Published in Laissez-Faire City Times, 3 septembre 2001
"What has economics to do with law?" is the first question that David Friedman asks in his introduction to the economic analysis of law.[1] Suppose that murder was punished by death and that the same punishment will now be assigned to armed robbery. For an armed robber, the marginal punishment for killing his victim will thus be zero. The consequence will be that more robbers will kill their victims. The relation between economics and law, then, is that legal rules create incentives that lead to more or less efficient consequences.
The economics analysis of law is concerned with the efficiency of legal rules. Founders of this field -- sometimes called "law and economics," or "law and econ" -- include Ronald Coase, who eventually won a Nobel Prize in economics, and Richard Posner, who is now a federal judge but remains a prolific scholar. David Friedman, the anarcho-capitalist theorist who now teaches law at Santa Clara University, is another creative thinker.
What is efficiency? In the neo-classical approach that underlies law and econ, efficiency means attaining the highest net value in terms of money, as evaluated by the individuals themselves. Efficiency is concerned only with the size of the economic pie, not its redistribution. Legal rules should be concerned with efficiency if only because they are not effective at redistribution. Suppose, for example, that a legal rule establishes minimum habitability standards for rented apartments (heating, hot water, air conditioning, or what have you) with the goal of redistributing income from landlords to poor tenants. To compensate for the added cost, landlords with previously substandard apartments will either charge more or spend less on other features of the contract (like the speed of repairs, for instance). Typically, total value created in the rental market will be lower as some poor tenants will be hurt and have to forego the apartments they preferred.
Or consider antitrust rules against predatory pricing, whereby a dominant firm cuts prices in order to drive away its competitors and gain a monopoly (and ultimately charge more). Economic analysis shows that no dominant firm can profitably do this (except in the special case of a natural monopoly, i.e., an industry where a single firm can produce at lower cost than many). The reason is that, through such a strategy, the dominant producer will lose more money than its competitors (who have the same cost of production since, by hypothesis, we are not in a natural-monopoly industry). At the limit, the smaller firms can just stop selling and wait until the dominant predator goes bankrupt. Historically, this is why Rockefeller's Standard Oil was never able to get 100 percent of the oil market in the late 19th and early 20th century.
Criminal Economics
Economic analysis also throws light on criminal law. From an economic point of view, the distinctive feature of crimes -- the reason we want to forbid them -- is that they not only transfer money or "utility" (satisfaction) from criminals to victims, but something net is lost in the process. Even if we consider a non-violent crime such as theft, the victim typically loses more than the thief gains. If that were not the case, the thief could have made a gain by purchasing the stolen property. In fact, on the competitive theft market, the marginal thief gets a risk-adjusted remuneration only marginally higher than he would obtain in alternative (non criminal) employment. Potential victims also spend resources to protect themselves. Consequently, the value of stolen goods for the thieves, net of resources spent on stealing and on protection, is lower than their value to the original owners.
A legal rule or system is efficient if rights are initially vested in persons for whom they have the greatest values or, when we don't know who these persons are, if transferring rights to them is easiest. The advantage of freedom of contract is that the contractual parties can set up their own terms of exchange. In criminal law, an efficient punishment is one "that imposes the damage done on the one doing it" (p. 223), so that it is taken into account in the criminal's incentives. Note how, in this consequentialist perspective, the goal of punishment cannot be anything but compensation or deterrence.
David Friedman suggests that a completely private system of law would not be as unfeasible as it looks at first sight -- although he remains quite prudent in this book. Historically, we have examples of completely private (Iceland from 930 to 1263) or partly private (the English common law) development of civil law. In ancient Iceland, crimes were treated as torts and prosecuted privately. In 18th-century England, they were also prosecuted privately, albeit before state courts. One problem, especially acute in the case of crimes, is the existence of judgment-proof defendants, i.e., individuals who cannot compensate their victims in money and must, for deterrence purpose, be jailed at additional costs. Friedman suggests that these problems could be solved by penal slavery, or by radical innovations like the sale of the criminal's organs for transplant.
Tyrants Should Not Be Efficient
We must compare anarchy not with a perfect state, but with the state as it is. This requires taking into account the incentives of state rulers, or state-supported groups, to use law to expropriate or otherwise oppress other individuals. Concludes Friedman: "The population as a whole might well be better off with less efficient punishment." (p. 240) We are better off with a not-too-efficient tyrant.
The main problem with the economic approach to law lies in the normative value of efficiency. The way law and econ uses this notion relies on interpersonal comparisons of utility. As Friedman argues, though, efficiency in this sense often does not clash with other values. Yet, the normative standing of efficiency is difficult to defend when the starting point of the market process is unacceptable. Consider the question of whether a free market in slaves maximizes value and realizes efficiency. The answer is, Yes, only if the preferences of the slaves are disregarded. The underlying property rights, or how individuals are allowed to express their preferences, matter. Indeed, in another context, Friedman admits that there might be "a limit to efficiency as a source of law." (p. 224)
A related issue is the choice between a posteriori punishments and a priori controls. Should we minimize the probability of car accidents through controlling driving conditions (say, speed), or through the negative incentives provided by liability for accidents? How far up-stream shall we go in the a priori direction? Why not, say, a ban on ownership of cars that can go faster than 60 mph? Similar questions can be raised in relation to crime. Should the law punish murderers, or instead attempt to prevent murders by a priori confinement of individuals statistically at risk of committing them (say, young black males)? The law-and-econ answer is: minimize the cost of murders. But this is not saying much if some individuals are, like slaves, deprived of the ownership of their own bodies and prevented from participating fully in the bidding process. Moreover, we must factor in the cost of increased state power and the risk of tyranny. Perhaps this is why efficiency is such a fleeting notion, why, by Friedman's own admission, it is difficult to evaluate ex post the efficiency of legal rules: "Once we know what the rule is, we can usually find an argument, even a plausible argument, for why it is efficient. Often enough, there is a matching argument that we could have used with equal effect if the rule had come out the other way." (p. 220) Efficiency may remain an undetermined standard until we bring in some exogenous standards. Libertarians call those standards by the name of individual liberty or individual rights.
On the other hand, there is the danger of developing extended theories of individual rights without consideration of their consequences. The economic way of thinking provides a good antidote. Economics is a way to look at the world by analyzing the consequences of rational or purposive individual action. Even if the consequences get lumped into a simplified standard, called "efficiency" in neoclassical economics, economics tells us something, even if not everything, about what is desirable in social interaction. The usefulness of this way of reasoning is brilliantly illustrated by Law's Order.
[1] David D. Friedman, Law's Order. What Economics Has to Do with Law and Why It Matters (Princeton University Press, 2000). Friedman shows again his technologically innovative spirit in the way he has paired his printed book with an on-line version, at http://www.best.com/~ddfr/laws_order.