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Law and Economics - Main Entry

by Richard A. Posner

Economic analysis of law, or as it is sometimes called “law and economics,” is at present the largest and most influential interdisciplinary field of legal studies, at least in the United States, though its influence is growing elsewhere, particularly in Europe, Latin America, and East Asia (including China, Japan, and Taiwan). The field[2] has a rich history; for convenience, though at some risk of oversimplification, that history can be divided into a Continental European branch with roots in Aristotle’s concept of corrective justice (set forth in the Nicomachean Ethics) and an Anglo-American branch with roots in Bentham.

The European branch, whose dominant figures are Weber and Hayek,[3] emphasizes the importance of the rule of law (in German, the Rechtsstaat) in providing an essential framework for economic development. One of Aristotle’s great insights was that the adjudication of a dispute ought to be conducted without regard for the merits of the parties—whether the plaintiff was a good person and the defendant a bad one, etc. Hence the notion of justice as a blindfolded goddess and the command to judges in the U.S. judicial oath to do justice “without regard to persons.” Hence in short the idea of law as neutral, impartial, impersonal, which is the essence of a government of laws rather than of men—a government that rules by abstract legal principles rather than by discretionary judgments of individual officials. In economic terms, the importance of Aristotle’s precept lies in the fact that economic activity would be greatly impeded if judges had regard to the character, social standing, or other characteristics of a litigant rather than simply to whether the litigant had an abstract legal right to a judgment. A standard that looked to individual desert would not only be uncertain; it would induce expenditures on ingratiating oneself with the judges and other officials that would be largely wasted from a social standpoint. In contrast, justice without regard to persons enables people to learn their legal obligations and comply with them (or not) without having to curry favor with judges or other officials. The “formal rationality” of the law, in Weber’s phrase—the fact that the law abstracts from the personal characteristics of the litigants—creates a knowable framework for economic activity.

Hayek gave a twist to the Weberian notion of the law’s formal rationality by urging that judges should enforce custom, which he claimed was the method of the English common law. His reasoning was that customs evolve from the actual practices of commercial and other relevant communities and having thus survived a competitive, evolutionary process are presumptively efficient. So judges who enforce custom will be bringing about efficient results. But this is a detail (and a questionable one, since the custom of a community—such as colluding on price or refusing to compensate victims of pollution—may be inefficient from the larger social standpoint). The essential insight of the Continental law and economics school is the dependence of economic development on the existence of a reasonably precise legal framework to which enterpreneurs and other businesspeople can adapt; the content of the legal principles that the courts apply is secondary. This is an especially cogent point with regard to contract, since the parties to contracts in effect make their own law, the law that defines the performance of the contract; the “real” law, the society’s law of contract, does not prescribe the content (the law) of the contract but merely endeavors to facilitate the parties’ contracting by minimizing contractual transaction costs.

These are essential points, but as an economic theory of law they are incomplete. For even contract law has a great deal of structure; it is not just telling courts to enforce promises. Some promises are unenforceable; others (“default terms”) are interpolated into contracts by the courts, such as best-efforts and good-faith clauses; the courts also prescribe defenses (such as impossibility) and remedies (such as expectation and reliance damages, restitution, and specific performance), and prescribe interpretive principles (such as the parol-evidence rule) to resolve disputes over the meaning of particular contracts. It is here, with respect to the texture of law rather than law’s underlying purpose of providing a framework for private economic activity, that the Anglo-American school of economic analysis of law enters the picture.

The distinctive characteristic of that school is the recourse to economics both to explain the procedures, institutions, and substantive doctrines of the law and to propose reforms in those procedures, institutions, and doctrines.[4] The first course is at once bolder and simpler than the second. It is bolder because it asserts that there is a considerable degree of isomorphism between economics and law, so that the theories of the former can be used to reveal the premises, methods, and aims of the latter, and simpler because it makes no normative assumptions, avoiding the uncertainties of normative analysis by eliding the question whether it is a good thing for law to embody economic principles. The second course, the use of economics as a guide to law reform, is more complex than the first, in making normative assumptions (what shall count as an improvement in economic welfare brought about by a change in law?), but less audacious, because it is natural to assume that making law an instrument of economic optimization would require wholesale changes in law—in short that law is not already economics.

Because economic theory is a theory of rational behavior, and because so much of law is concerned with activities that are not at their core commercial, such as crimes, accidents, bequests, adjudication, marriage and divorce, environmental protection, speech and religion, and race and sex discrimination, a comprehensive economic approach of law, whether positive (explanatory) or normative (reformist) would not have been possible without a general theory of rational behavior, that is, a theory not limited to buying and selling and other activities that take place in explicit markets. The pioneer in the development of that general theory was Jeremy Bentham in the late eighteenth and early nineteenth centuries. It was Bentham who proposed that everyone, in all activities of life, was endeavoring to maximize the excess of his pleasures over his pains, or in modern economic terminology to maximize his utility. Pleasures, pains, and utility need have no financial dimension. And so it is possible, for example, to model a person contemplating criminal activity as endeavoring to maximize the excess of the benefits to him (which need not be monetary) of his crime over the costs, including the expected cost of punishment (the disutility of punishment if he is caught and convicted, multiplied by the probability that he will be caught and convicted, with adjustment if the criminal is risk averse or risk preferring). In the case of imprisonment and capital punishment as opposed to fines, the expected cost of punishment is a nonmonetary cost.

Notice how in this analysis punishment is treated as a price; and the same is true of a civil judgment in an accident case. According to the influential “Hand Formula” (invented by the American judge Learned Hand), an injurer is negligent if the burden (cost) to him of inflicting the injury was less than the loss the injury inflicted on his victim multiplied by the probability that the injury would incur unless the injurer assumed the burden of prevention. The product of multiplying the loss if it occurs and the probability that it will occur is, in economic terms, the expected cost of injury. Algebraically, the injurer is negligent if B < PL.

To be able to see nonmonetary costs and benefits in economic terms is a legacy of Bentham’s approach. Bentham can be thought of as the inventor of nonmarket economics, without which economic analysis of law would be severely truncated.[5]

Prices allocate resources; and the “prices” that criminal punishment and tort judgments “charge” for engaging in criminal or negligent activity allocate resources to criminal and other dangerous activities. The rational criminal compares the expected benefits and expected costs—the latter influenced by the expected punisment cost—in deciding whether to commit a crime, and similarly a trucking company compares the cost of particular safety precautions with the expected accident costs that the precautions would avert and if the latter costs exceed the former the company knows that it will be found negligent and forced to pay a judgment if it fails to adopt the precautions; since by hypothesis the precautions are cheaper if the inequality holds (B < PL), the company will adopt them In this analysis, the function of tort liability is to deter noncost-justified injuries and thus is parallel to the more familiar deterrent function of criminal punishment.

Of course all this is greatly oversimplified, ignoring much friction in the legal system, but it provides a useful model for understanding the basic economic logic of the system, or what I described earlier as the isomorphism of economics and law.

Though Bentham had applied his utilitarian framework in great detail to criminal punishment, where it became influential, he did not apply it to other areas of the law, and, perhaps as a result, its broad relevance to an understanding of the essential economic logic of a legal system was overlooked for more than a century and a half. It was only in the 1960s, accelerating in the 1970s, that economics was recognized to be capable of offering insights into the structure of other fields of the common law (the significance of this qualification is about to be explained) besides criminal law.

“Common law” is the name given to law shaped by judges, primarily English and American judges, rather than by legislators. In nations that trace their legal system back to England, the basic private law, and some public law as well (such as the basic principles of the criminal law), are common law, i.e., judge-made rather than legislative. For reasons that are still not well understood, but may be connected with the influence of capitalist thinking in nineteenth-century England and throughout most of American history and with the relative absence of interest-group pressures in the adjudicative process, Anglo-American common law (broadly defined) exhibits almost everywhere the stamp of intuitive yet often sophisticated economic thinking, as documented in my text-treatise Economic Analysis of Law (6th ed. 2003). Among the fields in which this has been demonstrated are, besides tort law and criminal law (more precisely the common-law parts of criminal law, such as the doctrines of conspiracy, attempt, specific intent, recklessness, self-defense, accomplice liability, and necessity), property law (including intellectual-property law, to the extent it is common law, as in trade secret law, misappropriation, the fair-use privilege in copyright law, and much of trademark law), admiralty law (largely judge-made, though technically not common law because originally made by specialized admiralty judges), restitution, family law, agency law, procedure, evidence, and remedies. The structure of the legal profession, including its judicial and academic branches, has also been subjected to economic analysis.

Even before a belated Benthamite nonmarket economics was applied to the legal fields that I have just listed, a sophisticated economic approach to a select number of statutory fields, notably antitrust, was well under way. Here the emphasis was normative. This was not so much because antitrust law was believed to be in need of substantial reform in order to make it economically sensible; some economic analysts of antitrust law indeed believed this, but others did not. It was rather that economists tended to examine antitrust law in the context of particular cases, where the question as the economist saw it was how the case should be decided from an economic standpoint, or, if it had been decided already, whether it had been decided correctly from that standpoint, rather than whether antitrust law as a whole made economic sense. Economists and economically minded lawyers, beginning roughly in the 1950s, applied standard concepts of microeconomics, such as the theory of monopoly, to a body of law overtly economic in its use of terms like “competition”, “restraint of trade,” and “monopolize,” all terms that can be found in the U.S. antitrust statutes. Unlike the common law, these statutes seemed on their face to be extending an invitation to do economic analysis.

The 1950s saw nascent economic analysis of other areas of explicitly economic statute law, notably public utility and common carrier regulation, federal income taxation, and corporation law. Together with antitrust law, these continue to be important areas of the application of economics to law, with normative analysis predominant. But what is new since the 1950s besides the increased economic sophistication of these fields of explicit economic law is the application of economics to a wide variety of other statutory fields as well, some explicitly economic, some not, have been brought under the lens of economics, including securities law, environmental law, international trade law, labor and employment law, discrimination law, bankruptcy, banking and commercial law, the law of pensions, the law of secured transactions, the statutory parts of intellectual property law, health and safety regulation, and administrative law generally. Constitutional law, including issues of federalism, free speech, religious freedom, separation of powers, voting rights, and civil liberties have also been placed under the lens of economics.

In most of the statutory and constitutional areas, normative analysis predominates over positive analysis, but there is a good deal of the latter as well. Partly because the legislative process in the United States is cumbersome and undisciplined, judges have done a great deal to shape the output of legislators and, of course, of the framers of constitutional provisions. And the shaping tools employed by the judges have been drawn largely from the common law traditions to which most American lawyers are habituated. It would be an exaggeration to say that the judges have remade statutory and constitutional law in the image of the common law, but it is not surprising that as interpreted and applied by the judges many statutory and constitutional provisions are seen to bear an intuitive economic stamp similar to that borne by many of the doctrines of the common law.

Economic analysis has been extremely influential in American law and policy, having contributed to the deregulation movement and having altered doctrine in a variety of fields. Although its biggest practical impact has been on fields of explicitly economic regulation, such as an titrust and public utility regulation, where economic analysts have played a significant role in orienting American law in a free-market di rection, its mark is increasingly being felt in other areas of law as well, such as environmental law, where tradable emis sions rights are a hallmark of the economic approach to the en vironment; the law of eminent domain, where the increasing judi cial concern with “regulatory” takings bears the stamp of economic analysis; securities law, where the concept of “fraud on the market” has expanded the scope of liability for securities fraud; divorce law, where feminist and economic insights have joined to emphasize the economic di mension of household production, resulting in the adoption by courts of new methods for dividing property and calculating alimony in divorce cases; and the law of damages generally—it is nowadays rare in major cases not to have testimony by expert witnesses on the remedial phase of a case. This is true even in personal-injury cases, where translating loss in cases of death and disability into monetary present-value terms is now recognized to involve subtle economic issues, such as the choice of a discount rate for determining the present-value equivalent of a stream of future earnings interrupted by death or disability.

In the common law fields, the primary effect of economic analysis of law has been to clarify rather than to alter doctrine, other than in the area of remedies. An important exception, however, is the impact of economic analysis of portfolio management on the law regulating the investment duties of trustees. Economic analysis has also changed legal education and made the profession more receptive to modern social scientific methods of inquiry, including quantitative empirical analysis.

Economic analysis of law has not escaped criticism. The emphasis of that criticism has been on the use of economic analysis as a tool for reform. But the positive analysis has not escaped criticism, primarily from those who believe that the rational model of human behavior that is fundamental to modern economic theory involves too drastic a simplification of human behavior to guide analysis, especially of nonmarket behavior; and let us start there, noting three responses to the criticism. The first is to concede the premise that the rational model is an oversimplification but to deny the conclusion that therefore it cannot yield useful insights into behavior, noting that simple economic models have often been fruitful in accurately predicting behavior. For example, the theory of perfect competition, though a gross oversimplification with its unrealistic assumptions of perfect information and an infinite number of sellers selling a perfectly homogeneous good, accurately predicts how the demand for a good reacts if an excise tax is placed on it.

The second response is to note that most of the implications of the economic model do not require a rigorous concept of rational maximization; it usually is sufficient to assume that people are generally self-interested and at least minimally sensible in seeking to promote their self-interest. Indeed little more is required to generate most of the implications of economic analysis for law than the assumption that most people in most areas of life prefer more (provided it’s more of a good than a bad) to less.

The third response to the criticism of the rational model of human behavior is to alter the model to take account of the best-substantiated deviations from it—hindsight bias, difficulties in handling probabilities, hyperbolic discounting (the tendency to discount future events at a higher rate the farther in the future they lie), the endowment effect (the tendency to value an object merely because it is one’s own), and other cognitive or emotional factors that interfere with rational thought. The result is a richer account of behavior than conventional economics offers, and one with a number of applications to law[6]—for example, to evaluations of negligence in accident cases. That is a classic hindsight problem because the evaluation is made after the judge and jury know that an event occurred that might have been prevented by taking some precaution, although the event might not have been foreseeable when the decision whether to take the precaution was made, in which event the injurer should not be adjudged to have been negligent.

Criticism of the normative side of economic analysis of law has emphasized the inadequacy of “wealth maximization” as a criterion of welfare. To explain, the standard welfare criterion in modern economics is the Pareto criterion; a transaction or other event is a Pareto improvement if it makes at least one person better off and no one worse off. This is close to being a requirement of unanimity, which is an attractive criterion for an improvement but unfortunately one rarely attainable in the real world. Even voluntary transactions, such as sales of goods and services, have uncompensated third-party effects, as where a seller hurts a competitor by underselling him: the seller and his customer are better off, but the worse-off competitor is not compensated and so, strictly, the transaction does not satisfy the Pareto test. Out of practical necessity, most normative economics uses as its welfare criterion potential Pareto superiority, also known as Kaldor-Hicks efficiency or as wealth maximization. A transaction is potentially Pareto superior if the gains in dollar terms to the transactors exceed the loss in dollar terms to third parties adversely affected by the transaction even if the losers are not compensated. (Nonparties could also be beneficiaries, but we can ignore that complication.) The problem is that if the losers derive greater utility from a dollar than the winners, the transaction may reduce aggregate utility, a result ordinarily thought inefficient.

Thus a concept of law that views law’s aim of “mimicking the market,” which is to say bringing about the allocation of resources that the market would bring about if market transaction costs were not prohibitive (if they are not prohibitive, the market can be left alone to bring about the allocation, and so one important aim of law, particularly of property, contract, and tort law, is to minimize market transaction costs), may, like the market itself, reduce utility at the same time that it is increasing wealth. But against this it can be argued that prosperity is a genuine and substantial value and that distributive injustices brought about by market transactions and the market-mimicking transactions forced by the law in circumstances in which market transaction costs are prohibitive are best corrected by the taxing and spending powers of government, rather than by making law even more complicated and uncertain that it is by splitting its focus between allocative efficiency and distributive justice.[7]

The two schools of economic analysis of law—what I have termed the Continental  and the Anglo-American—merge when the focus of analysis shifts from the legal systems of the wealthy nations to the legal systems of poor nations, including the nations of the former Soviet bloc. On the one hand, because the judicial systems of such nations often have serious problems of corruption, political interference, and sheer incompetence, the emphasis of reform properly falls on strengthening the rule of law in the Aristotelian-Weberian-Hayekian sense, and so, for example, on making the rules of substantive law simple in order to facilitate the monitoring of judicial behavior threatened by corruption and interference.[8] On the other hand, the doctrinal content of the laws enforced in the courts of such nations cannot be ignored, and here the Anglo-American school of economic analysis of law has useful suggestions for making law compatible with a market organization of the economy.
Footnotes

[1] Judge, U.S. Court of Appeals for the Seventh Circuit and Senior Lecturer, University of Chicago Law School.

[2] Briefly described for a European audience in Richard A. Posner, Law, Economics, and Democracy: Three Lectures in Greece (University of Athens Department of History and Philosophy of Science 2002).

[3] See Max Weber on Law in Economy and Society (Edward Shils and Max Rheinstein eds. 1954); Friedrich A. Hayek, Law, Legislation and Liberty: A New Statement of the Liberal Principles of Justice and Political Economy, vol. 1: Rules and Order (1973); Richard A. Posner, Law, Pragmatism, and Democracy 274–277 (2003).

[4] For a comprehensive discussions, see Richard A. Posner, Economic Analysis of Law (6th ed. 2003); Steven Shavell, Foundations of Economic Analysis of Law (2004).

[5] On Bentham and his relation to modern economic analysis of law, see Richard A. Posner, Frontiers of Legal Theory, ch. 1 (“The Law and Economics Movement: From Bentham to Becker” (2001).

[6] See Behavioral Law and Economics (Cass R. Sunstein ed. 2000).

[7] See Posner, note 5 above, ch. 3 (“Normative Law and Economics: From Utilitarianism to Pragmatism”).

[8] See, for example, Jonathan Hay and Andrei Shleifer, “Private Enforcement of Public Laws: A Theory of Legal Reform,” 88 American Economic Review Papers and Proceedings 398 (May 1998).