Law & Economics Lecture 1: Basic Notions & Concepts

I. What is law and economics? Law & Economics Lecture 1: Basic Notions & Concepts Law and economics, a.k.a. economic analysis of law, is a branch of economics that uses the tools of economic theory to understand the workings and consequences of law and the legal system. You might think this is something you already have learned about in previous classes -- and to some extent you probably have. When you discussed price controls in your introductory economics class, you were analyzing the effect of a law (a legislative price control) on a particular market. You were able to analyze the consequences of that law in terms of its effect on quantities bought and sold (lower quantity sold, with a corresponding creation of a surplus or shortage) as well as its efficiency. Likewise, you've probably considered the consequences of antitrust laws and other legal regimes. But what you probably haven't done is explicitly consider how governments -- and particularly the courts -- go about enforcing laws. Much of economic analysis takes it as given that laws will be enforced, property rights respected, etc., without asking questions like: Can the laws be enforced perfectly? How much does it cost to enforce the laws? How much law enforcement is desirable? What types of procedures should we use to enforce the law? What types of punishments should be used? These are questions that law & economics addresses directly. In addition, you're probably used to thinking about law as something that is created by legislatures. That's certainly the case with laws like antitrust and price controls. But the vast body of laws that we live under are not, in fact, created that way. Much of our law is "common law," meaning a set of rules created by judges in the process of deciding cases. In particular, the rules of property, contract, product liability, malpractice, and many other areas are a product of common law. Law & economics gives direct attention to the common law. II. The Three Propositions of Law & Economics Law & economics as a discipline has largely been motivated by three distinct propositions about how economics can help us to understand the law. All three propositions, but especially the last two, are largely attributable to Richard Posner. These propositions are: That economic tools can explain the consequences of legal rules. That legal rules should be evaluated in terms of their efficiency. That the legal system has evolved toward more efficient rules over time. These are not the only propositions that L&E tries to address. Nor do all economists and legal theorists agree that they are all true. I have listed these items in roughly increasing

degree of controversy. There is very little disagreement that economics has something to say about the effects of different legal rules. There is a good deal of disagreement, however, about whether the economist's chosen standard of evaluation -- efficiency -- is the best or only standard of evaluation for legal rules. Many have argued that other considerations, such as justice, fairness, and equality, are just as important or more important. We'll delve into this debate more later. Finally, there is substantial disagreement about whether the law has indeed become more efficient over time. Some economists -- namely Richard Posner -- have spent much of their careers demonstrating the efficiency of the existing rules of common law. But others have argued that Posner is all wrong -- that he's ignored inefficient areas of law, misjudged the efficiency of areas he's analyzed, etc. Moreover, economists have proposed a variety of theories purporting to show that the law should, or should not, be expected to evolve in an efficient manner. We will consider some of these toward the end of the course. Note that the first and last propositions are positive propositions, whereas the second proposition is normative. Also, note that these three propositions roughly correspond to DDF's three enterprises of L&E, albeit in a different order. III. The Concept of Rationality What do economists bring to the study of law that wasn't there before? Many things, but perhaps the most important is the notion of rational choice. Economists have a welldeveloped model of how the world works, based on the idea that people act rationally. But what does it mean to be rational? It means, very simply, to act so as to satisfy one's desires as well as possible. It means doing the best you can in terms of your own goals, given the constraints you face. Note: It does not mean having preferences or desires that you or anyone else agrees with. Rationality is not a value judgment about the goals and preferences that people have; it is simply the proposition that people with goals and preferences will try to achieve them as effectively as possible. Rational choice is a notion with substantial, uncountable consequences. Among many other things, it implies that people alter their behavior to respond to altered incentives. Indeed, this could be said to be the single most important lesson of economics: that people respond to incentives. This means that we cannot assume that, when we alter the consequences of people's acts via changes in the law, people will continue to act in the same way. This may seem obvious, but DDF provides a couple of nice examples to demonstrate the significance of this point: What would happen if the punishment for armed robbery were raised, so that it were exactly the same as the punishment for murder? Prior to the change, armed robbers perceive that murder carries an additional punishment, so they have an incentive not to kill people while committing their crime. But after the change, there is no additional punishment for murder (i.e., the marginal punishment for murder is zero if

you re already committing an armed robbery), and that means armed robbers will be more likely to kill people. Thus, the change will tend to cause two effects: first, it will tend to reduce armed robberies; but second, it will tend to increase the fraction of armed robberies that lead to murder. What happens if landlord-tenant law requires that all rental units be "habitable" -- meaning they must meet certain minimum requirements relating to heating, air conditioning, hot water, etc.? It's not reasonable to assume that landlords will continue to behave as they do without the law, nor is it reasonable to assume they will simply comply with the law and change behavior in no other way. Providing these amenities is costly, and landlords will -- in the long run -- pass these costs on to customers in the form of higher rents. Some consumers will already have been paying for these amenities, and they will not experience the rent increase. Other consumers were not paying for these amenities before -- why not? If they valued these amenities more than their added cost, they could have bought them (by getting a different apartment or dealing with the current landlord). So these customers will end up paying for amenities that are not worth the price, or else not taking the rental unit at all. IV. Trade-Offs The next most important notion that economics brings to law is the notion of trade-offs. You are already familiar with many kinds of trade-offs from your previous economics classes. Because of the scarcity of resources, society cannot have everything it wants instead, it must give up some things to produce other things. Social trade-offs are represented by the downward slope of the production possibilities frontier. Individual trade-offs are represented by a budget constraint, which derives from the fact that an individual with a limited budget who wants to buy more of one thing has to buy less of another. Trade-offs are ubiquitous in law as well. Some examples of trade-offs in law include: More expenditure on criminal law enforcement means fewer resources to spend on other valuable things. Safer products require greater investment in safety, which means more expensive products. Higher quality products usually involve greater expense (DDF s example of habitability constraints on rental units). A higher conviction rate for the guilty also implies a higher conviction rate for the innocent. Placing greater responsibility on some parties (say, firms) often means placing less responsibility on other parties (consumers). In simple economic examples, a trade-off usually means giving up one good for another. But here, we re using the term trade-off more broadly. We mean that in order to achieve more of one valuable goal, you typically must achieve less of another.

V. The Law of Increasing Opportunity Cost, or Diminishing Marginal Returns In a great many areas, it s not merely the case that getting more of one thing means sacrificing some of another. It s also true that the size of the sacrifice required gets larger and larger. Say that you want to save more lives with better healthcare. To save the first 10,000 lives, it might cost $1,000,000 (in other goods and services forgone). But to save the next 10,000 lives, it might cost $1,500,000 (on top of the $1 million already given up). And to save the next 10,000 lives, it might cost another $2,000,000. The marginal cost of saving lives is increasing. The opportunity cost of anything is what you have to give up in order to get it. So another way of saying what we just said is that there are increasing opportunity costs to any activity. The more of the activity you do, the greater will be the opportunity cost of doing a little bit more. This fact is represented by the outward curvature of the production possibilities curve. Diminishing marginal returns is another way of looking at essentially the same phenomenon. Before, we were saving equal increments of lives (10,000), and the cost of each 10,000 was larger than the last. Now, let s look at equal increments of monetary sacrifice. The first million dollar sacrifice saved 10,000 lives. But the second million dollars doesn t save 10,000, because we know it took $2.5 million to save that many. The second million only saves, say, 7000 lives. So the second million saved fewer lives than the first million. This is an example of the law of diminishing marginal returns. The law of diminishing returns, or increasing opportunity cost, applies in numerous legal contexts. For instance, Putting more cops on the beat will prevent more crimes. But how many more crimes? Each added cop will most likely prevent fewer crimes than did the last, and the number of crimes prevented by each cop gets smaller and smaller. No matter how many cops you put out there, some crimes will still take place. Putting more inspectors on the factory floor will avoid more accidents (or product defects, or whatever). But each additional inspector will prevent fewer accidents than the last inspector. No matter how many inspectors you put out there, you can t reduce the probability of an accident to zero. VI. The Purposes of Punishment The primary way in which law is enforced is through the meting out of punishments for wrongdoing. But why do we punish people? What is the purpose of spending resources to make someone worse off? There are several different goals that may be involved: Retribution: giving people what they have coming to them. People who ve done bad things deserve to be punished. Restitution: paying back the victim. In civil court, a losing defendant usually has to make a monetary payment to the plaintiff, and part of the justification is

compensating the victim for the damage done to him. Some criminal penalties, such as community service, also have an element of restitution. Rehabilitation: reforming the wrongdoer. Personal (direct) deterrence: stopping this wrongdoer from doing it again. Social (indirect) deterrence: stopping other potential wrongdoers from doing it. Economic analysis of law is focused almost exclusively on deterrence. Why? (a) Because that s what economic tools equip us to do. The whole notion of incentives is driven by the idea of seeing how costs and benefits affect the actions that people take. (b) Because the other goals may be derivative; i.e., maybe we care about retribution because of the incentives it creates. It will often turn out that the prescriptions of efficiency analysis duplicate the prescriptions of justice that we ve been socialized to believe in. VII. Efficiency The problem with trade-offs, particularly the trade-offs involved in changing social policy and legal rules, is that they typically involve costs to some people and benefits to other people. Consider the case of the minimum wage. A minimum wage will tend to reduce the number of people employed. For those people who are laid off or never get hired in the first place, the minimum wage is clearly bad. For those who get jobs at the higher wage, the minimum wage is good. For the employers now having to pay higher wages, the minimum wage is bad. For skilled union workers who compete against unskilled workers, the minimum wage is good. How do we go about comparing all these costs and benefits? Efficiency is, as DDF puts it, essentially the economist s notion of maximizing the size of the economic pie. But for this concept to make any sense, we must have some means of comparing disparate costs and benefits of the sort created in any trade-off. The various notions of efficiency are all attempts at dealing with this problem. Pareto efficiency. This notion of efficiency was motivated by the idea that we cannot, in any meaningful sense, compare the gains of some people to the losses of other people. There is no interpersonal measure of happiness or utility. Say that an alien ship comes to earth and uses an energy beam on the two of us, giving me super strength while causing you to lose the use of one eye. Was the alien energy beam good or bad? We can t say, because one person got better off while another got worse off. But what if the energy beam gave me super strength without causing you to lose an eye? Then we can conclude the energy beam was good, because someone got better off and nobody got worse off. What if the energy beam caused you to lose an eye without giving me super strength? Then the energy beam was bad, because someone got worse off and nobody got better off. The Pareto Criterion says:

Situation A is Pareto superior to situation B if at least one person is better off in A, and no one is worse off in A. (e.g., energy beam gives me super strength and you keep your eye.) Situation A is Pareto inferior to situation B if at least one person is worse off in A, and no one is better off in A. (e.g., energy beam doesn t give me super strength and you lose your eye.) Situations A and B are Pareto incomparable if at least one person is better off in A and at least one person is better off in B. (e.g., energy beam has both effects.) Pareto Efficiency: Situation A is Pareto efficient if there does not exist another situation that is Pareto superior to A. That is, a situation is efficient if you can t make any Pareto improvements. The Pareto Criterion is nice because it doesn t require interpersonal utility comparisons (comparing the happiness of one person to that of another). The problem is that it doesn t give us much traction. Most policy changes we can think of make at least one person better off and one person worse off, and thus the Pareto Criterion has nothing to say. Consider the minimum wage again. Since it made employers and some workers worse off, while making other workers better off, the Pareto Criterion cannot compare the minimum wage to the free market. Similarly, almost any change in legal rules will make some people better off and some worse off. Kaldor-Hicks efficiency. The Kaldor-Hicks approach tries to remedy this problem with Pareto. What if there s a policy that will make you worse off, but $1 would be just enough to compensate you? And what if that policy is good for me, good enough that I d pay as much as $200 for the policy to be enacted? Then in theory, I could pay you off a dollar, you d be as well off as you were before, and I d be $199 better off than before. The Kaldor-Hicks Criterion says: Situation A is K-H superior to situation B if those who are better off in A could compensate those worse off in A and still remain better off than in B. (i.e., the gainers gain enough to compensate the losers; the gainers gain more than the losers lose.) Situation A is K-H inferior to situation B if those who are better off in A cannot compensate those worse off in A without making themselves worse off than in B. (i.e., the gainers do not gain enough to compensate the losers; the losers lose more than the gainers gain.) This may seem very intuitive, but here s the hitch: the compensation payments don t actually have to be made. Why not? Because if compensation is actually paid, so that losers don t actually lose, then we re back to Pareto superiority. We already knew that much without introducing the K-H Criterion. To say anything that Pareto didn t say, K- H must make comparisons in cases where compensation is not actually paid. Wealth maximization. Wealth maximization is another kind of efficiency, but it s really just a simple extension of Kaldor-Hicks. K-H made us think in terms of money for

compensation payments. So why can t we just think in terms of money all the time? Let s say that some policy change will create benefits for some people, and losses for other people. Suppose the dollar value of the benefits is $1 million, while the dollar value of the losses is $500,000. Then obviously, the winners could theoretically pay off the losers. More generally, any time situation A creates greater wealth than situation B when summed across all persons, A is K-H superior to B. Thus, the Kaldor-Hicks Criterion leads easily to wealth maximization as a standard of efficiency. And that is the kind of efficiency that economists usually employ in almost all analysis, in L&E and elsewhere. Justifications for wealth maximization. This standard is not without its detractors. There are some quite persuasive objections. One objection is that K-H implicitly makes interpersonal utility comparisons of the kind Pareto was supposed to avoid. If you say A is better than B when there are both winners and losers, even though no compensation is paid, you re implicitly saying that the gain in happiness for the winners is greater or more important than the loss in happiness for the losers. Another objection is that K-H is indifferent to distributional questions. If a new policy enriches one guy by $10 million, while making everyone else worse off by a total less than $10 million, that s fine. Or, turning the example around, if a new policy makes one guy worse off by $10 million, while making everyone else better off by a total of $10 million plus one, that s fine, too. To make the point stronger, throw in some class warfare rhetoric. Analytically, the wealth maximization approach effectively assumes that the value of a dollar is the same across all persons -- only by making this assumption could we conclude that a loss of $1 to you exactly balances a gain of $1 for me. But if interpersonal utility comparisons are not allowed, then that assumption is meaningless (which is not the same as wrong). Moreover, the value of a dollar is not even the same for a single person: as I get richer, the value of each additional dollar falls. Loosely speaking, a dollar is worth more to a poor person than to a rich person. How does the economist respond to these points? Well, he admits they are true. But he then makes the following points: First, there is value in distinguishing between the size of the pie and the distribution of the pie. Even if you think distribution is a very important goal, the size of the pie is also important. If your redistributionist policies cause a substantial reduction in the size of the pie, surely that should at least be taken into account, and economists urge us to do so. Second, for many of the questions we ll be looking at, the policies or legal rules in question are lousy methods of redistribution. There are other tools of redistribution, such as the tax-and-transfer tools of the government, that are better suited to the

task. When you use other policies as indirect means of transferring wealth between groups, you frequently causes losses in total wealth in the process. Plus, the transfers may not be targeted in the manner you want. A minimum wage may give some poor families more money, but other poor families may lose a breadwinner, while some suburban teenagers get a share of the benefits. Third, and specific to the L&E context, most legal rules are abstract in nature. They are not aimed at specific individuals, but at people in certain types of relationships. Any given individuals will typically end up on both sides of the relationship at one point or another. Sometimes you ll be the pedestrian who gets hit, sometimes the driver who hits him. Sometimes you ll be the person breaching a contract, sometimes you ll be the person harmed by someone else s breach. Or at least, you have a chance of being in each position. So from a long-run (and ex ante) perspective, higher total wealth often means higher wealth for each person. Your gains from being in one position compensate your losses from being in the other. In studying the law from the efficiency perspective, we will often do something that may seem strange: we will count the costs and benefits to everyone, including (for example) the costs and benefits to thieves and murderers. Why? First, because that's what efficiency is. Efficiency is defined in terms of the whole society, not just part of it. But second and more importantly, we don't want to bias our analysis. If the question we're trying to answer is, "Should theft be illegal?", it doesn't make sense to start by assuming the interests of thieves don't count. We want to find out what efficiency alone tells us about what makes good law, without being affected by other goals (such as justice, equality, and fairness) we might have. Otherwise, we engage in fallacious circular reasoning by assuming what we re trying to prove. What is fascinating is how often the efficiency analysis supports what we traditionally think of as just, despite adopting this neutral stance. VIII. Transfers and Rent-Seeking Transfer is the word economists use to refer to a quantity of wealth shifted from one person or group to another person or group as a result of some policy. A transfer is, strictly speaking, irrelevant to wealth maximization. If I take money from John s pocket and put it into Mary s, the effect on total wealth is zero. In this sense, efficiency is indifferent to transfers. But in a different sense, transfers are very relevant to efficiency. Why? Because transfers are beneficial to people who receive them, so they are willing to spend resources in order to acquire them. Likewise, transfers are costly to people who pay them, so they are willing to spend resources in order to avoid them. In the process of seeking and avoiding transfers, people spend resources that could have been spent producing valuable things instead of fighting over distribution. When people spend resources trying to get wealth transferred from others to themselves, it is called rent-seeking.

Consider a proposed law that will require government licenses for manicurists. This law will restrict the supply of manicurists, driving up the price and inducing some consumers to buy fewer manicures. The lower quantity of manicures sold, even though there are people willing to sell them at prices consumers are willing to pay, corresponds to a deadweight loss (a reduction in total wealth). But there is an additional effect: those manicurists who remain in business because they have licenses will make more money, at the expense of those consumers who continue to buy manicures at the higher price. This is a transfer from the consumers to the licensed manicurists. This transfer is precisely the motivation for supporting the licensing law in the first place. Trained manicurists will lobby for this policy in the state legislature. Untrained manicurists and consumers might lobby against it, though this is less likely because they are probably not as well organized. The lobbying expenditures are losses from a social perspective, because they do nothing to increase the size of the pie. They represent resources spent not creating any wealth, but just moving wealth from one place to another. This is an example of rent-seeking. DDF offers another: picking pockets. There are many examples of rent-seeking in the law, but for now I ll offer just one (also offered by DDF): The expenditures of plaintiffs and their lawyers trying to get money from defendants, and the expenditures of defendants and their lawyers trying to prevent it. They are essentially battling over a transfer. However, as DDF observes, this is not as obviously a case of dead-weight loss, because there could be benefits in terms of greater information, hence more accurate verdicts, hence better incentives for other people. In many other cases, however, rent-seeking actually creates worse incentives (as well as wasting resources in the manner discussed above).