Economics of the Law

A Primer

Wolfgang Weigel

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781134145355
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

There is an ever-increasing interest in the question of how and why legal norms can effectively guide human action. This compact volume demonstrates how economic tools can be used to examine this question and scrutinize these legal norms. Indeed, this is one of the first text to be based on civil law instead of the more usual common law, situating the study of both private and public law within the framework of institutional economics, with recommendations for further reading and a list of key terms in each chapter.

Besides the standard economic problems in property, tort, contract, crime and litigation, areas covered include:

• 
  
  

• new institutional economics
• public choice
• constitutional law
• public administrations
• regulatory impact analysis.

This book is essential reading for students in law schools and economics departments alike, particularly those engaged with the methodology of law and economics, applied economics and economic methods of legal policy.

1 Looking at legal norms from an economic viewpoint

A very first look at the map

You are about to start reading an introductory text on the economic analysis of law. This has been and to some extent still is a controversial topic – particularly from the point of view of legal scholars. Therefore, some preparatory remarks might be in order. First, there is the self-evident observation that an economy cannot work without law. As you shall shortly see in a stylized example, economic action is embedded in legally defined entitlements, procedural rules and sanctions for misconduct, to mention but a few. Economists have not denied this, but in their reasoning they treat the legal framework as abstract most of the time (they take it for granted implicitly and moreover they seem to assume that the legal system works effectively and smoothly). There are economic scholars who believe that this is unfortunate. So schools of ‘dissenters’ have emerged, which are called ‘institutionalists’. They will be introduced to you later (pp. 9–12).

An even more challenging relationship between economics and the law occurs when economics is brought into play as an instrument for a better understanding of the law. Sometimes economists are blamed for such application and they are labelled ‘imperialists’, because they intrude on foreign fields. However, it can easily be shown that such allegations are misleading. As economists and hopefully also lawyers will be aware in the course of reading this book, economics is not only an object of investigation, but also a distinct method for looking at things. Now, looking at the law from a historical perspective appears quite natural, as is looking at the law from a political perspective, so why not look at it from the sociological, psychological, philosophical or economic perspective? Each of these approaches uses a distinct methodology and each therefore can contribute to the better understanding of the issues at hand. One of the peculiarities of jurisprudence is the lack of a behavioural model of human action, by which the effectiveness (and failures, of course) of legal norms can be investigated. And it is one of the strengths of economics that it can provide such a model.

Through the application of economic model(s), economists can explain the ineffectiveness of legal norms and they can make predictions about effectiveness. They also have means by which they can develop recommendations toward the improvement of laws.

While these can definitely be beneficial for the people (society) at large, this requires the observation of these recommendations by the legislature (including bureaucrats engaged in drafting of laws) and the courts. There is a difference, however, in who is primarily addressed, which depends on the legal system in use in a given location. For the purpose of this book two types of legal system ought to be distinguished, namely civil law and common law. It should be pointed out that remarks on the differences in legal traditions are necessary since the original German edition of this book was written with a strong orientation towards civil law, this being the predominant system in German-speaking countries. With its focus on methodological questions the book is in principle applicable to all legal systems (including French or Roman Dutch law). However, as the economic analysis of law definitely falls within the domain of ‘applied economics’, one should be aware of the field of application. Although their distinctive features have been blurred in the course of time, the two systems may be characterized as follows:

• Civil law is characterized by codified sets of rules governing relation between persons (humans or legal personalities). Typical examples are family law, tort law, trade law and corporate law. Regulations contain statements about lawful and/or unlawful acts and their consequences. Courts are thus obliged to observe certain procedures but they are mainly concerned with comparing the (codified) facts of a case with the actual circumstances. The more detailed the facts the less discretion is left to the judge (obvious omissions notwithstanding which might call for decisions per analogiam).
• Common law, in turn, rests on procedural statutes that guide the courts to judge by comparing the evidence to previous judgements, thus stressing precedent, but also take guidance from principles of natural justice and fairness. Common law tends toward ‘judge-made law’ where no (matching) precedent is found. This being the underlying principle in a nutshell, it must not be overlooked that even with strong common law traditions an ever increasing number of issues is now codified.

The consequence of this very brief summary is that recommendations flowing from the economic analysis of law should be aimed at legislators in civil law countries, whereas the primary addressees are courts (judges) in the common law system.

Unfortunately, even for the vaguest principles there are exceptions. One such exception is that in civil law countries the economic analysis of law can be valuable for constitutional courts, for example in cases where the fundamental civil or economic rights of citizens are at stake (as is increasingly the case in Austria and Germany).

The situation is slightly different when it comes to public law. As you will have seen on the contents page of this book, there is a chapter devoted to public law – an innovation among introductory textbooks in this field. Normally, criminal law is seen as public law, since it deals with the codification of relations between individual wrongdoers and society (thus dealing with public affairs). Whereas criminal law has been a traditional subject of the economic analysis of law (in fact, it was among the first and enjoyed rigorous analysis by Nobel laureate Gary Becker in the 1960s), constitutional and administrative law have been much less so.

Constitutional law is primarily concerned with sets of rules designed to facilitate rule making. The purpose of a constitution following this definition is the stabilization of social interaction; it specifies rights and obligations that are (must be) observable and enforceable. The understanding of constitutional law has benefited much from ‘positive political theory’ or public choice.

Administrative law, in turn, comprises two interrelated areas: one dealing with the causes and consequences of bureaucratic action inside bureaucracies and the other focusing on external interaction, for example between legislators and the bureaucratic institutions comprising the executive branch, and also between these bureaucratic institutions and the citizens and enterprises, respectively. Research into the latter area is better known as research into regulation. The fields of administrative law are substantially covered by the economic theory of bureaucracy and the (law and) economics of regulation. Only more recently, in the course of public sector reform, issues such as labour contracts for civil servants, payment schemes and the like have caught the eyes of analysts. However, there is still much to do, as will be illustrated in Chapter 5.

For the sake of completeness, I would like to point out that in this introduction some very interesting areas cannot be covered, such as international treaties and codes stemming from organizations such as the United Nations or the World Trade Organization, canon law (the law of the church) and Islamic law, of course.

The idea of this first section was to have a look at the map before we start tracing our route, which we shall set off on now.

When law is allowed to enter the economy

When it comes to the introduction of basic principles, economists most frequently do this by drawing attention to how a market functions, preferably a market for a consumption good. A market is a distinct means of coordination for the supply of and the demand for some commodity. In the simplest form, exchange takes place, thus transferring a certain amount of the good at hand from the supplier to the consumer, when there is agreement about the unit price of the good. (We will consider the procedure in slightly more detail later.) I would like to demonstrate that it can be enlightening to bring into play the role of the law in actions like a market exchange. I promise that both lawyers and economists will be enlightened, although economists might be slightly more surprised.

Before we start, let us be clear about the scope of the economic analysis of law. Essentially, this deals with two questions:

1. How do legal norms affect human behaviour?
2. Are these effects socially desirable?

Of course, the second question entails two more, namely: If the effects are undesirable, why is that so? If one knows why they are undesirable, how can the situation be changed?

With this agenda in mind we can now turn to a closer examination of our market. Please be aware that this introduction cannot replace a primer in microeconomic theory and policy. (See ‘recommended reading’ at the end of the book for references.) It can merely serve as a reminder and as the basis for a fruitful discussion of legal norms. We turn to the market for an example: the soft drink Fresh, which is available in the familiar 33cl cans. The law of demand states that the number of cans bought will increase as the price per can goes down (other things remaining equal). Alternatively with an increase of the price, the number of purchases of cans will decrease proportionally. Thus, we have described Fresh as an ordinary consumption good. For the sake of completeness we should add that with consumers taste remaining constant and a fixed price, an increase in income (or in money for purchases) will lead to a (slight) increase in the level of consumption. A change of the price of competing soft drinks (of which a large variety are available) can also lead to a shift in the level of consumption of Fresh (up or down, in the opposite direction of the competitors’ price changes).

The law of supply, in turn, states that the number of cans offered will be higher the higher the price per unit, which can be achieved – where as usual the marginal cost of an increase in production is assumed to be given. Note that for the time being we do not make a distinction between production, wholesale and retail. Also, we assume that the price per unit is always above the minimum price for which supply is definitely profitable. Short-term shifts in supply are possible by curtailing the capacity of the bottling plant. Long-term shifts of the supply are not possible in our framework, because this would require the installation of additional capacity (an investment, which is presumably not readily available at short notice).

A market emerges when demand and supply intersect (see Figure 1.1). The number of cans exchanged will be determined by the price at the point of intersection. It is said that the market is in equilibrium, since the amount sold and the amount purchased are equal. The equilibrium is stable inasmuch as it will not change as long as the conditions hold under which it was brought about. The result is conditional, however, on the rational behaviour of fully informed participants in that market (since these are essential prerequisites for the further development of our ideas, we will have to come back to this issue under the label of homo oeconomicus, pp. 14–22).

The situation is advantageous for both sides. Let us check why: following the line of demand, one can see that there are consumers of Fresh, who would have been willing to pay a higher price per can than what they were charged. In the point of equilibrium, however, that willingness to pay and the actual charge are equal. Those who are located to the left of the equilibrium point enjoy the additional advantage given by the vertical distance between the price line and the demand curve. The sum of all these advantages is termed consumer surplus.

For the supplier the sale at equilibrium price means that for the last can sold the price just matches the additional cost of providing that can. Note that beyond that

Figure 1.1 Market equilibrium and welfare gains

A partial market for a commodity: with no obstacles (transaction costs) the supply schedule and the demand schedule intersect at equilibrium point P* and M*. Note that the willingness to pay on behalf of consumers between 0 and M* is higher or just equal to price P*. The accumulated gains are called ‘consumer surplus’ (the light grey triangle); suppliers up to P* enjoy a welfare gain, since their marginal cost as reflected by the supply schedule is – unless they are equal to P* – lower than the revenue, where the total gain is the producer surplus (the dark grey triangle).

point sales would incur losses, since the marginal cost would be higher than the attainable price. To the left of the equilibrium, however, the seller for each can sold enjoys a positive difference between the attainable price and the marginal cost. This is an additional profit, which becomes smaller the closer one gets to the equilibrium point. The sum of all these additional profits (or, in more technical terms: the area between the price line and the supply curve) is called the producer surplus. Clearly a rational supplier of Fresh (or any other tradable commodity) will maintain this offer so as to maximize surplus (rent) – unless there is no more promising alternative in sight.

Thus, under the ideal conditions of our example, both sides extract maximum advantages out of their position in the market for the soft drink Fresh.

Why might our findings be questionable?

What do you think about the following reservation? How come both sides of the market are trading peacefully? Why is it that they are evidently trading cans for money voluntarily? Does such activity not presume entirely unreal behaviour? If – as has been stated already – participants in the market are guided by trying to gain an advantage for themselves, then consumers who want a soft drink could steal cans or rob the supplier. What keeps them from doing so in our ideal market? Or did we make an implicit assumption, which should be made transparent in our discussion?

To illustrate, let me quote from an Austrian newspaper headline from around Christmas 2000 (at this time of the year in Austrian cities one finds stalls all over the place where roasted chestnuts are sold for one euro a dozen): ‘Snubbed customer had a knife. Criminal procedure for two hot chestnuts’. Conversely, the suppliers could satisfy their desire for money by force or guile.

Given such observations we will now set out to see whether there are forces at work that create sufficiently strong incentives to make trade in our market as peaceful as we have depicted it.

We are making progress! Let us pick up the conjecture that markets, in order to work appropriately, must be embedded in a legal and institutional framework. By tracing this conjecture further we are relating economic and legal issues to one another. We thus enter the domain of law and economics.

To be more specific with our example and the market for Fresh: in order for peaceful exchange to work the participants in the market must acknowledge private property, but possibly do so only in principle. This means that there must be effective institutions that enforce the observation of private property rights (see Box 1.1).

Box 1.1 Losses due to shoplifting

Let us stop for a moment and recall an event in the Austrian parliament, during a question time session in which the Federal Minister of Justice was asked his opinion on the likely consequences of the fact that, in 1998, losses due to shoplifting amounted to €545 million (an equivalent of 2 per cent of the GDP).

In his lengthy answer, the minister essentially stated that commerce must be designed in such a way that the incentives of perpetrating and the opportunities to perpetrate crimes were reduced. He was aware, he pointed out, that the then prevailing §42 of the Austrian Criminal Code provides a waiver for sanctions if an act lacks a certain type of offence.

Source: Minutes of the 152nd session in the 20th term of legislature, 5 December 1998.

As scholars of the economic analysis of law we can take this example as a starting point for the discussion of how economics can contribute to a better understanding of underlying problems and of how to take steps towards resolving them – exactly what we have stated at the beginning of this chapter as the essential questions our approach can help to answer!

Thus, from our observations (regarding the existence of private property as well as institutions for enforcement), two rather interesting and important questions emerge. First, what motivates people to acknowledge private property? And, second, how can such a fundamental agreement be accomplished? Shaping answers to these questions means delving into the world of economic order and, more specifically, constitutional order from the perspective of individual decisions. Moreover, the accomplishment of such fundamental rules can no longer be approached by means of a market. The fundamental rules at hand are res extra commercio by nature (although we will learn in the chapter on public law that this inherent property of rules can be violated!). The rules at hand are principally established by democratic vote, which is one type of coordination through non-market decisions (others being command or bargaining, norms, traditions and others).

Our market for Fresh as we have represented it in Figure 1.1 does not reveal whether any frictions arose in the course of the purchase, although we must admit that, in the present example, frictions or obstacles to the deal are much less likely than in the case of durables such as refrigerators, shoes or cars. Therefore, let us explore the...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• List of figures
• List of tables
• List of boxes
• Preface
• 1 Looking at legal norms from an economic viewpoint
• 2 The law and economics and property rights
• 3 Conflicts caused by accidents, damages, failed negotiations and broken contracts
• 4 Lawsuits and law enforcement
• 5 The law and economics of the public sector: legislative and executive
• 6 There is still a lot to say on … applications, alternatives, criticism
• Further recommended reading