Economic Foundations of Law

Stephen J. Spurr

• Publisher: Routledge
• Year: 2019
• ISBN:
  9781351239769
• Edition: 3
• Topic: Business
• Subtopic: Business General
• Index: Business

The third edition of Economic Foundations of Law introduces readers to the economic analysis of the major areas of the law: property law, torts, contracts, criminal law, civil procedure, corporation law and financial markets, taxation, and labor law. No prior knowledge of law is required, but a prior course in the principles of microeconomics would be quite helpful.

The text opens with a review of the basic principles of price theory and an overview of the legal system, to ensure readers are equipped with the tools necessary for economic analysis of the law. The third edition provides expanded or new coverage of key topics including intellectual property law, how the creation of new forms of property rights affects the conservation of species such as elephants and fish, controversies involving liability for medical malpractice and class actions, the transformation of personal injury litigation by the intervention of insurance companies as plaintiffs, how to predict the outcome of litigation with game theory, an economic analysis of the ownership and use of guns, bankruptcy law, and the economics of bank regulation.

Comprehensive and well-written, this text is a compelling introduction to law and economics that is accessible to both economics and law students.

1 Principles of microeconomics (I)

Welcome to the study of economic analysis of law! If you can master the material in this chapter and the next one, you will find all the applications of economic principles in the remainder of this text straightforward. The approach to the study of law taken in this text, and in the research referred to below, represents the future of legal scholarship.

These first two chapters introduce some fundamental economic principles. The basic tools of price theory – supply and demand curves, and the like – are humble and deceptively simple, and it is easy to underestimate the power of these ideas. A lack of understanding of these principles often leads to the adoption of inefficient and sometimes disastrous policies – government subsidies of crops and inefficient firms, protectionist policies in foreign trade, and the like. Outside the United States, of course, the ignorance of economics has resulted in mass starvation and blighted lives for millions living in poverty. Thus we can begin to appreciate the value of price theory by considering the consequences of making decisions without it.

In this chapter we will examine demand and supply curves, how price and the amount of the good sold are determined in a competitive market (with an application to the market for lawyers), elasticities, and the effects of government intervention in the market via taxes, subsidies or price controls. We develop these foundations of price theory only to the extent they are helpful for the analysis of law set forth in the chapters that follow. Readers who are familiar with price theory at the level of a college course in intermediate microeconomics may wish to skip the first two chapters, and proceed immediately to the chapter on an introduction to the legal system.

A basic principle: the fungibility of money

A good is “fungible” if units of the good are regarded as indistinguishable from one another, and thus freely exchangeable. Money is fungible. A’s $1 bill is for all practical purposes identical to B’s $1 bill. The idea of fungibility has important economic implications. Many state lotteries have been adopted in part because of political support resulting from promises made to the public that all net revenues of the lottery will be used only for public education. Suppose a state spends $500 million a year on its public schools, raising the funds from a property tax. The voters of the state approve a state lottery, relying on the promise that all net revenues of the lottery will be spent on public education. The lottery has $200 million in net revenues in its first year, and all of it is spent on the public schools. Suppose, however, the state now takes $200 million of its property tax revenues that were previously spent on education, and spends them instead on road repairs. In this case the total spending on education has not increased; the problem is that money is fungible.

Now suppose that, without a lottery, the state would have continued to spend $500 million on public education. However, there is a lottery, and its net revenues for the year are $800 million, all of which must be spent on education. In this case the lottery actually increases spending on education by $300 million. Even though money is fungible, a restriction or earmark that causes expenditures to be greater than they would otherwise be does have an effect.

Let us return to the previous example, where the lottery raised $200 million specifically for public education, but total spending on schools ($500 million) did not increase at all. Do things like this really happen? As it turns out, it is unusual to find such extreme examples of fungibility. There have been a number of studies of the effect that earmarking funds for public education has on total educational spending. One study¹ found that between 50¢ and 70¢ out of every dollar earmarked for education ends up in local school districts, notwithstanding the fungibility of money. Governments are usually not brazen enough to offset the additional funds completely. This has been attributed to the “flypaper effect,” i.e. the idea that money often sticks to the wall in the place where it is thrown. The idea is that government spending for a particular purpose, like public education, that has been promoted by an interest group, like the education lobby, tends to increase total expenditures for that purpose, because (1) the interest group will follow through to make sure the new funds that have been committed are not offset by an equal reduction of funds somewhere else, and (2) the government does not want to disappoint the interest group, because the interest group will then lose interest in supporting government programs. There is something like an implied contract that the government will not “double-cross” the interest group by reducing its spending to fully offset the new spending program that has been approved.

Cost

Let us now consider a basic economic term that is often misunderstood – the idea of cost. When an economist uses the word “cost,” a layman, or beginning student, often assumes he means the financial cost – the cost in terms of money. However, when the word “cost” is used in a discussion among economists, it does not even occur to them that it means only the financial cost. For cost is a very broad idea in economics: depending on the situation, the cost of a given action may include money, time, emotional stress, discomfort, the risk of physical injury or criminal prosecution, or other undesirable consequences.

In general, the cost of an action is the value of the best opportunity that is lost by taking that action. In other words, it is the value of the best alternative to the action being considered. Suppose Bill, a college student, is trying to decide what to do with his life. He is considering several alternative occupations: law, dentistry, accounting, and becoming a high-school cross-country coach. Among these alternatives, the two he finds most appealing are law and becoming a cross-country coach. In this case the cost of choosing law is that he will not be able to coach cross-country. His decision whether to enter law school should turn only on whether law is more attractive to him than coaching cross-country. The other alternatives to law are irrelevant to his decision because they are dominated by the option of coaching cross-country.

The cost of going to college, rather than going to work immediately after high school, includes not only the out-of-pocket expenses for tuition, books, and the like, but also the loss of earnings one could have had by working full-time instead of attending classes. There is also a psychic cost, namely the effort involved in studying and learning new and often difficult material. High school graduates go to college because the benefits they expect from college, in terms of increased earnings and greater knowledge, exceed these expected costs.

As the preceding example suggests, an important component of the cost of an action is the time it takes. Businesses whose workers must frequently wash their hands, like those involved in food preparation and health care, must decide whether their employees will use paper towels or electric hand driers to dry their hands. Manufacturers of hand driers contend that they cost less than paper towels, but their calculation does not consider the value of the time an employee requires to dry his hands. If the services of the average employee are worth $30 an hour to the employer, and the use of an electric hand drier takes a minute longer than paper towels, this represents an additional cost of 1/60 × $30 = $.50 each time an employee dries his hands. When this additional cost is considered, paper towels may be less expensive to an employer than electric hand driers.²

Sometimes one hears the expression “sunk cost.” A sunk cost is a cost that has already been incurred and cannot be recovered. The key thing to know about a “sunk cost” is that it is not a cost at all. The cost of an action, or decision, is the opportunities that are sacrificed, or the resources that are consumed, by taking that action or making that decision. One should act if the benefits of the action being considered exceed its costs. If, on the other hand, the costs of the proposed action exceed its benefits, one should not do it. If an expenditure has already been made, and would not be increased or reduced by an action being considered, it is not a cost of that action, and is not at all relevant to whether that action should be taken. Suppose your father was a physician, and for as long as you can remember, everyone in your family expected that you would also become a physician. After college you entered medical school (mostly because everyone expected you to do so), and your family eventually paid $200,000 for your medical school education. However, after graduating, you realized that what you really wanted to do, or at least consider seriously, is to become a writer. How should you decide what to do – whether to become a writer or pursue a career in medicine?...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of figures
• List of tables
• Preface
• Acknowledgments
• Table of cases
• 1 Principles of microeconomics (I)
• 2 Principles of microeconomics (II)
• 3 Introduction to the legal system
• 4 Property law
• 5 Problems of incomplete property rights
• 6 Informal creation of property rights
• 7 The law of contracts
• 8 Torts
• 9 The economics of litigation
• 10 Criminal law
• 11 Corporations and financial markets
• 12 Taxation
• 13 Labor law
• Glossary
• Notes
• Index