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 how they allocate resources and effort. Most economic models of human behaviour attempt to predict how people will respond given fixed amounts of supply and demand of resources. Assuming people are rational allows economists to generalize human behaviour in different scenarios where the supply and demand for resources changes. 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.
A rational person makes decisions that are in their best interest. This is not to be confused with the assumption that people have perfect knowledge, however.
The assumption that people possess perfect knowledge is sometimes made in economic models. In these models, people react quickly to changes in supply and demand because they know the exact moment when their best interests have changed. This assumption is not always clearly stated, and while it draws much attention, assuming that people possess equal information enables economists to predict how people would act when changes occur. A criticism with the assumption of perfect information is that, in law and business, it is often the different amounts of information parties possess that determines their success or failure. Assuming that all people equally possess perfect information about the interests of other parties is a fiction that makes economic models unrealistic.
In contrast with the assumption of perfect information, economists sometimes deal with models where people possess different amounts of information. This is known as information asymmetry. Law and economics scholars often make the assumption of perfect information, and believe it will lead to more efficient distributions of resources of everyone actually had perfect information.
Efficiency refers to the maximization of social welfare. Law and economics scholars think this is achieved when resources are allocated in a way that produces the greatest benefit. The greatest benefit means the total benefit of all the parties. Underlying the principle of efficiency is the premise that resources should be allocated to those who value them most. Economists assume people are rational and attain value from all of their purchases. Economists persist that efficiency results when everyone makes the most individually beneficial decisions in markets where competition exists.
The presence of competition is important to economists. Competition for market share between firms is necessary to lower prices. Economists think that efficient firms price their goods and services at the cost of production. When a firm prices goods and services higher than the cost of production, competing firms will take their market share. To enable competition, economists argue that barriers to enter markets should be eliminated. When barriers are eliminated, free-entry into markets allows competition to enter, and prices to correct to the cost of production.
It is assumed that people want goods and services, and that at each price point, either more or less people will be interested in them. When firms price goods and services at the cost of production, it allows the greatest number of people to purchase the good or service. This results in more collective benefit from the sale of the good or service. In this way, the collective utility of the greatest number of parties results in the most efficient outcome. If product prices fall below the cost of production this will cease to occur. When this happens producer receive negative utility for the production of their goods and services. So, economists say, firms should price their goods and services at the cost of product to compete with other firms, and provide the best value to society.
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 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 assertion 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 'internalizing' externalities. In application this means that externality bearer should be compensated by the firms that produce externalities, and that the value of compensation should be reflected in the price of those goods and services. Much like how a monopoly prices 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 only negative utility.
A common example of an externality is smog produced by a power plant. If air pollution were spread evenly to all consumers of electricity, the consumers would benefit equally from reductions in air pollution. When this is not the case, those people living in area where the plant's air pollution gathers face an additional costs for their consumption. In effect, the consumers of electricity that reside outside of the air pollution area, benefit from the externality. Home owners surrounding the power plant will experience a decrease in utility equal to the cost of the air-pollution. What avenues for justice can be utilized to internalize the cost to these parties? Is is where law and economics scholars weigh in.
An Approach to Property Rights
Law and economics scholars think property rights should be allocated to unburden the bearers of externalities. They think that rights themselves should be sold like property, and they justify this idea by the ability of firms to readily compensate those infringed by production activities. The goal is to enable firms to internalize externalities, and the means involve allowing firms to purchase rights held by others.
A source of resistance to this approach arises from the idea that nothing would be inalienable. This is not currently a position many people would take in the world. The thought that certain rights should not be for sale is a popular one. Some people criticize law and economics scholars on this approach to property by saying that society holding certain rights and freedoms inalienable creates value in itself. Regardless, law and economics scholars say that if rights were treated as sellable property the world would be a more efficient place.
Law and economics scholars believe that the costs of intruding on the rights of others should exist without barriers. The law and economics scholars argue that in making all rights alienable, society has the best chance of maximizing social welfare. In other words, society has the greatest ability to produce the goods and services people are willing to buy at prices that represent the true costs of production when everyone can be compensated without restriction.
Transaction Costs: Coase Theorem
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 how it is less expensive for people to share resources, like telephones, offices, and employees.
For example, imagine you are a lawyer with your own one-person firm. Should you answer the phone when you could instead be advising a client? If you could be advising a client, answering the phone presents an opportunity cost. If not answering the phone results in getting your next client, you might think it a good idea to make your current client wait. If hiring an employee to answer the phone is more expensive than making your current client wait, then you have no choice but to make your client wait. However, perhaps you should get together with another lawyer and share the cost of the employee so that you both benefit from their service. If you chose to do this, you would reduce your transaction costs. Coase explores how firms bundle all kinds of costs, and reduce cost of production for all kinds of goods and services in society.
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. When parties are in a conflict, a bargain may also include exchanging property rights, like in 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 find 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. The theory is a feature of law and economics that enables solutions to be found, often by simplifying resolution processes.
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.
Compared to Pareto efficiency, the Kaldor-Hicks criterion is considered to be a more realistic version of how conflicts are resolved in the world. The Kaldor-Hicks criterion is often used to as a way to test whether a Pareto optimal exchange has occurred in the process of internalizing transactions.
The Kaldor-Hicks criterion seeks to internalize externalities so that markets can run efficiently. The criterion seeks to address over-consumption that results from the existence of externalities in markets. A primary assumption of the Kaldor-Hicks criterion is that all property rights are for sale. Once this assumption is established, the Kaldor-Hicks criterion requires an authority to determine the value of compensation required to internalize externalities; next, the authority will collect an internalization fee from producers. At this point, firms can produce goods and services at supposedly fair prices. But this is not the entire story. The formerly externality bearing parties should, under the efficiency principle, be compensated for externalities. The value of the compensation is set by the authority, not by parties themselves. This is difficult for some economists to support because externality bearing parties do not express the degree to which they value their rights by the amount of compensation they receive. Finally, parties affected by externalities will have a right to refuse to sell their rights by paying producers to stop production. The way in which the Kaldor-Hicks criterion involves objectively assessed compensation enables it to resemble conflict resolution in the world. The same parties in Pareto efficiency that were able to value their rights subjectively do so differently in the criterion. In the Kaldor-Hicks criterion, the right to refuse to sell your rights is only made possible by paying producers of the externality to stop production. In other words, the price the externality bearing parties have to pay to refuse the sale of their rights is the amount of producer's total benefit of 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 (RHA), the application is as follows. An authority collects what it determines is fair compensation to the RHA. The mining activity should continue until the RHA is willing to pay Bob to stop. The RHA may receive $1 for each 100lbs of coal shipped, at the discretion the authority; however, mining will continue until Bob is paid by the RHA to stop mining, or until he no longer benefits from mining. So, if Bob sells his coal for $10/100lbs, and he pays $5/100lbs in costs, his benefit is $5/100lbs. The amount of benefit received by Bob for mining is now a cost the RHA is required to pay if they want bob to stop mining. This may seem terribly unfair, but some economists think this is actually how many problems in the world are resolved.
The Kaldor-Hicks criterion can be broken down into steps. First, rights have to be completely alienable, or for sale. Second, an authority has to enter into the conflict and determine the value of the externality. Third the externality bearing party must be compensated. And finally, the option for the third party to buy out the producer is possible.
The Kaldor-Hicks criterion is often used by policy analysts that work on compensation schemes such as carbon credits. One of the strange features of the criterion is that it does not actually require that compensation is paid to externality bearing parties. Whether compensation is paid is a matter for the policy authority to decide. Surprisingly, the criterion's emphasis is the injustice of transactions where the value of externalities artificially reduces prices of goods and services. This is because externalities, when not internalized, have the effect of lowering prices of goods and services, which leads to over-consumption at the expense of externality bearing parties. For Kaldor-Hicks, only when product prices reflect their complete cost of production will markets be efficient.
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 is thought to be more realistic. One of its aims is to reduce the ability of hold-outs to create inefficiencies. A hold-out is a party that does not want to sell their rights at the expense of all parties receiving a greater benefit by them doing so. In actual fact, the value that externality bearing parties place on their rights is realized in the Kaldor-Hicks criterion if they decide to pay producers to stop producing. The problem is externality bearing parties hold an onus in the Kaldor-Hicks criterion. 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. Injustice occurs when the compensation for rights is less than the amount a party values their right and the buy out price is greater than the value they place on the right.
Ultimately, the Kaldor-Hicks criterion compromises the short-run interests of parties in an effort to balance the value received by winners with the losses suffered from losers. At the expense of allowing winners to win more, the criterion makes property right holders responsible for the costs of industry. This prevents the problem of hold-outs. Many economists think that while the criterion might be a good way test whether Pareto efficiency has been achieved, restricting parties from expressing the amount they value resources has dire consequences.
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. Eliminating all unwanted activity would cost society more than the unwanted activity itself. 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 in negligence enables parties to act solely in their best interests where no duty to do otherwise exists. This allows society to creates incentives for duty holders to act cautiously. Contributory negligence, creates incentives on potentially injured parties to prevent accidents in negligence also.
Absolute victim liability and absolute injurer liability have the effect of create incentives to opposite parties. Law and economic theorists think that these assignments of liability should be considerately made. Absolute victim liability will place the duty to prevent injury on the victim. This will be used when the cost to prevent accidents from being caused is lower for the potential victim than for the potentially injuring party. Situations where this may be useful arise when a party knows that they have thin-skull attributes, or when the activity presents a known and easily avoidable potential of injury. An example of an absolute victim liability measure arises in insurance plans where injured parties in car accidents forfeit their claims when not wearing seat-belts.
The final liability assignment presented by Dimock is absolute injurer liability. Absolute injurer liability exists when injuring parties are held responsible for all damage, regardless of their taking precautionary measures. The effect is simply the opposite of victim liability. It is important to note that in addition to these liability structures analyzed by Dimock, 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. They make assignments when they determine which party pays the least cost to best prevent accidents. This party is called the least cost avoider. In pursuit of efficiency, economists try to make the least cost avoider hold liability. In other words, law and economics scholars think parties who can most easily prevent accidents should. The think that the best way of doing this is creating incentives on the least cost avoiders to make it in their best interests to take precautions. Sometimes imposing liabilities on innocent parties appears strange; however, economists will always seek to prevent damage at the lowest cost. Despite how unjust this might otherwise appear, law and economic scholars ultimately justify liability assignments by reducing accidents at the lowest cost to society.
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 the maintenance of 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 of law and economics scholars 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 at a higher price. In these cases, where they can sell to the other party for so much more that they can afford to pay damages for their breach and still receive more benefit, contract law allows them to do so. In effect, law and economic scholars think people should only be obligated to make good on their promises when it is in their best interest.
Application of Law and Economics to the Case:
Chaoulli v. Quebec (Attorney General), is a case about Quebec health and insurance legislation that prevents the creation of a two tier health care system in Quebec. In the case, the court found that the right to security of the person (s.7) was violated by the existence of the legislation. The facts involve a suffering patient, Mr. Zeliots, and physician, Chaoulli, who is seeking to establish private health-care services. The case turns on the evidence of Mr. Zeliots, who suffers as a result of long lineups and waiting periods preventing him from receiving reasonably prompt health care treatments.
Legal issues used to decide the case relate to how the Charter of Rights and Freedoms can be applied to strike provincial health care laws. The application analysis will focus on principles of law and economist scholars who will support the use of the Charter of Rights and Freedoms under the facts presented in this case. Sometimes, the Charter of Rights and Freedoms will not be a popular vehicle for law and economics scholars. Concerns law and economic scholars have with the Charter will be very similar to those of utilitarians. The concern is that, when section 1 is not applied to support their view of utility maximization or efficiency, the Charter creates a standard of inalienable rights. This is precisely what utilitarians, law and economics scholars, and consequentialist moral theorists do not want to see.
However, section 1 of the Charter does allow for the utilitarian principle to prevent a standard of rights from becoming inalienable. In this way, 'the greatest good for the greatest number' is an underlying principle in the Charter of Rights and Freedoms. When the application of the Charter makes it possible for an individual to chose to pay for a service, and the costs of their actions can be internalized, law and economics scholars will be pleased. If the Charter is utilized to protect a right that could otherwise be sold to a firm for the purpose of internalizing production costs, law and economics scholars will disapprove. In other words, the Charter of Rights and Freedoms will be unpopular with law and economics scholars when it is used to prevent the sale of rights.
As it concerns the Quebec health and insurance legislation, law and economics scholars will inquire about the logic of the penalties for disobeying the legislation. The penalties are clearly measures seeking to disincentize physicians and insurance providers from adopting or supporting privatized heal care services. The aim of law and economics scholars will be argue that penalties should represent the cost that society pays for disobedience with the law. The position of law and economics scholars on penalty setting will include consideration of the chances of being caught for the offence, also. As it pertains to the Quebec health and insurance legislation, the costs to society must be clear, and the evidence presented in this case is that society may actually be damaged by the provisions of the health and insurance legislation. This will be the case where citizens want to pay for a service, for a price that includes any negative effects it has on society, and are made unable to do so.
About the general issue of the privatization of health care services, law and economics scholars have a reputation for supporting privatization, and when considering their assumptions about efficiency the reasons are obvious. Economists support competition in markets because they believe the force of competition creates efficient markets. Economists think people are rational utility maximizers. They think that firms will set prices as high as they reasonably can, and that the only thing that stops them from setting their prices above the cost of production is the force of competition. Only when firms can freely enter into markets will competing firms have an incentive to lower their prices to the cost of production. When prices rise above the cost of production, firms make profit. Many economists believe this sends a signal to investors and business people that competition is needed in that market.
In this case, it is difficult to conceptualize how adding a new tier to a public health care system will make the entire industry more efficient. The costs of health care are quite high in Canada (highest marginal health care service costs in the world, next to America). The effect that a second tier may have on the public health care system is unknown. Economists may have models that they would use to rationalize how this case should be decided and organized, and they will be presented below, but first it is important to consider the complications that can arise from implementing a two tier system are empirically unknowable. Many speculate that a two tier system will destroy public health care in Canada.
The essential ratio that results from a law and economics analysis of a case like this, involves two steps. The first step is to reduce transactions costs by finding a party who values the right at issue the most, and making it possible for them to purchase the right. The second step is to consider all the parties negatively impacted by externalities created by the first step, and compensate them by internalizing the purchase of the right.
Applying the ratio stated above, law and economics scholars will seeks to do two things. First, they will seek to reduce transaction costs by empowering Mr.Zeliots, the patient suffering as a result of the health care and insurance legislation. They will make it possible for him to choose whether he wants to purchase private health care services or not. Second, law and economics scholars will seeks to compensate parties affected by the negative impacts of letting Mr. Zeliots purchase private health care. The value of the compensation will be included in the price of private health care. These externalities will include costs required to stabilize the public medical system so that the current benefactors of that system are not negatively impacted by Mr.Zeliots' ability to choose.
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