Law and Economics

Economists have long offered insight into the law. With respect to libertarianism and the analysis of the market, Nobel laureate Friedrich von Hayek’s definitive works The Constitution of Liberty and Law, Legislation, and Liberty applied crucial insights from the Austrian School of Economics to legal issues. On the left, John R. Commons of the University of Wisconsin, in his The Legal Foundations of Capitalism (1921) and other works, applied economic analysis to legal institutions. A number of other economists also have dealt with legal issues, among them Nobel laureate Gary Becker’s pioneering work on issues centering on discrimination and family law. During the 1960s and 1970s, however, a group of scholars went beyond simply applying economic insights to legal issues and developed a body of work that became the known as the law and economics movement. The emergence of this movement was one of the most important developments in 20th-​century legal thought. Indeed, Professor Ian MacNeil, despite being critical of many aspects of the movement, called law and economics “the most powerful single monofocused discipline in American legal studies.” Largely associated with the University of Chicago during its early days, scholars who have centered their study on the interrelationship between law and economics today apply a variety of methodologies to bring the tools of economic analysis to bear on legal issues.

Two individuals dominated this movement. Ronald Coase, who was awarded the Nobel Prize in 1991, and author of a pathbreaking article in the field, “The Problem of Social Cost,” is often credited with initiating this approach in 1960. He was quickly joined by University of Chicago law professor Richard Posner, who is currently a judge on the U.S. Court of Appeals for the Seventh Circuit. Posner, through numerous articles and books and his definitive treatise, the Economic Analysis of Law, has played a major role in expanding the parameters of the field.

Coase’s contribution cannot be understated. “The Problem of Social Cost,” one of the most often cited articles in both economics and law, laid most of the intellectual groundwork for many of later developments in the field. Coase wrote the article as a response to the earlier work by A. C. Pigou, which was crucial in structuring modern welfare economics. In the 1920s, Pigou pioneered the analysis of market failures and focused on the most appropriate means of correcting these failures. For example, where a firm polluted a river with waste water, thus imposing costs on downstream users, the appropriate response had been to create a tax on waste water that brought the firm’s private costs into line with the social costs of its behavior. Pigouvian solutions are correspondingly heavily reliant on central government intervention. Coase’s analysis, in contrast, focused on the allocation of property rights. If downstream entities held a right to receive unpolluted water, they would be in a position to then use the legal system to force the upstream polluter to pay damages or stop to polluting. The solution to “market failures” thus lay with better definition of property rights, not corrective taxes.

Equally important, Coase took his analysis a step further by showing that, at least in economic terms, the precise allocation of property rights was irrelevant to the parties involved reaching a solution. Nor does it matter if property rights are allocated to the upstream polluter or to the downstream user because in either case having a clear property right would produce an equally efficient solution. If the gains from polluting the river outweighed the harms done to the downstream user, the two parties would be able to negotiate a transfer of the rights to the polluter regardless of where the right originated. If the costs of the pollution were to outweigh the gains, the inverse would hold true. The problem was thus reciprocal and not one-​sided.

Finally, and most significant, Coase used these insights to argue that where transaction costs (e.g., the cost of hiring negotiators, drafting agreements, etc.) were zero, the same solution would result regardless of who was initially allocated the property right. Although Coase never explicitly formulated these conclusions in exactly this way, the fact that the assignment of property rights has distributional consequences is frequently referred to as the “Coase Theorem.” Transaction costs are of course not zero in the real world, something of which Coase was fully aware. Nonetheless, the insight is significant because Coase’s analysis pointed toward our understanding of transaction costs and how they may be reduced, in opposition to the Pigouvian preoccupation with calculating optimal taxes.

Richard Posner’s contribution is no less significant than is Coase’s. Drawing together the still relatively sparse body of law and economics scholarship in 1972, the first edition of the Economic Analysis of Law systematized thinking in the field and helped spark a dramatic increase in the breadth and depth of scholarship. Posner brought to the study of law and economics an emphasis on positive, theoretical analysis of individual behavior. Posner also can be credited with developing an explicit philosophical basis for the law and economics movement. Further, Posner has played a major role in developing the argument that the common law has proved itself economically efficient.

Like a new religion, the movement’s success led to the development of distinct denominational subgroups. Three major subgroups warrant particular mention. One, often associated with a number of faculty members of the Harvard Law School, developed sophisticated mathematical models of legal issues. In many ways, this group of scholars mirrored developments in the economics profession in general, where increasing mathematicization brought both technical sophistication and raised concerns about the relevance of the work to real world issues. One of the most astute scholars in this group, Professor Steven Shavell, summarized their insights into tort law with his 1987 book, The Economic Analysis of Accident Law.

A particularly apt example is Shavell’s identification of the problem of optimal activity levels in negligence cases. Traditional negligence tort rules hold a defendant liable only when the defendant failed to take a reasonable level of care to prevent harm. Because these rules do not take into consideration whether the defendant should have engaged in the risky activity at all, they tend to underdeter harm-​causing activities. In contrast, strict liability rules require defendants to pay for all the harm they cause and so do not suffer from this problem.

Another group of scholars have employed econometric and other empirical techniques to examine the predictions of economic theory relating to legal institutions. For example, Brent Mast, Bruce Benson, and David Rasmussen have applied econometric techniques to criminal justice issues. In one article, they examined the impact of civil forfeiture laws on police activity. They found that, throughout the 1980s and 1990s, states increased the ability of law enforcement agencies to seize property in connection with allegations of illegal activity, most often in connection with drug prohibition. Using data on police activity and differences in state forfeiture laws, the authors demonstrated that when police departments were able to keep larger proportions of seized property, they increasingly diverted law enforcement activity into those areas. In another major work in this area, Yale Law School Professor Robert Ellickson used detailed examination of individual behavior among Shasta County, California, residents to test the Coase Theorem.

Finally, a third group draws on the Coasian tradition and emphasizes property rights in their researches. Often termed new resource economists or free-​market environmentalists, this group has emphasized ways in which the creation and allocation of property rights can solve problems ranging from overgrazing of public lands to the inefficient allocation of water rights. Terry L. Anderson and Don R. Leal’s Free Market Environmentalism epitomizes this approach. Work in this tradition tends to be less focused on the heavily mathematical models and more concerned with explaining how real institutions function.

Law and economics analysis often supports libertarian conclusions. Benson has taken a careful look at the economics of the criminal justice system and argues that market forces are capable of substituting for most state activity in this area. Despite conclusions of this nature, however, there are significant differences between rights-​based libertarian thought and law and economics. The most prominent of these divergences is the strongly utilitarian basis that underpins the conclusions drawn by law and economics analysis. The research done by Posner and his followers particularly tends toward utilitarian justifications for legal rules. Both law and economics scholars and libertarians, for example, are likely to agree that freedom of contract promotes economic well-​being. In cases where a model suggests that it does not, however, a law and economics adherent might be willing to trade liberty for prosperity, whereas a libertarian is unlikely to agree to this. This distinction is well illustrated by the differences in approach between Judge Posner and his University of Chicago colleague professor Richard Epstein. Epstein’s work more consistently favors liberty over utility.

The impact of law and economics can be gauged by comparing it to a parallel development in law that arose on the left in the 1970s. The critical legal studies movement developed at roughly the same time and had considerable influence on the legal academy in its early years. By the mid-​1980s, however, the “crit” movement had fractured into racial, sexual orientation, and gender subgroups (critical race theory, gay and lesbian legal theory, and feminist legal theory), none of which has managed to exert a serious influence on the development of legal studies.

Further Readings

Anderson, Terry L., and Donald R. Leal. Free Market Environmentalism. San Francisco: Pacific Research Institute for Public Policy, 1991.

Barzel, Yoram. Economic Analysis of Property Rights. Cambridge: Cambridge University Press, 1989.

Benson, Bruce L. The Enterprise of Law: Justice without the State. San Francisco: Pacific Research Institute for Public Policy, 1990.

Coase, Ronald. The Firm, the Market and the Law. Chicago: University of Chicago Press, 1988.

Ellickson, Robert. Order Without Law. Cambridge, MA: Harvard University Press, 1991.

Mast, Brent D., Bruce L. Benson, and David W. Rasmussen. “Entrepreneurial Police and Drug Enforcement Policy.” Public Choice 104 nos. 3–4 (2000): 285–308.

Posner, Richard A. Economic Analysis of Law. 5th ed. Boston: Little, Brown, 1998.

Shavell, Steven. Economic Analysis of Accident Law. Cambridge, MA: Harvard University Press, 1987.