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Economics and the Law from Posner to Post-Modernism.

This overview presents the core elements of the different perspectives on the varied traditions within law and economics. One perspective considers what economics has to offer the law. This includes the microeconomic analytic framework based on self-interest to predict and evaluate the actions of consumers and firms (in traditional microeconomic analysis), voters and their elected representatives (in public choice theory), common law and settlements, torts and injury law (the Chicago school of law and economics), and contract law (in neoinstitutional transaction cost and agency issues).

Economics and the Law

Economics focuses on resource allocation and an individual's choice to achieve happiness. Although much analysis covers household and firm purchasing and production decisions, in recent decades other decisions have been investigated regarding marriage, crime, voting, the law, and the constitution. While economics does apply to a single isolated individual--a Robinson Crusoe--much economic (and legal) analysis relates to the interaction of people and groups. The pursuit of self-interest is presumed to guide decisions ranging from purchases and production to whether to break the law. Self-interest forms the basis of the economic explanation of the behavior of people.

The traditional economic focus on resource allocation involves explaining how people behave, evaluating how this behavior affects the happiness of others, and determining the net effect on the happiness in society, that is, the effect on economic efficiency. While economic efficiency may be largely taken for granted by those who enjoy a high standard of living, the economic system produces the necessities of life. In the extreme case of zero economic efficiency, there would be no necessities and virtually the entire population would die in a very short time. Basically, any reduction in economic efficiency is a cost to society and reduces the standard of living. Consequently, economists (in general) and the Chicago school (in particular) tend to put much emphasis on efficiency and prefer not to lower it except for clear and well-defined reasons.

One source of apparent tension between law and economics may be the tendency of some to think of economic activity and legal issues in the context of a zero-sum game where the gain to one person must come only with an equal loss to one or more others. In a superficial sense, this may be true when A pays B X dollars as the consequence of a transaction or court case. For the economic and legal system, this is not even an approximation and would be so only if economic efficiency were constant.

Mercuro and Medema have presented a very thoughtful and comprehensive "overview of the core elements of the different perspectives on the varied traditions within Law and Economics" [p. 1]. They consider several traditions: the Chicago school of law and economics, public choice theory, institutional and neoinstitutional law and economics, the New Haven school, modem civic republicanism, and critical legal studies. Their work will permeate comments on and evaluation of the current state of economics and the law.

A legal system is necessary to any economic activity. Property rights to at least one's own body, time, food, and other necessities are essential. Furthermore, any economic interaction requires some property rights and a legal system that limits, for example, theft, assault, and murder. Market transactions and contracts are generally voluntary. Hence, they are in the self-interest of each party and are beneficial for them (providing there are no third parties who are adversely affected) and for economic efficiency. Law that defines property rights and allows enforceable contracts is essential to any (economic) life. However, where should the law limit contracts? Are there externalities to the contract? Are there other reasons for limitations? As Mercuro and Medema argue, Coase [1960], who is associated with the Chicago school, has shown that contracts are an even more powerful tool in promoting economic efficiency and in resolving effects on third parties than was previously thought. If third parties who are affected by a contract, transaction, or other activity can contract with the primary party (and, in so doing, create a market for the effect), then it is in the mutual interest of all to reach the economically efficient solution.

Law helps determine how individuals interact and, in the process, constrains some choices (that is, some kinds of contracts). For example, selling human organs is currently not permitted. Would society be better off if organs were sellable? Some economists advocate that organ markets be allowed, albeit with some restrictions. Buying a new car without certain occupant safety devices is not permitted nor is operating that car without the use of those devices. Braking safety may have externalities, but, with seatbelt use like organ sales, the unconstrained market may be more efficient.

The third parties affected by a transaction or contract may be so numerous that they cannot effectively negotiate with the primary party as, for example, with widespread air pollution. Alternatively, the third party may not be knowable in advance as, for example, with activity that results in accidental injury. In either case, the market will not efficiently resolve the externality issue, and the role of the law (for example, torts) is different from that of just a market facilitator.

The public choice theorists have argued that the constitution should limit as much as possible the creation of laws and the role of government to that of market facilitator. Further, the constitution and government structure should at least in principle be accepted unanimously (or at least more than a simple majority) since any proposition supported by all would improve efficiency.

No area of the law is inherently more economic than antitrust. After all, this area of the law essentially involves the maintenance of competition. Yet, for much of the post-Sherman Act period, confusion about goals pervaded the enforcement efforts. Credit for encouraging a more economic approach is due to a large extent to the Chicago school which stresses the use of economic theory to explain certain behavior as simply profit-maximizing and efficiency-enhancing instead of monopolistically output-restrictive. Other economists questioned certain aspects of antitrust, but the Chicago school provided a coherent, unified critique.

Tying agreements, which require the purchase of one good to obtain another, are an example of such an improved analysis. Until the mid-1950s, the conventional wisdom labeled tying agreements as an example of using monopoly leverage to extend monopoly from one product to another. In several articles, the Chicago school questioned this extension of a monopoly notion. Could anyone think that the owner of a patented industrial salt-dispensing machine was trying to obtain a monopoly over salt? The Chicago school suggests that a much more plausible explanation of tying is exploiting the existing monopoly power through metering usage, thereby achieving price discrimination. The impact of this (and most) price discrimination might well be greater output and higher profit. If, as was often the case, the monopoly resulted from innovation and perhaps patents, then higher profit was a desirable reward and incentive. Greater output was obviously also desirable since monopoly normally restricts output. Applying microeconomic theory to tying, a practice previously thought to be without merit, has almost certainly improved public policy. Indeed, in Jefferson Parish Hospital v. Hyde [1984], the U.S. Supreme Court almost reversed the long-standing stringent policy toward tying to make its treatment similar to most other areas of antitrust law. In a concurring opinion, the Justices wrote, "The ultimate decision whether a tie-in is illegal under the antitrust laws should depend on the demonstrated economic effects of the challenged agreement" [p. 41]. Using economic theory to determine the probable intent and effects of tying represented a major improvement in its legal treatment.

Similarly, predatory pricing had long been considered a practice that could yield or perpetuate a monopoly. The Chicago school questioned the profitability of predation where entry was not difficult and the cost of eliminating competitors was great. Thereby, they questioned public policy toward the practice. In particular, were allegations of predation more likely to be complaints of competitors against the rigors of competition? The Chicago school's application of economic theory to behavior (previously thought be anticompetitive) forced other analysts and policy makers to rethink their positions. In a case alleging a low-price conspiracy in television sets, the U.S. Supreme Court stated:

"A predatory pricing conspiracy is by nature speculative. Any agreement to price below the competitive level requires the conspirators to forego profits that free competition would offer them. The foregone profits may be considered an investment in the future....The success of any predatory scheme depends on maintaining monopoly power for long enough both to recoup the predator's losses and to harvest some additional gain. For this reason, there is a consensus among commentators that predatory pricing schemes are rarely tried, and even more rarely successful" [Matsushita Electric v. Zenith Radio, 1986, p. 589].

The Chicago school also questioned other antitrust policies, essentially claiming that they were not based on solid microeconomic theory. For example, the Chicago school has argued that the positive correlation between industry concentration and profitability may reflect the presence of economies of scale rather than anticompetitive behavior. Moreover, Chicago school writers have argued that monopoly may result from efficiency. Therefore, attacking monopoly may lessen social welfare in those cases. Similarly, the policies that regularly opposed horizontal mergers were criticized as often protecting competitors rather than competition.

The Chicago school's approach focuses on efficiency and the goal of promoting it. For example, a patent monopolist will generally choose to take the extra profit from price discrimination if possible, but his customers as a group may be better off with price discrimination. In the early days of plain paper copiers (the early 1960s), Xerox leased and metered its copiers, which achieved price discrimination, and expanded output by allowing both low- and high-volume users to obtain Xerox copiers. Moreover, its pricing had made consumer acceptance much more likely and facilitated the innovation of xerography.

Another example is vertical mergers. Any type of merger might generate enough production efficiencies to offset any increase in market power. Remarkably, a vertical merger of two firms that have sequential market power is expected to increase profit and lower price even if there are no production efficiencies at all. Recognizing possible economic efficiencies in which all parties would gain has substantially changed antitrust policy on vertical mergers.

Whether or not the Chicago school's antitrust position is shared, they deserve credit for raising issues and demanding solid economic analysis. Furthermore, as Mercuro and Medema note, the Chicago school has been accused of focusing only on efficiency, thereby neglecting considerations of distributional equity. Chicago school writers essentially have stressed policies that maximize the value of output, given the existing distribution of income, that is, on economic efficiency. Mercuro and Medema might have provided more criticisms of the Chicago school to illustrate the debates within economics. For example, in a lively monograph, Adams and Brock [1991] question many of the assumptions of the Chicago school, including its deemphasis of entry barriers.

Posner [1975, p. 777], a foremost scholar of the Chicago school, has argued that the most common meaning of justice is economic efficiency. He argues that convicting a person without trial, taking property without compensation, or allowing a negligent driver to escape paying for the damage he caused would be wasteful and, hence, unjust. Indeed, he suggests, as Mercuro and Medema note, that people would voluntarily accept wealth maximization as an ex ante principle for common law because it would generally raise the real standard of living.

The conflict between efficiency and equity is best illustrated by a hypothetical choice in which there are two alternatives. In one, all of the benefits go to the wealthiest members of society. In the other, all of the very slightly smaller benefits go to the poorest members of society. The former alternative with the larger benefits is more efficient, but the latter might be preferred by many who desire income redistribution even at the expense of a very slight reduction in the overall standard of living. Many economists would argue that any such redistribution can be much more effectively handled by tax laws than by individual judicial decisions. Other equity issues may not involve leveling the income distribution. Mercuro and Medema [pp. 59-60] suggest that it may be efficient but perhaps inequitable to impose the cost of pollution on the victim.

A major area of the law concerns negligence and torts or injury. Economics has done much in this area. Decisions about the appropriate level of precautions should presumably take into account the cost of precautions. Suppose a firm spends on precautions (which would prevent some undesirable event from occurring) the expected cost of the event. Has the firm done as much as the law should require? Certainly, if the event affected only the firm (or individual) itself, there would be no legal issue. The firm (or individual) might expend on precautions only as long as the expected saving from the precautions at least offsets the cost of the precautions. This is the economically efficient solution. A legal issue may arise when the beneficiary of the precautions is different from the one incurring the expenditure. As Coase [1960] has shown, if there are only two (or few) parties who can contract regarding the degree of precaution, then the efficient solution will emerge since it is in their mutual interest to find it. Legal rules here do not affect efficiency (but can affect income distribution) as long as they do not preclude contracting. For example, the federal Occupational Safety and Health Administration, which limits the allowable contracts in the context of workplace safety, may reduce efficiency but, in effect, may attempt to redistribute income to workers from firms.

Economics has had a substantial impact on pollution control. For example, on occasion, firms can trade pollution rights so that a firm incurring a high cost to reduce pollution can buy the right to pollute from another firm at a lower cost. Thus, the law lowers the cost of any given pollution reduction.

Public Choice Theory

Public choice theory (analysis of the process of choosing a form of government and officials to operate it) is based on the assumption that people in government attempt to pursue their own self-interest. The early work of economist Anthony Downs [1957] analyzed voting and candidate behavior, assuming that candidates choose platforms in an attempt to win. This leads to platforms that conform to the preference of the median voter. Niskanen [1971] argued that the interest of many government officials may be best served by maximizing the size of their staffs. Median platforms and maximum staffs are not economically efficient. Owners of firms choose managers to operate those firms for the benefit of the owners, inadvertently pursuing efficiency for the economy. Citizens who choose government officials to run the government are less fortunate.

Mercuro and Medema [p. 63] argue that Priest, Rubin, and Posner have suggested that settlements and common law judgments tend to be economically efficient. Settlement tends toward efficiency because self-interest of the parties is best served when they are dividing the biggest pie (or the smallest loss) which is the efficient solution. For similar reasons, inefficient judgments are the most likely to be challenged.

Public choice theory also explains some of the policies or laws that lessen societal welfare. For example, restrictions on importing steel or automobiles into the U.S. almost certainly cost consumers much more than what the directly affected workers and stockholders gain. Yet, most legislators and government officials supported the restrictions. Similarly, U.S. agricultural price support programs almost certainly cost buyers far more than what the industry gains. Legislators who want election or reelection often support such policies because affected groups have much more to gain per affected person than the buyers or the general populace and, consequently, are often willing to contribute financially or otherwise to the friendly legislator. Furthermore, price support programs create a large bureaucracy that is very interested in the continuance and expansion of the policies. Since legislators control the budgets of bureaucracy, they can influence the administration of the policy for the benefit of influential constituents. Another example might be the Occupational Safety and Health Administration.

Indeed, these considerations can provide an incentive for vague legislation that leaves much room for bureaucratic interpretation. These effects reach beyond legislation that has a negative effect on societal welfare. For example, although environmental policies may increase society welfare (compared to no policy), the form of these policies and their administration may restrict the gains in societal welfare and require too much interpretation, administration, and cost. Mercuro and Medema [p. 92] quote Buchanan as saying, "Bias results in...larger government." Little help is expected from the electoral process. The rational voter has little reason to cast a well-informed ballot since becoming informed and voting will likely cost more than what his vote will gain from possibly breaking a tie, hence becoming influential.


Other schools of thought, such as the institutionalists, have suggested other motivation besides self-interest. Mercuro and Medema [p. 109] note that Commons, for example, emphasizes collective action and examines the impact of law and economic structure and performance. Law and economics affect each other in an evolutionary process. He notes that an expanded definition of property permitted economic transition to capitalism from feudalism [p. 113]. Mercuro and Medema note that institutionalists regard workplace safety as simply "a change in rights or interest to which government gives effect" [p. 117]. Both differ with the Chicago school since they do not regard efficiency as the ultimate goal and also perceive efficiency as a function of rights [pp. 117-8]. They argue that a multitude of efficient solutions exist, each of which depends on a specific structure of rights, and that the issue of distribution cannot be separated.


Contractual issues are at the heart of much of the neoinstitutionalists' work in law and economics. They have analyzed property rights, agency issues, and the contracting process [Mercuro and Medema, p. 142]. Oliver Williamson [1975], a leading scholar in this school, has examined how the cost of monitoring compliance with a contract may be sufficiently great to warrant internal firm production. Thus, vertical integration may be an optimum because of monitoring costs. The uncertainty about the success of a particular movie has resulted in revenue-sharing contracts between the theater-exhibitor and the producer-distributor. Vertical integration between distributor and exhibitors may save on contracting and monitoring with a cost-efficient outcome.


The study of economics and the law has advanced substantially in many areas. Perhaps the most fundamental of these is recognizing mutual interdependence. One perspective is consideration of what economics has to offer the law. As Mercuro and Medema argue, this includes the microeconomic analytic framework based on self-interest to predict and evaluate the actions of consumers and firms (in traditional microeconomic analysis), the actions of voters and their elected representatives (in public choice theory), common law and settlements, torts and injury law, and contract law (in neoinstitutional transaction cost and agency issues). Perhaps the predominant tool of economic evaluation is economic efficiency. Yet, some have argued that as an objective, it may sometimes need to be partially sacrificed for equity. Others maintain that the most common meaning of justice is efficiency. In any case, Mercuro and Medema's work emphasizes the contributions and controversies that economics has added to the law. Economics and the law have reaped the benefits from integration.


Adams, Walter; Brock, James W. Antitrust Economics on Trial, Princeton, NJ: Princeton University Press, 1991.

Downs, Anthony. The Economic Theory of Democracy, New York, NY: Harper, 1957.

Coase, Ronald H. "The Problem of Social Cost," Journal of Law and Economics, 3, October 1960, pp. 1-44.

Jefferson Parish Hospital District No. 2 v. Hyde, 466 U.S. 2, 1984.

Matsushita Electric Industrial Co. v. Zenith Radio, 475 U.S. 574, 1986.

Niskanen, William A. Bureaucracy and Representative Government, Chicago, IL: Aldine, 1971.

Posner, Richard A. "The Economic Approach to the Law," Texas Law Review, 53, May 1975, pp. 757-82.

Williamson, Oliver E. Markets and Hierarchies - Analysis and Antitrust Implications: A Study in the Economics of Internal Organization, New York, NY: Free Press, 1975.
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Publication:Atlantic Economic Journal
Date:Dec 1, 1999
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