AN OVERVIEW OF THE ECONOMIC ANALYSIS OF LAW

We know how the Utilitarians believe in the ‘felicific calculus’ of securing justice through
securing the ‘greatest happiness of the greatest number.’ We thus know Bentham’s idea of
classifying all actions into those producing pleasure and those producing pain. However, the
pleasure-or-pain analysis is a difficult analysis to make because it is difficult to make sure of
what actually brings people happiness and pain. Hence, it becomes a theory difficult to
practically apply and ascertain while actually making legislative policies. But money is easier
to measure than utility.

The economic analysis of law helps to remedy this problem. Instead of judging every action
by pleasure or pain, what the economic analysis of law does is make the assumption that every
human is a “rational maximizer of his satisfactions.” Thus, the economic analysis of law
assumes “what I want is what I am willing to pay” for either in terms of money or by the use
of other resources including the resources of time and human effort.

Richard Posner, one of the stalwarts of this theory, further explains that human action is aimed
at maximizing wealth. However, wealth, according to the scholars in the area of law and
economics is not merely money but also social resources like time and effort. The economic
analysts thus reduce the world into a world of ‘loss and gain’ producing actions, making the
approach more scientific and universally acceptable than Utilitarianism.

Though the work of Richard Posner is seen as the greatest contribution to this theory, there
have been othersbefore him like Ronald Coase and Guido Calabresi. Before moving on to
Posner it is necessary that we discuss them first.

A BRIEF OVERVIEW ON COASE AND TRANSACTION COSTS

Imagine a factory in the middle of a city emitting smoke. The emissions are damaging laundry
from five houses in the vicinity of the factory. The question in this case is whether we give
preference to the citizens’ rights to clean air, or the right of the factory to pollute the air. You
may say preference should be given to rights of the citizens. It is the factory that is causing the
damage, and therefore support should be extended towards citizens. However, economic
analysts of law, they’ll go ahead and contradict you. They’ll say, though it’s true that the factory
is causing the damage, the damage wouldn’t be there if the houses weren’t located so close to
the factory. Thus, for people like Coase, in terms of causation, both parties cause the damage.
Then the question arises, if not causation then how we determine the end of justice? The answer
Coase provides is EFFICEINCY.

Let us consider the previous example. To solve the pollution problem, imagine that each of the
five citizens suffer Rs. 750 in terms of the damage done to their laundry. So, the total damage
suffered by the citizen’s is of Rs. 3750. Now, the problem can be alleviated in two ways.

A) You can have the citizens buy the factory a smokescreen worth Rs. 1500.
B) You can have the factory buying each person affected a tumble dryer to dry their
clothes, so that they don’t have to dry it in their balconies. Each tumble dryer costs Rs.
500. So the total cost of buying the five tumble dryers would be 2500.
In case of a law suit who then buys the smokescreen or the tumble-dryers for the other party?
We would believe again that whatever we choose, it is the factory that should pay, based on
our idea of ‘polluter pays’. For an economic analyst of law, the job is more difficult. He would
look at the transaction costs involved in the process, because for him a bargain is more efficient
when, the transaction costs are lower in a transaction. You may ask what are transaction costs?
Transaction costs basically include the costs of identifying the parties with whom one has to
bargain, the costs of getting together with them, the costs of the bargaining itself as well as all
costs for enforcing the results of such a bargain. In situations of zero-transaction costs (which
is extremely rare to come across in real life), the solution is deemed to be effective and efficient.
If both solutions have zero transaction costs, in context of the above example, then the judge
no longer has to decide the cases on the basis of efficiency because it already gets decided, and
then gets to apply his notions of justice.

In most real-life examples, including the example that we are working with, there are positive
transaction costs. In such a case the legal rule should be aimed at ‘minimizing the effects of
transaction costs.’1 In a hypothetical example let us assume, that each citizen incurs transaction
costs (in terms of transportation costs, time, effort etc.) of Rs. 600 each if they have to buy a
smokescreen for the factory, leading to the total transaction costs being Rs. 3000. So the total
costs for installing the smokescreen at the factory becomes the price of the smokescreen (Rs.

1
A.M. Polinsky, An Introduction to law and economics, 13 (2013).
1500) plus the transaction costs of the citizens (Rs. 3000) equaling a total of 4500. On the other
hand, the factory being a larger institution, in the given example, incurs lesser transaction costs
of around Rs. 1000. So the total cost of buying the tumble dryers become- the price of the
tumble dryers (Rs 2500) and the transaction costs (Rs 1000) coming to a total of Rs. 3500.
According to Coase’s economic analysis of law, it thus becomes easy to choose to buy tumble
dryers for each house rather than install a smokescreen at the factory.

Now let us consider the M.C. Mehta Oleum Gas Leak case. The cost of letting the factory run
would have far overweighed the costs of shutting the factory down. In the sense, if the factory
would operate then the compensations that would be need to paid in terms of the health
impediments and life risk that would be suffered, not by a handful of people as seen in the
above example but thousands of citizens’ of Delhi would have outweighed the cost of shutting
the factory. And that would be the sole factor for an economic analyst of law to shut the factory
down according to Coase.

Guido Calebresi and Efficiency

Calabresi’s idea of efficiency is not as ‘narrow’ in terms of lesser costs when compared to
Coase. In his analysis, he looks at the nature of rights and the issue of distribution of rights as
well. Calabresi believes that a just society has to make ‘first order legal decisions’ about which
rights will prevail over other rights. For example, in terms of the factory producing smoke and
spoiling the citizen’s laundry, we have to essentially choose between the citizens’ right to clean
air, and the factories right to pollute. He warns that unless there are first order legal decisions
to allocate the entitlements, the wealth and power of industrialists will result in giving them a
general right of pollution.

How do we choose between such conflicting rights? Calabresi says there are three types of
reasons we can use to choose one right over the other; a) Economic efficiency, b) distributional
preferences, and c) other considerations of justice.

How do we determine efficiency? Calabresi believes the best way to do so is by applying the
Pareto standards. Economic efficiency would be gained, thus if we choose the set of rights,
which would lead to an allocation of resources that cannot be changed to make one party gain
any more from that said arrangement without making the other party worse off.

The Pareto optimality according to Calabresi is a given distribution of wealth, with different
distributions suggesting their own optimality like for example, a person’s right to silence may
be secured because he is willing to pay more for it than his neighbor is willing to pay for his
right to make noise. Unlike Coase and Posner who base their theories on the efficient outcome
of a dispute between two parties, Calabresi tries to look at efficiency in terms of the decisions
the society is to make.

The society, represented by its legislature, at first chooses the initial entitlements on whatever
basis it wants. Some of these entitlements are then renegotiated by the individuals through
property rules. Some of them may be bought and sold at prices determined by the state (they
are governed by liability rules), whilst other being inalienable rights cannot be sold or bought
or exchanged in any conditions (inalienable human rights remain non-negotiable). Thus,
entitlement allocation, according to Calabresi, involves a lot of State intervention especially in
terms of liability rules.

Now one question may arise: why can’t a society simply decide who should receive any given
entitlement and then the same can be achieved through a voluntary negotiation? Why do we
need liability rules at all? In case of a transfer through voluntary negotiation, the chances of
transfer not occurring is high, but it may occur if there is a collective determination of the value.

Calabresi gives an example:A number of 1000 people own a land of 1000 acres in thousand
parcels. As a factory it would benefit a city of 1,00,000 people with jobs. For the factory, each
citizen is ready to pay Rs 100. This can only be feasible in a pareto optimality if we assume,
each person values their entitlements to their lands at less than Rs. 100,00,000 (number of
people multiplied by how much each one is ready to pay) at an average of 10,000 a tract. In
this hypothesis, let us assume each person values their land at 8,000 a tract. Then the pareto
optimality is met, and the transfer can be easily met. Problem arises in applying this in reality.
Each person may not own the same type of land. One person’s land may be more fertile than
another’s in the same area. There might be several reasons (political interferences etc.) due to
which the original landowners are afraid to disclose the true valuations of the land. This would
disturb the pareto optimality, and the efficiency of the transaction would become very difficult
to determine. In such cases, it is efficient for the state to impose market valuation.

In case of an entitlement protected by property rules, it can be sold voluntarily, and its value is
determined by that transaction. But in case of an entitlement protected by liability rules, the
value is harder to determine and sometimes the compensation may be over compensation or
under compensation. In a collective determination by the state, the conditions of the Coarse
theorem are also relaxed as the bargaining have not taken place. The modification of this
economic approach does involve aspects of justice in the context of distribution of entitlements
and the designation of which entitlements will be protected by property rules, liability rules
and inalienability rules but the goal continues to be economic efficiency. The issues of justice
and distribution are clearly subordinate to efficiency.

Moreover, both approaches, Coase’s and Calabresi’s, assume that the value of Re. 1 is same to
everyone, which is clearly a false assumption. Richard Posner has addressed this issue.
Richard Posner’s Economic Analysis of Law

Richard Posner makes a descriptive claim and a prescriptive claim about the economics of
justice. The descriptive claim is that the common law is best explained through situations where
judges try to maximise economic welfare. The prescriptive claim is all about wealth
maximisation.

While trying to show that the important job of a judge lies not only in applying the common
law rules in interpreting a legislation but to engage in such an interpretation which promotes
economic efficiency. Posner says judges do arrive at decisions in economic terms, may be
subconsciously and most often the economic considerations in the judicial decision are
concealed. For example- in United States v Carroll Towing Company2, it was held that the
defendant is guilty of negligence if the loss caused by the accident multiplied by the probability
of the accident exceeds the burden of precaution which the defendant might have to take. This
decision recognises the economic efficiency.

Posner also said that the common law facilitates wealth maximising transactions through
property laws and it also protects property through law of torts and criminal law. Common law
also protects the process of exchange through contracts law. Common law prescribes
procedural laws for efficiently resolving disputes. Posner does not make a general claim that
efficiency plays a central role in common law but has provided a non-exhaustive list showing
how the rules are in terms of efficiency in order to conform to the dictates of wealth
maximisation. This list includes contributory negligence, employment at will, assumption of
risk, wrongful interference with contract rights etc.

2
United States v Carroll Towing Company,159 F 2d 169 (1947).
It is relatively easy to apply economic analysis of law in fields like contract law, property law,
and tort law as they conform to capitalist economy than other fields of law like family law,
constitutional law etc.

Posner argues, that Judges decide laws in terms of prosperity because of several reasons:-

a) Prosperity is a relatively uncontroversial policy for the judges to aim at, given the fact
that they operate within generally conservative parameters.
b) The Laissez-faire principles of the early 19th century had the greatest impact on
formation of most doctrines in common law, which through the precedential system
survive to this day.
c) Judges are also driven towards economic efficiency because inefficient decisions have
much greater social costs than efficient ones. 3
Posner believes, that it is possible to reduce hundreds and thousands of cases ‘to a handful of
mathematical formula’. A few principles like cost-benefit analysis, the prevention of free-
riding and unjust enrichment, risk aversion etc. can explain most of the judicial doctrines and
decisions, writes Posner.4

The role of the economic analyst of law is thus two-fold. First, such an analyst has to reduce
law to the economic formulae, and second, they are to criticize judges for failing to maximise
wealth fully.
How do judges make decisions on the basis of ‘efficiency’ in several realms of law.

CONTRACT LAW

The basic tenants of law of contract according to Posner can be explained in terms of efficiency.
For example, consideration promotes the need for economic exchange. According to Posner,
the contract making is divided into two phases: agreement (executor stage) and performance
(executed stage). In the period between these two stages one party is left at the mercy of the
other. The focus of contract law is to protect one party from the other during this period.

Posner gives an example of a lost cat. If someone offers Rs 1000 as reward for the lost cat,
someone who finds the cat has a legally enforceable claim even when there is no negotiation
with potential finders and there is no acceptance of the offer. But this contract should be

3
Ibid at 360.
4
Richard Posner, The Problems of Jurisprudence, 354-55(1990).
enforced as it promotes a value maximizing transaction. How is this a value-maximising
transaction? It is because the cat may be worth Rs 15,000 to the owner but it may be worth less
than Rs 100 to the finder so the exchange of money increases the social welfare and such an
exchange would not occur if the finder did not have a legally enforceable claim. This is
highlighted in a real life case of Carlill v. Carbolic Smoke Ball Co.5

Though the economic analysts have been very prompt at reformulating contract law in terms
of efficiency, however their fundamental assumptions about contract law are too general and
sweeping.

CRIMINAL LAW

Posner has also developed economic explanations for those areas of the law which are
seemingly beyond the bounds of economic efficiency. Posner talks about the economic aspects
of criminal and constitutional law in his books.

A person may commit a criminal offence if he expects his utility to exceed the level of utility
if he had pursued lawful alternatives. He may choose to be a criminal because his options and
the valuation of their benefits may be higher. Thus, criminal law seeks to influence the
behaviour of criminals to impose costs on criminal activities providing the individual with the
incentive to not commit criminal offences. Thus state intervention in the form of criminal laws
is required to coerce rational maximizers away from operating outside the market, and to make
the individuals to be rational maximisers within the paternalism of the state.

Criminal law signifies the most difficult problem for the economic analysts, because the right
of taking action is taken away from the individual suffering to be put in the hands of the state.
How is then the approach efficient? Why would the victim, a rational maximiser and taxpayer
exchange the value of his suffering not for compensation but for jailing of the perpetrator of
harm in a jail maintained by the taxpayers’ money?

For example, suppose the fine for stealing is returning the stolen item, plus an exorbitant
amount of Rs. 10,00,000. The people unable to pay this would be jailed. This may deter people
who have an earning of less 10-20 lakh per annum from stealing. But for someone makes Rs
1,20,00,000 in a year, the said person may commit the crime in the hope of getting away with
it, for then he knows, on getting caught he would only have to pay a month’s salary as fine

5
Carlill v. Carbolic Smoke Ball Co,1 QB 256 (1856).
and return the item he has stolen without any stigma attached to the punishment, but would
take the risk as on stealing he might gain the value of the stolen good and not get caught at all.
It is not merely the punishment that deters a criminal but the stigma attached to it. Taking that
stigma away would also take the deterrence value away from penalties.

It is difficult to be swayed by the argument that fines are deterrent enough. Criminal law
through punishments would stop the poor from maximizing gains beyond the market
framework. But a rich who has the capacity to pay might value his undue maximization more
than how he views money and commit crimes with the full understanding that he can pay a fine
and get away with such payment only. Therefore, this approach to criminal law is not very
convincing.

OTHER CRITICISMS OF ECONOMIC ANALYSTS

The economic analysts make very general assumptions about the nature of laws. Nobody can
deny that economics plays a major role in the law, but in explaining the total domination of the
economic consideration only, the economic analysts ignore a plethora of other factors. There
are problems of equating justice with wealth maximisation. For example, if wealth is
concentrated with few people who buy BMW or Audi, then if the allocative efficiency to be
consistent with the poor population, then the economy’s productive activity should be
channelled into the manufacture of these luxury items. But on the other hand, with a more
equitable distribution of wealth, productive efforts would go into manufacture of the basic
needs. If there is no rearrangement of society’s productive activity or allocation of goods and
services, there will be no improvement in the economic welfare of the society where
distribution of wealth is market-transaction based.

Another biggest critic of Posner’s theory was Ronald Dworkin. In his ‘A Matter of Principle’,
he gives anillustration.

“Derek has a book Amartya wants. Derek would sell the book to Amartya for $2
and Amartya would pay $3 for it. T (the tyrant in charge) takes the book from Derek
and gives it to Amartya with less waste of money or its equivalent than would be
consumed in transaction costs if the two were to haggle over the distribution of the
$1 surplus value. The forced transfer from Derek to Amartya produces a gain in
social wealth, even though Derek has lost something he values with no
compensation. Let us call the situation before the forced transfer takes place
 ‘Society 1’ and the situation after it takes place ‘Society 2’. Is Society 2 in any
respect superior to Society 1? I do not mean whether the gain in wealth is
overridden by the cost of justice, or in equal treatment, or in anything else, but
whether the gain in wealth is, considered in itself, any gain at all. I should say, and
I think most people would agree, that Society 2 is not better in any respect”6

Posner replied to this criticism by changing the value in Dworkin’s example. Posner suggested
that if the value of the book is $3000 to Amartya and $2 to Derek, then the transfer will increase
the happiness in the society. This is little off-spin to Posner’s argument that wealth
maximisation is a better value than utility maximisation. Posner gives an example in his book
‘The Economics of Justice’ to show that there is no plausible reason for taking the transfer
away from market place and to put it in the hands of a tyrant.

“Derek owns a home, Amartya owns an airline. An airport is built near Derek’s
home, and Amartya’s airline produces noise that reduces the value of the home by
$2,000. Derek sues the airline, alleging nuisance. The evidence developed at trial
shows that it would cost the airline $3,000 to eliminate the noise and thereby restore
Derek’s home to its previous value; on these facts the court holds that there is no
nuisance. This example is analytically the same as Dworkin’s, but it illustrates more
realistically than his how a system of wealth maximisation would operate in a
common law setting, and it makes less plausible his argument that wealth is not a
‘component of social value’.7

In Dworkin’s book example, some people may agree with the transfer as the end result is that
of the book is with the person who is willing to pay the most, thereby increasing the overall
utility as well as wealth. But Dworkin counters this argument with a twist in his example 8-
what if Derek is willing to sell the book only because he is poor and sick and needs money to
buy the medicine and Amartya is rich and can afford the book and is willing to spend $3 on an
off-chance that he might someday read the book? Dworkin explains that once social wealth is
divorced from utility, it loses the plausibility as a component of value. Overall, the economic
analysts of law are criticised for viewing law in terms of free market and wealth maximisation.

6
Ronald Dworkin, A Matter of Principle, 242(1985).
7
Richard Posner, The Economics of Justice, 168 (1985).
8
Ronald Dworkin, A Matter of Principle, 245 (1985).