an introduction to economic analysis of law

CHICAGO

JOHN M. OLIN LAW & ECONOMICS WORKING PAPER NO. 53

(2D SERIES)

VALUES AND CONSEQUENCES:

AN INTRODUCTION TO ECONOMIC ANALYSIS OF LAW

Richard A. Posner

THE LAW SCHOOL

THE UNIVERSITY OF CHICAGO

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Values and Consequences:

An Introduction to Economic Analysis of Law

Richard A. Posner1*

I am going to give a very brief, thumbnail sketch of economic analysis of law, and then focus on just two uses of the analysis, and in doing so try to give you a bit of its flavor. The first use is to make law simpler to understand and evaluate; and the second is to press you to defend your values.

That there is a relation between economics and law has been known for an awfully long time, at least since Hobbes’s discussion of property in the seventeenth century. But until very recently, the relation received focused attention only in relation to a handful of legal fields, mainly antitrust and public utility regulation, that dealt explicitly with competition and monopoly, which as early as the 1930s were receiving the sustained and sophisticated attention of leading English and American economists. (Competition and monopoly had received the attention of economists since Adam Smith; hence the qualification “sustained and sophisticated.”)

In retrospect, an economic literature dealing with other fields of law, notably Robert Hale’s work on contract law, which also dates from the 1930s, can be identified. But even after the Journal of Law and Economics commenced publication—at this law school, naturally—in 1958, the “law and economics” movement, if discernible at all, would have been associated primarily with problems of competition and monopoly, although occasional forays had been made into taxation (Henry Simons) and corporations (Henry Manne), even patents (Arnold Plant), and if one went back to the eighteenth century there was Bentham’s largely forgotten utilitarian—essentially, economic—analysis of crime and punishment. It was not until 1961, when Ronald Coase’s article “The Problem of Social Cost” was published,2 and at about the same time Guido Calabresi’s first article on torts,3 that an economic theory of the common law could be glimpsed. When Gary Becker published his article “Crime and Punishment: An Economic Approach,”4 reviving and refining Bentham, it began to seem that perhaps no field of law could not be placed under the lens of economics with illuminating results. And within a few years, sure enough, papers on the economics of contract law, civil and criminal procedure, property, 1* Chief Judge, United States Court of Appeals for the Seventh Circuit; Senior Lecturer, University of Chicago Law School. This is the text of a Coase Lecture given at the University of Chicago Law School on January 6, 1998.

2 3 Journal of Law and Economics 1 (1960 [but actually published in 1961]).

3 Guido Calabresi, “Some Thoughts on Risk Distribution and the Law of Torts,” 70 Yale Law Journal 499 (1961).

4 76 Journal of Political Economy 169 (1968).

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consumer protection, and other areas new to economists had appeared and the rough shape of the mature field was discernible. Later, books and articles would extend the economic analysis of law into such fields as employment, admiralty, intellectual property, family law, legislation, environmental law, administrative law, conflict of laws, and judicial behavior; and this is only a partial list. The field has developed to the point where the dean of the Yale Law School, a critic of the field, said recently: “The law and economics movement was and continues to be an enormous enlivening force in American legal thought and, I would say, today continues and remains the single most influential jurisprudential school in this country.”5

The economic analysis of law, as it now exists not only in the United States but also in Europe, which has its own flourishing law and economics association, has both positive (that is, descriptive) and normative aspects. It tries to explain and predict the behavior of participants in and persons regulated by the law. It also tries to improve law by pointing out respects in which existing or proposed laws have unintended or undesirable consequences, whether on economic efficiency, or the distribution of income and wealth, or other values. It is not merely an ivory-towered enterprise, at least in the United States, where the law and economics movement is understood to have influenced legal reform in a number of important areas. These areas include antitrust, the regulation of public utilities and common carriers, environmental regulation, the computation of damages in personal injury suits, the regulation of the securities markets, the federal sentencing guidelines, the division of property and the calculation of alimony in divorce cases, and the law governing investment by pension funds and other trustees, and to have been a significant factor in the deregulation movement and in free-market ideology generally. Most major and many minor law schools have one or two full-time economists on their faculty; a number of law professors have Ph.D.’s in economics; there are six scholarly journals devoted to economic analysis of law, with a seventh on the way; the use of economists as expert witnesses has become conventional in a range of important fields; judicial opinions refer to economic concepts and cite economic books and articles; and a number of federal judges, including a Justice of the Supreme Court (Stephen Breyer), are alumni of the law and economics movement. Economic analysis of law is generally considered the most significant development in legal thought in the United States since legal realism petered out a half century ago.

Noneconomists often associate economics with money, capitalism, selfishness—with a reductive, unrealistic conception of human motivation and behavior, a formidable mathematical apparatus, and a penchant for cynical, pessimistic, and conservative conclusions. It earned the sobriquet of “the dismal science” because of Thomas Malthus’s thesis that famine, war, and sexual abstinence were the only ways in which population and food supply could be equilibrated. The essence of economics is none of these things, 5 Remarks of Anthony T. Kronman, The Second Driker Forum for Excellence in the Law, 42 Wayne Law Review 115, 160 (1995).

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however. The essence is extremely simple, although the simplicity is deceptive; the simple can be subtle, can be counterintuitive; its antithesis is “complicated,” not “difficult.”

Most economic analysis consists of tracing out the consequences of assuming that people are more or less rational in their social interactions. In the case of the activities that interest the law, these people may be criminals or prosecutors or parties to accidents or taxpayers or tax collectors or striking workers—or even law students. Students treat grades as prices, so that unless the university administration intervenes, unpopular professors, in order to keep up their enrollments, will sometimes compensate students for the low perceived value of the course by giving them higher grades, that is, by raising the price that the professor pays for the student.

I said that the tracing out of consequences is subtle as well as simple, and here is an example. Have you heard of the spendthrift trust? That is a trust, very common, indeed standard, in which the trustee is forbidden to pay out any of the money or other property in the trust to the creditors of the trust’s beneficiaries. The law will enforce such a restriction, yet it has seemed to many students of the law a fraud on creditors; for the trust beneficiary, assuming that his whole wealth is in the spendthrift trust, can borrow all he wants, spend what he borrows, and not be forced to repay the lenders. But if you think about this for a moment, you’ll be driven to the opposite conclusion—that, provided the provision preventing creditors from reaching into the trust is not concealed, a spendthrift trust limits borrowing by the trust beneficiary, because he can’t offer security to the lender. And the next step in the analysis is to see how increasing the rights of debtors in bankruptcy, far from causing an avalanche of reckless borrowing, could reduce the amount of borrowing, and so the incidence of bankruptcy, by causing lenders to make smaller loans to risky borrowers. So lenders may oppose easy bankruptcy not because they fear there will be more defaults, but because they fear a reduction in the volume of loans. To see this, imagine how many, or rather how few, loans there would be if borrowers had no obligation to repay. Notice also how creditors are as hurt by excessively stringent as by excessively lenient bankruptcy rules: if creditors had the legal right, as under ancient Roman law, to carve up a defaulting borrower into as many pieces as there were creditors, most people would be afraid to borrow. Can you see now why loan sharks in Chicago break the legs of defaulting borrowers, but do not kill them?

Rationality implies decision making, and people often have to make decisions under conditions of profound uncertainty; fortunately, economists have devoted a good deal of attention to decision under uncertainty. A simple but important example of a law-related decision under uncertainty is the decision as to how much care to take to avoid an accident. The accident will occur with probability P, and let us assume that if it does occur it will impose a cost that I’ll call L, for loss; and assume further that eliminating the possibility of such an accident would impose on the potential injurer a cost, which I’ll call B (for burden). Then it is easily seen that the cost of avoiding the accident will be 3 Values and Consequences

less than the expected accident cost (or benefit of avoiding the accident) if B is smaller than L discounted (multiplied) by P, or B<PL, and if this condition is satisfied then the potential injurer can be said to be negligent if he fails to take the precaution. This is the negligence formula of Judge Learned Hand, announced in a judicial opinion in 19476 but not recognized as an economic formula for negligence until many years later. It is a simple formula but its elaboration and application to specific doctrines in the law of torts have generated an immense and illuminating literature.

By glancing at the Hand Formula you can see how an injurer could be deemed negligent even if the probability of an accident were very low (because B might be low or L very high), or even if the cost of avoiding the injury were very high (because P and/or L might be very high). You can put a minus sign before B, and thus model the case in which the injurer would incur a cost saving by not injuring: the case, in short, of deliberate injury; and you would see how in that case the injury is never cost-justified. Or you can think of B not as the cost of taking a precaution, but as the cost of reducing the output or other activity of the potential injurer, since that’s another way of avoiding injuring people. And that will give you a clue to the role, or a role, of strict liability in the law. Suppose you kept a tiger in your backyard for self-defense, and the tiger got out and bit a neighbor’s head off. It would be a case of high P and high L, and maybe high B in the sense that you couldn’t have been more careful than you were to keep the tiger in your yard; but B might have been low if viewed as the cost of not having a tiger at all, but substituting another method of self-protection; and in fact this is a case where strict liability is imposed.

Well, I could go on and on with these examples, moving from one tort doctrine to another through the whole field of torts and then to contracts and property and so on throughout the legal system. But time does not permit that and if you want a fuller sketch of the field today, I suggest you take a look at my book Economic Analysis of Law, a new edition of which has just appeared.7 I want to move on to the two specific uses of economic analysis that I said I’d concentrate on—making law simpler and challenging you to defend your values. I shall begin with a case that the Supreme Court decided in 1911, an antitrust case called Dr. Miles.8 The issue was the legality under the Sherman Act of a contract that a supplier of patent medicines entered into with his dealers forbidding them to charge a price for his medicines lower than the retail price that he fixed; this is the practice known as resale price maintenance. The Supreme Court, holding the practice illegal, noted that it had the same effect as would an agreement among the dealers to fix the price at which they would sell Dr. Miles’s medicines: a dealers’ cartel. But the Court overlooked another effect. If dealers cannot compete in price, yet would 6 United States v. Carroll Towing Co., 159 F.2d 169 (2d Cir. 1947).

7 Richard A. Posner, Economic Analysis of Law (5th ed. 1998).

8 Dr. Miles Medical Co. v. John D. Park & Sons Co., 220 U.S. 373 (1911).

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