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

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Legal Perspectives: Law and Economics

Generally speaking, the study of economics concerns distribution outcomes involving scarce resources. Less generally, economic thought can be broken into two categorical approaches; namely, these are positivist and normative. Positivist economics is primarily concerned with how and why people respond to changes in market conditions. Normative economics are concerned with the organization of incentives and offers suggestions of how markets should be organized to achieve efficient results. Law and economics is a blended methodology of descriptive and suggestive measures.

Economics is fascinated by human behavior 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.


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


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

The Coasian theory is yet another framework for analyzing economically efficient outcomes in law and economics.

Looking Closer

The following sections will attempt to apply the principles discussed above to specific areas of law.

An overview of Law and Economics in Tort

An overview of Law and Economics in Criminal Law

An overview of Law and Economics in Contract Law