Legal theory which incorporates notions usually reserved to the field of economics, such as efficiency and pareto optimality.

Its origin is generally attributed to the Law School at the University of Chicago.

Law and Economics

Main assumption:

People are rational actors who seek to maximize their material self-interest (wealth-maximization).

Positive claim of law and economics:

The common law is efficient.

(There are several definitions of efficiency including: Pareto efficiency and Kaldor-Hicks efficiency.)

Normative claim of law and economics:

Law should be efficient.

Criticisms of the law and economics approach:

1) People do not always behave rationally.

2) Wealth is a crude measure of the things people really care about (utility is not necessarily measured by wealth) and so may not reflect what our laws should emphasize.

3) Wealth-maximization is amoral.

4) Some of the things that people would be willing to pay for are illegitimate (commodification of things that should not be commodified).

The law and economics movement has been discussed in previous writeups. This article questions the foundations of law and economics theory. To put the article in perspective, the reader may wish to call to mind the Supreme Court's recent unpopular decision in Kelo v. New London, which upheld a city's eminent domain power. Readers may need to familiarize themselves with the Ultimatum Game to make full sense of this article.

The law and economics movement is based on the premise that just legal rules are those that are economically efficient, in the sense that they maximize economic utility. An individual’s utility from a particular rule is determined by the summation of the benefits and costs that the individual derives from the rule. These costs and benefits, if non-monetary, are determined by the price that a person would pay to avoid or acquire them. A legal rule is Pareto efficient when it increases the sum of all individuals’ utilities under the condition that no individual’s utility is negative.

Though the application of economics to law is reasonable on its face, modern scientific insight into human nature indicates that traditional efficiency analysis inadequately represents our innate conception of justice and fails to adapt to situational variation in the values we place on goods and services. Our biological disposition to place a higher value on that we already possess than on that we hope to acquire, known to economists in the form of the offer/asking price discrepancy, renders efficiency analysis difficult, and currently indeterminate. As a stronger example of the gap between traditional economics and the innate “economics” we evolved through natural selection, the economically irrational results of the Ultimatum Game demonstrate that even a Pareto efficient outcome, in which all parties are better off economically, may be unjust. When applied to rules of law, both the Ultimatum Game and the offer/asking price discrepancy provide rationales for choosing property rules over liability rules and for awarding damages greater than market value.

The offer/asking price discrepancy significantly impacts many areas of law, and it is not surprising that it has been written on extensively. The purpose of damages in tort law, for example, is to make the plaintiff as well off as she was before injured by the defendant. Suppose the defendant’s negligence has resulted in the plaintiff’s loss of property. Though damages are traditionally assessed by the average market value of equivalent property, it may make sense to award the plaintiff excess damages. The amount of damages that should be awarded, in keeping with the tort damages principle, depends on the particular cause of the offer/asking price discrepancy. If, for example, the discrepancy is rooted in the plaintiff’s desire to avoid the indignity of selling property, then the market value is the proper measure of damages, because the plaintiff will not suffer this indignity cost in the court’s award of damages. But if the discrepancy results from an evolved attachment to personal belongings, then the plaintiff’s asking price should be the measure of damages. Thus, further research into the psychology underlying the offer/asking price discrepancy could have immediate application to the economic analysis of legal rules.

While the offer/asking price gap shows that the “irrational” characteristics of human nature may necessitate modification of economic efficiency analysis, the results of the Ultimatum Game lead one to question whether utilitarian efficiency analysis is in discord with our evolved notion of justice. The game is closely analogous to common real-world situations over which courts preside. Under standard contract doctrine, for example, Tom may intentionally breach his contract with Sally, for his own benefit, if he pays her expectation damages—the value she would have gained from fulfillment of the contract. In products liability law, a company may sell products certain to cause occasional harm to buyers, recompensing them with standard torts damages and reaping the difference between its pre-liability profits and its liability payouts. And under the law of eminent domain, the government can force a landowner to transfer her land at market value to a developer, who will acquire all profits from its development. In each of these cases, as in the Ultimatum Game, the result is Pareto efficient: the active party benefits by using another passive party, who is left no worse off than before. The Ultimatum Game shows that a typical individual finds it unjust for another to profit from him without distributing the profits equitably. Yet, as we have just seen, parties relying on standard doctrines in the law of torts, property, and contracts are incentivized to do exactly that.

It is likely that myriads of such Pareto efficient outcomes throughout the law are resented by the passive party, who feels that the active party has unjustly enriched herself. These results arise when courts have opted for liability rules, which are enforced by damages and remuneration, over property rules, which are ultimately enforced by the criminal law. Property rules force negotiation between parties on equal terms over the distribution of profits arising from a breach of legal duties. A property rule for breach of contract, for instance, would require specific performance of the contract, not expectation damages, from the party in breach. The two contractual parties could then negotiate over distribution of the benefits the party in breach hopes to accrue by eschewing contractual performance. Although there are often strong arguments in favor of liability rules in many areas of law, the sentiments of injustice revealed by the Ultimatum Game are compelling arguments for property rules.

Both the offer/asking price discrepancy and the outcomes of the Ultimatum Game provide the foundation for a theory that damages under liability rules—limited, perhaps, to individuals as opposed to sophisticated business enterprises—should be higher than market value. Alternatively, but more radically, they offer a cogent rationale for favoring property rules over liability rules. As discussed herein, the extent to which efficiency analysis deviates from our evolved sense of justice is a topic of great practical importance. Whether modern economics-based theories of law reasonably approximate our innate sense of justice is an open question that should continued to be explored by researchers of human nature.

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