Course:Law3020/2014WT1/Group M/Law As Efficiency

Law and Economics: Law as Efficiency

Overview of Theory:

The central claim of law and economics is that law serves the goal of economic efficiency: law is best seen as a tool for wealth-maximization in society. Furthermore, proponents of law and economics accept three central claims:

1) A descriptive claim: some legal rules are efficient (some proponents hold that specific branches of law, i.e. torts, contracts, are efficient whereas others hold that all law is efficient);

2) An explanatory claim: the best explanation of why we have the rules we do is that they are efficient;

3) A normative claim: we ought to have efficient rules, efficient rules are good rules.

Pareto-Superiority: To understand the law and economics approach it is necessary to understand the basic economic principle of efficiency. The simplest measure of efficiency is the Pareto-superiority, which holds that one state, S1, will be superior to another state, S, if and only if at least one person is better off in S1 than in S and no one is worse off in S1 than S. There are no losers in this model.

Kaldor-Hicks Test: This test holds that a state, S1, is Kaldor-Hicks efficient to another state, S, if and only if, in going from S to S1, the winners could compensate the losers so that no one was worse off than they were in S and at least one person would be better off than he or she was in S. Unlike Pareto-superior models, Kaldor-Hicks moves are allowed even when the move makes some people worse off, provided only that the gains to the winners be large enough that they could fully compensate the losers.

With these two principles of efficiency sense can now be made of what economic analysts say about law. Economic analysts would give applause to voluntary transactions because when two people make a voluntary transaction (with the precursor that they are rational) they will both be better off. Thus, one way of ensuring wealth is maximized is by facilitating voluntary transactions. However, markets fail in important ways. There are third party effects from transaction in which a transaction between two individuals may have implications for a third party. For example, if I buy a bicycle, it may raise the price of bicycles on the overall market affecting other purchasers. As such, there can be losers and it is necessary to move from a Pareto-superior model to the Kaldor-Hicks test that allows for losers.

Legislators and Judges: Proponents of law and economics view what judges and legislators do as very different. Legislators are inefficient and rarely satisfy Pareto principles because almost any government action taken through law (vast bulk of what governments do is redistributive) will make some people better only at the expense of others. On the other hand judges have little power to engage in significant redistribution but have considerable scope to pursue to pursue efficiency. Judges often deal with disputes that arise from market failures (third party effects, transaction costs, etc) and thus efficiency is something they can pursue. Furthermore, cases decided inefficiently are usually appealed since one party will bear unnecessary costs. Stare decisis helps to refinforce this doctrine.

Application to Hodgkinson v Simms:

The case of Hodgkinson v Simms dealt with the issue of fiduciary duty. It was held that fiduciary duty exists in a financial advisor client relationship where the elements of trust and confidence and reliance on skill and knowledge and advice are present. It was further held that policy considerations could be taken into account when deciding whether a fiduciary duty exists. In this case, policy consideration supported a fiduciary duty because this was a situation in which the client gave their trust to their advisor to control large sums of money and it was clearly important and beneficial (for both the individuals involved and the overall community) to enforce a duty of honesty and good faith in such a situation. The proper approach to damages for breach of a fiduciary duty was held to be restitutionary. The plaintiff is entitled to be put in as good a position as he/she would have been in had the breach not occurred.

Proponents of law and economics would likely contend that this is a good case for judges to create law because it deals with a market failure and thus the judge can pursue efficiency when making a decision.

Under the Pareto-superior theory a fiduciary duty would ensure there are no losers. Proponents of law and economics under the Pareto-superior model would contend that financial advisors such as Simms should only make decisions that maximize the overall wealth of them and their clients and that no one in the relationship should be worse off. As a result they should provide compensation to their clients for any decision that makes their client worse off. Thus, proponents of law and economics would agree with the end result in the present case, on the basis that Simms made a decision that made his client worse off and therefore he should have to compensate his client for that decision. Because such a fiduciary duty would help ensure wealth maximization proponents would also agree with the decision that such a duty be found in the first place.

Under the Kaldor-Hicks test there can be losers provided only that the gains to the winners be large enough that they could fully compensate the losers. Proponents of law and economics under the Kaldor-Hicks test would contend that financial advisors should only make decisions that would create more wealth than there initially was (even if that means their client losing). As long as the total wealth created is enough that the client could potentially be compensated for his or her loss. If on the other hand the total wealth created is not large enough to compensate the client the decision should not have been made. Thus, proponents of law and economics would agree with the end result because no wealth was created (total wealth only decreased – property values decreased) and therefore Simms should have to compensate Hodgkinson. Again, because such a fiduciary duty would help ensure wealth maximization overall, proponents would also agree with the decision that such a duty be found in the first place.