New Challenges for Law and Economics

Abstracts: 

The Limits of Normative Law and Economics?, Eric A. Posner

“Normative law and economics” (NLE) is a social practice conducted by many law professors and some economists. This practice is highly controversial in law schools, partly because its practitioners have made excessively ambitious claims about its value. I argue that, properly understood, NLE has two narrow, legitimate functions. First, this work identifies what I call “consistency failures” in existing law, and draws them to the attention of judges and policymakers. The only normative assumption in the work is that if the government properly has some goal X, it should not engage in actions that subvert that goal. Second, certain strands of NLE can be understood as recommending incremental reform of institutions that are widely accepted as necessary for the proper functioning of society (or are, for all intents and purposes, entrenched), while refusing to take a position on whether those institutions are justified. Both functions are in essence a form of cost-effectiveness analysis and neither relies on controversial claims about moral values or social ideals. Much work of NLE that goes beyond these boundaries implicitly assumes that controversial normative positions are correct or widely accepted.

Transactions Benefits, Daniel Markovits

At least since Ronald Coase, Law and Economics has been deeply engaged with transactions costs.  These frictions can prevent resources from being efficiently deployed in production and goods from reaching their highest valuing users.  The systematic study of how to reduce or minimize transactions costs has yielded explanations, for example, of the boundary between the firm and the market, the allocation of initial entitlements, and the choice between deploying property rule or liability rule remedies when entitlements are breached. 

But the inevitable frictions that attend to human affairs can produce gains as well as losses, and Law and Economics has almost entirely neglected the study of these transactions benefits.  At least three varieties of transactions benefits appear immediately once one starts to look for them.  Publicity benefits arise when features of one transaction become known and are valuable to other circumstances, and perhaps to the legal system at large.  Owen Fiss and Judith Resnik, for example, oppose settlement and arbitration because, even if these forms of dispute resolution involve lower transactions costs than adjudication, they also (for this very reason) fail to generate adjudication’s valuable transactions benefits.  Legitimacy benefits arise when the frictions involved in legal arrangements transform the beliefs and desires of those who experience them in ways that sustain the authority that the arrangements have over the parties within them.  Accounts from social psychology of the authority of adjudication and, more broadly, the role that procedure plays in producing legitimacy emphasize this variety of transaction benefit.  Finally, solidarity benefits arise when legal frictions constitute intrinsically valuable relationships among the parties who produce them.  Democratic legitimacy in public law and contractual collaboration in private law illustrate this variety of transactions benefit.

The three species of transactions benefit pose increasingly profound challenges for law and economics.  Publicity benefits are well captured by traditional economic models, which might treat them as positive externalities.  Law and economics can therefore recognize publicity benefits without changing any of its deep substantive or methodological commitments.  Legitimacy and especially solidarity benefits pose a much deeper challenge for law and economics, as they move towards the view that value inheres not in states of affairs but rather in relations among persons, a view that is difficult to compass from within the functionalist approach to law that law and economics embraces.

What Do Lawyers Contribute to Law & Economics?, Robert E. Scott & George G. Triantis

The Law and Economics movement has transformed the analysis of private law in the United States and increasingly around the world.  Starting with just a few adherents fifty years ago, it has become an established fixture in academic scholarship in fields of study as diverse as business law, contracts, torts and property. It is inconceivable today that scholars in these and other fields are unfamiliar with the basic tools of marginalist analysis, game theory, problems of private information and rational choice under scarcity and uncertainty. As the field developed from 1970 to the early 2000s, legal scholars using methods derived principally from economics have developed countless insights about the operation and effects of law and legal institutions thereby permitting policy makers to better understand the social order.  Throughout this entire period, the discipline of law and economics has benefited from a partnership among trained economists and academic lawyers. Yet, the tools just described derive primarily from economics and not law.  A logical question thus demands attention:  what role do academic lawyers play in law and economics scholarship. We begin with the premise that the academic lawyer serves as a knowledge resource for the economist who applies her methodology to legal matters. And, in that role, a legal academic might draw on economic methods and insights to further understand the operation and impact of law in society.  Several leading law-and-economists have written that this is the extent of the lawyer's trade: applying economic methods to legal knowledge..  In this essay, we set out to elaborate an alternative claim that, in addition to the legal resources they provide to the economic analyst, academic lawyers have cognizable analytical skills developed both through their involvement in law as an applied discipline and through their mastery of the common law method. We use case studies to show that the plaintive cry -- don't forget the lawyers! -- is a wise admonition for the next generation of law and economics scholars to heed.

Economic Analysis in Law, Hanoch Dagan & Roy Kreitner

This Essay explores the relationship between economic analysis and legal theory. We claim that legal theory must account for law’s coerciveness, its normativity, and its institutional structure. Economic analyses that engage these features are an integral part of legal theory, rather than external observations about law from an economic perspective. These analyses, or economic analysis in law, play a crucial role in understanding the law and in developing legal policy arguments. After establishing its terminology, the Essay maps out three contributions of economic analysis in law: prescriptive recommendations in areas amenable to preference satisfaction as a normative criterion; analyzing efficiency as one aspect of a broader normative inquiry; and exposing feasibility constraints. Finally, the Essay turns to an exploration of possibilities for extending economic analysis in law beyond its comfort zone. It suggests that economic analysis might expand into areas where values other than preference satisfaction are or ought to be dominant considerations.

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Remixing Resources, Lee Anne Fennell

This paper will address the interplay between distribution and efficiency in the allocation of resources. It proceeds from the premise that combinations of resources are of central and increasing importance to social welfare. Complementarities between units of the same resource, between different resources, and between human capital and other resources all bear on law’s pursuit of allocative and investment efficiency. Distribution plays a crucial role, both as a precondition for certain valuable combinations and as one determinant of the social welfare consequences of the resulting resource arrangements. Structuring law to facilitate the most valuable combinations of resources is a primary task for law and economics—and one that requires connecting, rather than separating, considerations of distribution and efficiency.

Willingness-to-Pay: A Welfarist Reassessment, Oren Bar-Gill

Despite enduring criticism, the Willingness to Pay (WTP) criterion continues to exert substantial influence on policymaking, especially through the vehicle of cost-benefit analysis.

In this Article, I use a welfarist framework to evaluate WTP-based policymaking and the critiques of WTP-based policymaking. A welfarist cares about individual preferences or utilities – and how they are aggregated into a social welfare function – not about individuals’ WTP. But since we cannot directly observe preferences or utilities, we use WTP as a proxy for utility. Much of the criticism levied against the WTP criterion can be understood as saying that WTP is a bad proxy for utility – that WTP contains limited information about preferences.

The main goal of this Article is to explore the conditions under which WTP can serve as a good proxy for utility. A major criticism of WTP is that wealth effects prevent WTP from serving as a good proxy for utility. I formalize this critique and extend it. In particular, I analyze the effects of the distribution of wealth in society on the informational content of WTP. The basic claim is that WTP contains more information about preferences, and thus serves as a better proxy for utility, when the distribution of wealth is more equal. Conversely, in a society with great wealth disparities, there is a greater risk that WTP will be a poor proxy for utility. I develop a methodology for quantifying the informational content of WTP. This methodology requires the specification of a functional relationship between wealth and utility, which captures the decreasing marginal utility from money. The power of this methodology is demonstrated using a particular functional relationship that is borrowed from other applications in the economic literature and supported by data.

The informational content of WTP depends on how WTP is measured and applied. First, I distinguish between two types of policies: (i) policies that are not paid for by the individuals who are affected by the policy, but rather by general funding sources (like tax revenues); and (ii) policies that are paid for by the individuals who are affected by the policy (e.g., a regulation that mandates certain car safety features and results in higher car prices). Second, I distinguish between two types of WTP measures: (i) individualized WTP that measures the benefit from a policy by eliciting the WTP of the individuals who are affected by the policy; and (ii) uniform, average WTP that measures a universal benefit, such as a reduction in mortality risk, by eliciting and aggregating the WTP of all individuals; this aggregate WTP measure (the VSL) is then used whenever a policy affects mortality risk, even if the specific policy does not affect most of the people from whom WTP was elicited. When the cost of the policy is not borne by the affected individuals, individualized WTP has low informational content and increases wealth disparity. Uniform, average WTP has higher informational content and reduces wealth disparity, at least in the case of universal benefits. Therefore, when possible, a uniform, average WTP should be preferred in this scenario. When the cost of the policy is borne by the affected individuals, individualized WTP has high informational content but increases wealth disparity. Uniform, average WTP has lower informational content and indeterminate distributional implications. Here, the choice between individualized WTP and uniform, average WTP is more difficult. The analysis provides further justification for the common use of uniform, average WTP measures, but only when the cost of the policy is not borne by the affected individuals.

I briefly consider two extensions. The first involves time. I present a dynamic extension of the relationship between the informational content of WTP and the wealth distribution. Since WTP is affected by wealth, the initial wealth distribution will affect the policies that a WTP-based analysis prescribes. But these chosen policies will then change the distribution of wealth, which will then change WTP and thus lead to further policy change. This further policy change will again affect the distribution of wealth. Etc. Through this dynamic, inequality can increase over time. In addition, the dynamic extension forces us to rethink the WTP for the initial policy. Since the initial policy will affect, through the evolving wealth distribution, many future policies, the stakes are higher and thus WTP for the initial policy will be higher. Indeed, individuals would borrow against future wealth to increase WTP and secure their favored initial policy. The second extension emphasizes the effect of forward-looking rationality on the WTP measure. Consider the standard WTP question: “how much are you willing to pay for Policy X?” For a rational individual, this question would elicit a response that is sensitive to changes in the wealth distribution brought about by the policy – in the short-term and in the long-term (incorporating the dynamic extension). A myopic individual, on the other hand, will consider only the immediate effects of the policy, ignoring its implications for the wealth distribution and for future policy debates. Therefore, the question of rationality raises additional concerns about WTP-based policymaking.

Essential Role of Empirical Analysis in Developing Economic Theory, Jennifer Arlen

Economic theory is, by necessity and design, an exercise in simplification. The theorist endeavors to understand an economic problem by removing extraneous features of the real world and create a model that incorporates the core characteristics of the decision-making problem that can be expected to affect people’s choices.  Economic models thus are, by design, “unrealistic” in that they abstract away from many features of the real world. Yet they nevertheless can provide valuable insights—that enable us to both predict behavior and formulate normative policy—to the extent that the model captures those aspects of the decision that indeed determine, and reliably predict, the choices people make.

Economic models cannot, themselves, tell us whether they meet the prerequisites for a good theory.  Instead, economic theory must rely on empirical analysis to test the validity of the theoretical models by testing the reliability of their predictions. Economic theory also depends on empirical analysis for identifying what are the essential and legitimate structural features for a model. Throughout the history of law and economics, empirical analyses have led to improvements in theoretical law and economics by both producing results that are inconsistent with the theory, and helping to identify critical features of the decision-making problem that are not accurately captured in the prevailing theories.

This article explores the many ways in which law and economics theory is dependent on empirical analysis and then provides examples of areas of law in which the theory was altered and improved following insights from empirical analyses.

The Eventual Decline of Empirical Law and Economics, Saul Levmore

This Article suggests a co-evolution of empirical and theoretical work in law and economics. Empirical work alone is suggestive, but should not be taken too seriously. The weaknesses in empirical work are a kind of virus that begins with over-statements and misapprehensions and then spreads as more scholars copy the mistakes and engage in empirial work as a means of entry into the field. Empiricism will become suspect as its current assumptions are questioned, and as attempts at replication show its weaknesses. Empirical work looks very different when underlying distributions are understood as reflecting power-laws, or as simply random. Once inconvenient distributions are acknowledged, the key question is why observations might be distributed in this fashion. This is likely to be a task for theorists.

This Article focuses on three weaknesses of empirical work. First, much of the empirical work in law and economics is driven by models that are formed by error minimization techniques, and these techniques are unreliable when errors are surprisingly distributed (that is, when they suffer from heteroscedasticity. Second, it is likely that when empiricists fit data with one model, the process is flawed because there is a hidden transition to a second distribution. Discovering multiple distributions requires theoretical work. These and other problems are exacerbated by the likelihood that conclusions are based on the tail end of data sets, inasmuch as scholarly journals only bring to light statistically significant results. Finally, empirical work in law and economics suffers from the absence of very large data sets. Without such sets it is difficult to test conclusions and to escape the ever-present problem of omitted variables. Moreover, “reversal paradoxes” are a serious problem without large data.

The larger claim is that data and theory must work together. Data can suggest theories, and theories can be tested, to a degree, with data. Some theoretical insights are so convincing that data testing, though comforting, may be unnecessary – and testing may, in any event, be tainted by the spread of the theory. It is likely that the recent surge of empirical work in law and economics will be slowed without the development of new theories.

The Economics of Class Actions Waivers, Albert Choi & Kathryn Speier

Many firms require consumers, employees, and suppliers to sign class action waivers as a condition of doing business with the firm.  Indeed, three recent US Supreme Court cases, Italian Colors, Concepcion, and Epic Systems, have endorsed companies’ ability to block class actions (along with class arbitrations) through mandatory individual arbitration clauses.  Are class action waivers serving the interests of society or are they facilitating socially harmful business practices?  This paper synthesizes and extends the existing law and economics literature by analyzing the firms’ incentive to impose class action waivers on consumers, employees, and other contractual parties.  While in many settings the firms’ incentive to block class actions is aligned with maximizing social welfare, in many other settings it is not.  We examine conditions in which class action waivers can compromise product safety, facilitate anticompetitive conduct, and support harmful employment practices.  Our analysis delivers a more nuanced, policy-based understanding of the recent Supreme Court cases, highlights several new unresolved issues, and identifies future challenges for legal scholarship.

 Economic Challenges for the Law of Contract, Alan Schwartz & Simone M. Sepe

This Essay introduces general equilibrium theory (GET) and mechanism design theory (MD) in a general sense (rather than in piece meal applications) to the study of contract law. As a positive matter, this introduction reveals three understudied areas: (i) when the equilibrium contract is individually rational but collectively irrational; (ii) what is the role of courts in market completion projects; and (iii) how to implement renegotiation-proof contracts. As a normative matter, this Essay has two main implications. First, it shows that formalist interpretative practices are more efficient than contextualist interpretative practices. Second, given that the ex ante negative effects of renegotiation are likely to dominate the ex post benefits, the law of contract modification should be reformed accordingly.