Economic Analysis of Law

Michael J. TrebilCOCK
Note: some parts were lifted from the net (an ignoramus like me finds it hard to digest academic
journals) pero indicated naman. For easier understanding to mga beh

A Conceptual Overview of the Economic Perspective on Law

Intellectual History
Positive and Normative Economic Analysis

Central preoccupation of economics: question of choice under conditions of scarcity

o Given scarcity, economics assumes that individuals and communities will (or
should) attempt to maximize their desired ends by doing the best they can with the
limited resources (means) at their disposal. To the extent that means (or resources)
can be made relatively scarce, more ends or goals of individuals or communities can
be realized
The legal system structures the choices available to individuals and groups in a whole
range of settings
Law and econ scholarship employs two conceptually different kinds of analysis
o Positive analysis- descriptive or predictive analysis
o Normative analysis- prescriptive or judgmental analysis (more controversial)

Positive Analysis/Impact Analysis

In positive economic analysis of legal issues, the analysis asks this kind of question: if this
(legal) policy is adopted, what predictions can we make about the likely economic impacts,
allocative (the pattern of economic activities) and distributive (winners and losers) of the
policy, given the ways in which people are likely to respond to the particular incentives or
disincentives created by the policy?
o To predict the behavioral responses, the analyst assumes that most individuals are
motivated by rational self-interest, in the sense of maximizing their individual
utilities subject to whatever constraints are imposed on the choices open to them
o Utility functions may be infinitely varied
Mother Superior Therese may be motivated by pure altruism to buy siomai on
the best possible terms in order to feed her poor, desolate kids
Coddler Mia may be motivated out of desire to sustain a decadent lifestyle by
buying narcotics for her homies, causing enormous human suffering as a
result
In conventional supply and demand analysis, it is assumed that in most contexts more
goods or services will be supplied at higher than lower prices and that fewer goods or
services will be demanded at higher prices than lower prices supply curves slope up to the
right, demand curves slope down to the right
o Even the supply of altruism is likely to be inversely related to its cost more blood is
likely to be supplied altruistically than steak and potatoes
o Thus, positive economic analysis is individualistic and subjective in its behavioral
premises
Understanding the incentives effect of these various legal regimes is a necessary prelude
to formulating normative judgments about the merits of the regime under analysis relative

to alternative policies that might be employed to pursue the same or alternative social
goals
There are drawings on the reading yall I think u are off better reading them on your own
So basically, those examples (with the drawings) illustrate the fundamental presumption
of neoclassical economics: that economic agents, ion all their various activities, respond to
incentives.
o This proposition is central to understanding the functioning of any pricing system,
whether it involves explicit (grocery store) prices or implicit (penalties for different
crimes) prices.
Neoclassical economist: the legal system is simply an institutional arrangement for
prescribing, and setting implicit prices for certain activities, within some overarching
consequentialist objective.
o Crucial aspect of the scholar is the empirical testing of the presumption (that agents
do indeed respond to the implicit pries specified by the legal system, whether it be
in contracts, tort, crim law etc.)
Field of law and economics is in its own right a powerful organizing and sorting tool, but
ultimately it will be judged on the empirical validity of its propositions.
the examples above illustrate the conventional form of positive analysis of legal or
regulatory impacts (impact analysis)

Positive theories of Legal Doctrine

a less conventional form of positive analysis of law is positive analysis of the structure of
legal doctrine
In here, common law rules that have displayed strong survival characteristics probably
reflect an implicit economic logic which, when rendered explicit, provides a persuasive
explanation of the substantive content of these rules . This is controversial!

Normative Analysis

The orientation is individualistic and subjective like in positive analysis

Normative analysis (aka welfare economics) asks this question: is it likely that this
particular transaction or this particular proposed policy or legal change will make
individuals affected by it better off in terms of how they perceive their own welfare (not as
some external party might judge that individuals welfare)?
Two concepts of efficiency are of central importance: Pareto efficiency and Kaldor-Hicks
efficiency
o Pareto efficiency: asks of any transaction or policy or legal change: will this
transaction or change make somebody better off while making no one worse off?
many prefer this over kaldor
o Kaldor-Hicks efficiency: would this collective decision, for example, a change in
legal rules generate sufficient gains to the beneficiaries of the change that they
could, hypothetically, compensate the losers from the change in order to render the
latter fully indifferent to it, but still have gains left over for themselves?
Effectively a form of cost-benefit analysis
Neoclassical economists attach strong normative value to regimes of private exchange
and private ordering and often bring some degree of skepticism to bear on the capacity of
collective decision makers (legislatures, bureaucrats, regulators or courts) to adopt
policies or laws that will unambiguously increase net social welfare

Based on the premise that if two p[parties are to enter into a voluntary private
exchange, the presumption is that the both of them must feel that the exchange is
likely to make them better off otherwise they wouldnt enter into it
Rebuttable by forms of market failure e,g, monopoly, externalities and
information failures.
Political justification for the primacy of private ordering: individual autonomy is seen as a
paramount social value and a central precondition to individual freedom.
o Private ordering minimizes the extent to which individuals are subjected to
externally imposed forms of coercion or socially ordained forms of status
o Private ordering is the quintessential form of government with the consent of the
governed
o

Limitations of the Economic Perspective

Critique on pareto efficiency

o It takes existing preferences of whatever kind as given and provides no ethical
criteria for disqualifying morally monstrous or self-destructive preferences as
unworthy of recognition (standard critique to utilitarianism)
o Wholly insensitive to the justice or injustice of the prior distribution of endowments
Claim about centrality of the individual autonomy as a central social value has been
contested by scholars who see that the autonomous, individual self or classical liberal
theory as reflecting an impoverished, pre-social conception of human life

The Economic Role of Property Rights

Introduction
The definition and specification of property rights is primarily the function of the law of
property and to a lesser extent the law of torts (nuisance).
o Protection of property rights is principally the function of both tort law (nuisance,
trespass, conversion and detinue) and the criminal law
o Providing for the transferability of
The Prisoners Dilemma Problem (I used the original sample sa wiki tamad n kc magtype)
Two members of a criminal gang are arrested and imprisoned. Each prisoner is in solitary
confinement with no means of speaking to or exchanging messages with the other. The
prosecutors do not have enough evidence to convict the pair on the principal charge. They
hope to get both sentenced to a year in prison on a lesser charge. Simultaneously, the
prosecutors offer each prisoner a Faustian bargain. Each prisoner is given the opportunity
either to: betray the other by testifying that the other committed the crime, or to
cooperate with the other by remaining silent. Here is the offer:

If A and B each betray the other, each of them serves 2 years in prison

If A betrays B but B remains silent, A will be set free and B will serve 3 years in prison
(and vice versa)

If A and B both remain silent, both of them will only serve 1 year in prison (on the
lesser charge)

It is implied that the prisoners will have no opportunity to reward or punish their partner other
than the prison sentences they get, and that their decision will not affect their reputation in
the future. Because betraying a partner offers a greater reward than cooperating with them,
all purely rational self-interested prisoners would betray the other, and so the only possible
outcome for two purely rational prisoners is for them to betray each other. The interesting
part of this result is that pursuing individual reward logically leads both of the prisoners to
betray, when they would get a better reward if they both cooperated. In reality, humans
display a systematic bias towards cooperative behavior in this and similar games, much more
so than predicted by simple models of "rational" self-interested action.
--end of wiki sample-

The joint welfare maximizing solution available is for neither to confess. Each prisoner
however faces the temptation to confess on the assumption that the other will not confess
in order to receive the lightest sentence. If each reason in this way, both may end up
confessing and receiving three years in prison each, which is the joint welfare minimizing

outcome.
In the original sample, the parties whose welfare are directly at stake are not able to
communicate with each other. However, even if communication is possible in some

settings, defection rather than cooperation strategies may dominate.

Prisoners dilemma in property rights

Tribe A grows corn and Tribe B on the neighboring valley produces only beef.

The tribes want to vary their diet since they got fed up with eating the same food

So the question is how to transfer beef to A and corn to Bthey may engage in

theft or trade!
In the short run, obvious na mas oks ang theft kasi it entails lower costs while sa

trade automatic na may kailangang ipalit (parang alchemy)

However, if ganito mag-isip ang mga tinamaan, the two tribes might engage in
defensive and predatory strategies, thus resulting in no corn or beef produced
because all the energies of both tribes are wasted in predatory and counterpredatory activities.

The Tragedy of the Commons

-

An economic problem in which every individual tries to reap the greatest benefit from a given
resource. As the demand for the resource overwhelms the supply, every individual who consumes
an additional unit directly harms others who can no longer enjoy the benefits. Generally, the

resource of interest is easily available to all individuals (investopedia.com beybe).

The tragedy of the commons occurs when individuals neglect the well-being of society (or the
group) in the pursuit of personal gain. For example, if neighboring farmers increase the number of
their own sheep living on a common block of land, eventually the land will become depleted and
not be able to support the sheep, which is detrimental to all. end of investopedia article

The problem of common property resources or common pools is pervasive in contemporary society
and it can be usually found in environmental issues like overuse of beaches, crowding out of
broadcast frequencies on the airways and highway congestion

The Pervasiveness of Property Rights Issues

Property rights issues are pervasive in both contemporary and traditional societies
Most environmental problems and other related problems such as that of endangered
species like whales or elephants can be seen as exemplifying classics Prisoner Dilemma
and common pool problems
In the intellectual property sphere, debates over commercial piracy, compulsory licensing
of patented drugs and other innovations, unilateral copying of texts, reverse engineering,
copying of computer software etc. all raise property rights issues that exhibit many of the
characteristics of the Prisoners Dilemma and the Tragedy of the Commons paradigm
Property rights is also involved in land reform

The Economic Perspective on Contract Law

The Economic Functions of Contract Law

Neoclassical economists have a prediction in favor of resource allocation through voluntary

exchanges as opposed to collective decisions because they believe that one can have a
higher degree of confidence in the welfare implications of private exchanges, where both
parties stand to benefit, than collective decisions where typically there are both winners
and losers.
However this does not speak to the economic role of contract law.
In an economic perspective, there are at least four major identified functions of
contract law

Fxn 1: Containing Opportunism in Non-Simultaneous Exchanges

Even if a stable regime of property rights is established between the members of Tribe A
and Tribe B, this in itself does not ensure that mutual gains from a trade will be realized
Theft is ruled out but facilitated exchange is yet to be realized
If one tribe delays in the delivery of an item, the other tribe might be disinclined to
deliver what they should deliver in return
In this event, potential for pareto superior exchange would not be realized (a
variant of the Prisoners dilemma problem0
In contemporary societies, the law of contracts by providing remedies in the event of
breach of contractual promises provides an essential check on opportunism in nonsimultaneous exchanges by ensuring that the first mover does not run the risk of
defection, rather than cooperation by the second mover

Fxn 2: Reducing Transaction Costs

Supply parties to given categories of exchanges with standard sets of implied terms

Fxn 3: Discouraging Carelessness in the Exchange Process

Law of contracts discourages carelessness in the exchange process which causes

detrimental reliance.

The law assigns liabilities for negative outcomes from an exchange to the party who could
have avoided the problem by taking cost justified precautions

Fxn 4: Identifying Pareto Superior Exchanges

Central economic role of contract law is to formulate a set of excuses for contract
performance that permits the enforcement of efficient exchanges, but discourages the
enforcement of inefficient exchanges that do not meet the criterion of the pareto
efficiency
Pareto criterion requires at least one party to an exchange perceive himself as
better off and the other party no worse off but in practice both parties should
perceive the exchange as mutually beneficial
Lack of voluntariness, imperfect information or externalities are likely to provide the
principal foundations for an economically grounded set f excuses

Conditions for a Pareto Superior Exchange

Milton Friedman: the p[possibility of coordination through voluntary cooperation rests on

the elementary, yet frequently denied proposition that both parties to an economic
transaction benefit from it, provided the transaction is bilaterally voluntary and
informed
Kulang pa daw to sabi ni Trebilcock

Analytical Challenges
Commodification

The extent to which a healthy private sector presupposes the existence of a public
sector and the design of incentive structures I the public sector that are
complementary to the existence of a healthy private sector are issues that have
been insufficiently explored in much of the standard economics literature : bribery
Whether human attributes should lie beyond the exchange process: is sale of sexual
services, surrogacy contracts, porn viewing etc, permitted?

Voluntariness

Voluntariness is an elusive and complex concept

In a world of scarcity, few of us have unconstrained choices in any exchange
relationship in which we enter
E.g is it objectionable for an exceptionally talented movie star to exploit his
fans by charging very large fees for his services?

Asymmetric Information

Issue of imperfect information in pervasive in the contracting process

Is one obliged to disclose facts? Will there be fraud?

Externalities

Friedman accepts as a limiting example of involuntariness he case of externalities or

neighborhood effects

To the extent that a contract between two parties entails negative externalities for a
third, one cannot assume that the exchange is Pareto superior once one takes
account of third party effects
Is the third party effect sufficient to negate the mutual gains from exchange?
E.g. I enter into a contract to buy a bread but the bread is called jj baby and it
drives me crazy because it reminds me of the suffering of his students. Is this
third party effect sufficient to negate the mutual gains from exchange
realized by me and bread talk?

Gratuitous Promises

If I declare that I would donate 100K a month to Mias save the whales foundation
for 5 years, may I revoke this promise even though the foundation has not paid for it
in an economic transaction? In other words, why should promises have to be paid
for in order to be viewed as binding?