The origins and the evolved domain of law and economics

Law and economics is probably the most successful example of the recent surge of applied economics into areas that were once regarded as beyond the realm of economic analysis and its study of explicit market transactions.

The origins of modern law and economics

Extensive research has been carried out to identify the historical and antece­dents to modern law and economics. Indeed, this volume contains several biographical entries devoted to precursors and early European exponents of the law and economics movement. It is interesting to see that, although the recognition of law and economics as an independent field of research is the result of studies carried out in the United States after the 1970s, most of the precursors can be found in Europe. Notable antecedents to law and econom­ics include the work of Adam Smith on the economic effects of legislation (1776), and Jeremy Bentham’s theory of legislation and utilitarianism (1782 and 1789).

In the United States, it was not until the mid-twentieth century - through the work of Henry Simon, Aaron Director, Henry Manne, George Stigler, Armen Alchian, Gordon Tullock and others - that the links between law and economics became an object of serious academic pursuit. The regulation of business and economic law fell within the natural interest of the first Ameri­can scholars of law and economics. Early research concentrated on areas related to corporate law, tax law and competition law. In so doing, the first generation of law and economics scholars paralleled the efforts of other economists, trying to explain the functioning of explicit economic markets and the impact of alternative legal constraints, such as taxes and regulation, on the market.

In the 1960s the pioneering work of Ronald Coase and Guido Calabresi brought to light the pervasive bearing of economics in all areas of the law.

A difference in approach is detectable between the law and economics contributions of the early 1960s and those that followed in the 1970s. While the earlier studies appraise the effects of legal rules on the normal function­ing of the economic system (that is, they consider the impact of legal rules on the market equilibrium), the subsequent generation of studies utilizes eco­nomic analysis to achieve a better understanding of the legal system. Indeed, in the 1970s a number of important applications of economics to law gradu­ally exposed the economic structure of basically every aspect of a legal system: from its origin and evolution, to its substantive, procedural and constitutional rules.

Despite some resistance to the application of economics to non-market behaviour, the important bonds between legal and economic analysis, as well as the social significance of the object of study, were in themselves a guaran­tee of success and fruitfulness for law and economics.

An important ingredient in the success of law and economics research has come from the establishment of specialized journals. The first such journal, the Journal of Law and Economics, appeared in 1958 at the University of Chicago. Its first editor, Aaron Director, should be credited for this important initiative, successfully continued by Ronald Coase. Other journals emerged in the following years: in 1972, the Journal of Legal Studies, also housed at the University of Chicago, was founded under the editorship of Richard Posner; in 1979, Research in Law and Economics, under the editorship of Richard Zerbe, Jr; in 1981, the International Review of Law and Economics was established in the United Kingdom under the editorship of Charles Rowley and Anthony Ogus (later joined by Robert Cooter and Daniel Rubinfeld); in 1982, the Supreme Court Economic Review, under the editorship of Peter Aranson (later joined by Harold Demsetz and Ernest Gellhorn); in 1985, the Journal of Law, Economics and Organization, under the editorship of Jerry Mashaw and Oliver Williamson (later joined by Roberta Romano); in 1994, the European Journal of Law and Economics was launched under the editorial direction of Jurgen Backhaus and Frank Stephen; in 1999, the Ameri­can Law and Economics Review, under the editorship of Orley Ashenfelter and Richard Posner; and, most recently, in 2004 the Journal of Empirical Legal Studies under the editorship of Theodore Eisenberg, Jeffrey J.

In many respects, the impact of law and economics has exceeded its planned ambitions. One effect of the incorporation of economics into the study of law was to irreversibly transform traditional legal methodology. Legal rules began to be studied as a working system - a clear change from the Langdellian tradition, which had relied almost exclusively on the self-con­tained framework of case analysis and classification, viewing law as little more than a filing system. Economics provided the analytical rigour neces­sary for the study of the vast body of legal rules present in a modern legal system. This intellectual revolution came at an appropriate time, when legal academia was actively searching for a tool that permitted critical appraisal of the law, rather than merely strengthening the dogmatic consistencies of the system.

The marriage of law and economics has also affected the economic profes­sion, contributing to the expansion of the original domain of microeconomic analysis - the study of individual and organizational choices in the market - to the study and understanding of other institutions and non-market phenomena.

The evolved domain of law and economics

Despite the powerful analytical reach of economics, it was clear from the outset that the economist’s competence in the evaluation of legal issues was limited. While the economist’s perspective could prove crucial for the posi­tive analysis of the efficiency of alternative legal rules and the study of the effects of alternative rules on the distribution of wealth and income, econ­omists generally recognized the limits of their role in providing normative prescriptions for social change or legal reform.

Recognition of the positive nature of the economic analysis of law was not sufficient to dispel the many misunderstandings and controversies in legal academia engendered by the law and economics movement’s methodological revolution. As Coase (1978) indicated, the cohesiveness of economic tech­niques makes it possible for economics to move successfully into another field, such as law, and dominate it intellectually. But methodological differ­ences played an important part in the uneasy marriage between law and economics. The Popperian methodology of positive science was in many respects at odds with the existing paradigms of legal analysis. Rowley (1981)

Positive, normative and functional schools in law and economics 61 characterizes such differences, observing that positive economics follow the Popperian approach, whereby testable hypotheses (or models) are derived by means of logical deduction and are then tested empirically. Anglo-American legal analysis, on the other hand, is generally inductive: lawyers use indi­vidual judgments to construct a general premise of law. Much work has been done in law and economics despite these methodological differences, with a reciprocal enrichment of the analytical tools of both disciplines.

Law and economics relies on the standard economic assumption that indi­viduals are rational maximizers, and studies the role of law as a means for changing the relative prices attached to alternative individual actions. Under this approach, a change in the rule of law will affect human behaviour by altering the relative price structure - and thus the constraint - of the optimi­zation problem. Wealth maximization, serving as a paradigm for the analysis of law, can thus be promoted or constrained by legal rules.

The early years of law and economics were characterized by the uneasi­ness of some traditional legal scholars in the acceptance of the notion of wealth maximization as an ancillary paradigm of justice. Although most of the differences gradually proved to be largely verbal - and many others were dispelled by the gradual acceptance of a distinction between paradigms of utility maximization and wealth maximization - two objections continue to affect the lines of the debate.

In his well-known defence of wealth maximization as a guide for judicial action, Posner (1985) distinguishes wealth or expected utility from market prices. While market prices may not always fully reflect idiosyncratic valuations, they avoid an undertaking of interpersonal utility comparisons, with the opportunity for ex post rationalization of positions taken on emo­tional grounds. Posner’s view is sympathetic to the premises of a property rights approach to legal relationships, and he stresses the importance of an initial distribution of property rights prior to any calculation of wealth maximization. His paradigm of wealth maximization serves as a common denominator for both utilitarian and individualist perspectives. By combining elements of both, Posner provides a theory of wealth maximization that comes closer to a consensus political philosophy than does any other overarching political principle.

In contrast, Calabresi (1980) claims that an increase in wealth cannot constitute social improvement unless it furthers some other goal, such as utility or equality. Denying that one can trade off efficiency against justice, he argues instead that efficiency and distribution are ingredients of justice, which

is a goal of a different order than either of these ingredients. Calabresi thus defends law and economics as a worthy examination of certain ingredients of justice, rather than a direct examination of justice itself.

The intellectual resistance that has characterized the birth of law and economics can only be temporary. Both legal practitioners and policy makers are becoming aware of the important role of economic analysis in their discipline, and we have already mentioned notable contributions to main­stream economic theory from lawyers in the law and economics movement.

Coase also examines the reasons for the movement of economists into the other social sciences, and attempts to predict the future of this phenomenon. Groups of scholars are bound together by common techniques of analysis, a common theory or approach to the subject, and/or a common subject matter. In the short run, Coase maintains, one group’s techniques of analysis may give it such advantages that it is able to move successfully into another field and maybe even dominate it. In the long run, however, the subject matter tends to be the dominant cohesive force. While the analytical techniques employed by economists - such as linear programming, quantitative methods and cost-benefit analysis - may recently have aided the entry of economists into the other social sciences, Coase predicts that such a movement can only be temporary. After all, the wisdom possessed by economists, once its value is recognized, will be acquired by some of the practitioners in these other fields (as is happening in the field of law).

As the domain of law and economics continues to expand, its perspective on methodological issues has not been stagnant. While this chapter empha­sizes the wide range of substantive applications, some degree of controversy still surrounds several of the methodological, normative and philosophical underpinnings of the economic approach to law. Most of the ideological differences tend to lose significance because their operational paradigms often lead to analogous results when applied to real cases. Some scholars, however, perceive that the current state of law and economics as comparable to the state of economics prior to the advent of public choice theory, in so far as an understanding of ‘political failures’ was missing from the study of market failures (Buchanan, 1974; Rowley, 1989) Public choice may indeed inject a sceptical - and at times disruptive - perspective into the more elegant and simple framework of neoclassical economics, but this added element may well be necessary to better understand a complex reality. In a way, the systematic incorporation of public choice theory into the economic approach to law has contributed to bridging the conflicting normative perspectives in law and economics, at least by bringing the debate onto the more solid ground of collective choice theory.

Economics is a powerful tool for the analysis of law. If humans are rational maximizers of their utility, wealth or well-being then they respond rationally to changes in exogenous constraints, such as laws. This rationality assump­tion provides the basic foundation for much law and economics literature. Building upon the standard economic assumption that individuals are rational maximizers, the sophisticated tools of price theory become a useful aid in the study and choice of legal rules (Cooter, 1984). While there is much consensus on the value of economic theory in the study of legal rules, important method­ological differences arise with respect to the choice of the appropriate instruments of legal analysis and the choice of method for evaluation of social preferences. I shall briefly discuss these methodological issues in turn.