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Law and Economics, 6th edition Robert Cooter Berkeley Law

�omas Ulen

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Authors’ Note

LAW AND ECONOMICS (pdf 6th edition)

by Robert Cooter and Thomas Ulen

This is a pdf version of the latest version (6th edition) of Law and Economics

by Cooter and Ulen. The ownership of this book has reverted from the publisher to

its authors, so we are posting it online for everyone freely to read or use as a

textbook. After more than thirty years as the field’s leading textbook, it continues to

cover the latest developments in the economic analysis of property, torts, contracts,

legal process, and crimes. Each new edition refines the analytical core, incorporates

new applications, and expands previous discussions of empirical legal studies and

behavioral law and economics. We hope that you enjoy reading this book as much as

we enjoyed writing it.

Looking forward to next year, this duet will become an internet symphony

that takes full advantage of the internet revolution in publishing. Improvements

will be posted to the internet continuously in small amounts (7.1, 7.2, 7.3, etc.), until

a new edition appears with large changes (8.0). Not just a textbook, the 7th edition

will have supporting materials, including translations. For updates, join the email

list found by googling “Cooter and Ulen Berkeley Law Repository”. Perhaps you will

have something to contribute to the website. For the best feast, the host supplies the

main course each guest contributes a dish.

Law&Economics

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T H E P E A R S O N S E R I E S I N E C O N O M I C S

Abel/Bernanke/Croushore Macroeconomics*

Bade/Parkin Foundations of Economics*

Berck/Helfand The Economics of the Environment

Bierman/Fernandez Game Theory with Economic Applications

Blanchard Macroeconomics*

Blau/Ferber/Winkler The Economics of Women, Men and Work

Boardman/Greenberg/Vining/ Weimer

Cost-Benefit Analysis

Boyer Principles of Transportation Economics

Branson Macroeconomic Theory and Policy

Brock/Adams The Structure of American Industry

Bruce Public Finance and the American Economy

Carlton/Perloff Modern Industrial Organization

Case/Fair/Oster Principles of Economics*

Caves/Frankel/Jones World Trade and Payments: An Introduction

Chapman Environmental Economics: Theory, Application, and Policy

Cooter/Ulen Law & Economics

Downs An Economic Theory of Democracy

Ehrenberg/Smith Modern Labor Economics

Ekelund/Ressler/Tollison Economics*

Farnham Economics for Managers

Folland/Goodman/Stano The Economics of Health and Health Care

Fort Sports Economics

Froyen Macroeconomics

Fusfeld The Age of the Economist

Gerber International Economics*

Gordon Macroeconomics*

Greene Econometric Analysis

Gregory Essentials of Economics

Gregory/Stuart Russian and Soviet Economic Performance and Structure

Hartwick/Olewiler The Economics of Natural Resource Use

Heilbroner/Milberg The Making of the Economic Society

Heyne/Boettke/Prychitko The Economic Way of Thinking

Hoffman/Averett Women and the Economy: Family, Work, and Pay

Holt Markets, Games and Strategic Behavior

Hubbard/O’Brien Economics*

Money, Banking, and the Financial System*

Hughes/Cain American Economic History

Husted/Melvin International Economics

Jehle/Reny Advanced Microeconomic Theory

Johnson-Lans A Health Economics Primer

Keat/Young Managerial Economics

Klein Mathematical Methods for Economics

Krugman/Obstfeld/Melitz International Economics: Theory & Policy*

Laidler The Demand for Money

Leeds/von Allmen The Economics of Sports

Leeds/von Allmen/Schiming Economics*

Lipsey/Ragan/Storer Economics*

Lynn Economic Development: Theory and Practice for a Divided World

Miller Economics Today*

Understanding Modern Economics

Miller/Benjamin The Economics of Macro Issues

Miller/Benjamin/North The Economics of Public Issues

Mills/Hamilton Urban Economics

Mishkin The Economics of Money, Banking, and Financial Markets*

The Economics of Money, Banking, and Financial Markets, Business School Edition*

Macroeconomics: Policy and Practice*

Murray Econometrics: A Modern Introduction

Nafziger The Economics of Developing Countries

O’Sullivan/Sheffrin/Perez Economics: Principles, Applications, and Tools*

Parkin Economics*

Perloff Microeconomics*

Microeconomics: Theory and Applications with Calculus*

Perman/Common/McGilvray/Ma Natural Resources and Environmental Economics

Phelps Health Economics

Pindyck/Rubinfeld Microeconomics*

Riddell/Shackelford/Stamos/ Schneider

Economics: A Tool for Critically Understanding Society

Ritter/Silber/Udell Principles of Money, Banking & Financial Markets*

Roberts The Choice: A Fable of Free Trade and Protection

Rohlf Introduction to Economic Reasoning

Ruffin/Gregory Principles of Economics

Sargent Rational Expectations and Inflation

Sawyer/Sprinkle International Economics

Scherer Industry Structure, Strategy, and Public Policy

Schiller The Economics of Poverty and Discrimination

Sherman Market Regulation

Silberberg Principles of Microeconomics

Stock/Watson Introduction to Econometrics

Introduction to Econometrics, Brief Edition

Studenmund Using Econometrics: A Practical Guide

Tietenberg/Lewis Environmental and Natural Resource Economics

Environmental Economics and Policy

Todaro/Smith Economic Development

Waldman Microeconomics

Waldman/Jensen Industrial Organization: Theory and Practice

Weil Economic Growth

Williamson Macroeconomics

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S I X T H E D I T I O N

Law& Economics

ROBERT COOTER University of California, Berkeley

THOMAS ULEN University of Illinois, Urbana-Champaign

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Copyright © 2012, 2008, 2004, 2000 Pearson Education, Inc. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617 671-3447, or e-mail at http://www.pearsoned.com/legal/permission.htm.

Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps.

Library of Congress Cataloging-in-Publication Data Cooter, Robert.

Law and economics / Robert Cooter, Thomas Ulen.—6th ed. p. cm.

Rev. ed. of: Law & economics / Robert Cooter, Thomas Ulen. Includes index. ISBN 978-0-13-254065-0 1. Law and economics. I. Ulen, Thomas. II. Cooter, Robert. Law & economics. III. Title. K487.E3C665 2011 340’.11—dc22

2010049060 10 9 8 7 6 5 4 3 2 1

ISBN-10: 0-13-254065-7 ISBN-13: 978-0-13-254065-0

vii

Preface x

1. An Introduction to Law and Economics 1

I. What Is the Economic Analysis of Law? 3

II. Some Examples 4

III. The Primacy of Efficiency Over Distribution in Analyzing Private Law 7

IV. Why Should Lawyers Study Economics? Why Should Economists Study Law? 9

V. The Plan of This Book 10

2. A Brief Review of Microeconomic Theory 11

I. Overview: The Structure of Microeconomic Theory 11

II. Some Fundamental Concepts: Maximization, Equilibrium, and Efficiency 12

III. Mathematical Tools 14

IV. The Theory of Consumer Choice and Demand 18

V. The Theory of Supply 26

VI. Market Equilibrium 28

VII. Game Theory 33

VIII. The Theory of Asset Pricing 37

IX. General Equilibrium and Welfare Economics 37

X. Decision Making Under Uncertainty: Risk and Insurance 43

XI. Profits and Growth 49

XII. Behavioral Economics 50

3. A Brief Introduction to Law and Legal Institutions 55

I. The Civil Law and the Common Law Traditions 56

II. The Institutions of the Federal and the State Court Systems in the United States 59

III. The Nature of a Legal Dispute 62

IV. How Legal Rules Evolve 64

Contents

4. An Economic Theory of Property 70

I. The Legal Concept of Property 73

II. Bargaining Theory 74

III. The Origins of the Institution of Property: A Thought Experiment 76

IV. An Economic Theory of Property 81

V. How are Property Rights Protected? 94

VI. What Can be Privately Owned?—Public and Private Goods 102

VII. What May Owners Do with Their Property? 105

VIII. On Distribution 106

Appendix: The Philosophical Concept of Property 109

5. Topics in the Economics of Property Law 112

I. What can be Privately Owned? 112

II. How are Property Rights Established and Verified? 143

III. What May Owners Do with Their Property? 156

IV. What are the Remedies for the Violation of Property Rights? 166

6. An Economic Theory of Tort Law 187

I. Defining Tort Law 189

II. An Economic Theory of Tort Liability 199

Appendix: Liability and Symmetry 228

7. Topics in the Economics of Tort Liability 230

I. Extending the Economic Model 230

II. Computing Damages 253

III. An Empirical Assessment of the U.S. Tort Liability System 261

8. An Economic Theory of Contract Law 276

I. Bargain Theory: An Introduction to Contracts 277

II. An Economic Theory of Contract Enforcement 283

III. An Economic Theory of Contract Remedies 287

IV. Economic Interpretation of Contracts 291

V. Relational Contracts: The Economics of the Long-Run 299

viii Contents

9. Topics in the Economics of Contract Law 307

I. Remedies as Incentives 307

II. Formation Defenses and Performance Excuses 341

Appendix: Mathematical Appendix 373

10. An Economic Theory of the Legal Process 382

I. The Goal of the Legal Process: Minimizing Social Costs 384

II. Why Sue? 386

III. Exchange of Information 391

IV. Settlement Bargaining 399

V. Trial 403

VI. Appeals 410

11. Topics in the Economics of the Legal Process 419

I. Complaints, Lawyers, Nuisances, and Other Issues in the Legal Process 419

II. An Empirical Assessment of the Legal Process 442

12. An Economic Theory of Crime and Punishment 454

I. The Traditional Theory of Criminal Law 455

II. An Economic Theory of Crime and Punishment 460

13. Topics in the Economics of Crime and Punishment 485

I. Crime and Punishment in the United States 485

II. Does Punishment Deter Crime? 491

III. Efficient Punishment 501

IV. The Death Penalty 510

V. The Economics of Addictive Drugs and Crime 518

VI. The Economics of Handgun Control 522

VII. Explaining the Decline in Crime in the United States 526

Case Index 533

Name Index 535

Subject Index 539

Contents ix

x

Preface

This sixth edition of Law and Economics arrives as the field celebrates its(roughly) 30th birthday. What began as a scholarly niche has grown into one ofthe most widely used tools of legal analysis. The subject has spread from the United States to many other countries. As scholarship deepens, the concepts in the core of law and economics become clearer and more stable, and new applications develop from the core like biological species evolving through specialization. With each new edition, we continue to refine the explanation of the analytical core and to incorporate new applications selectively as space permits. This edition expands previous discus- sions of empirical legal studies and behavioral law and economics. As we incorporate new material and respond to the suggestions that so many people have sent us, the book feels more like a symphony and less like a duet. We hope that you enjoy reading this book as much as we enjoyed writing it.

The book continues to cover the economic analysis of the law of property, torts, contracts, the legal process and crimes. Instructors and students who have used previ- ous editions will notice that we have reversed the order in which we treat torts and con- tracts, and we have divided the material on legal process into two chapters—one on theory and one on topics—in parallel with our treatment of all the other substantive ar- eas of the law. Below we describe what is new in this edition, followed by an account of the book’s website.

New to This Edition The Sixth Edition has been revised and updated to reflect the latest developments in law and economics. Major changes to the text are as follows:

• Tables and graphs have been updated. • New boxes and suggested readings have been added throughout the text. • Web Notes have been updated and added. • Chapter 6 contains additional information on liability and customs in trade. • Chapter 8 improves the explanation of contractual commitments through a better

representation of the principal-agent problem.

• Chapter 9 now includes new material on lapses, vicarious liability, incomprehensi- ble harms, punitive damages, mass torts, medical malpractice, and some behav- ioral aspects of contract remedies.

• Chapter 10 contains a new treatment of decision making by potential litigants and their lawyers, and new figures and decision trees.

• Chapter 11, a new chapter, combines new material on the legal process and an updated empirical assessment of various aspects of legal disputes.

• Chapter 12 now contains the theoretical material on crime and punishment, updated and clarified.

• Chapter 13 applies the theoretical insights of the previous chapter to wide-ranging policy issues in criminal justice and updates data and information from previous editions.

Online Resources The Companion Website presents a wealth of supplementary materials to help in teaching and learning law and economics. “Web Notes” throughout the book indi- cate the points at which there is additional material on the Companion Website at www.pearsonhighered.com/cooter_ulen. These notes extend the text presentations, provide guides and links to new articles and books, and contain excerpts from cases. We also include some examples of examinations and problem sets.

An updated Instructor’s Manual, reflective of changes to the new edition, will be available for instructors’ reference. The Instructor’s Manual is available for download on the Instructor's Resource center at www.pearsonhighered.com/irc.

Acknowledgments We continue to be extremely grateful to our colleagues at Boalt Hall of the University of California, Berkeley, and at the University of Illinois College of Law for the superb scholarly environments in which we work. Our colleagues have been extremely generous with their time in helping us to understand the law better. And in one of the great, ongoing miracles of the academic enterprise, we continue to learn much from the students whom we have the pleasure to teach at Berkeley, Illinois, and elsewhere.

We should also thank the many colleagues and students at other universities who have used our book in their classes and sent us many helpful suggestions about how to improve the book. We particularly thank Joe Kennedy of Georgetown, who has given us remarkably thorough and singularly helpful comments on improvements in the text.

We’d like to thank the following reviewers for their thoughtful commentary on the fifth edition: Howard Bodenhorn, J. Lon Carlson, Joseph M. Jadlow, and Mark E. McBride.

We would also like to thank those who have provided research assistance for this sixth edition: Theodore Ulen, Timothy Ulen, and Brian Doxey. And, also, for their long-time support and help: Jan Crouter, Dhammika Dharmapala, Lee Ann Fennell,

Preface xi

Nuno Garoupa, John Lopatka, Richard McAdams, Andy Morriss, Tom Nonnenmacher, Noel Netusil, Dan Vander Ploeg, and David Wishart.

Finally, we owe particular thanks to our assistants, Ida Ng at Boalt Hall and Sally Cook at the University of Illinois College of Law. They do many big things to help us get our work done, as well as many little things without which much of our work would be impossible to do. Thanks so much.

ROBERT D. COOTER Berkeley, CA

THOMAS S. ULEN Champaign, IL

November, 2010

xii Preface

For the rational study of the law the black-letter man may be the man of the present, but the man of the future is the man of statistics and the master of economics. . . . We learn that for everything we have to give up something else, and we are taught to set the advantage we gain against the other advantage we lose, and to know what we are doing when we elect.

Oliver Wendell Holmes. THE PATH OF THE LAW, 10 HARV. L. REV. 457, 469, 474 (1897)1

To me the most interesting aspect of the law and economics movement has been its as- piration to place the study of law on a scientific basis, with coherent theory, precise hypotheses deduced from the theory, and empirical tests of the hypotheses. Law is a social institution of enormous antiquity and importance, and I can see no reason why it should not be amenable to scientific study. Economics is the most advanced of the social sciences, and the legal system contains many parallels to and overlaps with the systems that economists have studied successfully.

Judge Richard A. Posner, in MICHAEL FAURE & ROGER VAN DEN BERGH, EDS., ESSAYS IN LAW AND ECONOMICS (1989)

UNTIL RECENTLY, LAW confined the use of economics to antitrust law, regulated in-dustries, tax, and some special topics like determining monetary damages. Inthese areas, law needed economics to answer such questions as “What is the de- fendant’s share of the market?”; “Will price controls on automobile insurance reduce its availability?”; “Who really bears the burden of the capital gains tax?”; and “How much future income did the children lose because of their mother’s death?”

Beginning in the early 1960s, this limited interaction changed dramatically when the economic analysis of law expanded into the more traditional areas of the law, such as property, contracts, torts, criminal law and procedure, and constitutional law.2 This

1

1 An Introduction to Law and Economics

1 Our citation style is a variant of the legal citation style most commonly used in the United States. Here is what the citation means: the author of the article from which the quotation was taken is Oliver Wendell Holmes; the title of the article is “The Path of the Law”; and the article may be found in volume 10 of the Harvard Law Review, which was published in 1897, beginning on page 457. The quoted material comes from pages 469 and 474 of that article.

2 The modern field is said to have begun with the publication of two landmark articles—Ronald H. Coase, The Problem of Social Cost, 3 J. L. & ECON. 1 (1960) and Guido Calabresi, Some Thoughts on Risk Distribution and the Law of Torts, 70 YALE L.J. 499 (1961).

2 C H A P T E R 1 An Introduction to Law and Economics

new use of economics in the law asked such questions as, “Will private ownership of the electromagnetic spectrum encourage its efficient use?”; “What remedy for breach of contract will cause efficient reliance on promises?”; “Do businesses take too much or too little precaution when the law holds them strictly liable for injuries to con- sumers?”; and “Will harsher punishments deter violent crime?”

Economics has changed the nature of legal scholarship, the common understanding of legal rules and institutions, and even the practice of law. As proof, consider these in- dicators of the impact of economics on law. By 1990 at least one economist was on the faculty of each of the top law schools in North America and some in Western Europe. Joint degree programs (a Ph.D. in economics and a J.D. in law) exist at many prominent universities. Law reviews publish many articles using the economic approach, and there are several journals devoted exclusively to the field.3 An exhaustive study found that ar- ticles using the economic approach are cited in the major American law journals more than articles using any other approach.4 Many law school courses in America now in- clude at least a brief summary of the economic analysis of law in question. Many sub- stantive law areas, such as corporation law, are often taught from a law-and-economics perspective.5 By the late 1990s, there were professional organizations in law and eco- nomics in Asia, Europe, Canada, the United States, Latin America, Australia, and else- where. The field received the highest level of recognition in 1991 and 1992 when consecutive Nobel Prizes in Economics6 were awarded to economists who helped to found the economic analysis of law—Ronald Coase and Gary Becker. Summing this up, Professor Bruce Ackerman of the Yale Law School described the economic approach to law as “the most important development in legal scholarship of the twentieth century.”

The new field’s impact extends beyond the universities to the practice of law and the implementation of public policy. Economics provided the intellectual foundations for the deregulation movement in the 1970s, which resulted in such dramatic changes in America as the dissolution of regulatory bodies that set prices and routes for airlines, trucks, and railroads. Economics also served as the intellectual force behind the revolu- tion in antitrust law in the United States in the 1970s and 1980s. In another policy area, a commission created by Congress in 1984 to reform criminal sentencing in the federal courts explicitly used the findings of law and economics to reach some of its results. Furthermore, several prominent law-and-economics scholars have become federal judges and use economic analysis in their opinions—Associate Justice Stephen Breyer of the U.S. Supreme Court; Judge Richard A. Posner and Judge Frank Easterbrook of the U.S. Court of Appeals for the Seventh Circuit; Judge Guido Calabresi of the U.S.

3 For example, the Journal of Law and Economics began in 1958; the Journal of Legal Studies in 1972; Research in Law and Economics, the International Review of Law and Economics, and the Journal of Law, Economics, and Organization in the 1980s; and the Journal of Empirical Legal Studies in 2004.

4 William M. Landes & Richard A. Posner, The Influence of Economics on Law: A Quantitative Study, 36 J. L. & ECON. 385 (1993).

5 See, e.g., STEPHEN M. BAINBRIDGE, CORPORATION LAW AND ECONOMICS (2002). 6 The full name of the Nobel Prize in Economics is the Bank of Sweden Prize in the Economic Sciences in

Memory of Alfred Nobel. See our book’s website for a full list of those who have won the Nobel Prize and brief descriptions of their work.

I. What Is the Economic Analysis of Law? 3

Court of Appeals for the Second Circuit; Judge Douglas Ginsburg, and former Judge Robert Bork of the U.S. Court of Appeals for the D.C. Circuit; and Judge Alex Kozinski of the U.S. Court of Appeals for the Ninth Circuit.

I. What Is the Economic Analysis of Law? Why has the economic analysis of law succeeded so spectacularly, especially in

the United States but increasingly also in other countries?7 Like the rabbit in Australia, economics found a vacant niche in the “intellectual ecology” of the law and rapidly filled it. To explain the niche, consider this classical definition of some kinds of laws: “A law is an obligation backed by a state sanction.”

Lawmakers often ask, “How will a sanction affect behavior?” For example, if punitive damages are imposed upon the maker of a defective product, what will happen to the safety and price of the product in the future? Or will the amount of crime de- crease if third-time offenders are automatically imprisoned? Lawyers answered such questions in 1960 in much the same way as they had 2000 years earlier—by consulting intuition and any available facts.

Economics provided a scientific theory to predict the effects of legal sanctions on behavior. To economists, sanctions look like prices, and presumably, people respond to these sanctions much as they respond to prices. People respond to higher prices by consuming less of the more expensive good; presumably, people also respond to more severe legal sanctions by doing less of the sanctioned activity. Economics has mathe- matically precise theories (price theory and game theory) and empirically sound methods (statistics and econometrics) for analyzing the effects of the implicit prices that laws attach to behavior.

Consider a legal example. Suppose that a manufacturer knows that his product will sometimes injure consumers. How safe will he make the product? For a profit- maximizing firm, the answer depends upon three costs: First, the cost of making the product safer, which depends on its design and manufacture; second, the manufac- turer’s legal liability for injuries to consumers; and third, the extent to which injuries discourage consumers from buying the product. The profit-maximizing firm will adjust safety until the cost of additional safety equals the benefit from reduced liability and higher consumer demand for the good.

Economics generally provides a behavioral theory to predict how people respond to laws. This theory surpasses intuition just as science surpasses common sense. The re- sponse of people is always relevant to making, revising, repealing, and interpreting laws. A famous essay in law and economics describes the law as a cathedral—a large, ancient, complex, beautiful, mysterious, and sacred building.8 Behavioral science resembles the mortar between the cathedral’s stones, which support the structure everywhere.

7 See Nuno Garoupa & Thomas S. Ulen, The Market for Legal Innovation: Law and Economics in Europe and the United States, 59 ALA. L. REV. 1555 (2008).

8 Guido Calabresi & A. Douglas Melamed, Property Rules, Liability Rules, and Inalienability: One View of the Cathedral, 85 HARV. L. REV. 1089 (1972).

4 C H A P T E R 1 An Introduction to Law and Economics

A prediction can be neutral or loaded with respect to social values. A study finds that higher fines for speeding on the highway will presumably cause less of it. Is this good or bad on balance? The finding does not suggest an answer. In contrast, suppose that a study proves that the additional cost of collecting higher fines exceeds the result- ing benefit from fewer accidents, so a higher fine is “inefficient.” This finding suggests that a higher fine would be bad. Efficiency is always relevant to policymaking, because public officials never advocate wasting money. As this example shows, besides neutral predictions, economics makes loaded predictions. Judges and other officials need a method for evaluating laws’ effects on important social values. Economics provides such a method for efficiency.

Besides efficiency, economics predicts the effects of laws on another important value: the distribution of income. Among the earliest applications of economics to public policy was its use to predict who really bears the burden of alternative taxes. More than other so- cial scientists, economists understand how laws affect the distribution of income across classes and groups. While almost all economists favor changes that increase efficiency, some economists take sides in disputes about distribution and others do not take sides.

Instead of efficiency or distribution, people in business mostly talk about profits. Much of the work of lawyers aims to increase the profits of businesses, especially by helping businesses to make deals, avoid litigation, and obey regulations. These three ac- tivities correspond to three areas of legal practice in large law firms: transactions, litiga- tion, and regulation. Efficiency and profitability are so closely related that lawyers can use the efficiency principles in this book to help businesses make more money. Economic efficiency is a comprehensive measure of public benefits that include the profits of firms, the well-being of consumers, and the wages of workers. The logic of maximizing the comprehensive measure (efficiency) is very similar to the logic of maximizing one of its components (profits). A good legal system keeps the profitability of business and the wel- fare of people aligned, so that the pursuit of profits also benefits the public.

II. Some Examples To give you a better idea of what law and economics is about, we turn to some ex-

amples based upon classics in the subject. First, we try to identify the implicit price that the legal rule attaches to behavior in each example. Second, we predict the conse- quences of variations in that implicit price. Finally, we evaluate the effects in terms of efficiency and, where possible, distribution.

Example 1: A commission on reforming criminal law has identified cer- tain white-collar crimes (such as embezzling money from one’s employer) that are typically committed after rational consideration of the potential gain and the risk of getting caught and punished. After taking extensive testimony, much of it from economists, the commission decides that a monetary fine is the appropriate pun- ishment for these offenses, not imprisonment. The commission wants to know, “How high should the fine be?”

The economists who testified before the commission have a framework for an- swering this question. The commission focused on rational crimes that seldom occur unless the expected gain to the criminal exceeds the expected cost. The expected cost

II. Some Examples 5

depends upon two factors: the probability of being caught and convicted and the sever- ity of the punishment. For our purposes, define the expected cost of crime to the crimi- nal as the product of the probability of a fine times its magnitude.

Suppose that the probability of punishment decreases by 5 percent and the magni- tude of the fine increases by 5 percent. In that case, the expected cost of crime to the criminal roughly remains the same. Because of this, the criminal will presumably re- spond by committing the same amount of crime. (In Chapter 12 we shall explain the exact conditions for this conclusion to be true.) This is a prediction about how illegal behavior responds to its implicit price.

Now we evaluate this effect with respect to economic efficiency. When a decrease in the probability of a fine offsets an increase in its magnitude, the expected cost of crime remains roughly the same for criminals, but the costs of crime to the criminal justice sys- tem may change. The costs to the criminal justice system of increasing a fine’s probabil- ity include expenditures on apprehending and prosecuting criminals—for example, on the number and quality of auditors, tax and bank examiners, police, prosecuting attor- neys, and the like. While the cost of increasing the probability of catching and convicting white-collar criminals is relatively high, administering fines is relatively cheap. These facts imply a prescription for holding white-collar crime down to any specified level at least cost to the state: Invest little in apprehending and prosecuting offenders, and fine se- verely those who are apprehended. Thus, the commission might recommend very high monetary fines in its schedule of punishments for white-collar offenses.

Professor Gary Becker derived this result in a famous paper cited by the Nobel Prize Committee in its award to him. Chapters 12 and 13 discuss these findings in detail.

Example 2: An oil company contracts to deliver oil from the Middle East to a European manufacturer. Before the oil is delivered, war breaks out and the oil company cannot perform as promised. The lack of oil causes the European manu- facturer to lose money. The manufacturer brings an action (that is, files a lawsuit) against the oil company for breach of contract. The manufacturer asks the court to award damages equal to the money that it lost. The contract is silent about the risk of war, so that the court cannot simply read the contract and resolve the dispute on the contract’s own terms. The oil company contends that it should be excused from performance because it could do nothing about the war and neither of the con- tracting parties foresaw it. In resolving the suit, the court must decide whether to excuse the oil company from performance on the ground that the war made the performance “impossible,” or to find the oil company in breach of contract and to require the oil company to compensate the manufacturer for lost profits.9

War is a risk of doing business in the Middle East that one of the parties to the con- tract must bear, and the court must decide which one it is. What are the consequences of different court rulings? The court’s decision simultaneously accomplishes two things. First, it resolves the dispute between the litigants—“dispute resolution.” Second, it guides future parties who are in similar circumstances about how courts might resolve their dispute—“rule creation.” Law and economics is helpful in resolving

9 For a full discussion of the cases on which this example is based, see Richard A. Posner & Andrew Rosenfield, Impossibility and Related Doctrines in Contract Law, 6 J. LEGAL STUD. 88 (1977).

6 C H A P T E R 1 An Introduction to Law and Economics

disputes, but it particularly shines in creating rules. Indeed, a central question in this book is, “How will the rule articulated by the lawmaker to resolve a particular dispute affect the behavior of similarly situated parties in the future?” And, “Is the predicted behavior desirable?”

The oil company and the manufacturer can take precautions against war in the Middle East, although neither of them can prevent it. The oil company can sign backup contracts for delivery of Venezuelan oil, and the manufacturer can store oil for emer- gency use. Efficiency requires the party to take precaution who can do so at least cost. Is the oil company or the manufacturer better situated to take precautions against war? Since the oil company works in the Middle East, it is probably better situated than a European manufacturer to assess the risk of war in that region and to take precautions against it. For the sake of efficiency, the court might hold the oil company liable and cite the principle that courts will allocate risks uncovered in a contract to the party who can bear them at least cost. This is the principle of the least-cost risk-bearer,10 which is consistent with some decisions in cases that arose from the Middle Eastern war of 1967. Chapters 8 and 9 consider this principle’s foundation.

Example 3: Eddie’s Electric Company emits smoke that dirties the wash hanging at Lucille’s Laundry. Eddie’s can completely abate the pollution by in- stalling scrubbers on its stacks, and Lucille’s can completely exclude the smoke by installing filters on its ventilation system. Installing filters is cheaper than installing scrubbers. No one else is affected by this pollution because Eddie’s and Lucille’s are near to each other and far from anyone else. Lucille’s initiates court proceed- ings to have Eddie’s declared to be a “nuisance.” If the action succeeds, the court will order Eddie’s to abate its pollution. Otherwise, the court will not intervene in the dispute. What is the appropriate resolution of this dispute?

Efficiency requires Lucille’s to install filters, which is cheaper than Eddie’s in- stalling scrubbers. How can the court produce this result? The answer depends on whether or not Eddie’s and Lucille’s can cooperate. First, assume that Eddie’s and Lucille’s cannot bargain together or cooperate. If Lucille’s wins the action and the court orders Eddie’s to abate the pollution, Eddie’s will have to install scrubbers, which is ef- ficient. However, if Lucille’s loses the action, then Lucille’s will have to install filters, which is inefficient. Consequently, it is efficient for Lucille’s to lose the action.

Now, consider how the analysis changes if Eddie’s and Lucille’s can bargain together and cooperate. Their joint profits (the sum of the profits of Eddie’s and Lucille’s) will be higher if they choose the cheaper means of eliminating the harm from pollution. When their joint profits are higher, they can divide the gain between them in order to make both of them better off. The cheaper means is also the efficient means. Efficiency is achieved in this example when Lucille’s and Eddie’s bargain together and cooperate, regardless of the rule of law. Ronald Coase derived this result in a famous paper cited by the Nobel Prize Committee when he received the award. Chapter 4 elaborates on this famous result.

10 The principle assumes that the entire loss from nonperformance must be allocated by the court to one of the parties. Alternatively, the court might divide the loss between the parties.

III. The Primacy of Efficiency Over Distribution in Analyzing Private Law 7

III. The Primacy of Efficiency Over Distribution in Analyzing Private Law

We explained that economists are experts on two policy values—efficiency and distribution. The stakes in most legal disputes have monetary value. Deciding a legal dispute almost always involves allocating the stakes between the parties. The decision about how much of the stakes each party gets creates incentives for future behavior, not just for the parties to this dispute but also for everyone who is similarly situated. In this book we use these incentive effects to make predictions about the consequences of le- gal decisions, policies, rules, and institutions. In evaluating these consequences, we will focus on efficiency rather than distribution. Why?

By making a rule, the division of the stakes in a legal dispute affects all similarly situated people. If a plaintiff in a case is a consumer of a particular good, an investor in a particular stock, or the driver of a car, then a decision for the plaintiff may benefit everyone who consumes this good, invests in this stock, or drives a car. Most propo- nents of income redistribution, however, have something else in mind. Instead of con- templating distribution to consumers, investors, or drivers, advocates of income redistribution usually target social groups, such as the poor, women, or minorities. Some people passionately advocate government redistribution of income by class, gen- der, or race for the sake of social justice. A possible way to pursue redistribution is through private law—the law of property, contracts, and torts. According to this philos- ophy, courts should interpret or make private laws to redistribute income to deserving groups of people. For example, if consumers are poorer on average than investors, then courts should interpret liability rules to favor consumers and disfavor corporations.

This book rejects the redistributive approach to private law. Pursuing redistributive goals is an exceptional use of private law that special circumstances may justify but that ought not be the usual use of private law. Here is why. Like the rest of the population, economists disagree among themselves about redistributive ends. However, economists generally agree about redistributive means. By avoiding waste, efficient redistribution benefits everyone relative to inefficient redistribution. By avoiding waste, efficient re- distribution also builds support for redistribution. For example, people are more likely to donate to a charitable organization that efficiently redistributes income than to one that spends most of its revenue on administration.

A piquant example will help you to appreciate the advantages of efficient redistri- bution. Assume that a desert contains two oases, one of which has ice cream and the other has none. The advocates of social justice who favor redistribution obtain control over the state and declare that the first oasis should share its ice cream with the second oasis. In response, the first oasis fills a large bowl with ice cream and sends a youth running across the desert carrying the bowl to the second oasis. The hot sun melts some of the ice cream, so the first oasis gives up more ice cream than the second oasis re- ceives. The melted ice cream represents the cost of redistribution. People who disagree vehemently about how much ice cream the first oasis should give to the second oasis may agree that a fast runner should transport it. Also they might agree to choose an honest runner who will not eat the ice cream along the route.

8 C H A P T E R 1 An Introduction to Law and Economics

Many economists believe that progressive taxation and social welfare programs— the “tax-and-transfer system,” as it is usually called—can accomplish redistributive goals in modern states more efficiently than can be done through modifying or reshuf- fling private legal rights. There are several reasons why reshuffling private legal rights resembles giving the ice cream to a slow runner.

First, the income tax precisely targets inequality, whereas redistribution by private legal rights relies on crude averages. To illustrate, assume that courts interpret a law to favor consumers over corporations in order to redistribute income from rich to poor.11

“Consumers” and “investors” imperfectly correspond to “poor” and “rich.” Consumers of Ferrari automobiles, skiing vacations, and the opera tend to be relatively rich. Many small businesses are organized as corporations. Furthermore, the members of unions with good pension plans own the stocks of large companies. By taxing income progres- sively, law distinguishes more precisely between rich and poor than by taking the indi- rect approach of targeting “consumers” and “investors.”

Second, the distributive effects of reshuffling private rights are hard to predict. To illustrate, the courts cannot be confident that holding a corporation liable to its con- sumers will reduce the wealth of its stockholders. Perhaps the corporation will pass on its higher costs to consumers in the form of higher prices, in which case the court’s holding will redistribute costs from some consumers to other consumers.

Third, the transaction costs of redistribution through private legal rights are typi- cally high. To illustrate, a plaintiff’s attorney working on a contingency fee in the United States routinely charges one-third of the judgment. If the defendant’s attorney collects a similar amount in hourly fees, then attorneys for the two sides will absorb two-thirds of the stakes in dispute. The tax-and-transfer system is more efficient.

Besides these three reasons, there is a fourth: Redistribution by private law distorts the economy more than progressive taxation does. In general, relying on broad-based taxes, rather than narrowly focused laws, reduces the distorting effects of redistributive policies. For example, assume that a law to benefit consumers of tomatoes causes a de- cline in the return enjoyed by investors in tomato farms. Investors will respond by with- drawing funds from tomato farms and investing in other businesses. Consequently, the supply of tomatoes will be too small and consumers will pay too high a price for them. This law distorts the market for tomatoes.

For these reasons and more, economists who favor redistribution and economists who oppose it can agree that private legal rights are usually the wrong way to pursue distributive justice. Unfortunately, lawyers without training in economics seldom ap- preciate these facts.

We have presented several reasons against basing private law on redistributive goals. Specifically, we discussed imprecise targeting, unpredictable consequences, high transac- tion costs, and distortions in incentives. For these reasons, the general principles of private law cannot rest on income redistribution. (In special circumstances, however, a private law can redistribute relatively efficiently, such as a well-designed law giving crippled people the right to sue employers for not providing wheelchair access to the workplace.)

11 Courts might always find in favor of the individual consumer when he or she sues a corporation regarding liability for harms arising in the use of the corporation’s products.

IV. Why Should Lawyers Study Economics? Why Should Economists Study Law? 9

Web Note 1.1

Besides efficiency, what other policy values should matter to making law and applying it? In Fairness Versus Welfare (2002), Louis Kaplow and Steven Shavell of the Harvard Law School say “None.” Others disagree. See Chris Sanchirico, Deconstructing the New Efficiency Rationale, 86 CORNELL L. REV. 1005 (2001), and Daniel Farber, What (If Anything) Can Economics Say About Equity?, 101 MICH. L. REV. 1791 (2003).

There is a more complete discussion of this literature under Chapter 1 at the website for this book and links to additional sites of interest.

IV. Why Should Lawyers Study Economics? Why Should Economists Study Law?

The economic analysis of law unites two great fields and facilitates understanding each of them. You probably think of laws as promoting justice; indeed, many people can think in no other way. Economics conceives of laws as incentives for changing behavior (implicit prices) and as instruments for policy objectives (efficiency and distribution). However, economic analysis often takes for granted such legal institutions as property and contract, which dramatically affect the economy. Thus, differences in laws cause capital markets to be organized differently in Japan, Germany, and the United States. Failures in financial laws and contracting contributed to the banking collapse of 2008 in the United States and the subsequent recession, which was less severe in Japan and Germany. Also, the absence of secure property and reliable contracts paralyzes the economies of some poor nations. Improving the effectiveness of law in poor countries is important to their economic development. Law needs economics to understand its be- havioral consequences, and economics needs law to understand the underpinnings of markets.

Economists and lawyers can also learn techniques from each other. From econo- mists, lawyers can learn quantitative reasoning for making theories and doing empiri- cal research. From lawyers, economists can learn to persuade ordinary people—an art

Stern Warning for Students

If you are like most students who read this book—scholars of the highest moral caliber—you need not upset yourself by reading the rest of this paragraph. If you are one of those wicked students—we get a few every year—here is a stern warning for you. According to traditional Chinese beliefs, sinners are tried and punished in ten courts of hell after they die. The sixth court tries the sin of “abusing books,” punishable by being sawn in half from head to toe. The eighth court tries the sin of “cheating on exams,” punishable by being cut open and having your intes- tines ripped out. So don’t you dare abuse this book or cheat on the exams!

10 C H A P T E R 1 An Introduction to Law and Economics

that lawyers continually practice and refine. Lawyers can describe facts and give them names with moral resonance, whereas economists are obtuse to language too often. If economists will listen to what the law has to teach them, they will find their models be- ing drawn closer to what people really care about.

V. The Plan of This Book To benefit from each other, lawyers must learn some economics and economists

must learn some law. Readers can do so in the next two chapters. Chapter 2 briefly re- views microeconomic theory. If you are familiar with that theory, then you can read the material quickly as a review or skim the headings for unfamiliar topics. As a check, you might try the problems at the end of Chapter 2.

Chapter 3 is an introduction to the law and the legal process, which is essential reading for those without legal training. We explain how the legal system works, how the U.S. legal system differs from the rest of the world, and what counts as “law.”

Chapter 4 begins the substantive treatment of the law from an economic viewpoint. The chapters on substantive legal issues are arranged in pairs. Chapters 4 and 5 focus on property law; Chapters 6 and 7, on tort law; Chapters 8 and 9, on contract law; Chapters 10 and 11, on resolving legal disputes; and 12 and 13, on criminal law. The first chapter of each pair explains the basic economic analysis of that area of law, and the second chap- ter applies the core economic theory to a series of topics. So, Chapter 6 develops an eco- nomic theory of tort liability, and Chapter 7 applies it to automobile accidents, medical practice, and defective products. Chapters 4 through 11 deal with laws where the typical plaintiff in a suit is a private person (“private law”), and Chapters 12 and 13 deal with criminal law where the plaintiff is the public prosecutor (“public law”).

Suggested Readings

At the end of every chapter we shall list some of the most important writings on the subject. Please check the website for this book (www.cooter-ulen.com) for additional resources.

BOUCKAERT, BOUDEWIJN, & GERRIT DE GEEST, EDS., ENCYCLOPEDIA OF LAW AND ECONOMICS (rev. ed., 2011).

DAU-SCHMIDT, KEN, & THOMAS S. ULEN, EDS., A LAW AND ECONOMICS ANTHOLOGY (1997).

MICELI, THOMAS J, THE ECONOMIC APPROACH TO LAW (2d ed. 2008).

NEWMAN, PETER, ED., THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND LAW (3 vols., 1998).

POLINSKY, A. MITCHELL, AN INTRODUCTION TO LAW AND ECONOMICS (3rd, 2003).

POLINSKY, A. MITCHELL, & STEVEN SHAVELL, EDS., HANDBOOK OF LAW AND ECONOMICS, vs. 1 AND 2 (2007).