Economic Analysis of Law*
by D. Friedman
The economic analysis of law involves three distinct but related enterprises.
The first is the use of economics to predict the effects of legal rules. The second
is the use of economics to determine what legal rules are economically efficient,
in order to recommend what the legal rules ought to be. The third is the use of economics
to predict what the legal rules will be. Of these, the first is primarily an application
of price theory, the second of welfare economics, and the third of public choice.
Predicting the Effect of Laws
Of the three enterprises, the least controversial is the first--the use of economic analysis to predict the effect of alternative legal rules. In many cases, the result of doing so is to show that the effect of a rule is radically different from what a non-economist might expect.
Consider the following simple example. A city government passes an ordinance requiring landlords to give tenants three months notice before evicting them, even if the lease agreement provides for a shorter period. At first glance, the main effect is to make tenants better off, since they have greater security of tenure, and to make landlords worse off, since they now find it more difficult to evict undesirable tenants.
The conclusion is obvious; it is also false. The new ordinance raises the demand curve; the price at which tenants choose to rent any given quantity of housing is higher, since they are getting a more attractive good. It also raises the supply curve, since the cost of producing rental housing is now higher. If both the supply and the demand curve for rental housing rise, so does the market price. In the short run, the regulation benefits the tenant at the expense of his landlord. Once rents have had time to adjust, the tenant is better off by the improved security of his apartment but worse off by the higher rent he pays for it; the landlord is worse off by the increased difficulty of eviction and better off by the increased rent he receives.
One can easily construct specific examples in which such a regulation makes both landlords and tenants worse off, by adding to the lease terms which increase the landlord's costs by more than they are worth to the tenant and increase the market rent by more than enough to eliminate the tenants' gain but too little to compensate the landlords' loss. One can also construct examples in which both parties are better off, because the regulation saves them the cost of negotiating terms which are in fact in their mutual interest. Thus economic analysis radically alters the grounds on which the regulation can be defended or attacked, eliminating the obvious justification (helping tenants at the expense of landlords) and replacing it with a different and much more complicated set of issues.
In this example, and in many similar ones, the two parties are linked by a contract and a price. In such cases, the first and most important contribution of economics to legal analysis is the recognition that a legally imposed change in the terms of the contract will result in a change in the market price. Typically, the result is to eliminate the transfer that would otherwise be implied by the change.
This is not true for cases, such as accidents and crimes, where there is no contract and no price. In analyzing such situations, the essential contribution of economics is to include explicitly the element of rational choice involved in producing outcomes that are commonly regarded as either irrational or not chosen.
Consider automobile accidents. While a driver does not choose to have an accident, he does make choices which affect the probability that an accident will occur. In deciding how fast to drive, how frequently to have his brakes checked, or how much attention to devote to the road and how much to his conversation with the passenger next to him, he is implicitly trading off the cost of an increased risk of accident against the benefit of getting home sooner, saving money, or enjoying a pleasant conversation. The amount of safety the driver chooses to buy will be determined by the associated cost and benefit functions. Thus, for example, Peltzman (1975) demonstrated that safer autos tend to result in more dangerous driving, with the reduction in death rates per accident being at least partly balanced by more accidents, as drivers choose to drive faster and less carefully in the knowledge that the cost of doing so has been lowered.
This way of looking at accidents is important in analyzing both laws designed to prevent accidents, such as speed limits, and liability laws designed to determine who must pay for accidents when they occur. From the economic perspective, the two sorts of laws are alternative tools for the same purpose--controlling the level of accidents.
A driver who knows he will be liable for the costs of any accidents he causes will take that fact into account in deciding how safely he should drive. Elizabeth Landes, in a study of the shift to no-fault auto insurance, concluded that one effect of the reduction in liability was to increase highway death rates by about 10-15%.
The advantage of liability over direct regulation is that the knowledge that if he causes an accident he must pay for it gives the driver an incentive to modify his behavior in any way that will reduce the chance of an accident, whether or not others can observe it. Regulations such as speed limits control only those elements of driver behavior which can be easily observed from the outside--speed but not attention, for example. The disadvantage of liability is that it forces drivers, who may well be risk averse, to participate in a lottery--one chance in two thousand, say, of causing an accident and having to pay all of its cost.
An accident is one example of an involuntary interaction; a crime is another. Economic analysis of crime starts with the assumption that becoming a criminal is a rational decision, like the decision to enter any other profession. Changes in the law which alter either the probability that the perpetrator of a crime will be punished for it or the magnitude of the punishment can be expected to affect the attractiveness of the profession, hence the frequency with which crimes occur--as demonstrated empirically in Ehrlich (1972). Similarly, changes in crime rates will, via the rational decisions of potential victims, affect expenditures on defending against crime.
Economic analysis of law applies to the enforcement system as well as to the criminals. One striking example is the analysis of plea-bargaining. It is widely believed that a system of plea-bargaining results in a reduction in the average punishment received by defendants. Why, after all, would a defendant agree to a plea bargain unless he preferred the bargained outcome to the result of going to trial?
The argument is correct, but the conclusion may not be. Prosecutors have limited resources of money and manpower. Presumably, the more the prosecutor spends on a case, the more likely he is to get a conviction--at least if the defendant is guilty. By agreeing to plea bargains on many of his cases, the prosecutor is able to concentrate his resources on those defendants who refuse to accepted the offered bargain, thus increasing the probability that they will be convicted. One result is to allow the prosecutor to drive harder bargains with (guilty) defendants who do not go to trial, since each defendant knows that if he refuses the prosecutor's offer (and many other defendants accept), the prosecutor will be able to concentrate resources on convicting him. Hence the overall effect may be to increase the average severity of punishment.
It may also increase the accuracy of the justice system. In plea bargaining, as in similar civil negotiations, one reason that the parties may fail to reach agreement is that they disagree about what is likely to happen if the case goes to trial. If the defendant's estimate of the probability that he will be convicted is substantially lower than the prosecutor's estimate, the defendant is likely to refuse what the prosecutor regards as a fair offer; the case then goes to trial.
One reason for differences of opinion may be that the defendant knows something the prosecutor does not--whether or not he is guilty. Presumably, a guilty defendant is more likely to be convicted, all other things being equal, than an innocent one. If so, guilty defendants will find the bargains offered by the prosecutor more attractive than will innocent defendants. The defendants then self-select; on average, guilty defendants accept bargains, innocent defendants go to trial. The court and prosecutors can then concentrate their resources on investigating, and (hopefully) acquitting, the innocent defendants.
Another area of law, in which the application of economic analysis is less novel, is anti-trust. One important contribution of economic analysis has been to suggest that some elements of anti-trust law may be based on an incorrect perception of how firms get and maintain monopoly power.
McGee (1958) used arguments originally proposed by Aaron Director to show that if, as commonly alleged, Standard Oil had attempted to maintain its market position by predatory pricing--cutting the price of oil below cost in order to drive out smaller but equally efficient rivals--the effort would probably have failed. Standard's larger assets would be balanced by a larger volume of sales, and hence larger losses when those sales were at a price below cost. Even if the smaller firm had gone bankrupt first, its physical plant would have remained, to be purchased by some new competitor. Based on a study of the record of the Standard Oil anti-trust case, McGee concluded that predatory pricing was a myth; Rockefeller had in fact maintained his position by buying out rivals, usually at high prices.
The argument, if correct, implies that some conventional anti-trust activity is misplaced. Pricing policies which are attacked as predatory may in fact be ways in which new firms break into existing markets, using low prices to induce potential customers to try their products. If so, prohibiting such policies reduces competition and encourages the monopoly that the law is intended to prevent.
Further work in the field has raised the possibility that, even if predatory pricing
is unworkable, there may be other tactics by which a monopoly can maintain its position
against equally efficient potential entrants. So far, however, it is unclear both
whether such tactics are in practice workable and whether there is any way in which
a court could distinguish them from similar actions taken for legitimate purposes.
Efficiency: Prescribing Laws
The use of economic analysis to determine what the law ought to be starts with one simple and controversial premise--that the sole purpose of law should be to promote economic efficiency. There are two problems with this premise. The first is that it depends on the utilitarian assumption--that the only good is human happiness, defined not as what people should want but as what they do want. The second is that economic efficiency provides at best a very approximate measure of what most of us understand by "total human happiness," since it assumes away the problem of interpersonal utility comparisons by, in effect, treating people as if they all had the same marginal utility of income.
One reply to this criticism is that while few people believe that economic efficiency is all that matters, most people who understand the concept would agree that it is either an important objective or an important means to other objectives. Hence while maximizing economic efficiency may not be the only purpose of laws, it is an important one--and one that economic theory can, in principle, tell us how to achieve. Further, economic theory suggests that an improvement in efficiency may be something that courts can achieve, whereas redistribution, for reasons suggested in the discussion of landlord-tenant relations, may not be.
Once one accepts economic efficiency as the objective, the standard tools of welfare economics can be used to analyze a wide variety of economic issues. Consider, for example, the eviction regulation discussed earlier. If the additional security of tenure is worth more to the tenant than it costs the landlord to produce, then landlords will find it in their interest to include that condition in the lease contract whether or not the law requires them to; the increase in the rent they will be able to get for their apartments will more than make up for the cost of delays in evicting undesirable tenants. If, on the other hand, security of tenure costs the landlords more than it is worth to the tenants, then they will not choose to offer it--and, viewed from the standpoint of economic efficiency, a regulation compelling them to do so is undesirable.
So one conclusion suggested by such analysis is a strong case for freedom of contract--allowing the parties to a lease, or any other contract, to include any terms mutually agreeable. To the extent that one accepts that argument, the function of legal rules is simply to specify a default contract--a set of terms that applies unless the parties specify otherwise. If the default contract closely approximates what the parties would agree to if they did specify all the details of their agreement, it serves the useful purpose of reducing the cost of negotiating contracts.
An important example of such analysis occurs in the case of product liability law. Just as with lease contracts, the first step is to observe that changes in who bears the liability for product defects will produce corresponding changes in market price, so that shifting liability from, say, buyer to seller will not in general result in the buyer being better off and the seller worse off. Changes in liability law will, however, change the incentives facing both buyer and seller with regard to decisions they make that affect the damage produced by defects. To the extent that a buyer cannot judge the quality of a product before he buys it, a rule of caveat emptor gives the seller an inefficiently weak incentive to prevent defects, since he pays the cost of quality control and receives no corresponding benefit. On the other hand, a rule of caveat venditor provides the seller with the appropriate incentive, since he ends up paying, via damage suits, for the cost of defects, but it gives the buyer an inefficiently low incentive to try to use the product in a way that will minimize the damage from defects--by, for example, driving an automobile in a way that does not rely too heavily on the brakes always working perfectly.
This suggests that different legal rules may be appropriate for different sorts of goods. It also suggests that some intermediate rule, such as contributory negligence, in which the producer of a defective good may defend himself against a damage suit by showing the accident was in part the result of imprudent use by the purchaser, may be superior to both caveat emptor and caveat venditor.
Just as in the case of tenant and landlord, the analysis suggests that while the law may set a default rule, it ought to permit freedom of contract. Sellers can then convert caveat emptor into caveat venditor by offering a guarantee, and buyers can convert caveat venditor into caveat emptor by signing a waiver.
Another area of interest is corporate law. Here the central problem is that of structuring the contract which defines the corporation so as to control the principal-agent problem resulting from the separation of ownership and management. One solution, missed in Smith's classic statement of the problem (Smith (1776)), is the takeover bid, used to discipline managers who fail to maximize the value of the assets they manage. The question of whether the law should assist or oppose managers in their attempt to prevent takeovers has been a lively issue in the recent literature.
Freedom of contract is of no use where there is no voluntary agreement among the parties. The law must somehow specify who is responsible under what conditions for the cost of accidents, and what the punishment is to be for crimes. One traditional approach to the former problem is the "Hand Formula," according to which someone is judged negligent, hence legally responsible for an accident, only if he could have prevented it by precautions that would have cost lost than the expected cost (probability times damage) of the accident. This seems to fit very neatly into the economic analysis of law, since it punishes someone only if he has acted inefficiently by failing to take a cost-justified precaution.
It has, however, two serious difficulties. One is that "accidents" are usually the result of the joint action of two or more parties. My bad brakes would not have injured you if you had not chosen to ride a bicycle at night wearing dark clothing--but your bicycle riding would not have put you in the hospital if my car had had good brakes. In such a situation, the efficient solution is to have precautions taken by whichever party can take them most cheaply--even if the other party could prevent the accident at a cost lower than the resulting damage. This suggests that the Hand formula should be interpreted as making that party liable who could have avoided the accident at the lower cost. Situations in which the probability and cost of accidents are continuous functions of the level of precaution taken by both parties require additional elaborations of the formula.
A second problem is that the Hand formula requires the court to make judgements, both about the probability of accidents given various levels of precaution and about the cost of both precautions and accidents to the parties involved, which it may not be competent to make. This suggests the desirability of legal rules which are sufficiently general so that they do not depend on a court making case-by-case evaluations of cost and benefit, but which give the parties incentives to use their private knowledge of costs and benefits to produce efficient outcomes. The attempt to construct such rules, for a wide variety of legal problems, makes up an important part of the law and economics literature.
Crimes, like accidents, involve involuntary interactions. The economic analysis of crime focusses on two related issues--the incentives facing the criminal and the incentives facing the system of courts and police. The first leads to the question of what combination of punishment and probability of apprehension would be applied, for any crime, in an efficient system; the answer involves trading off costs and benefits to criminals, victims, and the enforcement system. The second leads to questions about the procedures used by the court system to determine guilt or innocence (also an issue in other parts of the law), and of the relative advantages of private enforcement of law, as in our civil system, in comparison to public enforcement, as in our criminal system.
The public vs private enforcement controversy in the current literature started with an article by Gary Becker and George Stigler, pointing out that our system for enforcing the criminal law produces serious incentive problems. The gain to a policeman from catching a criminal and having him convicted is typically much smaller than the loss to the criminal. There is therefore an opportunity for the two to engage in a transaction in their mutual benefit; the criminal pays the policeman and the policeman "loses" the evidence. In order to prevent this, the system must expend substantial resources watching policemen as well as watching criminals.
The solution suggested by Becker and Stigler was a bounty system, in which enforcers
are paid a price for bringing in criminals equal to the fine which the criminals
must pay when convicted. Posner and Landes pointed out that this is similar to the
way civil law now works. The plaintiff (and his lawyer) produce the evidence and
prosecute the defendant; if they win, the defendant pays damages and the plaintiff
collects them. This raises the question of whether the present division between criminal
and civil law is economically efficient--whether there is some reason why the offenses
that are presently civil are handled better by private enforcement and those presently
criminal are handled better by public enforcement. The literature contains economic
arguments both pro and con.
Economists Learning from Law: The Coase Theorem
So far, all of the examples of economic analysis of law have involved using existing economic theory to analyze the law. There is at least one area, however, where the interaction of law and economics has resulted in a substantial body of new economic theory. This is the set of ideas originating in the work of Ronald Coase and commonly referred to as the Coase Theorem.
According to the traditional analysis of externalities associated with Pigou, an externality exists where one party's actions impose costs on another, for which the first need not compensate him. This leads to an inefficient outcome, since the first party ignores the costs to the second in making his decision. Thus, for example, a railroad company may permit its locomotives to throw sparks, even though they cause occasional fires in the neighboring corn fields. The cost of modifying the engine to prevent sparks would be borne by the company; the cost of the fires is an externality imposed on the adjacent farmers. The traditional solution is a Pigouvian tax. The railroad company is charged for the damage done, and can either pay or stop doing the damage, whichever costs less.
Coase pointed out that, in this and many other cases, the cost is not simply imposed by one party on the other; rather, it arises from incompatible activities by two parties. The fires are the result both of the railroad company using a spark-throwing locomotive and of the farmers choosing to grow inflammable crops near the rail line. The efficient solution might be to modify the locomotive, but it also might be to grow different crops. In the latter case, a Pigouvian tax on the railroad leads to an inefficient outcome.
Hence the first step in Coase's analysis suggests that there is no general solution to the problem of externalities. The legislature, in setting up general laws, cannot know which party, in any specific case, will be able to avoid the problem at the lowest cost. If it attempts to solve that problem by a law making whichever party can avoid the problem at the lower cost liable, the court is left with the problem of estimating the costs. Each party has an incentive to overstate the cost of its potential precautions, in order to make the other party liable for preventing the damage.
The second step is to observe that both this argument and the traditional analysis of externalities ignore the possibility of agreements between the parties. If the law makes the railroad liable for the damage when the farmers can prevent it at a lower cost, it will be in the interest of both farmers and railroad to negotiate an agreement in which the railroad pays the farmers to grow clover rather than corn along the rail line. Hence this line of analysis leads to the conclusion that whatever the initial definition of rights--whether the railroad has the right to throw sparks or the farmers to enjoin the railroad or collect damages--market transactions among the participants will lead to an efficient outcome.
The final step in the argument is to observe that inefficient outcomes do in fact occur, and that the reason is transaction costs. If, for example, any farmer can enjoin the railroad from throwing sparks, then the railroad, in dealing with the farmers, is faced by a hold-out problem. A single farmer may try to collect a large fraction of what the railroad would save by not having to modify its locomotives, using the threat that if his demands are not met he can enjoin the railroad from running unmodified locomitives, whatever the other farmers do. If, on the other hand, the railroad is free to throw sparks and it is up to the farmers to offer to pay for the modifications, then in raising the money to do so they face a public good problem; a farmer who does not contribute still benefits. Transaction cost problems of this sort may prevent the process by which bargaining among participants would otherwise lead to an efficient outcome.
The conclusion of all of this is the Coase Theorem, which states that in a world of zero transaction costs any initial definition of rights will lead to an efficient outcome. It is important not because we live in such a world, but because it shows us a different way of looking at a large range of problems--as resulting from the transaction costs that prevent the parties affected from bargaining their way to an efficient outcome.
This approach represents both an important change in the traditional economic
analysis of externalities and a powerful tool for analyzing legal institutions. Many
such issues can be seen as questions of how property rights are to be bundled. When
I buy a piece of land, should what I acquire include the right to make loud noises
on it? To prevent passing locomotives from throwing sparks on it? To leave objects
lying about that might be hazardous to neighbors who accidentally trespass? From
the perspective of the Coase Theorem, all such questions can be approached by asking
first what bundling of rights would lead, under various circumstances, to an efficient
outcome, and second, if a particular initial bundling of rights leads to inefficient
outcomes, how easy will it be for the parties to negotiate a change, with the party
who has a greater value for one of the rights in a bundle purchasing it from its
One example is the law of attractive nuisance. Does the ownership of a piece of land include the right to put on it open cement tanks full of deadly chemicals, protected only by large signs--which are no barrier at all to a trespasser too young to read? The immediate answer is that the right to decide whether the tanks are fenced is worth more to the neighborhood parents than to the owner of the property. The further answer is that if the law gives the right to the owner, including it in the bundle labelled "ownership of land," it will be difficult for the parents to buy it, since the parents face a public good problem in purchasing an agreement from the owner to put high fences around his tanks. Hence we have an argument for the existing law of attractive nuisance, under which the parent can enjoin the property owner from leaving the tanks unfenced, or sue for damages if his child is injured. This is one example of the way in which the Coase Theorem approach helps illuminate a wide range of legal issues.
Economic analysis, of law or anything else, can be viewed either as an attempt to learn what should be or as an attempt to explain what is and predict what will be. In the case of the economic analysis of the law, attempts to explain and predict have taken two rather different forms.
On the one hand, there is the argument of Richard Posner, according to which the common law tends, for a variety of reasons, to be economically efficient. The analysis of what legal rules are efficient thus provides an explanation of what legal rules exist--and the observation of what legal rules exist provides a test of theories about what rules are efficient.
On the other hand, there is the approach associated with public choice theory, which views legislated, administrative, and perhaps even common law as outcomes of a political market in which interest groups seek private objectives by governmental means. Since the amount a group is willing to spend in order to get the laws it favors depends not only on the value of the law to that group but also on the group's ability to solve the public good problem of inducing its members to contribute, expenditures in the political market will not accurately represent the value of the law to those affected, hence inefficient laws--laws which injure the losers by more than they benefit the gainers--may well pass, and efficient laws may well fail. The most obvious implication of this line of analysis is that laws will tend to favor concentrated interests at the expense of dispersed interests, since the former will be better able raise money from their members to lobby for the laws they prefer.
In looking at economic analysis of law, one striking observation is the way in which economists tend to convert issues from disputes about equity, justice, fairness or the like into disputes about efficiency. In part, this is because economists do, and traditional legal scholars often do not, take account of the effects that legal rules have on market prices. The result is frequently to eliminate the distributional effects of changes in such rules. In part, it is because economists do, and legal scholars sometimes do not, assume that rules modify behavior. If so, then in evaluating the rules we must ask not only whether they produce a just outcome in a particular case, but whether their effects on the behavior of those who know of the rules and modify their actions to take account of them is in some sense desirable.
A second observation is that economic analysis frequently demonstrates the existence of efficiency arguments for rules usually thought of as based entirely on considerations of justice. One simple example is the law against theft. At first glance, it appears to involve no question of economic efficiency at all; the thief is better off by the same amount by which the victim is worse off, hence the transaction, however unjust, is not inefficient.
That conclusion is wrong. The opportunity to gain by stealing diverts resources to that activity. In equilibrium, the marginal thief receives the same income from stealing (net of risk of imprisonment, cost of tools, etc.) as he would in some alternative productive activity; there is no gain to the marginal thief to balance the cost to the victim. Hence theft can be condemned as inefficient with no reference to issues of justice.
A third observation is the degree to which the examination of real legal issues and real cases forces the economist to take account of some of the complexities of real-world interactions which he might otherwise never notice, and thus provides him the opportunity to increase the depth and power of his analysis.
A final, and important, observation is that economics provides a unity among disparate fields of law which is lacking in much traditional legal analysis. In the words of one of the field's leading practitioners:
"Almost any tort problem can be solved as a contract problem, by asking what the people involved in an accident would have agreed on in advance with regard to safety measures if transaction costs had not been prohibitive. ... Equally, almost any contract problem can be solved as a tort problem by asking what sanction is necessary to prevent the performing or paying party from engaging in wasteful conduct, such as taking advantage of the vulnerability of a party who performs his side of the bargain first. And both tort and contract problems can be framed as problems in the definition of property rights; for example, the law of negligence could be thought to define the right we have in the safety of our persons against accidental injury. The definition of property rights can itself be viewed as a process of figuring out what measures parties would agree to, if transaction costs weren't prohibitive, in order to create incentives to avoid wasting valuable resources." Posner (1986)
Any note as short of this can provide only a very incomplete description of the field, and one heavily biased towards the author's own interests. The references cited below, and the references in Posner (1986) and Goetz (1984), provide a much more extensive survey.
*: This article is expanded from one originally written for The New Palgrave: A Dictonary of Economic Theory and Doctrine, Macmillan Press (1987), with the permission of the editors.
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