The Economic Analysis of Law: Some Fundamental Concepts
Reviewed by Jason Soon
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Well-developed legal institutions play a pivotal role in the proper functioning of market economies. But how do legal rules evolve? And what are the consequences of alternative rules? The economic analysis ofÊ law may have some of the answers.

Economists have rarely been shy about trespassing into the boundaries of other disciplines. However, the economic analysis of law arguably did not come to be recognised as a separate field of study until the release in 1973 of The Economic Analysis of Law by Judge Richard Posner, affiliated with the University of Chicago Law School.

The purpose of this article is not to attempt a survey of the voluminous literature spawned by that work, which has seen economic analysis extended to criminal law, the law of contract, corporate law and even constitutional law. Rather, it is to introduce beginners to two important concepts employed in the school of economic analysis of law broadly known as Chicago School Law and Economics, namely wealth maximisation and the Coase theorem.

Before we explore these two concepts, however, we need to understand some of the key premises underpinning this burgeoning scholarly movement.

What is Law and Economics?

The term Law and Economics refers to a body of scholarship whose objective is to apply the insights of modern economics to the full range of the law, i.e. the system of legal rules which underpin various societies.1 

The application of economics to law can not only help us explain how legal rules evolve, but also what the consequences of alternative rules might be. Law and Economics therefore uses economic analysis as a way of evaluating these rules by questioning how well they serve particular social objectives, i.e. how efficient they are. This is the positive approach.

What is meant by efficiency in this case is the concept of allocative efficiency, a state of affairs whereby resources are allocated to their most valuable usesÑÔvaluableÕ, that is, from the perspective of the members of a society.

Law and Economics also uses the guiding principle of efficiency to suggest the reform of legal doctrines and institutions. This is the normative approach and it is by far the most controversial premise in Law and Economics.

The positive approach

The model of rational choice at the centre of much of modern economics has been found applicable to a wide range of market and non-market behaviour. By seeking to understand how the behaviour of people is affected by incentives created by the law, the positive approach can help us understand the consequences of alternative rules.

This approach is supported by appeal to the analogy of the law as a pricing machine. The law ÔpricesÕ various forms of human behaviour by the use of fines, penalties and other measures. These alter the balance of costs and benefits faced by individuals in deciding whether or not to persist in certain behaviour.

It follows from the assumption of rational maximising behaviour that changes in incentives and disincentives due to changes in laws are likely to affect the choices made by individuals on the margin.Ê

For example, this approach would predict that the policy of mandatory automobile safety legislation is unlikely to reduce the number of driver deaths. This prediction was confirmed in a 1975 study by Sam Peltzman of car accident statistics following the implementation of legislation mandating the use of seatbelts, penetration resistant windshields and other safety equipment.

Law and Economics would argue that such equipment, by reducing the probability of death following an accident (i.e. thus reducing the implicit ÔpriceÕ of speeding), would increase the incidence of speeding (i.e. the amount of speeding drivers are willing to implicitly ÔpurchaseÕ), and thus increase the number of accidents.

As it turned out, the increase in the number of accidents just balanced out the decrease in the probability of driver deaths, leading to no net fall in driver deaths, but a net increase in the number of pedestrian deaths from car accidents.

The normative approach: wealth maximisation

As previously discussed, Law and Economics proposes an efficiency criterion for reform of the legal system. ÔWealth maximisationÕ, a concept popularised by Posner, serves as a means of applying the efficiency test to legal rules.

The wealth maximisation approach proposes the maximisation of the sum of Ôwillingness to pay.Õ Willingness to pay is defined as the value in dollars or dollar equivalents of desired states of the world, measured by the willingness that people are willing to pay for something or what they demand in money to give it up.

In evaluating legal rules, this approach would ask how much each individual would be willing to pay to either get rid of or keep certain rules.

The proper implementation of a willingness to pay test would require us to infer the willingness to pay from situations where people have backed up their words with action. One way to get around these difficulties is to observe the behaviour of people in analogous situations. For example, we can work out how much a safe workplace means to people by looking at cases where people work in unsafe workplaces and working out how much higher (presumably) their wages are to compensate for this.

The test can be further refined by the addition of the principle of constrained Pareto-optimality. This principle holds that a change is desirable if, and only if, it is possible to compensate losers from the change. Note that there is no requirement that losers actually be compensated, only that it would be possible to do so if the need arose. The usefulness of this principle is to increase the probability that all changes proposed involve a net addition to the value of the social pie.

Applying the concept of wealth maximisation

What relevance does wealth maximisation or efficiency have to human welfare? Why should it be the normative criterion of Law and Economics? The issues raised by these questions have not been resolved to everyoneÕs satisfaction. However, a number of short justifications come to mind.

One is that ultimately all valuation, rather than being objectively determined as a Ôuse valueÕ of particular goods, is up to the subjective perspectives of participants in an economy. Thus, wealth maximisation, by aiming to allocate resources to those who most highly value them, leads to the socially best possible use of resources.

Another justification is that policies aimed at wealth maximisation increase the opportunities for mutually beneficial trades. Mutually beneficial trades, by definition, lead to outcomes where at least one person is better off and no one is worse off.

In applying the wealth maximisation criterion, a judge would attempt to replicate the outcome of a market where legal rights and liabilities could be bargained over. For instance a wealth maximising allocation of liability in accident cases would ensure that liability goes to the party who could have avoided the accident at least cost.

The Coase theorem

An equally powerful concept in the economic analysis of law is the Coase theorem, named after the Nobel laureate in Economics, Ronald Coase.

The Coase theorem tells us that in a world of zero transaction costs2 , resources will be allocated to their highest valued uses so that wealth will be maximised, irrespective of the initial allocation of those resources. How does this come about?

Imagine the archetypal property disputeÑa farm is located next to a railroad. Sparks fly off the railroad whenever a train passes through, causing damage to the crops of $400. The railroad could avoid causing damage by rerouting but that leads to a loss of $500. The farmer and the railroad company take their claims to court. The court decides in favour of the farmer, granting an injunction preventing the railroad from moving trains through that area.

As hardheaded economists who donÕt fall for emotional rhetoric about Ôthe little guy versus the big corporationÕ, we lament the decision. The efficient outcome would be to allow the train to continue passing through since the most highly valued use of the disputed property is to have a train pass through it.

However, it doesnÕt matter in a world of zero transaction costs. After the case, the railroad company would be willing to pay the farmer anything up to $500 for the farmer to allow it to run its trains through the disputed area, since there is prospect of a monetary gain from doing so even after the farmer has been bought off. The farmer would be willing to accept any payment of at least $400 because he would be no worse off or possibly better off with anything in that range. Depending on the strength of bargaining by both parties, the final outcome will be a bribe of anything from $400 to $500.

Conclusion? In a world of zero transaction costs, where there is a property rights dispute, if people are left to bargain among themselves, the efficient outcome will be arrived at irrespective of how property rights are assigned, whether they are assigned to the ÔplaintiffÕ or the ÔdefendantÕ. There is one qualificationÑthe final distribution of wealth will differ depending on the initial allocation of property rights. This is because if the parties spend their money in different ways depending on their income this will then affect the demand for other goods and services they buy.

Our simple parable therefore clarifies many hitherto unnoticed points.

Firstly, the issue of causation of harm, from a wealth maximisation perspective, is completely irrelevant to the resolution of this issue in a zero transaction costs world.

In our example, the railroad may have caused harm to the farmer by scorching his crops but the optimal outcome for society is for the train to continue running because this leads to the most highly valued use of the disputed property.

Imagine an alternative scenarioÑwhat if the railroad had been operating there for many years, but then the farmer bought the land next door, knowing that sparks were likely to fly off the tracks and burn his crops? What if this prospect resulted in the farmer getting the land at a discounted price? Who is really in the wrong now? Could the farmer in fact be accused of extortionate behaviour?

What the above deconstruction reveals is that the cause of damage in most disputes really arises from the proximity of two incompatible property rights uses. Deciding one way or another harms the interests of one of the parties. But the relevant consideration is the net cost or benefit of the corresponding use of the resource, which the law gives a preference to by deciding in favour of one party and against another.

The parable also suggests that in a world of positive transaction costs, which is the world we live in, the initial allocation of property rights is important. Consider what would happen if the court held in favour of the farmer where the costs of transaction between the farmer and the railroad outweigh any benefits (which are at most $100) from assigning the use to the railways. In that case, the railway may make a rational decision not to bargain with the farmer. Hence the disputed property may not be allocated to its highest valued use.

Conclusion

The concept of wealth maximisation underlies most of the normative tests behind Chicago School Law and Economics. Armed with an understanding of this concept, one can proceed to evaluate the efficiency of particular outcomes.

Properly understood the Coase theorem adds credence to our original intuition that the results of adjudication do in fact matter, and that well developed legal
institutions are crucial to the performance of economies and the general welfare.

References

Coase, Ronald H. 1960, ÔThe Problem of Social Cost,Õ reprinted in Ronald H. Coase 1988, The Firm, The Market and the Law, University of Chicago Press, Chicago.

Pelzman, Sam. 1975, ÔThe Effects of Automobile Safety RegulationÕ, Journal of Political Economy 83(4): 677-725.

Posner, Richard A.Ê 1973. Economic Analysis of Law, Little, Brown, Boston.

ÑÑÑ. 1979, ÔUtilitarianism, Economics and Legal Theory,Õ Journal of Legal Studies 8: 103-140.

Jason Soon is an Economist with Ernst & Young. He is also Adjunct Scholar at The Centre for Independent Studies and former Assistant Editor of Policy.

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