Economic Analysis of Law
This article will provide an overview of the economic analysis of law. The article will explain the basic concepts that are foundational to an economic analysis of legal theories, including efficiencies, positive law, normative law and the Coase Theorem. In addition, this article also explains how economic analyses have been integrated into the basic areas of the common law, including torts, contracts and property law. Economic analysis of law is also critically important in government regulations that have been created and enforced to regulate financial markets. This article explains how government regulations affect antitrust enforcement, intellectual property protections and oversight of the various financial markets. Finally, examples are provided that illustrate how an economic analysis of the law continues to shape our modern legal framework. These examples include discussions of distributive justice, taxation and law enforcement within the criminal justice system.
Keywords Allocation of Resources; Common Law; Efficiency; Opportunity Costs; Positive Law; Retribution; Transaction Costs; Wealth Maximization
Economic analysis of law is a method of incorporating ideas taken from the discipline of economics and melding them into considerations of legal theories and principles. Economic analysis of law generally involves both the study of human behavior in response to legal rules and the economic implications of that behavior and an evaluation of the economic and social effects of legal principles across the spectrum of socioeconomic and sociological classifications. While economic analysis of the law has become an increasingly influential field, it is not a modern school of thought. In the 18th century, economist and philosopher Adam Smith wrote about the economic effect of legislation on merchants and commerce. However, the study of economics in relation to laws that regulate non-market activities, such as due process or law enforcement, is a relatively new phenomenon.
The inception of the modern school of law and economics is often considered to be the publication of two articles in the early 1960s by economists Ronald Coase and Guido Calabresi that revolutionized legal theory and laid the groundwork for many of the ideas that were developed in the following years. Coase and Calabresi, working independently from one another, published "The Problem of Social Cost" and "Some Thoughts on Risk Distribution and the Law of Torts," respectively. The movement gained even more traction with the publication of Richard A. Posner's "Economic Analysis of Law," which he wrote while a professor at the University of Chicago. Posner's work, which was followed by other academics and legal theorists associated with the University of Chicago, led to an era of economic principles being applied to all aspects of the law, which became dubbed the "Chicago School" of thought. This period of legal theory in particular examines the impact on the law when courts adopt economic efficiency as their guiding standard. More recently, the study of law and economics has essentially been divided into two classes-one that seeks to oppose the efficiency view of the Chicago School by maintaining that there is an ideological bias inherent in the application of economics to law, and the other that seeks to incorporate law and economics into a broader spectrum of interdisciplinary theories about law.
Economic analysis of law is usually divided into two subfields; positive and normative. Positive law and economics uses economic analysis to predict the effects of various legal rules. The positive school restricts itself to the study of the incentives produced by the legal system, largely because its adherents believe that efficient legal rules evolve naturally. On the other hand, the normative school, historically associated with the early contributions of the Yale school, sees the law as a tool for remedying "failures" that arise in the market. Thus, a positive economic analysis of liability as it relates to tort law would predict the effects of a strict liability rule as opposed to the effects of a negligence rule. Normative law and economics would make policy recommendations based on the economic consequences of various liability theories.
As these schools of thought have developed, the theories stemming from the economic analysis of law have become increasingly influential. Today, courts, legal professors and even attorneys frequently apply economic principles to a range of potential legal outcomes to aid in the process of arriving at a more equitable outcome in a legal dispute or a greater understanding of the social costs of legal precedents. The following sections will provide a more detailed discussion of the basic concepts of the economic analysis of law.
Basic Concepts on the Economic Analysis of Law
The application of economics to law can help explain the consequences of laws and legal outcomes in terms of their social and economic impact. The economic analysis of law therefore uses economic methods and principles to evaluate how well laws and legal outcomes advance legal and moral objectives and the degree to which they also serve such social objectives as efficiency or fairness. Efficiency, as a social objective, is based upon the concept of allocative efficiency, or the allocation or distribution of resources according to their most valuable uses to the members of a society. In addition, economic analysis of law is usually divided into two subfields, positive and normative. Positive law and economics uses economic analysis to predict the effects of various legal rules, while the normative approach suggests ways to reform legal doctrines and institutions in light of a society's core beliefs. The following sections will further explain these concepts.
Efficiency in business or economic terms is often associated with the concept of accomplishing an outcome at the lowest possible cost. However, there are other concepts of efficiency that are also important in an economic analysis of the law. For instance, allocative efficiency is the study of whether an industry is producing the appropriate amount of a particular good or service. For instance, it is economically sensible for a company to produce an item as long as the value attributed to it by buyers exceeds the social cost of its production. This is because the demand for the item will likely ensure that the supply of items produced will be consumed, and thus the resources allocated to the production of the good will have been used efficiently. Companies will likely continue to produce the good as long as it is allocatively efficient, or economically advantageous, to do so, which is generally until the demand and supply for a good intersect. Any continued production of the good after that may meet with diminishing demand, and thus continued allocation of resources for the production of that good is no longer efficient.
Another concept of efficiency is Pareto optimality and Pareto superiority. Vilfredo Pareto, an Italian economist, studied the distributions of wealth in different countries. Pareto noted that, consistently, only a minority, or about 20% of the population, controlled the remaining majority, or approximately 80%, of a society's wealth and resources. This same distribution has been observed in other areas and has been termed the Pareto effect. For instance, the Pareto effect has been noted in the context of quality improvement, in that 80% of problems usually stem from 20% of the causes. This concept led to the development of two further theories of efficiency, which are that an allocation is Pareto superior if achieving it means at least one person is better off and no one is made worse off, and an allocation is Pareto optimal if any movement from that allocation would make at least one person worse off.
Finally, a more recent version of efficiency is the Kaldor-Hicks, or wealth maximization, theory. In the context of legal analysis, the Kaldor-Hicks efficiency theory holds that in order for a law to be efficient, those individuals made better off by the law would have to be made sufficiently better off that they could compensate those who are made worse off. In other words, the Kaldor-Hicks criterion requires not that no one be made worse off by a change in allocation of resources, but only that the increase in value be sufficiently large that the losers can be fully compensated.
The positive approach to the economic analysis of law seeks to understand how the behavior of people is affected by incentives created by the law. This approach uses the analogy of the law as a type of pricing machine. The law "prices" various forms of human behavior through the use of fines, penalties and other measures. These alter the balance of costs and benefits individuals face in deciding whether or not to engage in certain behavior.
For example, this approach might predict that implementing mandatory automobile safety legislation, such as requiring the use of seatbelts, penetration resistant windshields and other safety equipment, would be unlikely to reduce the number of driver deaths. An economic analysis of such legislation might argue that such equipment-by reducing the probability of death following an accident and thus reducing the implicit "price" of speeding-would increase the incidence of speeding, or the amount of speeding drivers are willing to implicitly "purchase," and thus increase the number of accidents. In actuality, one study of accident statistics showed that the increase in the number of accidents just balanced out the decrease in driver deaths, resulting no net decrease in driver deaths but a net increase in the number of pedestrian deaths from car accidents.
The normative approach to the economic analysis of law proposes an efficiency criterion for shaping the legal system based on wealth maximization. Wealth maximization is based upon the maximization of the sum of the "willingness to pay" exuded by a society's members. In an economic context, willingness to pay is a measurement of the value in dollars that people are willing to pay for something or the dollar amount that they demand to give it up. In the legal context, this approach asks how much each individual would be willing to pay to either get rid of or keep certain laws or rules.
For example, economists could determine how much a safe workplace means to people by examining employees who work in unsafe environments and figuring out how much higher their wages must be to compensate for the unsafe workplace. This concept is also used by insurance companies that seek to determine the point at which a rise in premiums would result in behavioral changes of the insured.
The Coase Theorem
A final concept that has been extremely influential in the economic analysis of law is the Coase Theorem, attributed to Ronald Coase, whose work earned him the Nobel Prize in Economics in 1991. The Coase Theorem holds that in the absence of transaction costs, or costs associated with buying and selling investments, resources will ultimately be allocated to their most valuable uses, regardless of how the resources are initially allocated, because interested parties will bargain privately to correct any inefficiency in the allocation. However, many critics have argued that the Coase Theorem can only exist on paper because transaction costs are almost always present and are frequently set too high to facilitate the most efficient bargaining.
The common law is the body of law that has developed in the United States, based on principles and precedents developed in England and Great Britain, that includes customs, general principles and precedents set by court decisions that are applied to situations not covered by statute. The common law forms the basis for many significant areas of law, such as torts, contracts, evidence, criminal law and even wills and trusts. Economic analysis has been applied to all areas within the body of law. The following sections explain the intersection of economic analysis of law and the basic subjects of common law, including torts, contracts and property.
A tort is a civil wrong that subjects the wrongdoer to a suit for damages by the victim. Torts may be intentional or unintentional, and the economic implications of each is different. In unintentional torts, the injury occurs from an accidental harm that one person causes to another. An economic approach to unintentional torts seeks to minimize the costs of accidents by allocating the costs of accidents resulting in injury to the persons or parties who are in the best position to avoid or minimize the losses. This is because, in theory, that person or party is able to make a decision about whether the benefits of the activity outweigh the costs to which the activity gives rise, including the risk of injury.
The most significant scholarly work to examine this theory is Guido Calabresi's "The Costs of Accidents." In his work, Calabresi identifies three types of costs that result from accidents. Primary costs are those associated with the harm to the injured party, such as the cost of medical care and lost earning capacity. Secondary costs are the societal costs resulting from accidents. The third type of costs is associated with administering the tort system. Calabresi noted that eliminating or minimizing one cost may not be consistent with minimizing another cost. For example, a system that always assigns the primary costs of accidents to the party that causes the accident may be very expensive to administer, and this raises the question of whether that is the most efficient allocation of costs associated with accidents.
Further, while the categorizing the types of costs is a useful way to enumerate the harms and costs associated with accidents, an economic analysis of tort law would not necessarily seek the minimization of these costs. For instance, at some point the cost of avoiding accidents inevitably becomes greater than the harm that would be caused by those accidents, and thus a more appropriate economic analysis would be to both search for a way to minimize the sum of the costs of accidents and the costs of prevention efforts to avoid accidents.
In intentional torts, the economic analysis shifts from accident avoidance and prevention to compensation of the victim and retribution or punishment for the wrongdoer. Tort law has adopted a number of economic theories to develop the principles of negligence, liability and damages. For instance, in the landmark case United States v. Carroll Towing Co., 159 F.2d 169 (2d Cir. 1947), Judge Learned Hand saw the issue of liability as being the function of three variables: The probability of the harm (P), the amount of harm should an accident occur (L) and the cost of prevention (B). Judge Hand noted that P multiplied by L is the "expected harm." Thus, under the Hand formula, when PL exceeds B, or when the expected harm is greater than the cost of prevention, a party is regarded as negligent. Conversely, if the expected harm is less than the cost of prevention, the party is not negligent.
If a party is not negligent, the party may still be required to bear the costs of the injured based upon a finding of strict liability. Strict liability means that a party is liable for damage caused by her activity even if there is no showing of negligence. This theory is justified in terms of economic efficiency in that, presumably, those parties who are more likely to be in control of the activity and could have taken measures to prevent the injury will be the ones held strictly liable. Furthermore, streamlining the fault finding process can reduce the administrative costs of the legal process, and this cost savings can also be allocated toward compensating the victim.
If a party is found negligent or strictly liable, the victim is entitled to collect damages from the wrongdoer. Compensatory damages compensate the victim for actual damages suffered by the injury, while punitive damages are awarded to the victim to punish the wrongdoer and to attempt to deter the defendant and other persons from pursuing a course of action such as that which damaged the plaintiff. Generally, negligence victims are only entitled to compensatory damages, while victims of an intentional tort may sometimes obtain punitive damages as well as compensatory damages.
The economic function of modern contract law is to facilitate the voluntary transaction of property rights so that goods and services move into the hands of those who value them the most. While the actual exchange of goods or services for money may also be regulated by other areas of the law, contract law governs the process of the exchange, once the terms of the exchange are agreed upon. Because contracts are frequently...
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