Legal change in economic analysis
John N. Drobak and Douglass C. North
One school of law and economics analyses legal problems by using economic principles. Scholars working in the new institutional economics reverse that process and incorporate legal analysis in their explanation of economic events.
The new institutionalists believe that economic growth cannot be understood with neoclassical theory alone. Neoclassical theory can be a powerful explanatory and predictive tool, but it is also a static theory that often oversimplifies, sometimes erroneously, the dynamic world. In an attempt to bring order to this uncertain and constantly changing world, human beings have used institutions - the rules of the game of a society - to structure human interaction. Institutions provide the framework of incentives that shape economic, political and social organization. They provide a foundation for the formation of property rights. Institutions affect economic performance by determining, together with the technology employed, the transaction and transformation costs that make up the total costs of production. Informal institutions include such things as norms of behaviour, codes of conduct and business conventions. Many formal institutions, such as constitutions, statutes, regulations and decisions of courts, are legal. Some formal institutions are created by non-governmental organizations - religious laws, corporate rules of self-governance and use restrictions imposed by residential groups, for example (see North, 1990).An institution is defined by how it is enforced, as well as by the written or understood terms of the rule. Enforcement can be carried out by third parties (government enforcement, social ostracism), second parties (retaliation) or the first party (self-imposed conduct). Judicial or bureaucratic enforcement of written rules can give a clearer (and sometimes different) meaning to a written rule.
The history of the enforcement of the competition laws in the United States and in the European Union illustrates the importance of understanding the law as applied, not just the law as written. The operative language of the Sherman Act, the principal competition law in the United States, is brief: it proscribes ‘contracts, combinations or conspiracies... in restraint of trade’ and makes ‘monopolization’ illegal. Over 100 years of judicial application of those two brief phrases has created a voluminous, intricate set of competitive rules. The European Union has enacted comparable provisions dealing with anti-competitive practices. Articles 85 and 86 of the Treaty of Rome deal respectively with anti-competitive agreements and with dominant firms having market power. This structure is like that in the Sherman Act. The wording of the two articles, containing lists of prohibited practices, is much more detailed than the Sherman Act, although it is similar to the anti-competitive rules fashioned by the courts in the United States out of the Sherman Act. Notwithstanding these striking similarities, the competition laws in the United States and in the European Union are very different, primarily because the European laws are applied to strengthen the common market in the tradition of the European social market economies.The law facilitates economic growth in many different ways. As Ronald Coase (1960) demonstrated, the law can provide a baseline for commercial transactions by establishing a default rule, applicable unless the parties specify otherwise. This enables the parties to know ex ante their relative rights and obligations; if these are less desirable, they can contract around them. This ability to rearrange the terms of the default rule makes, in one important sense, the terms of the rule unimportant. All that is important is that a default rule exist. There are two instances, however, when the terms of the default rule do matter. The clarity and transparency of any law is relevant to the transaction costs associated with using the law.
The clearer and more transparent the law, the less costly it will be to use. Furthermore, there are times when a default rule will be used, whether from a failure to reach the bargain or from a breakdown in the bargain itself. Then the meaning of the rule may sometimes have a strong effect on economic growth. Bass v. Gregory, one of the series of nuisance cases discussed by Coase, provides an excellent example of the importance of this.That case involved a suit by the owner of the Jolly Angler pub to establish the legal right to use a ventilating shaft on a neighbour’s land. For over 40 years, the pub had operated a brewery in its cellar, venting the production process through a shaft that connected into an old well located in the neighbour’s yard. When the neighbour blocked the ventilation through the well, the pub owner sued. The outcome of the lawsuit established a legal rule with both short- and long-term consequences. As Coase (1960, p. 15) saw it, ‘The economic problem was to decide which to choose: a lower cost of beer and worsened amenities in adjoining houses or a higher cost of beer and improved amenities’. His rule for making the choice was to maximize the value of production from both parcels. In Bass v. Gregory the court ruled that the pub had the right to vent its brewing operations through the well. Assuming that the brewery, with its established ventilating system, added more to productive output than the neighbour lost, the value of production would have been maximized. This short-term consequence of the decision was a good economic result in terms of Coase’s criteria. Of course, if the court had reached the poorer economic outcome by ruling for the neighbour, the parties could still have reached the desirable result through the neighbour’s sale of the right to the pub owner, assuming no impediments to bargaining. Thus the short-term goal of maximizing productivity can be reached either way.
The long-term consequences of the court’s decision - the downstream economic effect - can have an even bigger impact on economic growth.
Consider the incentives for future conduct resulting from the decision in Bass v. Gregory. If the defendant had been the pub’s neighbour for years, the court was enforcing a relationship the parties had created over time, in effect enforcing settled expectations. That is an important, albeit not surprising, principle worthy of reinforcement. Suppose the neighbour, instead, was a recent purchaser of the land who was surprised and bothered by the pub’s exhaust gases. The court’s decision has important lessons for this type of real estate purchaser. First, the buyer must seek a remedy from the seller of the property, not from the pub or a similarly situated neighbour. Second, the buyer is obligated to inspect the property, inquiring about the use of visible aspects of the property, like the well. This prophylactic rule, designed to encourage buyers to prevent problems as in Bass v. Gregory from ever arising, has positive downstream economic effects. One could argue that the court was wrong, because a ruling for the neighbour would have created an incentive for all easements (including the right to use someone else’s property for ventilation or exhaust purposes) to be reduced to writing and then recorded on the public records. This could be said to reduce transaction costs in the aggregate since a buyer need only rely on the land records and not make a physical investigation of the property. A ruling for the neighbour, however, would have actually raised aggregate transaction costs because it would compel the unnecessary recording of untold minor transactions. Since economic growth is furthered by the correct incentives, a court should consider the downstream economic effect as one of the primary factors driving its decision. There will naturally be cases where this goal will not be helpful, as where the downstream effect is too uncertain or where the costs of the competing outcomes are indeterminate. These were not problems in Bass v. Gregory. Judging the result by both the short-term productivity goal and the downstream economic effects, the court’s ruling for the pub owner was the one that did the most to further economic growth.The nuisance cases discussed by Coase are but one small part of a large body of commercial law that provides the framework for a market system. Some types of rules for exchange are important even in primitive economies. As economies became more complex, with increased specialization and division of labour, bringing more and complex transactions, commercial law had to become more specialized. A modern market-based economy depends on bodies of law dealing with property, contracts, debtor-creditor and bankruptcy. The recent experiences of the formerly communist countries in Central Europe in their attempts to move to a market system reinforce the importance of some type of securities law governing emerging capital markets. Economic growth also depends upon a criminal law that provides for security of both people and property. It is extremely difficult, perhaps impossible, for a sustained economic growth to occur in countries where extortion, theft and other violent crimes undermine market transactions. The warlord economies of some African countries and the disruption of market activities in Russia by the mafia are examples of this.
Both commercial and criminal law regulate relations between individuals. Sustained economic growth also depends upon legal institutions that constrain government. These need to take two forms. First, it is important that the law somehow prevent governments from acting as a mafia and extracting wealth for the rulers, without any consideration of the economic well-being of citizens. Democracy is one solution to this problem, since citizens can vote out rulers who disregard their economic well-being. The constitutional structure of government also advances this interest, with checks and balances between various parts of government and allocation of various powers to different branches of government serving to limit any attempts by rulers to govern only for their selfinterest. Second, the history of economic growth in the Western economies has shown that market participants need to be able to trust the promises of governments (North and Weingast, 1989).
There are many incentives for a government to renege on its commitments. This is especially true for financial obligations, where the short-term financial gain to the state (or to certain groups of voters) will be seen as outweighing uncertain long-term consequences. In the United States, for example, the contracts clause in the Constitution prohibits state and local governments from repudiating debt obligation (Drobak, 1997). Most nations prohibit outright expropriation of property. Governments can also ‘take’ property through various kinds of regulations that fall short of expropriation. The United States and Germany, to cite two examples, have constitutional provisions limiting the taking of private property through excessive regulation (Epstein, 1985; Kommers, 1997, pp. 241-97). These kinds of provisions deter government actions that would otherwise undermine the credibility of the government and harm the workings of the market.The effectiveness of all these laws hinges on an unbiased, honest judiciary and bureaucracy and on a dispute resolution system that is relatively efficient. Confidence of the market participants in the judiciary and the bureaucracy is crucial to the smooth running of a market system and to economic growth. All of these legal institutions, and the means of enforcement, make up the ‘rule of law’, an essential component of sustained economic growth. Real economies cannot operate without these legal underpinnings. Likewise, realistic economic analysis has to incorporate legal institutions. The merging of law and neoclassical theory has been an important contribution of the new institutional economics.
References
Articles 85-6, Treaty Establishing European Economic Community, entered in force, 1 January 1958, 298 U.N.T.S. 11.
Coase, Ronald (1960), ‘The problem of social cost’, Journal of Law and Economics, 3, October, 1-44.
Drobak, John N. (1997), ‘Credible commitment in the United States: substantive and structural limits on the avoidance of public debt’, in John N. Drobak and John V. C. Nye (eds), The Frontiers of the New Institutional Economics, San Diego and London: Academic Press, pp. 247-66.
Epstein, Richard A. (1985), Takings: Private Property and the Power of Eminent Domain, Cambridge, MA and London: Harvard University Press.
Kommers, Donald P. (1997), The Constitutional Jurisprudence of the Federal Republic of Germany, 2nd edn, Durham, NC and London: Duke University Press.
North, Douglass C. (1990), Institutions, Institutional Change and Economic Performance, Cambridge: Cambridge University Press.
North, Douglass C. and Barry R. Weingast (1989), ‘Constitutions and commitment: evolutions of the institutions of public choice in 17th century England’, Journal of Economic History, 59 (4), December, 803-32.
Sherman Act, 15 U.S.C. §§ 1, 2 (1997).
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