line with the theoretical structure elaborated in Sections 4 and 5 of this chapter
are given in Section 5.
Finally, mandating certain conduct by law may itself create a relationship
between law enforcers and the addressees of a law, which can be norm
generating. In this vein, McMaster and Sawkins (1996) argue for considering
the regulatory relationship itself as a relational contract using the term more or
less in the sense of Macneil (see p. 1181).
Acknowledgments
I acknowledge the helpful comments of an anonymous referee.
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0790
LEGAL ERROR
Warren F. Schwartz
Professor of Law
Georgetown University Law Center
Copyright 1999 Warren F. Schwartz
Abstract
Important legal rules, most significantly the rule which makes an injurer liable
if she is negligent, require that in order to avoid liability an injurer must take
socially optimal care. Since the rule is cast in general terms and, consequently,
does not specify what the injurer must do to avoid liability, the judge or jury
deciding the case must determine what socially optimal care for the injurer was
in the circumstances in which the injury occurred. Legal error occurs when the
judge or jury set socially optimal care at too low or too high a level.
An injurer deciding what to do to minimize the sum of precaution costs and
liability costs takes the possibility of error into account. The possibility that too
little care will be required will tend to induce the injurer to take too little care.
The effect of the possibility that too much care will be required depends on the
causality rule which is applied. If an injurer who is held liable for failing to
take that care determined to be required is liable for all harm which occurs,
including that harm which would have occurred even if the required care had
been taken, the possibility that excessive care may be required will tend to make
an injurer take excessive care. If, however, an injurer is liable only for that
harm which would not have occurred if the required care had been taken, the
injurer will take optimal care even if liability will be imposed if more than
optimal care is not taken. It is difficult to draw any confident conclusions as
to the frequency with which each of the two causality rules are employed.
A second model is employed to analyze legal error. Under this model, an
injurer does not choose a level of care but makes a binary choice between
compliance and violation of the rule. Under this approach both errors in
holding injurers who have complied with the rule liable or in exonerating
injurers who have not complied with the rule will reduce the incidence of
compliance with the rule.
The practical usefulness of the analysis of legal error is greatly reduced by
the absence of evidence either as to the errors which actually occur or the effect
of those errors on the incentives of injurers.
JEL classification: K00
Keywords: Legal Error, Causality in Torts, Implementing a Negligence Rule,
Injurers Compliance Strategy
1029
1030 Legal Error 0790
1. Introduction
Legal rules imposing liability on injurers for the harm they do to victims are
often framed to require that injurers must exercise reasonable care (or some
equivalent term) to avoid causing harm to persons who may be injured by their
actions. Rules cast in this form do not specify what injurers must do to avoid
causing injury. The determination of what constituted reasonable care in the
circumstances which in fact obtained when the particular injurer caused harm
to the particular victim is made by the judge or jury empowered to decide the
claim for damages brought by the victim against the injurer.
A common example in the literature (Polinsky, 1989, p. 40) is the speed at
which an automobile is driven. Since the reasonable care standard does not
specify a speed at which automobiles must be driven in various circumstances
the judge or jury is required to decide what speed was reasonable. If the speed
at which the car was driven exceeds that determined to be reasonable the
injurer is liable to the victim. Legal error occurs when the judge or jury
incorrectly determines what speed was reasonable in the circumstances which
obtained when the injury occured.
2. Legal Error
The analysis of legal error, in accordance with the standard economic
interpretation of the negligence standard, posits that there is a socially optimal
speed (or, more generally, of course, level of precautions to avoid causing
harm) at which the total of (1) the cost of precautions to avoid causing harm
(in the example, going more slowly), and (2) the expected harm to victims, is
as low as possible. Intuitively, as the driver goes more slowly the benefit
derived from her trip declines because she arrives at her destination at a later
time; but so, too, does the expected harm she will cause others. Socially
optimal speed is the one which maximizes the value of the trip to the driver net
of the expected harm caused to others. This is posited as the speed which the
reasonable care standard obliges the driver not to exceed.
To facilitate exposition, reducing the speed at which a car is driven will be
used throughout as the example of taking care to avoid causing harm. The
analysis is, however, general, applying to all instances in which an injurer
incurs costs to reduce the expected harm to victims by decreasing the
probability that harm will occur or the magnitude of that harm which does
occur.
The determination of what the socially optimal speed is in any particular set
of circumstances is not straightforward. In principle, the judge or jury must
determine both expected harm to victims and benefit to the injurer at different
speeds and choose the speed which maximizes the value of the trip to the
0790 Legal Error 1031
injurer net of expected harm to victims. As a result, sometimes the speed
chosen by judge or jury may exceed the social optimum and sometimes it may
be less than the social optimum. In either event, what has been designated
legal error has occurred.
3. The Impact of Legal Error on Injurers Incentives
The analysis of legal error focuses on the question of how the behavior of
injurers will be affected by the expectation that legal error will sometimes
occur. This analysis takes two forms, depending on what is posited as the
controlling rule with respect to the liability of an injurer for harm which would
have occurred even if the injurer had taken the care (in the example driven at
the speed) which she was legally obligated to take.
Calfee and Craswell and Goetz independently developed the analysis of the
effects of legal error on the assumption that an injurer who is held to have
failed to take the required level of care is liable for all harm which occurs,
including that harm which would have occurred even if the mandated care had
been taken. In the terms of our example, reducing speed to the socially optimal
level does not necessarily mean that all expected harm will be eliminated.
However, the analysis developed by Calfee and Craswell and Goetz proceeds
on the assumption that the liability of the injurer includes that harm which
would have occurred even if socially optimal care had been taken. Kahan and
Grady proceed from a different assumption. They posit that an injurer is liable
only for that harm which would have been prevented by taking the required
care. The difference in the assumption made by Calfee and Craswell and Goetz
on the one hand, and Kahan and Grady, on the other, leads to dramatically
different conclusions as to the effect of legal error on the incentives of injurers.
The Calfee and Craswell and Goetz analysis concludes that legal error impairs
the incentives of injurers in two ways, one (to return to the example) tending
to induce them to drive too fast and the other to induce them to drive too
slowly. The actual speed chosen by an injurer depends on the relative strength
of these two tendencies. Generally, unless the variance in the errors
determining socially optimal care is very great, the tendency to take too much
care will dominate and, in the terms of the example, the driver will go too
slowly. By contrast, Kahan and Grady conclude that legal error can only
operate to induce injurers to take too little care, in the terms of the example,
drive too fast.
To understand the impact of legal error on injurers it is necessary to analyze
how an injurer decides at what speed to drive. If there were no legal error, so
that legally mandated speed were always set equal to socially optimal speed, the
injurer, under the assumption underlying the analysis of Calfee and Crasswell
and Goetz, has a powerful incentive to drive at the socially optimal speed. If
1032 Legal Error 0790
she goes faster she becomes liable for all harm which occurs, including the
harm which would have occurred even if she had driven at the socially optimal
speed. And, she has no reason to go more slowly because it is unnecessary to
do so to avoid all liability for harm to victims.
Legal error changes this calculation by introducing two possibilities: (1)
Sometimes, even if the injurer drives at or below the socially optimal speed, she
will be held liable for all harm which occurs. (2) Sometimes, even if the injurer
exceeds the socially optimal speed, she will not be held liable.
To understand how these possibilities affect the choice of speed by the
injurer it is necessary to analyze the decision process of an injurer seeking to
adapt optimally to the possibility of legal error. The injurer wants to minimize
the sum of two costs : (1) the costs of care to avoid causing harm (slowing
down); and (2) expected liability. Expected liability, in turn, depends on the
expected harm and the probability that the injurer will be held liable and be
required to compensate victims for the harm done to them. Since expected
liability depends both on harm caused and the probability of being held liable,
and taking care (in the example, slowing down) affects both, the injurer
considers both in deciding how much care to take (how fast to go).
The injurer first calculates the probability of being held liable at various
speeds by anticipating the distribution of views as to what constitutes socially
optimal speed which will be held by the decision makers to whom a claim for
damages by a victim may be assigned. The probability of being held liable for
going at any particular speed depends on the proportion of potential decision
makers the injurer anticipates will conclude that socially optimal speed is less
than the speed at which the car is driven. This is, of course, an exercise in
prediction by the injurer with respect to the views that will be taken by judges
and juries. The analysis simply shows how the behavior of the injurer will vary
with her belief as to what the actual distribution of views will be.
The estimate of the injurer as to the probability of being held liable
associated with various speeds becomes a crucial component in the injurers
choice of the speed which is individually optimal because it will minimize the
sum of the costs of care (slowing down) and expected liability. The analysis of
the injurers choice of speed posits that the distribution of views of potential
decision makers is such that the two possibilities noted above exist: (1) there
is some probability that the injurer will be held liable even if the speed she
chooses is at or below the social optimum; and (2) there is some probability that
the injurer will not be held liable even if the speed she chooses exceeds the
social optimum. More generally, it is posited that the lower (higher) the speed
chosen the smaller (larger) is the probability of being held liable.
The first of these possibilities will tend to cause the injurer to choose too
low a speed (take too much care) and the second to choose too high a speed
(take too little care). The reason which induces the injurer to choose too low
0790 Legal Error 1033
a speed simply is that if there is some probability that liability will be imposed
even if the socially optimal speed is chosen, it is individually beneficial for the
injurer further to decrease her speed and, thus, reduce the probability of being
held liable. If the benefit, in the form of reducing the probability of being held
liable, exceeds the cost of additional slowing down it will be in the interest of
the injurer to do so. Since, under the Goetz and Calfee and Croswell analysis,
liability extends to all harm, whether or not it would have been prevented by
taking socially optimal care, reductions in the probability of being held liable
are very valuable and, as a result, the incentive to take excessive care very
strong.
The way in which the probability that the injurer may not be held liable
even if she drives faster than the social optimum causes the injurer to choose
a speed higher than the social optimum is somewhat more subtle. Decreasing
speed is privately beneficial to the injurer (the impact on the probability of
being held liable aside) if it decreases either the probability of causing harm or
the severity of that harm which does occur.This is so because, as noted above,
expected harm is one component of expected liability. In this respect the private
perspective of the injurer and the social perspective are identical.The
probability that the injurer will not be held liable even if she chooses a speed
which exceeds the social optimum, however, causes the private calculation of
the injurer to depart from the social optimum.This is so because the private
value of reducing expected harm is not the entire reduction but, rather, the
reduction multiplied by the probability of being held liable. Thus, if, for
example, a reduction in speed is evaluated as costing the injurer four dollars but
reducing expected harm by six it is socially desirable that the reduction in speed
occur. However, if there is only a 50 percent chance that the injurer will be
held liable the injurers private evaluation of the reduction in expected harm will
be only three dollars and the injuer will prefer not to reduce speed even if it is
socially desirable to do so.
Thus, in sum, legal error tends both to induce the driver to go too fast and
too slowly. Which effect will dominate depends on the distribution of views of
potential decisionmakers and the costs and benefits associated with different
speeds. In general, absent great variance in the views of potential
decisionmakers the tendency to go too slowly will dominate.
Kahan and Brady accept the conclusion of Calfee and Craswell and Goetz
with respect to the impact of legal error in the form of failing to hold an injurer
laible even though she has not taken optimal care.They agree that error of this
kind will tend to cause injurers to take too little care (drive too fast).They,
however, disagree with the conclusion that error in the form of holding injurers
laible even though they have taken socially optimal care will induce injurers to
take excessive care (drive too slowly).
The source of this disagreement is the difference between what is assumed
to be the liability of an injurer for harm which would have occurred even if the
injurer had taken the care she was legally required to take. Grady and Kahan
1034 Legal Error 0790
posit that the injurer is liable only for the harm which would not have occurred
if legally mandated care had been taken. They demonstrate that, on this
assumption, an injurer will not be induced to take more than socially optimal
care even if she anticipates that legal error in the form of setting the required
level above socially optimal care will occur.
Kahan chooses an example which makes his position both clear and
persuasive. He hypothesizes a case in which the issue is the height of a fence
which is required to be built to protect people from being hit by cricket balls.
He illustrates the difference between his position and that taken by Calfee and
Craswell and Goetz by asking whether a person who builds a fence which is
lower than is legally required would be liable for injury resulting from a ball
flying so high that it would have sailed over the legally required fence if it had
been in place. It seems quite plausible to answer no to this question since the
failure to build the fence has not caused the injury.
But Kahan argues that if this is so the anticipation of legal error in the form
of imposing liability on a person who builds a fence which is of socially optimal
height, on the erroneous premise that a higher fence is socially optimal, will not
induce the building of the higher fence. He reasons as follows. Suppose, for
example, that a socially optimal fence is ten feet high but decision makers
conclude that it is eleven feet high and, as a result, impose liability if the
socially optimal ten foot fence is built. Indeed, suppose that there is no
distribution of views but that this error is made by all decision makers. Kahan
concludes that even on this strong assumption the socially optimal ten foot
fence will be built.
He arrives at this conclusion by asking whether the cost of increasing the
size of the fence from ten feet to eleven feet will, from the perspective of the
person deciding how high a fence to build, be justified by the associated
reduction in expected liability. The essential premise underlying his answer to
this question is that if the legally mandated eleven-foot fence is not built,
liability is limited to harm resulting from balls which would not have gone over
it. If the socially optimal ten-foot fence is built it will block all balls flying no
higher than ten feet. Thus the benefit achieved by increasing the size of the
fence from ten feet to eleven feet is to avoid liability for those balls which
would have gone over a ten-foot fence but be blocked by an eleven-foot fence.
Since it is assumed that the ten-foot fence is socially optimal the cost of
increasing the size of the fence above ten feet must exceed the associated
reduction in liability. As a result, the ten-foot, socially-optimal fence, and not
the erroneously mandated eleven-foot fence, will be built.
0790 Legal Error 1035
4. The Actual Consequences of Legal Error
It is not clear the extent to which the Calfee and Craswell and Goetz analysis,
or that of Grady and Kahan, better captures the consquences of legal error. In
principle, the account of Grady and Kahan appears to be persuasive. It may be,
however, that because application of this approach requires a determination of
the question of what harm would have occured even if required care had been
taken, that the Calfee and Craswell and Goetz approach is taken when this
question is particularly difficult to answer.
In the example used by Kahan it is easy to separate the harm which would
have been prevented if different levels of care had been taken from that which
would have occurred anyway. A ball flying so high that it would have gone
over a fence of specified height is an easy concept to understand and apply.
The case of optimal speed for a car, and many others, are much more
problematic. Suppose that a person is hit by a driver going faster than the
required speed. It is true, and explicitly assumed in the standard analysis, that
there will be some probability that the person would have been injured even if
the driver had been going at or below the required speed. Taking this
probability into account requires some means for distinguishing the harm
which would have been prevented from the harm which would have occurred,
if the required care had been taken. Moreover, the uncertainty as to exactly
which victims would not have been harmed would require some probablistic
method of awarding damages such as has been proposed with respect to cases
where uncertainty of damages is present (Shavell, 1987, p. 115).
All of this may simply be too complicated to be worth dealing with. In
principle, the issue of what harm would have occurred to the particular plaintiff
even if required care had been taken is present in all cases. Often, however, the
issue is ignored and the injurer is held liable for all harm which occurs when
she fails to take the care required by the governing rule. Thus the approach of
Grady and Kahan may reflect actual practice when it is feasible to determine
what harm would have occurred even if the required care had been taken and
the approach of Calfee and Craswell and Goetz taken when it is not feasible to
do so.
5. The Impact of Litigation Costs
In order to focus on the impact on the incentives of injurers of errors in
determining the controlling legal standard the analyses so far considered all
assume that litigation is costless. This assumption implies that all victims who
have any chance of prevailing will sue.
If, however, the assumption of litigation being costless is relaxed, an injurer
has available an additional strategy for reducing expected liability (Menel). A
1036 Legal Error 0790
victim will only sue if the expected recovery exceeds the cost of suing. Putting
the possibility of strategic exploitation of the costliness of defense and
uncertainty of outcome aside, the expected value of suing depends on the
amount of damages which it is anticipated will be recovered and the probability
of recovering. Although taking strategic possibilities into account complicates
the analysis, it remains true that the probability of success is an important
determinant of the value of a suit. Thus, if the victim-plaintiffs probability of
success can be reduced, so, too, can the expected value of the action. If the
expected value of the action can be reduced to an amount less than the costs of
the suit, the suit will not be brought.
Since the probability of a plaintiff succeeding varies with the care taken (the
speed at which the car is driven) the injurer can reduce her expected liability
by choosing a level of care which reduces victims chances of success to so low
a level that the expected value of suing becomes less than the cost of suing. As
a result, increasing care (going more slowly) is individually beneficial for an
injurer in that not only can it make it less likely that those victims who do sue
will recover, but also it reduces the number of victims who have a sufficiently
high chance of prevailing that they will sue.
6. Modeling the Compliance Decision as a Binary Choice
There is a second body of scholarship which analyzes legal error using a
different conceptual framework than the one discussed above (Png, 1986;
Polinsky and Shavell, 1989; Kaplow, 1994a). Under this framework, a person
is posited as making a binary choice between complying with the law and
violating it. As a result of various mistakes that may be made, including error
in deciding what the applicable law is, there is some probability that she will
be held liable even if she complies with the law and some probability that she
will be exonerated even if she violates the law. Both of these possibilities make
the alternative of violating the law relatively more desirable for the person
making the choice than would be the case in the absence of legal error or other
factors leading to the guilty being exonerated or the innocent convicted. Thus
legal error, under this conception, decreases deterrence in the sense that fewer
people choose to comply with the law than would be the case in the absence of
legal error.
This underdeterrence result appears on first impression to be inconsistent
with the overdeterrence, or excessive compliance, result reached by Calfee and
Croswell and Goetz. The difference is, however, explained by the different way
in which the compliance decision is conceptualized under the two approaches.
As Calfee and Craswell and Goetz (and indeed Grady and Kahan) frame the
question the compliance decision is a continuous one of choosing the optimal
0790 Legal Error 1037
amount which should be done to avoid causing harm. The individual optimum
is determined by the effectiveness of care in reducing expected harm and the
probability of being held liable associated with different levels of care. In this
framework overdeterrence means that individuals take excessive care and
underdeterrence that individuals take too little care. By contrast, under the
view which conceives of the compliance choice as a binary one, there can be no
overdeterrence and underdeterrence which means that some people choose to
violate rather than comply.
The essential difference between the two approaches derives from two
interrelated consequences of positing the compliance choice as a binary one: (1)
the person making a compliance choice cannot adapt her behavior to the legal
system by taking into account the variations in the probability of being held
liable associated with doing more or less to avoid the harm which the legal rule
is designed to prevent. (2) Under the binary approach error consists of imposing
liability on the innocent or convicting the guilty. There is no place in the
analysis for different magnitudes of error. Under the continuous approach,
however, legal error consists of arriving at a standard which departs from the
social optimum. There are, consequently, more or less egregious errors,
depending on how far the standard departs from the social optimum.
Moreover, the magnitude and frequency of these errors matter because the
person making a compliance choice takes them into account in choosing how
much will be done to avoid causing the harm which the legal rule is designed
to prevent. It is in this process of adaptation that the incentive to overcomply
arises. By doing more than is socially optimal the probability of being held
liable can be reduced. This possibility is not taken into account when the
compliance choice is posited as a binary one.
7. The Existing Evidence as to the Incidence of Legal Error and its
Impact on
the Incentives of Injurers
The analysis of legal error provides insights essential to an understanding of
legal systems. It is clear that policy objectives cannot be achieved by enlisting
decision makers who will make no mistakes. Deciding what behavior is
reasonable (or some equivalent term), in various circumstances, is not a simple
undertaking and sometimes a defendant will be asked to do too much to avoid
the harm the rule is designed to avoid and sometimes too little. The adaptation
of injurers and victims to the inevitability of error by judges and juries
constitutes an essential part of the process through which law affects behavior.
Positive and normative analysis which ignores this adaptation to the
expectation of error is seriously incomplete.
1038 Legal Error 0790
The analysis of legal error is particularly useful in providing a means for
understanding and evaluating various procedural features. Most fundamentally,
under all of the analyses discussed above, legal error causes the behavior of
persons subject to a legal regime to depart from the social optimum. A change
in the system which reduces error will, consequently, cause behavior better to
conform to the social optimum. It is thus possible to decide whether the change
should be made by comparing its costs with the value of the associated
improvement in behavior. The analysis of legal error also provides another
perspective for evaluating the costliness of litigation. In general, the higher the
costs which a victim must incur in suing an injurer the greater must the
probability of success be for the victim to sue. The greater the probability of
success which must exist before a victim will sue, the greater are the
opportunities for injurers to decrease their expected liability by choosing a
compliance strategy which reduces the victims chances of succeeding below the
level required for suit to be brought.
Although the analysis of legal error thus offers the possibility of better
understanding a legal system, the subtlety and complexity of the analysis make
it very difficult to utilize to predict outcomes in particular circumstances or
make concrete proposals for legal reform. Theoretical analysis teaches that
outcomes depend on: (1) the distribution of views of potential decision makers
as to what an injurer must do to avoid causing harm in order to escape liability;
(2) the controlling rule as to whether an injurer is liable for harm which would
occur even if required care had been taken; (3) the costliness of litigation to
injurers and victims and (4) the information that injurers and victims have
about each of the first three factors and that victims have about what injurers
know and injurers have about what victims know.
To predict how a change in the system will affect the universe of outcomes
one must somehow gain reliable answers to these factual questions and properly
analyze the complex adaptations which would occur if the system were
changed.
At the present time, it seems fair to say that the analysis of legal error
constitutes a fundamental aspect of our understanding of how legal systems
function. It has, however, so far yielded neither useful predictions of outcomes
nor the foundation for specific proposals for reform.
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0790 Legal Error 1039
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Standards, 70 Virginia Law Review, 965-1003.
Craswell, Richard and Calfee, John E. (1986), Deterrence and Uncertain Legal Standards, 2 Journal
of Law, Economics, and Organization, 279-303.
Goetz, Charles J. (1984), Law and Economics: Cases and Materials, St. Paul, West Publishing.
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658-pp.
Grady, Mark F. (1989), Untaken Precautions, 18 Journal of Legal Studies, 139-156.
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and the Environment, Cambridge, MA, Harvard University Press.
Gravelle, Hugh S.E. (1983), Judicial Review and Public Firms, 3 International Review of Law and
Economics, 187-205.
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Economics, and Organization, 433-452.
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of Legal Studies, 427-447.
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Law and Economics, 191-209.
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or the Economics of Imprecision), Informatica e Diritto, 253-274.
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International Review of Law and Economics, 101-105.
1040 Legal Error 0790
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Brown.
Polinsky, A. Mitchell and Shavell, Steven (1989), Legal Error, Litigation, and the Incentive to Obey
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0800
NORMS AND VALUES IN LAW AND
ECONOMICS
Denis J. Brion
Professor of Law
Washington and Lee University - School of Law
Copyright 1999 Dennis Brion
Abstract
The discourse of law and economics, both as an intellectual enterprise and as
a practice that takes place in the processes of the law, is rich with values.
This article explores the substance and nature of these values. The values in
law and economics discourse are not only heterogeneous in character but
they can also be advanced for a heterogeneity of purposes.
JEL classification: K00
Keywords: Discourse, Values, Explanatory Discourse, Descriptive
Discourse, Critique
1. Definitions
The discourse of law and economics, both as an intellectual enterprise and as
a practice that takes place in the processes of the law, is rich with values. In
order to explore the substance and nature of these values, begin with a
standard definition of economics:
Economics is the study of how people and society end up choosing, with or
without the use of money, to employ scarce resources that could have alternative
uses, to produce various commodities and distribute them for consumption, now
or in the future, among various persons and groups in society. It analyzes the c o s t s
and benefits of improving patterns of resource allocation. (Samuelson, 1976, p. 3)
This definition proceeds from the assumption that resources are scarce,
establishes the analytical focus as the allocation of resources to productive
activities and the distribution of wealth among the members of society, and
adopts efficiency in resource allocation as a fundamental criterion of
evaluation.
Law might be defined in a material sense as the complex of
constitutional provisions, bodies of legislative enactments, such as codes and
statutes, and, particularly in common law systems structured with an
independent judiciary, the continually developing body of judicial doctrine.
1041
1042 Norms and Values in Law and Economics 0800
Functionally, the law defines the scope, powers and limitations of such
elements of governance as the obligatory institutions of public agencies and
defines the permissible ambit of relations among legal persons and between
legal persons and entities of governance.
Proceeding from these definitions, law and economics is the use of the
analytical techniques and values of economic analysis either for explanation
or for prescription. In the realm of explanation, it is the enterprise of
developing models that, in economic terms, accounts for the phenomena of
human activity - the ongoing decisions and actions of such legal institutions
as legislative bodies and the judicial process, and such practices as the
legally permissible interactions of individuals. In the realm of prescription,
law and economics discourse advocates the application of economic
principles in the decision making of legal institutions, both substantively and
procedurally, and the use of economic principles in shaping the permissible
scope of interactions among legal persons.
A. Norms and Values
The discussion which follows will first describe the values that underlie the
explanatory discourse of law and economics and then describe the values
that underlie prescriptive discourse. This discussion will reveal that law and
economics discourse is a substantially heterogeneous enterprise. And it is
heterogeneous because the values that underlie it do not resolve into a
unified, mutually consistent whole (Rakoff, 1996; Trebilcock, 1993).
2. Explanatory Discourse
Explanatory discourse seeks to develop models that explain in economic
terms how humans interact both outside of, and within, social and political
institutions. This discourse has given considerable attention to interaction
among individuals, and to action within such public institutions as the
judicial system, legislative bodies and administrative agencies. In general,
the analytical approach to these models defines the basic agent of economic
action in terms of a homo economicus understanding of human nature - that
the individual is a self-interested actor, competitive in nature, who
undertakes to achieve the rational maximization of personal utility (Cooter
and Ulen, 1997).
Early work in law and economics proceeded from homo economicus
assumptions to address the economic aspects of individual interaction. The
Tragedy of the Commons (Hardin, 1968) explained the resource-destructive
0800 Norms and Values in Law and Economics 1043
course of activity when a number of individuals had access to a resource in
circumstances in which entitlements to the resource were poorly defined.
The seminal analysis in The Problem of Social Cost, which came to be
known as the Coase Theorem, holds that, in the absence of transaction costs,
the original assignment of entitlements does not affect the allocation of
resources to production in circumstances of conflict in resource use (Coase,
1960). In addition to the basic assumptions about human nature, both of
these analyses posited that the paramount criterion of evaluation of human
interaction is efficiency, implicitly defined as putting resources to the most
valuable use in production. And both of these analyses posit, implicitly or
expressly, that the prior definition of a pattern of individual entitlements to
resources makes possible market action that guides the allocation of these
resources toward efficiency.
Other early work describes the adjudication of private disputes in a
common law system as an efficient process. This occurs because parties to a
conflict have an incentive to litigate prior doctrinal rules that are inefficient,
which in turn tends to induce the judiciary to replace these rules with
efficient rules. The result is a tendency for the substance of judicial doctrine
to evolve toward a body of efficient rules (Goodman, 1978; Landes and
Posner, 1987; Priest, 1977; Rubin, 1977).
Public choice analysis takes as its focus the political process and the
processes of governmental institutions (Farber and Frickey, 1991),
characterizing itself as a descriptive, rather than a normative, enterprise.
(Brennan and Buchanan, 1988). Public choice analysis applies economic
analysis to political decision making, including theories of the state, voting
rules and voting behavior, apathy, party politics, logrolling, bureaucratic
choice, policy analysis, and regulation (Mercuro and Medema, 1997, p. 84).
Early public choice analysis describes the legislative process as a market for
political action, in which individuals, whether constituents or lobbyists,
express their demand in self-interested terms and legislators supply political
action on the same basis (Downs, 1957; Buchanan and Tullock, 1962).
Other work analyzes other elements of the political process in the same way,
such as voting generally (Black, 1958), bureaucratic action specifically
(Niskanen, 1971), and the public processes of governance generally
(Bartlett, 1973).
The mainstream of descriptive discourse thus proceeds from a small
number of particular principles. Human nature is posited in terms of the
self-interested, utility-maximizing homo economicus. The market is posited
as the paradigm of human interaction, whether the subject of exchange is
goods and services or it is public action. The criterion for the evaluation of
human interaction is efficiency in the allocation of resources to productive
activity. And the general mode of analysis adopts the static, equilibrium
model of neoclassic microeconomics, with a tacit presumption of a relatively
1044 Norms and Values in Law and Economics 0800
fixed endowment of resources to be allocated, and of individuals
participating in market activity with relatively fixed, rationally ordered
utility schedules (Ackerman, 1989).
Institutional analysis takes an alternative approach to deriving models to
explain human interaction by looking to institutions rather than markets as
the milieu of activity (Mercuro and Medema, 1997, pp. 101-156).
Institutions are defined as widely followed habits of thought and the
practices which prevail in any given period (Veblen, 1899). This approach
posits that human action is relational and interdependent, in contrast to the
atomistic character of human action in the neoclassic market model
(Schmid, 1989). There is mutual feedback between economic action and
institutions, with each shaping the nature of the other; thus, in contrast to
the neoclassic model that posits a process moving toward equilibrium,
institutional analysis posits a process of ongoing evolution (Schmid, 1989).
It describes economic action in terms of conflict rather than in terms of the
resultant cooperation that is described as the consequence of action within a
market model; and institutions are understood as the means for controlling
this inherent conflict (Mercuro and Medema, 1997, p. 107) The criterion of
evaluation is the efficacy of institutions in minimizing the transaction costs
inherent in economic action, thereby serving to maximize wealth (Coase,
1988).
3. Prescriptive Discourse
The substantive content of the materials of the law - constitutional
provisions, legislative enactments and judicial doctrine - is a principal focus
of prescriptive law and economics discourse. This aspect of the discourse
seeks to prescribe the substantive basis for choices made in legal processes,
particularly in the judicial process. This discourse presents several different
sets of underlying values. Three of these lie in the mainstream of
prescriptive discourse; others provide minor, though substantial, themes in
the flow of discourse.
In the general understanding, law and economics discourse is identified
with what has come to be called the Chicago School (Mercuro and Medema,
1997, pp. 51-83). Chicago School analysis is not, however, homogeneous,
either in terms of the prescriptions that it offers or in terms of its underlying
values. One substantial element of Chicago School proceeds from a
particular set of principles - private property is a right that emerges
spontaneously from interactions among individuals because cooperation
tends to increase individual welfare (Benson, 1993). Thus, private property
occupies a paramount position in the scheme of social values; the preferred
method for resource allocation is the free market in goods and services; the
0800 Norms and Values in Law and Economics 1045
role of the state is taken to be minimal, principally, the protection of
antecedent rights; wealth distribution is determined according to individual
attributes; and the principal criterion of evaluation is Pareto efficiency
(Malloy, 1990a, pp. 86-92).
According to this approach, the individual entitlement to property is to
be given maximum protection from the encroachment of other individuals,
and governmental action that erodes its use-value can occur only with full
compensation (Epstein, 1985). In the law of tort, the basic determinant of
liability is the liberty-based protection of the right to bodily integrity.
(Cooter, 1987). In the law of bargain, classic contract law applies - broad
freedom of alienation, strict enforcement against breach, and minimal
judicial policing of the substance of contract terms (Campbell, 1996; Gray,
1989).
The philosophical underpinnings of this approach are captured by Robert
Nozicks concept of the night watchman state (Nozick, 1974; Epstein,
1995). This approach is based on the values of Individualism. The autonomy
of the individual is the highest political and social value. By nature, humans
seek to maximize their individual welfare and cannot be changed in a
fundamental way by the action of coercive institutions. Economic resources
are a source of plenty, to be developed through the trial and error process of
individual action. The optimal social arrangement establishes the maximal
freedom of individual action; and public institutions are properly confined to
the function of protection of individual autonomy (Thompson et al., 1990).
A different element of Chicago School analysis proceeds from a different
set of principles - it posits aggregate societal wealth maximization as the
highest good; it rejects the concept of natural or inherent rights; it approves
of market action as a second-order value that serves the primary goal of the
maximization of aggregate societal wealth; and it adopts cost-benefit
analysis as a basic analytical technique (Malloy, 1990a, pp. 60-68; Medema,
1993). This approach is most closely identified with the work of Richard
Posner (Posner, 1981a, 1998). Collective institutions, both public
(governmental) and private (large-scale capitalist enterprise) have a
substantial role in achieving wealth maximization. Entitlements to resources
are contingent, rather than a protected right of the individual holder; thus,
resources are to be directed, whether by market action or by the supervening
action of collective institutions, to the most productive user (Kaplow and
Shavell, 1996). The function of the judicial process, under this approach, is
to mimic the market in the resolution of disputes (Medema, 1993; Calabresi
and Melamed, 1972). In consequence, the pattern of the distribution of
wealth is analytically irrelevant.
Thus, in the law of tort, the basis of liability is the minimization of costs
associated with instances of harm (Calabresi, 1970). In the law of bargain,
efficient breach, although it destabilizes the entitlement distribution effected
by an executory contract, is approved because it shifts resources to the higher
1046 Norms and Values in Law and Economics 0800
valuing user (Goetz and Scott, 1977). In the law of property, least cost
avoider analysis justifies shifting entitlements to the more productive user
(Polinsky, 1989; Posner, 1998).
This element of Chicago School analysis is based on hierarchical values.
The paramount criterion of evaluation is aggregate societal wealth.
Collective institutions, both private and public, have a substantial role in
directing resources toward wealth-producing activities. Entitlements are not
protected from erosion or transfer in order to shift resources to more
productive users, thereby subordinating individual rights to the social good.
A substantial spread in the distribution of power and wealth is acceptable in
order to achieve the maximization of aggregate wealth (Riley, 1989;
Thompson et al., 1990).
A third mainstream approach, identified with Yale Law School, also
rejects the concept of natural or inherent rights (Mercuro and Medema,
1997, pp. 79-83; Malloy, 1990, pp. 69-75) Although this approach accords a
substantial role to both public and private collective institutions, public
institutions have a paramount role. These institutions provide a milieu of
discourse by which the paramount values of society are determined, and
have a substantial role in directing economic and social arrangements to
advance the realization of these values (Ackerman, 1980, 1984;
Rose-Ackerman, 1992). Because these ends are collective rather than
individualistic in nature, then this approach, like the second branch of
Chicago School analysis, is substantially hierarchical in character. This
approach, however, is unlike the hierarchical branch of Chicago School
analysis in two respects. It tends to prefer more qualitative utility concepts of
social welfare over more quantitative measures of aggregate wealth
(Brownsword, 1997). And it treats the pattern of the distribution of wealth as
a highly relevant consideration in the determination of social welfare
(Rose-Ackerman, 1985).
By way of summary, the mainstream of law and economics prescriptive
discourse is dominated by approaches that are grounded either in
individualist values or in hierarchical values. These values are, however,
mutually inconsistent. Thus, mainstream discourse is properly characterized
more as a debate than as a collective enterprise refining a unitary social
scientific model under the aegis of a monolithic set of values.
As this discourse has matured, other voices, based on other values, have
entered the debate. A prominent alternative is the discourse of critical legal
studies, which itself is considerably heterogeneous (Unger, 1986; Kelman,
1987). Moreover, it has tended to be reactive in nature, in the sense of
seeking to reveal, and to criticize, the tendency of mainstream academic
discourse and judicial doctrine to advance hierarchical values behind a
rhetoric of individual values. Thus, there has been a tendency in a
0800 Norms and Values in Law and Economics 1047
substantial body of critical legal studies discourse not to offer a coherent
prescription for an alternative conceptualization of the substance and
processes of the law.
Notwithstanding this tendency, one approach with a distinctive character
has emerged (Unger, 1976, 1984). This approach posits that values are
properly chosen in a social milieu, and that the proper milieu for this choice
is the immediate community. The law, according to this approach, ought to
encourage the altruistic and cooperative tendencies of human nature over its
self-interested and competitive tendencies. And the distribution of wealth
ought to tend toward equality, thereby creating a social order that is
relational in nature rather than hierarchical or transactional.
Thus, the proper determinant of the use of property is not the self-interest
of the title-holder but instead the emergent values of the community in
which it is located. In the law of harms, liability is based on a breach of a
duty of care toward the physical and psychic integrity of others rather than
on a failure to exercise economic rationality in pursuing wealth-increasing
personal gain. And the process of exchange ought to be relational - an
interactive process for seeking mutual benefit and for seeking synergism in
the creation of common benefit (MacNeil, 1980; Brownsword, 1997;
Campbell, 1996, 1997). This approach is based on the values of
communality. Consistently with these values, the character of human
interaction is relational, rather than hierarchical, transactional, or
competitive. Wealth is distributed so as to tend toward equality. And the
relational milieu serves as a bulwark against the exploitation of the
individual by others seeking to enhance their self-interest or hierarchical
institutions seeking to amass and exercise power. A Social Law and
Economics, similarly based in the egalitarian values of communality,
emphasizes the equitable distribution of wealth, the broad assurance of
human dignity, and solidarity (Medema, 1993; Veljanovski, 1981b).
There is, as well, another distinct set of values that emerges from law
and economics discourse. Although much of the work of Richard Posner is
grounded in hierarchical values, he has also offered an extended account of
human action based on his concept of bioeconomics (Posner, 1992).
According to this account, human action is determined, driven by natural
appetites and attributes embedded in human nature. Human action, in this
view, is the consequence of the individual engaging in the rational
maximization of the satisfaction of these drives. Because it posits that
human action is determined, this approach carries a strong affinity to the
natural law tradition.
Other approaches offer a mix of values. A classic liberal approach is
based on the two paramount values of individual liberty and human dignity
(Malloy, 1990a, pp. 93-101, 1990b, 1988). Under this approach, the free
market is an important institution through which individuals exercise their
entitlement to liberty. The State, as well, plays an important economic role -
1048 Norms and Values in Law and Economics 0800
protecting and advancing human dignity by protecting the entitlements of
individuals from erosion by private action or by the action of collective
institutions, and maintaining individuals in the holding of a minimum level
of wealth. This approach thereby combines values derived from both
individuality and hierarchy.
John Rawlss A Theory of Justice presents a noted example of a mixed
approach (Rawls, 1971). His concept of the priority of liberty rests on an
Individualist foundation. The presumption in favor of an equal distribution
of wealth and the substantial role of the State both in maintaining a system
of liberties and in intervening in the pattern of wealth distribution rest on a
hierarchist foundation.
Margaret Jane Radin has developed another example of a mixed
approach by her concept of property for personhood (Radin, 1982, 1987,
1989). That certain kinds of property, central to the definition of the
individual, are protected from private alienation or public expropriation rests
on individualist values. That the definition of the individual, and thus the
specification of which particular property has the required nexus with
personhood, takes place in a social process rests on communitarian values,
as does the egalitarian thrust of the concept that certain property provides a
presumptively inalienable individual endowment.
4. Mutual Critique
Because law and economics discourse is underlain by a heterogeneity of
values, this discourse takes on the character of debate - the offering of
particular approaches to analysis and prescription, and the mutual critique of
these approaches.
4.1 Explanatory Discourse
A foundational assumption of explanatory discourse is that the primal agent
of economic action is homo economicus - the self-interested, competitive,
rational, utility-maximizing actor. This model comes under challenge as
failing to account for the capacity of individuals to exhibit egalitarian
altruism, to seek and achieve social solidarity, and to give their loyalty to
hierarchical organizations (Campbell, 1997; Huang and Wu, 1994; Kelman,
1983; Leff, 1974; Morse, 1997; Sen, 1977). Another basic assumption posits
that individual action in a free market will, with minimal administrative
cost, continuously move resources to the highest valuing users, thereby
achieving an efficient allocation of resources to production. The appeal to an
efficiency criterion comes under critique on the ground that, even under the
approach of neoclassic analysis, there is no unique efficiency point; instead,
0800 Norms and Values in Law and Economics 1049
there are different efficiency points corresponding to different patterns in the
distribution of wealth (Dworkin, 1980b; White, 1987b). The proposition that
individual action in a free market tends toward efficiency is challenged on
the grounds that, because of inevitable distortions, the market instead yields
a path-dependent stream of suboptimal goods and services (Eastman, 1996).
The proposition that legal rules ought to be chosen for their efficiency
comes under critique on the grounds that their efficiency consequences
cannot be determined - if analyzed on a partial equilibrium basis, they can
lead to general inefficiency; and general equilibrium analysis entails
insuperable information costs (Rizzo, 1980; White, 1987b). A similar
critique is made of the use of judicial remedies to provide incentives to
engage in efficient action that can lead to distortion if the distinction
between prices and sanctions is not taken into account (Nance, 1997). And
the account of common law adjudication as a process that generates efficient
rules comes under critique on the grounds that systemic bias in the selection
of disputes that come before courts prevents the development of efficient
rules for the various classes of disputes that can arise (Hadfield, 1992), and
that the pursuit of self-interest by the parties to litigation creates a tendency
toward the development of inefficient rules (Cooter and Kornhauser, 1980).
Another aspect of explanatory discourse is the tendency to adopt a
numerate approach to the enterprise of evaluation and, in general, to
advance law and economics discourse as a scientific enterprise (Horwitz,
1980). Although this approach is well grounded in enlightenment
rationalism (Toulmin, 1990), in law and economics discourse it proceeds in
part from the problem that interpersonal comparisons of utility cannot be
made because utility itself cannot be measured by a transitive scale of
evaluation (Kaldor, 1939). To assess instead the state of social welfare in
terms of wealth, a factor that is susceptible to measurement, however, is to
adopt a criterion of aggregate economic welfare that is considerably
narrower than utility (Weinrib, 1980; Hicks, 1939). Moreover, a numerate
approach tends to accept the results of measuring those factors that are
susceptible to measurement as the proper order of things (McCloskey, 1988),
thereby implicitly engaging in the is-ought fallacy.
The use of cost-benefit analysis as a means to assess the wealth impact of
a legislative measure or judicial decision follows the Kaldor-Hicks Test
derived from the classic papers published by Nicholas Kaldor and John R.
Hicks (Kaldor, 1939; Hicks, 1939). Because this test does not require
compensation in the aftermath of decisions that redistribute the entitlement
to resources, it can be shown that, because of the effects of changes in utility
positions and schedules in the absence of compensation, the test does not
accurately determine whether a welfare improvement has occurred
(Scitovsky, 1941; Mishan, 1969; Coleman, 1980b). In addition, the test itself
1050 Norms and Values in Law and Economics 0800
does not accurately capture the views expressed by Professors Kaldor and
Hicks, who took the position that wealth distribution is a relevant
consideration for the political decision maker, and that, on the assumption of
declining marginal utility in consumption, the principle of utility
maximization entails a presumption of relative equality in the distribution of
wealth, offset by a degree of inequality in order to provide an incentive to
produce (Kaldor, 1939).
An alternative approach to the dominant, neoclassic model
conceptualizes economic action in dynamic terms, tending toward
disequilibrium as technology, resource endowments, and perceptions of
utility change (Klein, 1977; Malloy, 1994). Producers can be seen as
possessing the power to create and manipulate demand, and not simply react
to demand (Bartlett, 1973), and the ultimate productive resource is human
intelligence and human inventiveness (Schultz, 1981; Reich, 1983, 1991).
Because human capacity is susceptible to enhancement by the investment of
maintenance and education, then wealth maximization can be understood
more in terms of a dynamic process of investment in human capital than in
the efficient allocation of material resources.
4.2 Prescriptive Discourse
Individualist and hierarchical approaches have tended to dominate
prescriptive discourse. Thus, the discourse of critical analysis as well has
tended to address the values that underlie these approaches. Also, the thrust
of this analysis has tended to take an expectable form - the critique of the
consequences of the realization of a particular approach from the standpoint
of the values of another particular approach.
The individualist value of the paramount importance of the
self-interested, atomistic individual comes under critique on the basis that its
implementation will fail to serve the values of efficient resource allocation
and wealth maximization (Campbell, 1996). This failure is especially acute
in the efficient production of public goods (White, 1987; Olson, 1971). It
also comes under critique because it precludes other-directed individual
action, to the exclusion of both organizational action and egalitarian
altruism (Radin, 1989; Sunstein, 1989). This, in turn, will prevent the
formation of the hierarchically directed organizations necessary to achieve
aggregate wealth maximization. It will also preclude the altruistic action
necessary to achieve a relatively equal distribution of wealth required for
broadly realized utility maximization and for participation in the economic
action that generates particular economic values on a sufficiently broad basis
(Kelman, 1983). And the transactional nature of the individualist approach
comes under critique because it leads to conceptually unrestricted
0800 Norms and Values in Law and Economics 1051
commodification, which leads in turn to the destruction of the integrity of
persons and particular kinds of objects (Radin, 1989; Sunstein, 1989).
The hierarchist principle of aggregate wealth maximization comes under
a multifarious critique. It is criticized as incoherent in terms of the
specification of what counts as wealth (Dworkin, 1980a; Rizzo, 1980), that
its maximization does not necessarily correspond to an efficient allocation of
resources (White, 1987a), and that it provides a criterion of social welfare
that is substantially inferior either to utility (Baker, 1975, 1980; Dworkin,
1980a) or to collective values (Driesen, 1997). It also comes under critique
because it treats the pattern of distribution of wealth as irrelevant (Schwartz,
1979). Because wealth distribution is irrelevant under the hierarchical
approach, the pursuit of wealth maximization can generate a wide disparity
in the distribution of wealth (Baker, 1975; Kennedy, 1981; Kronman, 1980;
MacPherson, 1985; Weinrib, 1980). Because the lack of wealth precludes an
individual from expressing her utility preferences in the market, a wide
disparity in the distribution of wealth leads to a distortion in the efficiency
point that the market can generate (Leff, 1974). Aso, the primacy of the
principle of wealth maximization has the effect of eroding individual
entitlements to resources, rendering these entitlements contingent rather
than vested (Chapman, 1982; Kronman, 1980; Reich, 1996; White, 1987).
One of the principal proponents of a cost minimization, wealth
maximization approach to the law of tort, Guido Calabresi, has been careful
to assert that the wealth maximization principle ought to be subordinate to
other principles, such as utility maximization, equity in the distribution of
wealth, and security in the holding by individuals of entitlements to
resources (Calabresi, 1980).
5. Summary
By way of summary, a rich array of values underlies the discourse of law and
economics. Descriptive models of economic action and the working of the
legal and political processes offer a mix of approaches to the explanation of
the phenomena of economic action. The dominant discourse presents models
that are numerate in character and that adopt the equilibrium approach of
neoclassic microeconomics. A minor theme in this discourse presents
models that are more qualitative in character and that adopt an alternative
dynamic approach.
The array of values that underlies prescriptive discourse is similarly
heterogeneous. The dominant discourse offers approaches based on
competing individualist and hierarchical values. Minor themes in this
discourse offer approaches based on the values of communality and
1052 Norms and Values in Law and Economics 0800
naturalism. And the discourse of critique proceeds as an implicit debate over
these alternative sets of values.
B. Theory
6. Theory
Related to the substance of the values that underlie law and economics
discourse and the heterogeneity of these values is the matter of the cause of
this heterogeneity - the question whether this conflict might be a
consequence of the particular natures of the categories of economics and of
law, or the inevitable nature of a discourse that takes place across the
boundary between distinct areas of intellectual endeavor or, perhaps, the
particular way in which this discourse has proceeded.
That this heterogeneity of values falls into a particular pattern in law and
economics discourse is replicated in other areas of discourse. Jurisprudential
theories can be understood as falling into a pattern of hierarchical positivism
and formalism, individualistic classical law, natural law, and communitarian
Marxist theory (Barry, 1988; Epstein, 1988; Peller, 1988). On a more
particular level, judicial doctrine in United States courts, rather than
developing, as the formalist account might predict, toward an ever more
complete structure of rules and principles, can be mapped onto this same
pattern of underlying values. This pattern can be seen in the different
conceptualizations of ownership of land that implicitly determine the
outcomes in particular cases - ownership as sole and despotic dominion
(Blackstone, 1765/69:2), a vested entitlement of the individual protected
from State interference [Pennsylvania Coal Co. v. Mahon, 260 U.S. 393
(1922)]; ownership as the nexus by which the individual is lodged in a
hierarchical order, in which the State holds the power to impose substantial
limits on the right to use [Penn Central Transp. Co. v. City of New York,
438 U.S. 104 (1978)]; ownership as a right subordinate to the natural biotic
webs that define the physical and biological order of the natural environment
[Just v. Marinette County, 201 N.W.2d 761 (Wis. 1972)]; and ownership as
the nexus by which the individual is lodged in a local community, in which
the always emergent matrix of communal values determines the limits on
individual use [Goldblatt v. Town of Hempstead, 369 U.S. 590 (1962)]. In
the criminal law as well, doctrine can be categorized in terms of the
conceptualization of criminality - subjective criminality, harmful
consequences and manifest criminality (Fletcher, 1978), underlain by,
respectively, individualist, hierarchical, and communitarian values.
The political ideologies manifested in the deliberations and actions of
legislative bodies and in public political discourse can be mapped onto a
0800 Norms and Values in Law and Economics 1053
similar pattern. The libertarian ideology embraces the values of
individualism. The moderate conservatism of business enterprise and the
social welfare values of left of center ideology embrace the values of
hierarchy. Interest group pluralism advances the values of communality.
And Green blocs and religious fundamentalists embrace the values of
naturalism.
The related social science of anthropology offers an explanation of this
phenomenon of values heterogeneity and the patterns into which values fall.
In anthropological discourse, a cosmology is defined in terms of bias:
Anything whatsoever that is perceived at all must pass by perceptual controls. In
the sifting process something is admitted, something rejected and something
supplemented to make the event cognizable. The process is largely cultural. A
cultural bias puts moral problems under a particular light. Once shaped, the
individual choices come catalogued according to the structuring of consciousness,
which is far from being a private affair. (Douglas, 1982, p. 1)
A bias is necessarily based on values. Particular sets of values make up a
cosmology. And, there is no single master cosmology; there are only
alternatives that are available for choice - particular cosmologies based on
the values of individuality, hierarchy, communality and naturalism
(Douglas, 1978; 1982; Thompson et al., 1990). Consciousness, the mental
world that distinguishes human beings from the rest of biological organisms,
must be organized around some set of deep values. The individual comes to
adopt a particular cosmology in the ongoing process of socialization that is
the milieu of human existence. And from this cosmology the individual goes
about the necessary function of constructing a mental world.
A critic of contemporary economic thinking, remarking on what he sees
as its poverty, has asserted:
The study of who gets what and why, unlike the study of plants or planets,
cannot help being an ideologically charged undertaking. Despite the laborious
techniques and scientific pretension, most brands of economics are covertly
ideological. Marxian economics, with its labor theory of value, assumes the
inevitability of class conflict, and hence the necessity of class struggle,
Keynesianism, with its conviction that industrial capitalism is systematically
unstable, offers an equally scientific rationale for government intervention.
Neoclassical economics, with its reliance on the efficiency of markets, is a
lavishly embroidered brief for laissez-faire. (Kuttner, 1985)
Economics, and the academic enterprise of law and economics discourse,
are not, however, impoverished by the heterogeneity of their underlying
values. Instead, this heterogeneity enriches the discourse. Economics and
1054 Norms and Values in Law and Economics 0800
law are, fundamentally, intellectual enterprises that address the deep
question of how, and on what values, humans shall organize the mental
worlds that they create. Law and economics discourse would be
impoverished only if it failed to reflect the full variety of values-based ways
in which humans create their worlds.
Law and economics discourse cannot accurately be considered to have
failed because it has not evolved toward values-homogeneity.
Values-heterogeneity is a consequence of its nature as an intellectual
enterprise - it comprises an ongoing debate over essentially contested
concepts (Gallie, 1956).
C. Debate
7. Debate
A final matter is the function of values in law and economics discourse. Not
only are these values heterogeneous in character but also they can be
advanced for a heterogeneity of purposes. Values can serve as the focus of
theoretical debate over whether a unifying set of values can emerge within a
particular culture. Such a debate would conform to the methods of
systematic philosophy and its foundationalist project (Rorty, 1979).
Alternatively, values can provide the means for refining a particular
conceptualization of economic action in legal processes. Such an enterprise
would conform to the methods of normal science (Kuhn, 1970).
Additionally, values provide the deep basis for advocacy - the enterprise of
achieving consensus, whether in academic discourse, political discourse or
discourse in the judicial process. Finally, values are a necessary ingredient to
the quasi-foundationalist enterprise of the pragmatic method, in which
discourse is directed toward the cash value of employing one or another set
of values in order to solve a particular problem in the arena of human action
(Cotter, 1996; James, 1987).
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0900
GENERAL STRUCTURE OF THE LAW
Donald Wittman
Department of Economics, University of California at Santa Cruz
Copyright 1999 Donald Wittman
Abstract
Economic theory can provide insight into the general structure of the law
and the organization of topics in this encyclopedia. After arguing that all of
law is contract law, I show how economics can be used to explain the choice
between criminal law and tort law, liability rules and property rights, prior
regulation and post liability, restitution and torts, and courts and
legislatures.
JEL classification: K1
Keywords: Structure, Torts, Contracts, Criminal Law, Property Rules,
Liability Rules
1. Introduction
Economic theory has a number of core concepts - supply and demand,
perfect competition versus monopoly, and high and low transaction costs -
among others. All of these concepts and the results derived from them can
generate insight into the legal system. The question at hand is whether the
theoretical distinctions can also explain the broad structure of the law. That
is, can economic analysis provide a partial explanation for the organization
of topics in the Encyclopedia of Law and Economics and the organization of
legal subjects, more generally? For example, is there an economic
explanation for invoking criminal sanctions in addition to civil penalties? Is
there an economic explanation for the choice between property rights and
liability rules? Do contract and constitutional law involve the same
underlying theoretical apparatus or do they employ different theoretical
constructs? The same can be asked with regard to torts and contracts, and
other categorizations.
2. All of Law is Contract Law
The first and possibly the best response is that all areas of the law are guided
by the same principle - to create efficient outcomes. An outcome is Pareto
efficient if one person cannot be made better off without making someone
1072
0900 General Structure of the Law 1073
worse off (we will not deal with the distinction between wealth
maximization and the Pareto principle here). A useful way of conceiving
such a result is to suppose that the parties write an optimal contract. In this
way, contract law, torts and restitution can be viewed as different
manifestations of contract law. For example, in automobile accidents, the
law implicitly asks what kind of contract would have been drawn up between
the victim and the injurer before the accident happened. The negligence
standard finds a person negligent if she did not undertake cost effective
preventive procedures. The hypothetical contract suggests that each party
would agree to be non-negligent. In the same way, restitution can be seen as
contract law for affirmative obligations between parties who otherwise are
not transacting with each other.
The analysis can be extended to other areas. As a city grows, it is
inefficient to allow pre-existing quarries, feedlots and the like to remain. To
use the contract analogy, if a contract had been written thirty years earlier,
the feedlot and the citys residents would have agreed to shut down the
feedlot when the city expanded. In the United States, such nuisances can be
shut down via a civil action or under a zoning regulation. Either way the
nuisance owner is not compensated - the courts interpretation of the
Constitution does not consider such a regulation a taking (see Boehm v.
Philadelphia, 1915) nor do the courts require the plaintiffs to compensate
the nuisance maker for moving costs (see Ensign v. Walls, 1948). Despite
their greatly different genealogy, these two areas of law treat the situation in
a similar way. And despite the fact that property law was developed before
contract law, the concept of contracts enlightens our understanding of the
limits of property.
Depending on ones taste, one can stretch the contract analogy still
further. During the enlightenment, the concept of a social contract was very
popular (see Rousseau) and this concept has been updated in the more recent
past to explain constitutional theory (see the chapters in the encyclopedia
devoted to this topic).
Economics as a discipline is a great generalizer that tends to cross
subject headings. Demand curves are drawn for cars, food and marriage.
Likewise in the law, an economic concept can be used in seemingly
unrelated areas. For example, if party X acts inefficiently, it makes economic
sense that a second party, Y, optimally mitigates the damages that might
arise. For example, if a plumber installs a bathtub drain improperly so that
bath water leaks into the ceiling below, economic efficiency dictates that the
homeowner stops using the bathtub once the problem is discovered. The cost
of not taking a bath is less than the benefit of not having the ceiling collapse.
This is known as mitigation of damages in contract law. Similarly, it
makes no economic sense for a farmer to plant a crop in the presence of
sulfur fumes from a nearby factory since sulfur fumes kill crops. Therefore
1074 General Structure of the Law 0900
the farmer will not be compensated for the cost of planting the crop, but only
for the lost profits in not being able to plant the crop in the first place
(United Verde Extension Mining Co. v. Ralston, 1931 - see Wittman, 1981).
This is known as the doctrine of avoidable consequences in tort law.
Finally, in continental law, a passerby is required to rescue a person lying
unconscious on a railroad track if the cost of rescue is trivial. Again, this is
just mitigation of damages in a different disguise. So three totally different
areas of law are guided by the same economic reasoning.
Having first argued that, at some fundamental level, economic theory
provides a unified explanation of the law and then giving an example of an
economic concept that is applied to seemingly unrelated legal subjects, I will
now try to argue that economic theory can also provide an explanation for
the differential structure of the law. Of necessity, the distinctions will be
more in shades of gray rather than in black and white.
3. Property Rights, Liability Rules and Communal Rights: The Role of
Transaction Costs
Transaction costs in its many guises is often the key to explaining structural
differences in the law. Consider the choice between protecting an
entitlement via a property right (voluntary transfer) and a liability rule
(compensated involuntary transfer). If a state wants to build a highway from
A to B, all landowners along the proposed highway have monopoly positions
and each will try to extract all the surplus value for herself. Ordinary market
mechanism are not viable (that is, they have extremely high transaction
costs) in this case. So the state employs eminent domain (a type of liability
rule). As another example, drivers do not negotiate with other drivers and
pedestrians for the right to put these other people in danger - the transaction
costs would be too high. Instead, they pay ex post for any involuntary
transfer (see Demsetz, 1972, for an extended argument). On the other side,
where market transaction costs are low, entitlements tend to be protected by
a property right - I cannot cut down my neighbors cherry tree and, if I
threaten to do so, my neighbor can get an injunction to prevent such an
action. Of course, if I pay him enough, he may let me engage in my
obsession.
The standard explanation for not using a liability rule in this case is that
it is an imperfect measure of relative value and shifts the costs of decision
making onto third parties (courts). Kaplow and Shavell (1996) have argued
that this explanation is flawed. Under the shadow of a court-imposed
liability rule, the parties can negotiate an outcome that does reflect higher
value. For example, if the courts say that the damage to my neighbor is only
$1,000 when I cut down his tree when in fact it is worth $2,000 to him not
0900 General Structure of the Law 1075
having his tree cut down, then he will be willing to bribe me $500 not to cut
down the tree and I will accept the bribe if cutting cherry trees is worth only
$1,200 to me (since cutting it down will mean a loss of the $500 bribe plus
the court imposed liability of $1,000).
But Kaplow and Shavells argument ignores transaction costs. To
illustrate, we consider the entitlement structure for movie stars. Paul
Newman is both a movie star and an entrepreneur (he has his own line of
spaghetti sauce and salad dressing). Paul Newman has the property right to
use photographs of himself or his name in advertising, and he can sell that
right if it maximizes the return on his human capital. In this way, sales are
value maximizing. However, such a property right system involves some
exchange costs. Paul Newman must be contacted and a price must be
negotiated. These costs are not trivial, yet they are unlikely to be very large
since this is not a case of bilateral monopoly (as hard as it is to believe, there
are substitutes for Paul Newman, perhaps Tom Cruise). Furthermore only a
few people might be involved.
If there were a communal right to Paul Newmans name in advertising,
then his name would be overused. Paul Newman Bail Bonds might bring
in increased profits to the bail bondsman, but decrease the overall profits of
products with Newmans name). Turning this communal right into Paul
Newmans property right would be extremely expensive. Every time he
bought out one person, another person would arise to make use of his name
or picture. So the right would likely remain a communal right, with overuse
but no exchange costs. If Paul Newman could buy back the rights, the
transaction costs would be very high - he would have to buy the right from
many to stop them from using his name (this should be compared to the case
were Paul Newman is given the right and then sells it to a few).
When the law gives Paul Newman the property right to his name for
advertising, even if the particular allocation is incorrect, it is easily remedied
(the other party will just buy the right to Paul Newmans name if it is worth
more to the other party than to Paul Newman). When Paul Newmans
entitlement to use his name for advertising purposes is only protected by a
liability rule, the courts assessment of the damage to Paul Newman may be
off. If the court overestimates the cost, essentially Newmans entitlement to
his own name is protected by a property right; if the court significantly
underestimates the damage, then his entitlement is virtually a communal
right. It is very hard to remedy such a mistake, and if it is corrected, very
high transaction costs are involved as the actor must buy back the right from
numerous contenders. Furthermore, the negotiated price depends on the
courts valuation or expected valuation. This adds a needless level of cost
and/or uncertainty. So transaction costs are a key to the choice between a
property right and a liability rule.
1076 General Structure of the Law 0900
Calabresi and Melamed (1972) provided the first economic explanation
for the choice between property rules and liability rules. Since then, there
has been a large literature on the subject. For alternative explanations see
Polinsky and Shavell (1984) who emphasizes strategic bargaining in the
absence of perfect information and Krier and Schwab (1995) who emphasize
court misinformation. See Ayres and Talley (1995) who argue that liabilty
rules may facilitate bargaining.
4. Taxes versus Quantity Regulation versus Liability Rules: The Role of
Imperfect Information
This topic covers some of the same territory as the previous section but
under the assumption that high transaction costs prevent negotiation
between the two sides.
Consider the case where a factory pollutes the air and the efficient
outcome is that the factory reduces the pollution rather than the neighbors
undertake damage prevention. If there is perfect information, pollution
taxes, quantity restrictions and liability for the damage can all be set to yield
the same efficient outcome. We employ the standard diagram where smoke
is on the horizontal axis and dollars are on the vertical axis (see Figure 1).
Then the marginal cost of increased smoke to the neighbors is increasing
and the marginal benefit to the firm of increased smoke is decreasing (since
the marginal cost of smoke abatement rises). The optimal amount of
pollution is where these two curves intersect. Setting a pollution tax (or per
unit of smoke liability rule) equal to t, the dollar value at the intersection of
the marginal cost and benefit curves, will encourage the factory to produce
until the tax equals the marginal benefit; that is, the factory will produce the
optimal amount, s*. Similarly, a regulation that the factory produce no more
than the optimal amount of smoke, s*, will again result in the optimal
amount of smoke. If the factory is liable (either to the victims or to the
government) for the area under the marginal cost of smoke curve, it will
again choose the optimal amount of smoke damage.
When there is imperfect information, the various methods need not
result in the same outcome (see Figure 2).
0900 General Structure of the Law 1077
Figure 1
$ C(s) = C 0+ C s1
Marginal cost of smoke
B(s) = B 0 + B 1 s
Marginal benefit of smoke
s* Smoke
Assume that the marginal cost of smoke is C(s) = C0 + C1s + u and that
the marginal benefit of smoke is B(s) = B0 + B1 s + v, where u and v are
independently and symmetrically distributed random variables with mean
zero. u and v are observed by the pollutee and the polluter, respectively, but
not by anyone else, including the courts or other government agencies.
Under quantity regulation, the level of smoke is set where the expected
marginal benefit from smoke abatement equals the expected marginal cost.
This level is denoted by Gs . Thus C0 + C1 Gs = B0 + B1 Gs , or
Gs = (B0 ! C0) / (C1 ! B1)
The optimal level of smoke is where actual marginal benefit equals
actual marginal cost. This level is denoted by s*. Thus C0 + C1s* + u = B0 +
B1 s* + v, or
s* = (B0 ! C0 + v ! u ) / (C1 ! B1).
Quantity regulation causes deadweight losses whenever s* is not equal to
Gs or v is not equal to u. The deadweight loss triangle is
0.5 | [ s* ! Gs ] [B(Gs ) ! C(Gs )] |
= | [0.5 (v ! u) / (C1 ! B1)] [ B0 + B1 Gs + v ! C0 ! C1 Gs ! u] |
= | [0.5 (v ! u) / (C1 ! B1)] [ B0 + B1 (B0 ! C0) / (C1 ! B1) + v ! C0
! C1 (B0 ! C0) / (C1 - B1) ! u]|
1078 General Structure of the Law 0900
= | 0.5 [ (v ! u) / (C1 ! B1) ] (v ! u) |
Since u and v are independent, the expected deadweight cost is
0.5 ( 2v + 2u ) / (C1 ! B1).
Figure 2
0900 General Structure of the Law 1079
The Pigovian or pollution tax, t, is the level needed to induce efficient
smoke production for the expected marginal benefit and cost
That is, t = C0 + C1 Gs = B0 +B1 Gs = B0 + B1(B0 ! C0) / (C1 ! B1).
The polluter choose a level of output, s', where
B0 +B1 s' + v = t = B0 + B1(B0 ! C0) / (C1 ! B1).
Equivalently,
s' = (B0 ! C0) / (C1 ! B1) ! v / B1
The deadweight loss triangle is
0.5 | ( s* ! s') [B(s') ! C(s')] |
= 0.5 | [ (v ! u) / (C1 ! B1) + v / B1] ( B0 + B1 s'+ v ! C0 ! C1 s' ! u) |
= 0.5 | [ (v ! u) / (C1 ! B1) + v / B1] [ (C1 / B1) v ! u] |
= 0.5 | [ B1 (v ! u) + v ( C1 ! B1) ] [ (C1 / B1) v ! u] / [(C1 ! B1) ( B1) ] |
So the expected deadweight loss of the Pigovian tax is
0.5 [( C12 / B12 ) 2
v + 2
u ] / (C1 ! B1).
Hence the expected deadweight cost of a pollution tax to a quantity
regulation is:
[( C12 / B12 )+ 2 2
v u ] / ( 2v + 2u )
Quantity regulation is preferred to a pollution tax if and only if the cost
curve is more elastic than the benefit curve (| B1 | < | C1 |). When | B1 | < | C1 |,
the Pigovian tax works poorly because the marginal cost to the firm, t , is
horizontal while the marginal cost to society is relatively vertical. Under
regulation, the smoke constraint can be viewed as a vertical marginal cost
curve to the firm which more nearly approximates the relatively vertical
social marginal cost.
1080 General Structure of the Law 0900
In contrast, strict liability (based on the expected marginal cost curve) is
superior to the previous methods regardless of the slopes of the coefficients
or the relative size of the error terms. Intuitively, strict liability is preferred
because the marginal cost curve to the firm has the same slope as the
marginal cost curve to society, in contrast to the Pigovian tax (which is
horizontal) and the quantity regulation (which is implicitly vertical). More
formally, the ratio of deadweight losses under a regulation relative to the
deadweight losses under a liability rule is 1 + ( 2v / 2u ) and the ratio of
deadweight losses under a Pigovian tax relative to the deadweight losses
under a liability rule is (1 + / B12 2u ).
C12 2
v
Furthermore, the liability rule alternative has lower information costs
than either of the other two methods. The liability rule requires that the
authority inform the polluter of two parameters C0 and C1 whereas quantity
regulation and the effluent tax require only one parameter, s or t,
respectively. Nevertheless, less information is needed to determine both C0
and C1 than is needed to determine s or t. Determining C0 and C1 requires
surveying only a group of victims of pollution, while determining either s or
t requires surveying groups of victims and polluters. For a more detailed
discussion see White and Wittman (1983a).
Of course this discussion has not considered other transaction costs. For
example, a system of regulation, once in place, requires relatively low court
costs in comparison to strict liability for pollution (since the optimal amount
of pollution is greater than zero). Although negligence liability has fewer
court cases than strict liability, it more nearly approximates a quantity
regulation in its effect.
5. Contracts, Specificatio, Contrat versus Tort, Delict, Responsibilite
Civile: The Role of Information Transmission
Common law, Roman law and civil law distinguish between two groups
(contracts, specificatio, contrat) and (tort, delict, responsibilite civile). These
groups roughly correspond to low and high transaction cost situations. In
contracts the parties are already transacting with each other; in many tort
situations the parties first meet after the damage. But does the nature of the
rules differ between these two groupings? A key difference may be the role
of information transmission.
Contract law is often concerned with promoting efficient information
exchange. Hadley v. Baxendale (1854) is the defining case. When the risk
of loss is known to only one party to the contract, then the other party is not
0900 General Structure of the Law 1081
liable for the loss if it occurs. This creates the right incentives for the
knowledgeable party to inform the other when it is cost effective for the
other party to undertake additional precaution.
There are many applications of the basic principle. In trade between two
parties involving a standard item, if the seller has superior information about
the product, it is often economically efficient to have the seller inform the
buyer. Even if it is not a standard product, such as selling a home, if the
information can be obtained cheaply by the seller (say by living in the
house), then it is economically efficient for the seller to transmit this
information to the buyer rather than having potential buyers undertake
repeated and costly inspections. Hence in many jurisdictions, home sellers
are required to state what items are in disrepair (however, they are not
required to state whether their neighbors house will be up for sale in few
weeks). Also, all easements on the property are required to be recorded and
on the deed.
On the other side, there are many situations where such information
transmission is not required. A geologist is not required by law to tell the
present owner of the land that the land is likely to have significant oil
deposits. To require such a disclosure would reduce the returns to
specialized knowledge regarding oil discovery and ultimately result in a
suboptimal amount of oil exploration. Thus in contracts, product liability,
and real estate much of the law is devoted to determining the optimal
amount of information transmission and then designing rules to promote
that outcome.
In contrast, the issue of optimal information transmission is likely to be
irrelevant for those tort cases involving harm between people who otherwise
would have little contact (that is, for high transaction cost cases). And in
such situations, the injurer is liable even for damages that are unforeseen.
For example, if a drunk driver smashes into a person with an eggshell skull
and as a consequence the victim suffers much greater damage than would
ordinarily be the case, the drunk driver is still liable for the additional
damage. It would not have helped if the victim carried around a big sign
stating that he was especially susceptible to head injuries, and in general
carrying around such a sign would not be cost effective. Furthermore, if
drunk drivers were liable for less than the actual harm to eggshell skulls,
then economic efficiency would require that drunk drivers be liable for more
than the actual harm to rock skulls.
However, the issue of information transmission is not entirely absent
from high transaction cost situations. Automobiles are required to have
brake lights, and in the United States mercaptane is added to natural gas (in
this way, people in the vicinity of a natural gas pipe line leak can be warned
of the danger by the smell).
1082 General Structure of the Law 0900
Contract and torts differ in another important way. Contracts are written
ex ante and, when possible, courts tend to rely on the written document
rather than engage in their own cost-benefit analysis. The parties to the
contact have a comparative advantage in determining the optimal contract.
As a consequence, courts tend to hold the breacher strictly liable for the
foreseeable damages rather than the courts determining on their own
whether the breacher was negligent (of course, one might argue that the
word breach is often synonymous with the word negligent). In contrast, the
implicit contract in torts is determined by the courts ex post. As a result, the
negligence rule is more likely to be invoked as the courts have to determine
the efficient outcome on their own. See Posner (1992, Chapter 6) for further
arguments along this line.
6. Crimes versus Torts: The Role of Limited Liability
The tort system deals with harms, so why do need a separate system for
crimes? For example, why is assault a crime in addition to being a tort?
Posner (1985, 1992, Chapter 7) has a well thought-out explanation for
needing criminal law in addition to civil law. Essentially, criminals are often
judgment proof (their wealth cannot cover their debts) and therefore the tort
system is inadequate.
Most crimes involve a coerced transfer in the context of low transaction
costs. The person who was shot in a robbery or gave up her wallet to avoid
being shot was not a volunteer to the transaction. In order to prevent the
conversion of a property right into a liability rule, a punitive damage should
be imposed on the perpetrator beyond the payment for the actual harm,
which itself may be very high (people do not like to be subjected to physical
violence). But unlike breach of contract and many other types of torts, it is
often hard to detect the perpetrator of a crime. If the criminal is not always
caught, the price to be paid has to be multiplied by 1 over the probability of
being punished. Also the criminal should pay for the cost of detection. This
raises the price of the crime for those who are actually caught still higher.
The resulting high price of a crime means that the criminal is often
judgment proof.
Because the person is judgment proof the victim of the crime or her heirs
will not have sufficient incentive to find the criminal and bring him to court
and the criminal will not be sufficiently deterred by the tort system. In turn,
this means that people may undertake self-protection (bodyguards, extra
locks, and so on) to avoid being robbed because they know they will not be
sufficiently compensated if they are robbed. So the criminal should be liable
not only for the robberies committed but also for the cost of prevention that
others undertook to prevent the robbery from occurring (but see Kermit and
0900 General Structure of the Law 1083
Lott, 1995, who argue to the contrary). This raises the optimal punishment
still further beyond the capacity of the tort system
So the robber needs a non-monetary punishment such as a prison
sentence to adequately deter and/or to physically restrain if deterrence is not
sufficient. Hence the state enters into the equation. Unlike ordinary torts
where the judgment itself involves no social cost but merely a transfer from
one party to another, incarceration involves significant costs. So optimal
punishment must take this into account.
It should be recognized that the judgment-proof explanation is not the
whole story. Criminals may be jailed for petty crimes even when they are
wealthy, wealthy anti-trust defendants may be both prosecuted for their
crimes and sued for their torts, and there are victimless crimes that are not
torts. Also the role of intention has not been fully analyzed. See Klevorick
(1985a, 1985b) and Fletcher (1985) for further arguments against the
economic model.
7. Prior Regulation versus Post Liability: The Role of Monitoring and
Detection Costs
The legal system sometimes regulates the inputs and at other times charges
for the output. For example, a person can be fined for drunk driving even in
the absence of an accident and/or be found liable for the damage when there
is an accident. To the economist, but perhaps not to the general public, the
question is why society does not rely solely on sanctioning the output. Fining
inputs involves monitoring and distortion costs. Since inputs only increase
the likelihood of an accident, there are many more occurrences of the former
than the latter. Hence, input monitoring is generally more expensive than
output monitoring. Also there are many inputs into the production of the
output. Imposing fines for only a few of the inputs will distort the choice set
towards those activities that cannot be monitored.
There are several answers to the puzzle. A person may not be sufficiently
deterred if they are judgment proof. The judgment-proof problem is much
less likely to occur if inputs are sanctioned. The cost of input monitoring can
be significantly reduced if there are only random checks. Also, it is
sometimes easier to observe inputs than outputs. There may not be other
witnesses to the scene of the accident besides those that were involved.
Under such circumstances, it may be hard to disentangle the truth. Thus it
may make more sense to monitor the inputs, such as drunk driving. See
Wittman (1977) and Shavell (1984b) for more detailed arguments.
Not all people are adequately deterred by the threat of punishment for the
outcome so they are prevented from further inputs. Drunk drivers sometimes
1084 General Structure of the Law 0900
lose their licenses and are put in jail if they continue to drive under the
influence. Private parties can obtain injunctions rather than suing ex post for
the resulting harm. Especially in criminal law, inputs are subject to sanction.
If X shot at Y and missed, the law does not wait until X has killed Y before
doing something about it. Of course, the punishment of attempts has to be
less than the punishment for completions; otherwise the person would have
more incentive to complete. See Posner (1992) for a more thorough
exposition.
Another line of argument considers the defensive action by other parties.
Others may undertake economically justified counter-measures to the
inappropriate input so that the likelihood of an accident is significantly
reduced. Such measures are costly and should be imposed on the party
acting inappropriately even if there is no accident. For example, others may
swerve out of the way or not even drive in the first place in order to avoid
drunk drivers. Such defensive activity by others is costly and should be paid
for by the drunk driver even though there was no accident. Hence there are
fines for drunk driving, speeding, and so on. For a more thorough argument
see Wittman (1981).
If both potential injurers and their victims are risk averse, then risk
sharing may be optimal. A potentially fruitful line of research is to
investigate how a division between input and output monitoring might
improve risk allocation. This would go beyond the standard principal-agent
models.
The choice of monitoring technology is applicable to goods as well as
bads. In comparison to their counterparts in stores, the income of traveling
salesmen are based more on sales than hours on the job. Paying household
help by the hour is easier than calculating the value of all of the individual
services which may vary from week to week. On the other side, hiring
someone to come in and just clean your rugs (or windows) is based on the
output.
Input and output monitoring need not be a choice between one or the
other. Sometimes it makes sense to do both. But there is always a question of
how much input monitoring is necessary - one might require pasteurization
but not specify the shape of the bottle in which the milk is sold.
8. Torts versus Restitution: The Role of Court Transaction Costs
Torts compensate for non-negotiated harms while restitution compensates
for non-negotiated benefits (Levmore, 1985).
In the absence of transaction costs, the distinction between harm and
benefit and tort and restitution is more apparent than real. This can be
illustrated by considering an example derived from Miller v. Schoene
(1958). Cedar trees are vectors for pests that create damage to apple trees but
0900 General Structure of the Law 1085
not to the host cedars. In the state of Virgina, apples are an important
agricultural crop while cedars are used mainly for ornamental purposes.
Should owners of cedar trees be liable for the harm to apple orchards and the
benefit to themselves if the cedar trees are not cut down or should apple
growers be liable for the harm to the cedar growers and the benefit to the
apple growers if they are? In the absence of transaction costs, this question
cannot be answered. Either way, one side is harmed while the other side is
benefited.
But in the real world there are transaction costs and such costs are
asymmetrical in the two regimes of restitution and tort. In this situation the
optimal outcome is clearly to have the cedar trees cut down. If cedar tree
owners are liable for the damage to apple growers, they will cut down their
trees and, except for mistakes, there will be no court cases. If apple growers
(or the state) are liable for the benefit derived from cutting down cedar trees,
then all of the cedar tree owners will go to court to collect for the benefit of
cutting down their trees. This involves high transaction costs. Although
courts can easily estimate that the total cost to all of the cedar tree owners is
less than the benefit to all of the apple tree growers, determining the cost to
each cedar tree owner is much higher. Furthermore, such a system would
require apple growers to compensate all people who would have otherwise
planted cedar trees but did not since the apple growers benefit from such a
decision. This would make court costs astronomical.
Restitution for benefits has higher court transaction costs than torts for
harm (hence the relative unimportance of the law of restitution in
comparison to tort law). So when does it make sense to have restitution? We
want restitution when the long-run entry of the desirable activity would be
seriously eroded if compensation for the benefit did not exist - that is, we
want compensation when the transaction costs of compensation are
outweighed by the increased existence of the desired activity. Consider
bounty hunters who track down people who fled on bail before their case
went to trial. If bounty hunters were liable for not catching the criminal, no
one would enter the business. So they are rewarded instead. Within the law
of restitution proper, doctors can collect for services to an unconscious
person found lying on the road even though the payment involves a
transaction cost. The doctor bill is generally standard (there is no need for
an expensive evidentiary hearing) and without such a payment doctors might
just drive by. See Landes and Posner (1978) and Wittman (1984).
9. Contracts versus Constitutions: The Role of Monopoly
In contracts, when the question of monopoly arises, the standard remedy is
to choose the competitive equilibrium price or behavior. For example, if a
1086 General Structure of the Law 0900
doctor comes upon an injured person in the middle of a desert, the doctor
cannot take advantage of her monopoly position by demanding the persons
life savings in return for rescue. She is only allowed to charge her customary
rate, that is the competitive price, for such services. Much the same holds for
breach of contract. Opportunism arises when one of the parties to a contract
exploits the monopoly power temporarily gained through the contractual
relationship. Again, the remedy is relatively simple - such opportunistic
behavior is punished by the courts so that the parties have incentive not to
breach in the first place.
In contrast, there is no easy solution to the problem posed by the
monopoly of political power - no third party can enforce the contract
between the government and the people. Thus creating an effective
government while at the same time avoiding the dangers of monopoly power
is the fundamental concern of democratic constitutional theory. The
Federalist Papers were devoted to finding the proper balance between a
well-functioning government and protection from tyranny.
Democracies need to prevent the majority from exploiting the minority
via the majoritys control of government and at the same time this protection
should not allow the minority to exploit the majority. The conflict is always
there. If all issues were resolved by simple majority rule, then the majority
could exploit the minority, especially if there were a clear majority/minority
cleavage in society (say along ethnic lines). Any tampering with simple
majority rule (including such seemingly innocuous changes as having a
majority rule legislature voted in by majority rule) will result in a bias for
the status quo. See May (1952) who demonstrates that only a simple
majority rule satisfies the conditions of anonymity (all people are treated
alike), neutrality (if people reverse their preferences, the choice is reversed),
and positive responsiveness. Consequently, any attempt to protect the
minority will enable the minority to extort monopoly rents from the
majority.
The problem is acute when unanimity is the decision rule. Although
unanimity as an intellectual concept is at the foundation of constitutional
theory, in practice it would be unworkable. Everyone would try to extract the
gains from an agreement for herself. This monopoly holdout problem would
make collective decision making impossible. In practice, something less
than majority rule is required so that transaction costs are not too high (see
Buchanan and Tullock, 1962).
Beyond the majority/minority issue is the agency problem. The
government usually has a near monopoly on the means of coercive power.
What is to prevent the military from over-throwing an election? Of course,
this problem exists for all governments, not just those that are democratic
(see Skepardas, 1997). This problem is thus more serious than the agency
problem facing corporations - stockholders can throw out their managers
0900 General Structure of the Law 1087
and board of directors. Many ingenious solutions have been suggested. In
the US the president is the commander and chief of the armed forces; each
state can have their own militia, and the people have the right to bear arms.
All of these are methods of breaking the monopoly of military power and
creating a more competitive system. But clearly, there are costs. State
militias are not a good way of organizing for modern warfare. And it is not
clear that these safeguards are really necessary (many democratic
governments do not guarantee the right to bear arms).
The constitution creates a competitive power arrangement. A federal
system limits the power of the central government; and the competition
between the states, amongst which the citizens can freely migrate, mitigates
against the abuses of monopoly power by the states. The separation of
powers between the legislative, executive and judicial branches is ultimately
more important for being a separation of power than of powers. In this way,
there is competition among the branches, each representing a different set of
actors. In order for policy to be implemented, an agreement between these
different centers of power is needed.
A second method of reducing the coercive power of a government, at
least for those governments that obeys the constitution, is to place limits on
the power of the government. Once again looking at the United States
Constitution, we can observe various limits. Religious freedom is
guaranteed. The takings clause prohibits taking of property without just
compensation and juries are of one's peers. See Brennan and Buchanan
(1980) for discussion of the appropriate limits on the state.
A constitution is an optimal social contract; it provides the underlying
rules for making laws. Like any contract, there is a need to protect the
parties from opportunism. Unlike the economic sphere, where a third party
can enforce contracts and reduce opportunism, constitutions need built-in
mechanisms that enforce but at the same time limit the ability of the
government to coerce. In this section we have argued that this is the critical
difference between contract law and constitutional law. As is always the
case, there are other views. For example, Posner (1992, Chapters 23-28) and
Wittman (1995, Chapter 10) argue that the United States constitution is
efficiency enhancing while Beard (1948) argues that much of the
constitution is merely a protection of the wealthy.
10. Courts versus Legislatures: The Role of Comparative Advantage
While there is considerable overlap between what courts and legislatures do
(legislatures regulate some activity that could be decided in court, and courts
in the United States decide whether certain legislative rulings are
1088 General Structure of the Law 0900
constitutional), there are critical differences. Legislatures are designed to
resolve conflict among many disparate positions. Courts are designed to
resolve disputes between two sides. Also courts are set up more for an ex
post review of the facts. So it makes sense that each concentrates in its area
of comparative advantage.
In the United States, and in many other countries as well, nuisances are
mainly controlled by zoning and urban regulation rather than by the
common law of torts. An important reason is that urban planning is
multifaceted rather than two-sided.
Courts are more adept at deciding efficiency issues than questions of
equity. Legislatures are designed to deal with issues of distribution - the
political process of electing representatives and of resolving differences
within the legislature is basically a means to resolve differences in values.
Thus legislatures decide tax and expenditure policy while courts are more
likely to determine the efficient incentives for optimal accident reduction
and the facts relevant to a particular accident.
There are interesting exceptions. In the United States, impeachment of
the president is undertaken by the legislature rather than the courts.
11. Concluding Remarks
Finally, we should not forget a major reason for the subheadings in law is
that there are returns to specialization. Both family law and bankruptcy law
may use the same economic analysis, but the factual details still differ.
Focusing in one area helps the practitioner if not always the theorist.
This contribution has shown how economic theory can provide insight
into the general structure of the law. There is considerable room for more
research in this area. The answers provided are not complete and there are
many more questions to be asked. Examples of the latter include: how and
why state laws differ from federal laws, and how and why civil and criminal
procedure differ.
Acknowledgments
I would like to thank Steven Shavell and the referee for helpful comments.
0900 General Structure of the Law 1089
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