Foundations: Lecture IV

Law and Economics:

Feedback on the argument handout: Very useful. But people did have different ideas about
which arguments they needed to work on.
Pretty much everyone could see that the class on arguments was of direct practical importance.
Id predict that, in about a year or so, youd say that the first two classes on legal history and
legal thought were even more important.
Connection to previous classes and feedback:
The legal realists like purposive arguments, rather than formalist ones. But there are important
uses for formalist arguments. Consider the voting age. If you are 18 and want to vote, you dont
want a person to deny you that right because 18 actually means the average maturity of an 18year-old. Youd say no, I want it to be strictly 18.
A former student called Professor Boyle. He found a state usury statute says that it was illegal to
charge more than 3% on debt. The student said that meant 3% in the context of 1810 (when it
was passed). (This may not be a terrific argument, but at least the student knew how to argue
against the words in the statute.)
Similarly, across your courses you will have noticed that some of the arguments change in
accordance with changes in understandings about the law. In the First Restatement, you may
have make contracts using a private code; 1 bale of cotton can mean 10 bales of cotton. But even
private code words cannot mean their opposites. For example, buy cannot mean sell. With the
Second Restatement, words can mean whatever you want them to mean. The UCC also heavily
relies on standards.
Why did the legal realists like standards? It isnt required by legal realism. So why did they
love them? They thought that the virtues of firm rules were overstated, given collective
ignorance. Ironically, theres now a resurgence of formalism in contract law (crystals v. mud
debate). Ex ante, people may prefer rigid rules, even if they dont make sense in a particular
case. The market can adjust to that. The mud people, however, say that courts need to have to
figure out what a contract actually means.
Two Points:
1) Arguments exist in time.
2) These arguments are cyclical. We go through alternative periods of decrying and extolling
formalism. Decrying/extolling virtues of common person. Etc.

Post-Legal Realism: What you get in law schools today is a sort of watered-down legal realism.
Professors will give you the rule, but then ask what the policy is behind the rule. They will use
this to test possible boundaries.
Typically, law professors start with the elements and then problematize each individual concept.
They seek the edge case: where do we stop? If it is battery when I shoot you with a laser beam,
is it battery when ex-girlfriend posts photos to Facebook of her with new guy?
Realism is there, it is just behind the scenes.
Realism did upset a lot of people. Many asked: what is its limiting principle? Judges arent
legislatures, and within the historical context (rise of fascism and communism), saying that legal
rights were arbitrary socially formed constructs wasnt particularly popular. Its much more
persuasive to say, I have a right! when the secret police knock down the door. A lot of realists,
in fact, went the complete opposite way after the onset of WWII.
Interestingly, Germany actually moved towards realism. Many Germans saw a lot of judges who
chose to follow their orders--formal rules--and allow horrific acts. So their response was the
German Free Law Movement, which advocated for an approach that considered whether the
orders are just. In this view, fidelity to the law required purposive morality, context, and
pragmatism.
Meanwhile in the US, out of that seething morass, there came a whole series of movements. For
instance, the Legal Process Movement argued that while substance might be the province of legal
realism (expectation v. reliance damages is a policy choice), you can figure out which institution
is competent to decide that. The legal process theorists thought that we could come to a neutral
consensus on process, even if not on the policy within substance.
Law and Economics was the most important of all these movements. It is an unquestioned part
of legal practice/administrative law/private/public law today. It is particularly important to have
a strong background with Law and Economics if you are skeptical and wish to criticize it.
In one sense, law and economics is as old as the debate of law itself. For example, there is the
apocryphal story about the beginning of a rebellion in China. Two peasants squatting in mud.
They were late to militia duties. The penalty for being late was death, and the penalty for
inciting a rebellion was death. Thus, they thought they might as well rebel; they were already
sentenced to death.
Similarly, the reform of the English criminal justice system was built around utilitarian ideas, in
which the social harm related to the punishment. Law and economics in that sense is as old as
the hills. In some ways, it is almost identical to some deterrence arguments (which is the
utilitarian framework)
Polinsky excerpt:

Law and Economics is the much more formalized form of these arguments. The first question is
where it applies? Where do we do the economic analysis? There are trade offs between
efficiency and equity (efficiency is size of pie, equity is how it is divided up). In footnote 5,
there is the stuff that Polinsky doesnt want to talk about: exogenously determined rights.
Exogenously determined rights can be any right at all, to the extent that the right isnt determined
by social utility. Most people believe that you have a right to free speech on the basis of being a
human being: thats exogenously determined. Most rights that you think are most important are
exogenously determined.
Nevertheless, the law and econ scholars have a comeback. Can I shout fire in a crowded theater?
No. The state can forbid me to do that. How? The benefit of free speech is outweighed by its
costs in that particular situation. Thus, the interpretation of the meaning of any right depends on
a weighing of costs and benefits. A question like this can only be answered by looking at
consequences.
So economics has a nice riposte to exogenously determined rights. The law deals with them,
to be sure, but the boundaries of those rights are determined by utilitarian factors.
Polinsky also says it doesnt consider the process by which income or wealth is acquired rather
than its final distribution. Whats that? Polinsky just threw John Locke out the window. We
wont look at the process by which you acquire income/wealth: thats immaterial. The process
itself is not a value. But what about due process? Process does really matter in other contexts.
Basically, economic analysis in law is deliberately playing in a smaller world. That may be a
good or bad thing.
Polinskys defense of this smaller world is that we make simplifying assumptions all the time. In
physics class, you can assume a frictionless surface. Those models are useful, even if youll
never have a true frictionless surface. We also used simplified calculations in our daily lives all
the time.
Lets think about edge cases, though. One scholar has argued that economic analysis should
work great in criminal law, with a preference for fines over imprisonment. Then, we can allow
the person to engage in the activity (if they genuinely want to) and pay the fine. That is the most
efficient. (Think about parking illegally to rush your child into the hospital--you really dont
care if you have to pay the ticket.) But what about fines for sexual assault or rape? There are
places where we say: No. We cant put a price on that.
No theory provides the ambit of its applicability. Law and economics cannot tell you how far to
push it, or where to apply it. You have to decide that. For example, when Mike Tyson was
convicted of rape, a prominent economist said he should be allowed to be go on fighting, and the
government should forward his earnings to victims of rape and rape prevention charities. Most
people are still uncomfortable with that, though, despite that it may better compensate his victim.

For instance, Richard Posner claimed that best way to deal with long adoption lists for babies is
to allow for the sale of babies. And some people who work in healthcare will say that being sold
is far from the worst thing that could happen to a baby.
Law and economics should force us to consider the limits of our queasiness. Those limits may
still be right in certain circumstances, or they may need to be reconsidered. Think about the
Moore case: should we be able to sell our spleen?
But remember footnote 5. Weve already tossed a lot out of the window before we begin the
game. And remember law and economics responses. 1) Law and economics says that everybody
simplifies the analysis: they just do it explicitly. Also, 2) people should go beyond their initial
reaction, to the reason behind the reaction. And that this testing of societal limits will make
things clearer.
The Coase Theorem: Coase wrote his paper when people were doing economic analysis
through a liberal, interventionist mode. That is, they were looking for reasons to intervene in the
market. For instance, early environmental regulation would look for externalities, like pollution.
If pollution doesnt have to be paid for by the company, it will not care about the external harms
that come from it. Liberal law and economics people like to wander through the economy
looking for externalities and seek to correct them. On NPR, for instance, there was an expert
talking about how much more expensive solar power is than coal. Liberal law and economics
advocates would say that misses the true cost of coal. The price of coal is constructed by a legal
system that has chosen not to make them accountable for the true cost.
Coase says if bargaining is frictionless (no holdouts, problems, everyone has perfect knowledge
of exactly what they want), then there would be no issue with externalities. All the injured
people would come to coal industry and bargain with them. It doesnt matter whether the coal
company has the right to pollute or not; they will come to an efficient bargain.
Of course, there are significant transaction costs in the world, so you still have to assign the
burden to one side. That was Coases point: it is impossible to have a world without transaction
costs, and its tough to make a decision about the proper outcome.
Ironically, Coases article spawned a conservative law and economics movement. Conserative
judges go around in cases with a view of the perfect bargaining system, and then mirror the result
that would have occurred under that system.
This brings us to the early days of Chicago law and economics movement. This was a
descriptive movement that was based around the belief that common law rules are often
economically efficient. What accounts for this? If there is an inefficient law or judgment, then
our total social output goes down. People then have an incentive to litigate to change it because
they want to maximize social output.
Thus, it functions sort of like judicial natural selection. The crazy, problematic rules get weeded
out, and the common law should continue to weed them out, through trial and error. Also, with

Coasian analysis, advocates thought that judges could seek the most efficient outcome, where the
winners gained so much that they could afford to compensate the losers and still come out ahead.
For example, if a rule change costs me $10 but give other side $25, then the other side could
compensate me and still have a positive outcome. Thats an economically efficient outcome.
But there is a split on whether the winner should be required to compensate the loser. In KaldorHicks efficiency, the analysis was just whether the winner could compensate the loser and still
come out ahead. If they couldnt, just change the rule. Polinsky thought it should be left to the
legislature to grant relief to losers. For analytical purposes, the winner shouldnt be made to.
This is only about whether there is a more efficient rule.
Conversely, in Pareto-superior efficiency, the winner should compensate the loser.
Pareto-superior seems much fairer. So why would anyone pick Kaldor-Hicks? It is really hard to
figure out who is being harmed and how much they should be compensated, and that costs
money to do. Think about the BP oil spill: who is actually damaged? Kaldor-Hicks says transfer
that cost to someone else to do. Pareto-superior says fix it.
Series of switches/toggles in law and economics: how you switch them determines the
outcome.
1) Diminishing marginal utility of wealth: the wealthier you are, the less a dollar means to you.
The mite means more to a widow than a bar of gold to a rich man. Consider whether we should
take that into account for damages. Should there be equal justice under the law, or should we
focus on actually deterring people. There are times when it is probably a good idea to consider
the wealth of an individual. For instance, with taxation, flat taxes hit poor harder than the rich,
so we use income taxation. Yet with penalties we tend to say that there should be a level playing
field. (Except punitive damages if people are really bad.)
2) How far should the analysis go? We can call this the scale switch, in time and remoteness. In
1800, a polluting factory was only liable to its immediate neighbors affected by pollution. The
law didnt include liability for acid rain or a polluted lake a hundred miles away. Today, the state
says lets try to capture more of these externalities. For example, Professor Salzman advocated
for extended producer liability, so that a manufacturer has to internalize the cost of using material
that is really difficult to recycle, or highly toxic.
But how far should we go? Firms leave jurisdictions for lower tax rates and labor costs. Think
about outsourcing: if every firm had to pay full cost of outsourcing, it would be highly
unprofitable. We dont want to restrict that though, because then there would be total gridlock
and no one could change or move around.
Keep in mind: you can broaden or narrow the analysis in terms of the time frame, too. How far
away in time should we consider externalities? Your grandkids may want to see a coral reef
some day, or a polar bear. Yet they may not be able to.

3) Wealth effect: the initial distribution of entitlements can dictate what the efficient distribution
is. Who has the right, initially, can change how the analysis plays out. Imagine that we have to
allocate the right to a bottle of water to two people dying of thirst in the desert. Who should get
the water? Ideally, the person who will pay the most for it. But if one person already has the
bottle of water, then they will not give it up for any amount of money. (For more information on
this, look at the Edward Baker article on Sakai. He writes remarkably clearly.)
Lets say a large number of poor people play basketball, and fewer rich people play golf. The
city has enough land for either basketball courts or a golf course. If the analysis is who can pay
the most, then the rich people will win. They can pay the most for it and compensate poor
people.
Think about also: why dont we have vaccines for malaria or river blindness? They are poor. It
isnt because they dont love their children enough. Their values have no impact because we
cant enter their values into the market. Social values and market values are not the same. It
would certainly be better to have an anti-malarial vaccine than a drug to help people lose weight,
but thats not what we get.
Consider also the Peevyhouse example: a strip-mining company signs a contract that requires
them to restore the valley to its original state after they are finished. The company strips it, and
then just offers to pay for the actual value of the land. Is this really an efficient breach? It is
efficient if we assume the Peevyhouses only have an entitlement to the market value of the land.
But if we flip the wealth effect, and ask the Peevyhouses what they would need to be paid to
give up the land, we would get an entirely different result. Specific performance would likely be
required by that analysis of efficient breach. Flipping from offering price to asking price
changes the metric. Suppose there was already a right to the basketball courts, how much would
it take for the people to give it up? Or a right to anti-malarial vaccine?
Another example: Will has a shirt. Professor Boyle wants the shirt and is willing to pay more
than Will for the shirt. Is it efficient for Professor Boyle to take shirt from him? The shirt, in
terms of market value, means more to Professor Boyle than Will. But Will has a property right in
the shirt. When do we change from property rules to a law and economics approach?
Other examples: necessity in Torts and takings in Property. In both cases, you move from
property rule to a liability rule, based on the question of who has the initial entitlement.
If Donald Trump wants to build a casino and a little lady has house in the middle of where he
wants to build it, he cant force her out. The wealth effect is one of the most important flips in
law and economics.
4) Value in the analysis: Think about the WHOs QALY analysis (quality of life years). Most
economics analysis denominates in dollars, but not always. We put value on human life every
day in ways that are not expressed in money. And economics is not cold or horrid for putting a
monetary value on human life (like speed limits, wages, and insurance). But how does it do it?
This depends on:
a. How well do you assume the market works? Some people shop at Whole Foods. The
parking spaces are way too close together. In perfect Coasian world, we would all come together

and come to an agreement with them to eliminate two spaces. We dont do that. In an efficient
market, you will be so irritated that you will go to Harris Teeter instead. And Whole Foods can
adjust. Typically, in the end, the parking space isnt that important. So maybe market is
functioning well.
What about discrimination in the labor market, though? In a perfect world, discrimination would
result in inefficiency that would be self correcting. Non discriminating firms would have a
competitive advantage, by hiring the undervalued targeted group. Theyd drive the
discriminators out of business and this would happen fast. In reality the scale is much slower.
Markets are sticky
Torts theorists of late 19th century believed that you didnt have to go and work in an unsafe
place if you didnt want to, so your presence there meant you consented to that risk at that wage.
Their rationale was: you consented to it and youre compensated for it. In perfect market, that
may be true. But in a market where only bad workplaces exist, there is a problem.
You all have different levels of assumptions about how well markets function. Thats informing
the analysis. Pre-workers compensation, workers had to sue for negligence. The industry
argued for custom determinations of negligence. If you have confidence in market, best
employers will make their workplaces safe and attract the best employees. Of course, the
problems are that the levels of worker mobility and knowledge fall short of perfection.
So markets can be inefficient and regulation needs to acknowledge that. You should articulate
your own assumptions about the efficiency of markets.
On the one hand, many of us believe markets are way more inefficient than they are. Some see
externalities that need to be corrected everywhere. For example, regulations on carrying a kid on
your lap during flights substantially decreased safety, because people with small children took to
the road, which is a much more dangerous environment.