Christian Turner Assistant Professor of Law
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- Ronald H. Coase , The Problem of Social Cost , 3 J. of Law and Econ. 1 (1960) (excerpted)
1.3.2. Law and EconomicsFrom A. Mitchell Polinsky and Steven Shavell, Economic Analysis of Law, in The New Palgrave Dictionary of Economics (2d ed.) Economic analysis of law seeks to identify the effects of legal rules on the behavior of relevant actors and whether these effects are socially desirable. The approach employed is that of economic analysis generally: the behavior of individuals and firms is described assuming that they are forward looking and rational, and the framework of welfare economics is adopted to assess the social desirability of outcomes. The field may be said to have begun with Bentham (1789), who systematically examined how actors would behave in the face of legal incentives (especially criminal sanctions) and who evaluated outcomes with respect to a clearly stated measure of social welfare (utilitarianism). His work was left essentially undeveloped until four important contributions were made: Coase (1960) on externalities and liability, Becker (1968) on crime and law enforcement, Calabresi (1970) on accident law, and Posner (1972) on economic analysis of law in general. … . 1. PROPERTY LAW. … . Externalities. When individuals use property, they may cause externalities, namely, harm or benefit to others. As a general matter, it is socially desirable for individuals to do more than is in their self-interest to reduce detrimental externalities and to act so as to increase beneficial externalities. The socially optimal resolution of harmful externalities often involves the behavior of victims as well as that of injurers. If victims can do things to reduce the amount of harm more cheaply than injurers (say install air filters to avoid pollution), it is optimal for victims to do so. Moreover, victims can sometimes alter their locations to reduce their exposure to harm. Legal intervention can ameliorate problems of externalities. A major form of intervention that has been studied is direct regulation, under which the state restricts permissible behavior, such as requiring factories to use smoke arrestors. Closely related is the injunction, whereby a potential victim can enlist the power of the state to force a potential injurer to take steps to prevent harm or to cease his activity. Society can also make use of financial incentives to induce injurers to reduce harmful externalities. Under the corrective tax, a party pays the state an amount equal to the expected harm he causes, for example, the expected harm due to a discharge of a pollutant into a lake. There is also liability, a privately-initiated means of providing financial incentives, under which injurers pay for harm done if sued by victims. These methods differ in the information that the state needs to apply them, in whether they require or harness information that victims have about harm, and in other respects, such that each may be superior to the other in different circumstances (Shavell, 1993). Parties affected by externalities will sometimes have the opportunity to make mutually beneficial agreements with those who generate the externalities, as Coase (1960) stressed. But bargaining may not occur for many reasons: cost; collective action problems (such as when many victims each face small harms); and lack of knowledge of harm (such as from an invisible carcinogen). If bargaining does occur, it may not be successful, owing to asymmetric information. These difficulties often make bargaining a problematic solution to externality problems and imply that liability rules are needed, as discussed by Calabresi and Melamed (1972). … .
6. CRITICISM OF ECONOMIC ANALYSIS OF LAW. Many observers, and particularly noneconomists, view economic analysis of law with skepticism. We consider several such criticisms here. Description of behavior. It is sometimes claimed that individuals and firms do not respond to legal rules as rational maximizers of their well-being. For example, it is often asserted that decisions to commit crimes are not governed by economists’ usual assumptions. Some skeptics also suggest that, in predicting individuals’ behavior, certain standard assumptions are inapplicable. For example, in predicting compliance with a law, the assumption that preferences be taken as given would be inappropriate if a legal rule would change people’s preferences, as some say was the case with civil rights laws and environmental laws. In addition, laws may frame individuals’ understanding of problems, which could affect their probability assessments or willingness to pay. The emerging field of behavioral economics, as well as work in various disciplines that address social norms, is beginning to examine these sorts of issues (Jolls et al., 1998). Distribution of income. A frequent criticism of economic analysis of law concerns its focus on efficiency, to the exclusion of the distribution of income. The claim of critics is that legal rules should be selected in a manner that takes into account their effects on the rich and the poor. But achieving sought-after redistribution through income tax and transfer programs tends to be superior to redistribution through the choice of legal rules. This is because redistribution through legal rules and the tax-transfer system both will distort individuals’ labor-leisure decisions in the same manner, but redistribution through legal rules often will require choosing an inefficient rule, which imposes an additional cost (Shavell, 1981; Kaplow and Shavell, 1994b). Moreover, it is difficult to redistribute income systematically through the choice of legal rules: many individuals are never involved in litigation; and for those who are, there is substantial income heterogeneity among plaintiffs as well as among defendants. Additionally, in contractual contexts, the choice of a legal rule often will not have any distributional effect because contract terms, notably, the price, will adjust so that any agreement into which parties enter will continue to reflect the initial distribution of bargaining power between them. Concerns for fairness. An additional criticism is that the conventional economic approach slights important concerns about fairness, justice, and rights. Some of these notions refer implicitly to the appropriateness of the distribution of income and, accordingly, are encompassed by our preceding remarks. Also, to some degree, the notions are motivated by instrumental concerns. For example, the attraction of paying fair compensation to victims must derive in part from the beneficial risk reduction effected by such payments, and the appeal of obeying contractual promises must rest in part on the desirable consequences contract performance has on production and exchange. To some extent, therefore, critics’ concerns are already taken into account in standard economic analysis. However, many who promote fairness, justice, and rights do not regard these notions merely as some sort of proxy for attaining instrumental objectives. Instead, they believe that satisfying these notions is intrinsically valuable. This view also can be partially reconciled with the economic conception of social welfare: if individuals have a preference for a legal rule or institution because they regard it as fair, that should be credited in the determination of social welfare, just as any preference should. But many commentators take the position that conceptions of fairness are important as ethical principles in themselves, without regard to any possible relationship the principles may have to individuals’ welfare. This opinion is the subject of longstanding debate among moral philosophers. Some readers may be skeptical of normative views that are not grounded in individuals’ well-being because embracing such views entails a willingness to sacrifice individuals’ well-being. Indeed, consistently pursuing any non-welfarist principle must sometimes result in everyone being made worse off; see Kaplow and Shavell (2001, 2002).
Ronald H. Coase , The Problem of Social Cost, 3 J. of Law and Econ. 1 (1960) (excerpted) This paper is concerned with those actions of business firms which have harmful effects on others. The standard example is that of a factory the smoke from which has harmful effects on those occupying neighboring properties. ... The traditional approach has tended to obscure the nature of the choice that has to be made. The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm. I instanced in my previous article the case of a confectioner the noise and vibrations from whose machinery disturbed a doctor in his work. To avoid harming the doctor would inflict harm on the confectioner.... ...[Consider] the contamination of a stream. If we assume that the harmful effect of the pollution is that it kills the fish, the question to be decided is: is the value of the fish lost greater or less than the value of the product which the contamination of the stream makes possible. It goes almost without saying that this problem has to be looked at in total and at the margin. I propose to start my analysis by examining a case in which most economists would presumably agree that the problem would be solved in a completely satisfactory manner: when the damaging business has to pay for all damage caused and the pricing system works smoothly (strictly this means that the operation of a pricing system is without cost). A good example of the problem under discussion is afforded by the case of straying cattle which destroy crops growing on neighboring land… . . I shall assume … that the price of the crop is $1 per ton. Also, I assume that the relation between the number of cattle in the herd and the annual crop loss is as follows:
Given that the cattle-raiser is liable for the damage caused, the additional annual cost imposed on the cattle-raiser if he increased his herd from, say, two to three steers is $3 and in deciding on the size of the herd, he will take this into account along with his other costs. That is, he will not increase the size of the herd unless the value of the additional meat produced (assuming that the cattle-raiser slaughters the cattle) is greater than the additional costs that this will entail, including the value of the additional crops destroyed… ...
...Assume initially that the value of the crop obtained from cultivating a given tract of land is $12 and that the cost incurred in cultivating this tract of land is $10, the net gain from cultivating the land being $2. I assume for purposes of simplicity that the farmer owns the land. Now assume that the cattle-raiser starts operations on the neighboring property and that the value of the crops damaged is $l. In this case $11 is obtained by the farmer from sale on the market and $1 is obtained from the cattle-raiser for damage suffered and the net gain remains $2. Now suppose that the cattle-raiser finds it profitable to increase the size of his herd, even though the amount of damage rises to $3; which means that the value of the additional meat production is greater than the additional costs, including the additional $2 payment for damage. But the total payment for damage is now $3. The net gain to the farmer from cultivating the land is still $2. The cattle-raiser would be better off if the farmer would agree not to cultivate his land for any payment less than $3. The farmer would be agreeable to not cultivating the land for any payment greater than $2. There is clearly room for a mutually satisfactory bargain which would lead to the abandonment of cultivation… . . ... ...A procedure which merely provided for payment for damage to the crop caused by the cattle but which did not allow for the possibility of cultivation being discontinued would result in too small an employment of factors of production in cattle-raising and too large an employment of factors in cultivation of the crop. But given the possibility of market transactions, a situation in which damage to crops exceeded the rent of the land would not endure. Whether the cattle-raiser pays the farmer to leave the land uncultivated or himself rents the land by paying the land-owner an amount slightly greater than the farmer would pay (if the farmer was him-self renting the land), the final result would be the same and would maximize the value of production… . . ... I now turn to the case in which, although the pricing system is assumed to work smoothly (that is, costlessly), the damaging business is not liable for any of the damage which it causes. This business does not have to make a payment to those damaged by its actions… ....I return to the case of the farmer and the cattle-raiser. The farmer would suffer increased damage to his crop as the size of the herd increased. Suppose that the size of the cattle-raiser’s herd is three steers (and that this is the size of the herd that would be maintained if crop damage was not taken into account). Then the farmer would be willing to pay up to $3 if the cattle-raiser would reduce his herd to two steers, up to $5 if the herd were reduced to one steer and would pay up to $6 if cattle-raising was abandoned. The cattle-raiser would therefore receive $3 from the farmer if he kept two steers instead of three. This $3 foregone is therefore part of the cost incurred in keeping the third steer. Whether the $3 is a payment which the cattle-raiser has to make if he adds the third steer to his herd (which it would be if the cattle-raiser was liable to the farmer for damage caused to the crop) or whether it is a sum of money which he would have received if he did not keep a third steer (which it would be if the cattle-raiser was not liable to the farmer for damage caused to the crop) does not affect the final result. In both cases $3 is part of the cost of adding a third steer, to be included along with the other costs. If the increase in the value of production in cattle-raising through increasing the size of the herd from two to three is greater than the additional costs that have to be incurred (including the $3 damage to crops), the size of the herd will be increased. Otherwise, it will not. The size of the herd will be the same whether the cattle raiser is liable for damage caused to the crop or not. ... It is necessary to know whether the damaging-business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no marked transactions to transfer and recombine them. But the ultimate result (which maximizes the value of production) is independent of the legal position if the pricing system is assumed to work without cost. … ...Of course, if market transactions were costless, all that matters (questions of equity apart) is that the rights of the various parties should be well-defined and the results of legal actions easy to forecast. But as we have seen, the situation is quite different when market transactions are so costly as to make it difficult to change the arrangement of rights established by the law. In such cases, the courts directly influence economic activity. It would therefore seem desirable that the courts should understand the economic consequences of their decisions and should, insofar as this is possible without creating too much uncertainty about the legal position itself, take these consequences into account when making their decisions. Even when it is possible to change the legal delimitation of rights through market transactions, it is obviously desirable to reduce the need for such transactions and thus reduce the employment of resources in carrying them out. 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