Category:Law as Efficiency: Law and Economics

Law as Efficiency: Law and Economics

Generally speaking, the study of economics concerns distribution outcomes involving scarce resources. Less generally, economic thought can be broken into positivist and normative accounts. Positivist economics concerns how and why people respond to changes in market conditions. Normative economics utilizes positivist findings and presents strategies for organizing market behaviour to achieve efficient allocations of resources. Law and economics is simply a normative economic approach to law.

Economics is fascinated by human behaviour surrounding the allocation of scarce resources. Before delving into normative economic theories, it is important to unpack some of the study’s primary concepts and elementary assumptions about human behaviour and what ideal allocation of resources looks like.

Rational Person Theory

Most economic models assume that people are rational. This is known as the rational person theory. The theory assumes people make rational decisions about their allocation of resources and efforts. Most economic models of human behaviour attempt to predict how people will respond given fixed amounts of supply of and demand for resources. Assuming people are rational allows economists to generalize human behaviour in different scenarios where the supply of and demand for resources shifts. This assumption draws much criticism; however, many economists justify the assumption in that it allows their theories to make moderately accurate predictions about how people will act in differing scenarios.

Perfect Information

The rational person is not to be confused with the assumption of perfect knowledge, which is a neo-classical economic theory that presupposes that all people possess perfect knowledge of market conditions. In some economic models, economists assume that people equally possess large amounts of market information about changes in supply and demand of resources. In these models, people react quickly to changes to the supply of and demand for goods and services. This assumption is not always clearly stated, and while it also draws much attention, assuming that people possess equal information enables economists to predict how people would act in situations where market changes in supply and demand occur. In reality, this assumption leads economists to blur the lines between long-run and short-run outcomes due to the time it takes information to spread. However, assuming that all people equally possess perfect information about changes in market conditions allows economists to generalize their predicts as to how people respond changes in market conditions.

In contrast with the assumption of perfect information, economists sometimes deal with models where people possess different information about market conditions. This is known as information asymmetry. Neo-classical economists, who take a normative approach to how policies concerning economic activity ought to be organized, believe that these scenarios lead to an inefficient distribution of resources.

Efficiency

For economists, efficiency refers to the maximization of social welfare. This means that economists generally think that rational people attain value from all of their purchases, and that the value they receive from their purchases should be maximized. This ideology is best understood as a variation of utilitarianism, and can be summarized as the greatest good for the greatest number.

Economists think that efficient firms price their goods and services in direct relation to the value it costs to produce them. A key assumption here is that firms that price their goods higher than the cost of production will be phased out by competition. Underlying this theory is the premise that efficiency will only result in markets where competition is allowed to enter without barriers. Free-entry into markets allows competition to enter, and prices to correct to the cost of production. The existence of monopolies, for instance, is a direct result of a barrier to enter into a market where one firm is the sole supplier of a good or service. When this happens, economists predict that the single firm supplying the market will increase its prices and exclude potential buyers from purchasing their product, to increase the firm’s over-all profit. Looking at this another way, a monopoly can increase the unit price of its products in order to make more profit from each unit of production. This results in monopolies producing less products, and offering less product to the market that would be bought at a price that reflects the cost of production. The net result of barriers to enter into markets is that firms in those markets can charge higher prices for their products, and will supply only those customers who are willing to pay more than those who would purchase the same products at the cost of production.

Social utility is maximized when consumers are able to purchase goods at the cost of production. It is important for firms to be able to compete in markets so that the competition forces producers to set their prices in this way. Inflating prices for the purpose of increasing profits produces an inefficient outcome because those consumers who could receive utility from purchasing a product at the cost of production are no longer able to. Conclusively, barriers to enter markets drive up prices and are an example where inefficiency results from social utility not being maximized.

Richard Posner, a law and economics academic, holds efficiency to be synonymous with justice. He asserts that, where the study of law and economics is criticized for ignoring justice, "A second meaning of justice, perhaps the most common is -efficiency." Cole and Grossman, "Principles of Law and Economics" 2005 Pearson Prentice Hall (Upper Saddle River New Jersey) p. 51

Externalities

Another example where social utility is not maximized occurs with externalities. Externalities are costs required to produce goods and services that are not accounted for in in the price of the good or service. This is a popular area in the study of law and economics because much of law is concerned with accounting for costs unjustly bore by other parties. It is on this point that law and economics scholars argue that the law should internalize costs bore by parties that are not reflected in the prices of goods and services. This argument arises from the position that social welfare is not maximized when the costs of producing goods and services are paid by those who do not receive value from them.

Ideologically, law and economics scholars refer to the amelioration of externalities as the internalizing of externalities. In application this means that those parties who bear costs from the production of goods and services should be compensated by the firms that produce them, and that the value of their compensation should be reflected in the price of those goods and services. Much like how a monopoly prices their goods and services too high, when firms produce goods and services that are the subject of externalities, the prices for these goods and services are set too low. As a result, society will consume more of these goods than is efficient. For each unit of production, a part of the cost of amelioration is bore by a party that receives negative utility.

A common example of an externality is smog produced from a power plant. If air pollution were spread evenly to all consumers of electricity, all consumers would benefit equally from reductions in air pollution. If a community were under these conditions, electricity consumption may be curbed in such a way that the demand for electricity would represent the amount of electricity people needed given the amount of air pollution they were willing to be exposed to. However, in reality, the problem is that air pollution often gathers around areas where plants operate, and the consumers of electricity that do not reside in these areas have little incentive to reduce their consumption of electricity. In effect, the consumers of electricity in this example benefit from an externality. Home owners surrounding the power plant will experience a drop in the market value of their properties that correlates with the cost of the pollution, and the consumers will not pay this price. What avenues for justice can be utilized to internalize the cost to these parties is a good question for a law and economics scholar.

An Approach to Property Rights

When law and economics scholars believe that property rights should be allocated to represent costs of the production of goods and services that would otherwise become externalities. This means that everything that people receive value from should be viewed as a property right. The results appear to yield a greater sense of justice for all parties; however, the normative assertions of law and economics scholars do not end with a list. Law and economics scholars believe that the costs of intruding on the rights of others should exist without barriers. This means that property rights of all people should be made alienable. The law and economics scholars argue that in making all property rights alienable, society has the best chance of achieving social welfare maximization. In other words, society has the greatest ability to produce the goods and services people are willing to buy at prices that represent their true costs of production when everyone can be compensated without restriction. It is with this point that the application of a general set of principles may become unsavoury to public opinion. In particular, critics of law and economics focus on the value of human rights. In general, a concern arises where law and economics scholars treat the subjectively assessed value people place on their right not to be interfered with as an objective commodity. While this criticism remains, law and economics scholars look closer at how parties benefit by selling their rights and find that efficient outcomes result when parties are fairly compensated for externalities under closer inspection.

As previously stated, normative economists endorse transactions between parties that maximize the utility of the parties. How this is done may yield interesting results however. For instance, if a consumer receives greater utility from acquiring a t-shirt than the amount of money they pay for it, and more utility is received by a retailer from selling the t-shirt than not selling it, an efficient result is certainly achieved. However, it is in situations where a t-shirt seller receives no utility from selling a t-shirt that an economist would say they should not sell the shirt. But, what about in situations where the buyer received so much benefit from buying the shirt. Can the loss of utility of the seller be outweighed? The answer is no, but sometimes in more elaborate scenarios it is difficult to see when this might be happening. Law and economics scholars have two models aimed to deal with problems like.

Pareto Efficiency

Pareto efficiency is more of a rule about how parties should continue to make trades until it is no longer in their best interest to continue trading. Pareto efficient may involve many parties and transactions. Its outcome says that parties should stop trading when all beneficial trades have been exhausted. A simple example might involve a property owner, and a coal miner who holds a licence to mine on the owner’s land. Assuming the two parties have a contract that entitles the land owner to $1 per 100lbs. of coal that is mined from her land, and that she possess the right to stop the miner from mining, the land owner should stop the mining at the point when she no longer is willing to receive $1 for each 100lbs. of coal that is extracted. The Pareto optimal trade is the last trade in a series of trades where both parties still receive some benefit from the exchange. The concept, when simplified, suggests that parties conduct business where it is in their best interest.

In a scenario involving externalities, three parties or more may be involved in a transaction. In the example above, a woman named Abby sells a licence to extract coal from her land to a miner named Bob. Meanwhile, Don represents a home owners association whose members all own homes along the road from Abby’s land to Bob’s final destination, a dock located at Port Thompson, 10 miles away. While Bob is mining coal, he loads trucks that carry 100lbs of the coal at a time to the port. The home owner’s represented by Don feel that the mining activity is impacting their property rights, and seek to be compensated $1 per 100lbs as a result. It is with fact such as these that the Pareto efficiency rule applies. The rule suggests that the exchange between the parties should continue so long as Bob receives enough value from the coal he mines to compensate the parties. Bob should continue mining so long as he still receives benefit from doing so; alternatively, Abby should permit Bob to mine so long as she receives benefit in doing so.

This might sound sufficient in theory, but what powers do the home owners have in reality? Law and economics scholars have realized that Pareto efficiency is a bit of a fiction in reality. While the Pareto efficiency theory might provide a nice way of looking at things in the abstract, those whose property rights have been impacted do not often possess the power to accept limited amounts of compensation, nor do they have the sufficient negotiating power to stop industrial activities in actual scenarios. For this reason, many law and economics scholars turn to the Kaldor-Hicks criterion.

Kaldor-Hicks Efficiency

The Kaldor-Hicks criterion is considered to be a more realistic application of economic principles. Like Pareto efficiency, the Kaldor-Hicks criterion asserts that producers should pursue production until it no longer benefits them to do so. The Kaldor-Hicks criterion can be used to test whether a Pareto optimal exchange has occurred in the process of internalizing externalities; however, under the Kaldor-Hicks criterion, it is possible to continue beyond the Pareto optimal exchange. The theory assumes that efficient transactions are those whose production costs have internalized externality costs by including the cost of compensating property rights holders impacted by the production of the good or service. In other words, efficient market transactions understood as Pareto efficient will also be Kaldor-Hicks efficient.

The Kaldor-Hicks criterion aims at internalizing production costs bore by property holders so that markets can run efficiently, and consumers do not over-consume at the expense of those property rights holders who bear the costs of externalities. But, some additional characteristics and distinctions are involved in the Kaldor-Hicks criterion. Where parties are said to reach a Pareto optimal result when they trade until no more trades can be made that benefit the parties, the Kaldor-Hicks criterion suggests that production should continue until externality bearing parties are willing to pay producers to stop production. While the Pareto model assumes that externality bearers should be free to set the value of their rights at a level that represents subjectively represents the utility they receive from retaining them, the Kaldor-Hicks criterion suggests otherwise. Externality cost bearers do not receive compensation voluntarily under the Kaldor-Hicks criterion. Another important distinction is that the value of their rights is objectively assessed. In the Kaldor-Hicks criterion, the point at which a producer should stop production may be decided by the externality bearer when they offer to pay the producer an amount equal to their benefit from production. In other words, externality bearing parties, under the Kaldor-Hicks criterion, can stop producers only by paying them to stop. This roughly means that if property rights holders want their rights back they must bribe producers to stop production.

In the example used earlier, where miner bob mines coal on Abby’s land and pays her for a licence to do so, and pays an amount equal to the compensation for the road homes association, the application is quite clear. The mining activity should continue until the home owners are willing to pay Bob to stop. The home owners association may receive $1 for each 100lbs of coal shipped, at the discretion of some policy making authority; however, mining should continue until either Bob is paid by the home owner’s association for the mining to stop, or until he no longer benefits from production. The amount of benefit received by Bob for mining is now the responsibility of the externality bearing party should they wish him to stop mining.

In isolation, the Kaldor-Hicks efficiency criterion requires that the unit price for goods and services properly reflects production costs. When property rights are infringed upon, it means that compensation must be objectively assessed and included into the cost of production and thereby passing-on the cost of the externality to consumers. However, the Kaldor-Hicks principle does not actually require that compensation is paid out. Whether compensation is paid is a matter for the policy authority to decide. Surprisingly, the criterion looks at market prices and emphasizes the injustice of transactions where the value of externalities artificially reduces the cost of production. This is because the low-price of a product will encourage consumers to purchase the product and increase the cost of the externality that is bore by another party. This means that the injustice of the externality is for a policy authority to resolve. Additionally, the theory supposes that compensation of externality bearing parties is non-voluntary. Parties that bear the cost of externalities should be the forced to surrender their property rights for an objectively assessed amount.

Where the ability of externality bearing parties to sell their rights for subjectively determined values would normally be a good way of assessing what their rights are worth to them, the Kaldor-Hicks principle may be more in line with reality. In actual fact, the value that externality bearing parties place on their rights is realized in the Kaldor-Hicks criterion when these parties decide to pay producers to stop producing. One criticism that comes to mind here is that the bargaining power of externality bearing parties can easily be manipulated when these parties simply cannot afford to pay producers to stop production.

While Kaldor-Hicks aims to see the cost of externalities become internalized into the price of the products, the theory is often used by policy makers who wish to create cost internalization schemes in order to capture market externalities before they are realized by those who bear their costs. Ultimately, the Kaldor-Hicks criterion balances the disutility of losers with the utility of winners. At the expense of allowing winners to win more, the criterion makes property right holders responsible for industry and any costs it creates that might fall onto them. Many economists disregard the Kaldor-Hicks criterion for this reason, and find, that while the criterion might be a good way test whether Pareto efficiency has been achieved, normatively restricting parties from setting their own prices and conducting their own affairs has dire consequences.

Ronald Coase

In his first publication on economics, “the Nature of the Firm,” Ronald Coase defines firms as utility deriving mechanisms that reduce transactions costs. In subsequent writings his idea took hold as a concept for law and economics. His position, that individuals face all kinds of costs when they try to do business on their own, was reformulated in subsequent writings. The principle of firms reducing transaction costs illustrates that hiring someone to answer a telephone makes sense when it is reasonable to expect lots of telephone calls; however, if you do not expect many telephone calls, and you are in business for yourself, it might be a better idea to answer the phone yourself.

Now imagine you are a lawyer with your own one-person firm, should you answer the phone when you could instead be advising a client? In this example, a transaction cost is defined as the cost of either answering the phone yourself, or not answering it at all. An efficient solution would be to hire someone to answer the phone where these transactions costs are greater than an employee's salary. An even better solution would be for several lawyers to gather together, and hire an employee to answers all of their phones. Firms, like in this example bundle all kinds of costs, and divide them, reducing the cost of production for all kinds of goods and services.

For Coase, transaction costs can represent many kinds of expenses. When two parties get together to bargain, the costs of their doing so are transaction costs, but the bargain may also include exchanging property rights, like a tort or contract dispute. Transaction costs will include lawyer fees, and even the costs like driving a vehicle to a market place or court house. Transactions costs emerge between two parties each time they seek to make an exchange of any kind. Sometimes transaction costs are referred to in contracts as being the responsibility of a particular party, and other times they are simply absorbed as a cost of doing business.

In a later publication, "the Problem of Social Cost," the Coase theorem emerges. The theorem holds that, when transaction costs are low, conflicted parties will reach economically efficient solutions by themselves. This theory has been used to support many kinds of non-government approaches to dispute resolution, and many lawyers consider the idea as support for solving legal problems through settlements.

Looking Closer: Reducing Unwanted Behaviour

Ultimately, for law and economics scholars efficiency requires that there will always be some criminal offences and avoidable accidents in society. To eliminate them all would simply cost more than a society should be willing to pay. Underpinning this idea is the concept of diminishing marginal returns. An analogy for diminishing marginal returns can be made from picking blueberries. A person can pick blueberries from a bush with great success if the bush has not already been picked that season. At first, the berries will be easy to pick, but as the picker continues, eventually a point is reached where each basket takes longer to fill than the last. This concept is known to economists as diminishing marginal returns. The notion that eliminating all risk of injury is out of the question for most economists; however, for some activities the threshold of elimination and acceptance is higher than others.

Economists think society’s interest in the reduction of avoidable accidents and criminal offences is limited by what society is willing to pay for reduction. In other words, for economists, reductions in crime and avoidable accidents are considered in terms of units of reduction. A reduction in criminal activity, for instance, is viewed as a purchase. Economists hold the view that, at some point, the purchase of each unit of crime or accident prevention will steadily increase until it exceeds what society is willing to pay.

An overview of Law and Economics in Tort Dimock’s survey tort law as examined by law and economics scholars focuses on efficient avoidable accident reduction, and the consequences of applying liability structures under various conditions. The thrust of her writing holds that economists seek to make parties liable, depending on the cost of their alternatives, in order to achieve an efficient distribution of compensation.

In tort law, law and economics scholars focus on liability assignments for intentional and non-intentional torts. In Dimock, these include negligence, absolute victim liability, and absolute injurer liability. In negligence, parties that possess a duty are found to be responsible for taking care to prevent accidents. Economists note how the duty requirement enables parties to act solely in their best interests where no duty to do otherwise exists, and creates incentives for duty holders to act cautiously. Contributory negligence, creates incentives on potentially injured parties to prevent injury also. Absolute victim liability means that the duty to prevent injury rests with the victim. This can sometimes be used to prevent accidents from causing severe damage, where parties have a choice not to engage in the activity. Results can be efficient where parties knowingly possess thin skull attributes, or can prevent damage by taking safety precautions. Such rules would appear to be at work in insurance law where injured parties in car accidents will be barred from claims for not wearing seat-belts. The final liability assignment is absolute injurer liability. Absolute injurer liability exists when injuring parties are held responsible for all damage, regardless of their level of precaution. It is important to note that in addition to these liability structures analyzed by Dimock, that no fault liability exists also, where both parties are responsible to share the costs of compensation. This final form is used by the province of Ontario for vehicle insurance, and in establishing fault for vehicle accidents in parking lots throughout Canada.

Law and economics scholars think that these assignments should be cautiously made for the purpose of reducing avoidable accidents to an efficient level. In pursuit of efficiency, economists focus on methods of reducing avoidable accidents, also. This involves examining the opportunity costs of parties to discover whose accident reduction behaviour faces is least expensive. In other words, parties who can most easily prevent accidents should, and liabilities for not doing so should be assigned to impose a duty to take better care on these parties whenever possible. Sometimes imposing liabilities on innocent parties appears strange; however, economists will always seek to prevent damage at the lowest cost, despite how unjust it might otherwise appear. Law and economic scholars think that interference with the property or welfare of others should not be frowned upon when, after compensating injured parties, it is in the best interest of the injuring party.

An overview of Law and Economics in Criminal Law Dimock’s examines criminal law from a law and economics perspective. She presents law and economic scholar’s concerns with when it is best to use sanctions verses incentives, an efficient level of crime reduction, and how to reduce crime through the correct use of penalties and enforcement.

The question economists often ask is, when should society use criminal law? Most of the time the question actually points to when people should be penalized, and economists are often quick to say that the loss of freedoms is best achieved by fines. When the person whose behaviour you wish to control is unable to pay, their behaviour will likely not be altered by fines, and therefore, prison must be considered.

Another question economists are concerned with is how much should society spend on crime reductions. Having addressed the efficient amount of crime reduction earlier, this might be a good place to talk about the best way to reduce crime. Economists talk about curtailing criminal behaviour by looking at penalties and the cost of enforcing them. By setting penalties high, for instance, people will be incentivized not to commit crimes; however, what if they thought they would never get caught. The balance between enforcement of penalties and the cost of getting caught creates a matrix that economists think criminals consider. Economists think people weigh penalties against the probability of their being penalized before deciding whether to commit an offence.

This enables policy makers to consider how best to set penalties, and allocate police funding. The most important factor in determining how to set a penalty is the cost of the behaviour to others. If the offence is car theft, the cost will be the value of the car being stolen and any additional transaction costs involved with having a car stolen. Since perfect enforcement is never possible, the penalties should always outweigh the possible gains of committing offences. This means that the punishment should never allow anyone to think that it is in their best interest to commit car theft. However, considering how high the penalty should be set involves an acknowledgment of the probability of the offender’s getting caught. Another consideration should be made by considering the cost of increasing the likelihood of capturing criminals against the societal cost of increasing the penalty.

criminal offences as though they occur against property. Law and economics scholars take the view that people’s personal rights, including those such as intrusion of their physical bodies, can be viewed as an intrusion upon a person’s property.

An overview of Law and Economics in Contract Law Dimock looks at contract law from a law and economics perspective by focusing on it maintains incentives to efficient exchange. Contract law is found by law and economics scholars, like Posner, to be flexible about agreements, with the object of preserving efficient exchanges.

Dimock finds the requirement of consideration to be an area of contract law that embraces economic theories of efficiency. In effect, consideration excludes contractual obligations from gift giving activities, which means that gift givers do not need to be as careful under the law as those engaging in consideration supported agreements. In Dimock, the position is that more utility results from contract law’s dismissal of enforcing gratuitous agreements.

Remedies for contractual breach are regarded as efficient by law and economics scholars, also. The idea that a contractually bound party may breach a contract as a matter of efficiency is at the heart of law and economics. Law and economics scholars support this idea, and find that it is not in the best interests of society for contract law to penalize parties for acting in their best interests. For instance consider a firm that enters into a contract to sell a good, only to later learn that they can sell the same good to another party for more. In these cases, where they can sell to the other party for so much more that they can afford to pay expectation damages and still carry out the deal, contract law allows them to do so. In effect, law and economic theorists think that people should only be obligated to make good on their promises when it is in their best interest. This is not to say that their promises should be discounted by changes in the market.