Law and Economics Minor:
Readings First Week:
Friedman, David D. (2000), Law’s Order: What Economics Has to Do with Law and
Why It Matters (Princeton, New Jersey: Princeton University Press):
Chapter 1: What Does Economics Have to do with Law?
An economist points out that if the punishments for armed robbery and for armed
robbery plus murder are the same, the additional punishment for the murder is
zero—and asks whether you really want to make it in the interest of robbers to
murder their victims. That is what economics has to do with law.
Economics, whose subject, at the most fundamental level, is not money or the
economy but the implications of rational choice, is an essential tool for figuring out
the effects of legal rules.
Whether armed robbers should get ten years or life is not a burning issue for most
of us. A question of considerably more importance is the standard of proof. In
order for you to be convicted of a crime or to lose a civil case and have to pay
damages, just how strong must the evidence against you be?
Legal rules are to be judged by the structure of incentives they establish and the
consequences of people altering their behavior in response to those incentives
Economic efficiency can most usefully be thought of as the economist’s attempt to
put some clear meaning into the metaphor “size of the pie.” What makes doing so
difficult is that the relevant pie is not a single object that we can weigh or measure
but a bundle of many different sorts of goods and services, costs and benefits,
divided among hundreds of millions of people. It is not obvious how those can be
all put in common units and summed to tell us whether some particular change in
legal rules (or anything else) increases or decreases the total.
consider whether you believe that people are, on the whole, rational. If we know
that doing something will make someone better off, is that a good—not certain, but
good—reason to expect him to do it? If the answer is “yes,” are you willing to
generalize, to apply it to police, judges, legislators, burglars, muggers, and potential
victims? If the answer is still “yes,” then you are in agreement with the fundamental
assumption on which the theory is built.
Chapter 2: Efficiency and All That
how to add people up. If a law benefits some and hurts others, as most do, how can
one decide whether the net effect is loss or gain, cost or benefit? How do you put a
pie containing everything that happens to every human being on earth, or even in
the United States, on a scale, so as to get a single measure of its size?
Marshall’s argument starts by considering some change—the imposition or
abolition of a tariff, a revision of the tax code, a shift in tort law from strict liability
to negligence. The result of the change is to make some people better off and some
worse off. In principle one could measure the magnitude of the effects by asking
each person affected how much he would, if necessary, pay to get the benefit (if the
change made him better off) or prevent the loss (if it made him worse off). If the
sum was positive, if total gains were larger than total losses, we would describe the
change as an economic improvement; if it was negative, an economic worsening.
We get the relevant information not by asking questions but by observing behavior,
by seeing how much people are willing to give to get things and making deductions
, from such observations. The reason I believe heroin addicts would be willing to
pay quite a lot to have heroin made legal is that I observe heroin addicts paying
quite a lot to get illegal heroin. The economist’s term for that approach is “revealed
preference.” Preferences are revealed by choices.
freedom of exchange is the efficient rule.
Marshall’s approach to defining economic efficiency has two major virtues:
1. It sometimes makes it possible to answer questions of the form “When and why
is strict liability in tort law efficient?” or “What is the efficient amount of
punishment for a particular crime?”
2. Although “efficient” is not quite identical to “desirable” or “should,” it is close
enough so that the answer to the question “What is efficient?” is at least relevant,
although not necessarily identical, to the answer to the question “What should we
do?
it is worth pointing out its limitations.
1. It assumes that all that matters is consequences. It thus assumes away the
possibility of judging legal rules by nonconsequential criteria such as justice.
Consider a sheriff who observes a mob about to lynch three innocent murder
suspects and solves the problem by announcing (falsely) that he has proof one of
them is guilty and shooting him. Judged consequentially, and assuming there was
no better solution available, it seems an unambiguous improvement—by two lives.
Yet many of us would have serious moral reservations about the sheriff.
2. It assumes that when evaluating the consequence of a legal rule for a single
person, the appropriate values are that person’s values as expressed in his actions,
that there is no relevant difference between the value of insulin and of heroin.
3. It assumes that, in combining values across people, the appropriate measuring
rod is willingness to pay, that a gain that one person is willing to pay ten dollars to
get just balances a loss that another is willing to pay ten dollars to avoid. But most
of us believe that, measured by some more fundamental standard such as
happiness, a dollar is worth more to some people than to others—more to poor
than to rich, more to materialist than to ascetic.
The final criticism of efficiency, that it ignores the fact that a dollar is worth more
to some people than to others, may be the most serious.
Marshall’s response was that most economic issues involve costs and benefits to
large and heterogeneous groups of people, so that differences in individual value
for money (in the language of economics, differences in the “marginal utility of
income”) were likely to average out.
My conclusion is that efficiency, defined in Marshall’s sense, provides a useful,
although imperfect, approach to judging legal rules and their outcomes.
Chapter 3: What’s Wrong with the World, Part 1
Net benefit to everyone is net benefit to me plus net benefit to everyone else. Since
my action maximizes the former and is irrelevant to the latter, it also maximizes
the sum
“pecuniary” or “transfer” externalities— effects on other people that result in a net
transfer between them but not a net cost to them. Since I impose no net cost on
others, when I take the action that maximizes net benefit to me I am also
maximizing net benefit to everyone.
The problem with external costs such as pollution is that they get left out of the
calculation of what things are or are not worth doing, with the result that we end
, up with not only efficient pollution, pollution whose prevention would cost more
than it is worth, but inefficient pollution as well
One solution is direct regulation: some government agency such as the EPA makes
rules requiring steel mills to filter their smoke, or build high smokestacks, or in
various other ways reduce their pollution. While this is an obvious solution, it has
some serious problems.
The first is that the EPA may not be interested in maximizing efficiency.
The second problem is that, even if the EPA wants to maximize efficiency, it does
not know how to do it.
A second advantage is that this approach generates not only the right amount of
pollution control but the right amount of steel as well. When the firm produces
steel, its costs now include both the cost of controlling pollution and the cost of any
pollution it fails to control. So the price steel is sold at now represents the true cost
of producing it. When steel is cheaper than concrete, buildings will be built of steel;
when concrete is cheaper, they will be built of concrete.
But the fundamental logic of all three cases is similar. Someone takes an action that
imposes costs on others. It is in his interest to take the action as long it produces a
net benefit for him, even if including the effects on the rest of us converts that to a
loss. We solve the problem with legal rules that force the actor to bear the external
cost himself, to internalize the externality. His net cost now equals net cost to
everyone, so he takes the action if and only if it produces a net benefit.
I mentioned earlier a special sort of externality called a pecuniary externality, one
that imposes no net cost, since the effects on other people cancel out. Unlike other
externalities, a pecuniary externality does not lead to inefficiency, since the actor’s
private net costs are equal to total net costs, just as they would be if there were no
externality at all.
“rent seeking.” It occurs when there is an opportunity for people to spend
resources transferring wealth from others to themselves. As long as the gain is
more than the cost, it is worth making the transfer—from the standpoint of the
recipient. As more people compete to be recipients, the gain falls. In equilibrium
the marginal recipient (the least talented pickpocket) just breaks even. The
inframarginal recipients (especially talented pickpockets) make some gain,
although less than what the victims lose (even talented pickpockets have some
costs). The victims lose both the amount transferred and the cost to them of their
defensive efforts. The term was coined to describe competition for government
favors—in the original example import permits that permitted the holders to buy
foreign currency at an artificially cheap price. Firms competed to get those
valuable favors by public relations efforts, lobbying, campaign contributions,
bribes. As long as a million-dollar favor can be obtained for substantially less than
a million, some other firm is willing to bid a little higher, so winning firms end up,
on average, paying about what the favors are worth.
Chapter 4: What’s Wrong with the World, Part 2
A takes an action that imposes a cost upon B. In order to make A take the action if
and only if it produces net benefits, we must somehow transfer the external cost
back to him. The polluting company is charged for its pollution, the careless
motorist is sued for the damage done when he runs into someone else’s car. The
externality is internalized, the actor takes account of all relevant costs in deciding
what action to take, and the result is an efficient pattern of decisions.
, The existence of externalities does not necessarily lead to an inefficient result.
Pigouvian taxes do not in general lead to the efficient result. Third, and most
important, the problem is not really externalities at all. It is transaction costs.
So Coase’s first point is that since external costs are jointly produced by polluter
and victim, a legal rule that assigns blame to one of the parties gives the right result
only if that party happens to be the one who can avoid the problem at the lower
cost. In general, nothing works. Whichever party the blame is assigned to, by
government regulators or by the courts, the result will be inefficient if the other
party could prevent the problem at a lower cost or if the optimal solution requires
precautions by both parties.
One implication of Coase’s argument is that the regulator can guarantee the
efficient outcome only if he knows enough about the cost of control to decide
which party should be considered responsible for preventing the jointly produced
problem and so required to bear the cost if it is not prevented
The second step in Coase’s argument is to observe that, as long as the parties can
readily make and enforce contracts in their mutual interest, neither direct
regulation nor a Pigouvian tax is necessary in order to get the efficient outcome. All
you need is a clear definition of who has a right to do what, and the market will
take care of the problem.
If transaction costs are zero, if, in other words, any agreement that is in the mutual
benefit of the parties concerned gets made, then any initial definition of property
rights leads to an efficient outcome. This result is sometimes referred to as the
Coase Theorem.
With externalities but no transaction costs there would be no problem, since the
parties would always bargain to the efficient solution. When we observe
externality problems (or other forms of market failure) in the real world, we
should ask not merely where the problem comes from but what the transaction
costs are that prevent it from being bargained out of existence
Ever since Coase published “The Problem of Social Cost,” economists unconvinced
by his analysis have argued that the Coase Theorem is merely a theoretical
curiosity, of little or no practical importance in a world where transaction costs are
rarely zero. One famous counter example concerns bees.
The disadvantage of a general rule is that it can be expected to give the wrong
answer in some specific cases, which means that a general rule will do a worse job
of guaranteeing efficient outcomes than would a perfectly wise court deciding each
case on its individual merits.
bright line rules; rules that require a case-by-case decision by courts are
sometimes referred to as standards.
A still more important example of a bright line rule is the general principle that all
human beings, with some narrow exceptions for children and lunatics, have the
same legal rights—very different from the legal rights of animals. The features of
human beings that give rise to legal rights are not all-or-none matters; most
humans are more rational and better able to communicate than most animals, but
again many of us can think of exceptions.
The Coasian answer is that the law should define property in a way that minimizes
costs associated with the sorts of incompatible uses we have been discussing:
airports and residential housing, steel mills and resorts. The first step is to try to
define rights in such a way that, if right A is of most value to someone who also
holds right B, they come in the same bundle. The right to decide what happens two
feet above a piece of land is of most value to the person who also holds the right to
