David D. Friedman
The Concise Encyclopedia of Economics

Law and Economics

by David D. Friedman
About the Author
A legal rule has two consequences. The most immediate is to determine who pays what penalty to whom if the rule is broken. Thus, one might describe a law against speeding as a rule providing that anyone caught driving more than fifty-five miles an hour on the Dan Ryan Expressway must pay fifty dollars to the city of Chicago. Viewed this way, a speeding law is simply a way of raising revenue and a speeding ticket a rather peculiar sort of tax bill.

But that is not why we have most speeding laws. Their purpose is not to tax speeding, but to prevent it. We pass such laws because we believe that a driver is less likely to drive fast if one probable consequence of doing so is a fine.

The economic analysis of law deals with legal rules, whether made by legislatures or by courts, from this second viewpoint—not as a way of handing out rewards and punishments to those who deserve them, but as a system of incentives intended to affect behavior. Economic theory is used to predict how rational individuals will respond to such rules and what the consequences will be. This way of thinking about the law, and the conclusions it implies, are obvious in cases such as the speeding law. In other cases the analysis and the conclusions are much less obvious.

Consider a city ordinance restricting the terms of rental contracts. Suppose the government of Chicago forbids any apartment lease that permits the landlord to evict the tenant without giving him at least six months' notice. An obvious consequence is that tenants are better off, since they now have six months' security, while landlords are worse off, since it takes them longer to evict undesirable tenants.

While this is obvious, it is probably not true other than in the very short run. What the argument omits is the effect of the rule on the behavior of landlords and tenants. By increasing both the cost to landlords of providing apartments and the value to tenants of the apartments they rent, the rule increases the rent at which the number of apartments supplied by landlords equals the number demanded by tenants.

In the simplest case, where the costs of the additional security are the same for all landlords and the benefits are the same for all tenants, one can show that the law either has no effect or makes both sides worse off. If the benefits to tenants from the additional security exceed the costs to landlords, the rule has no effect. Landlords would offer the guarantee even without the rule, since tenants are willing to pay more for it than it costs the landlord. If the benefit of the additional security to the tenants is less than its cost to the landlords, the rule makes both sides worse off. Landlords receive more rent, but not enough to compensate them for the cost of providing security. Tenants receive security, but pay more for it than it is worth to them.

One can construct more complicated situuations where the restriction benefits tenants at the expense of landlords, or landlords at the expense of tenants, or some landlords (or tenants) at the expense of others, but there is no particular reason to expect any such effect. The typical result of such a restriction on the terms of contracts, for rental housing or other things, is a net cost plus some more or less random redistribution of wealth. It is like a law requiring all cars to be equipped with air-conditioning and stereo tape decks. The result is not that consumers get additional features for free, but that some get (and pay for) features they would have bought anyway, while others are forced to buy features worth less to them than they cost.

So one implication of economic analysis of law is a presumption in favor of freedom of contract—the legal rule permitting parties to a contract to set any terms mutually acceptable and have them enforced by the courts. This presumption is not always true. It is possible to construct economic arguments against freedom of contract in particular situations. But such arguments depend on the existence of some form of market failure, such as an externality (a situation in which A's contract with B imposes costs on C). Courts will not, for instance, enforce a contract to commit a crime.

In contract law, as in many other areas of law, economic analysis affects not only conclusions about what the law should be, but the whole form of the arguments on which such conclusions are based. In order for the noneconomist to decide for or against laws requiring "pro-tenant" terms in leases, he need only know whether he favors tenants or landlords. For the economist that is almost irrelevant, since once the effect on rents of "pro-tenant" legal restrictions is taken into account, there is no reason to expect them to benefit tenants.

This is one example of the application of economics to the analysis of legal rules. Over the past twenty years economic arguments have been used to analyze the consequences of a wide variety of legal rules, including standards of proof, rules of evidence, damage rules for breach of contract, negligence rules for torts, and many others. An important—and controversial—element in much of this work is the claim that legal rules either are, or ought to be, designed to maximize economic efficiency—roughly speaking, to make the size of the economic pie as large as possible. (See Efficiency.) Judge Richard Posner, for instance, has argued that the common law, the set of legal doctrines that has evolved out of decisions by judges, tends to be efficient—that many of the rules developed by the courts seem very much like those that would be proposed by an economist designing a legal system to maximize economic efficiency.

Consider, for example, the issue of negligence. Suppose I take some action that results in damage to you. In many, though not all, situations I will be required to pay for your damage only if my action was negligent. Under the definition of negligence proposed by Judge Learned Hand, I am negligent if I could have prevented the accident at a cost to me that is less than the expected benefit from preventing it. The expected benefit is the probability that the accident will occur times the damage that will be done.

Suppose that if I do not have my brakes checked there is a 10 percent chance my car will skid into yours and do $1,000 damage. If I have the brakes checked, the chance is reduced to zero, so the expected benefit is .10 × $1,000 = $100. If the cost of the checkup is less than $100 then, under the Hand rule, I am negligent if I do not have the brakes checked, and will be liable for any accidents that result. If the cost is more than $100, then I am not negligent and will not be liable. This looks very much like a rule designed to produce the efficient outcome. If the cost of the precaution is greater than the benefit, then, on net, taking the precaution makes us worse off, so I should not be punished for not taking it—even if the result is an accident.

A similar analysis can be applied to the case of speeding tickets. I argued earlier that the purpose of speeding laws was not to collect money, but to prevent speeding. We could surely do so more effectively if we made the punishment more severe. If every speeder was hanged—or even if every speeder had his car confiscated—the number of speeders would rapidly approach zero.

One explanation of why we do not follow such a policy is that we do not wish to eliminate all speeding—just "inefficient" speeding. We punish speeding because it imposes a cost, in the increased likelihood of accidents, on other drivers. In some cases that cost may be worth paying. If we set the expected fine for speeding equal to the expected damage that the speeder does to other drivers, then each driver can decide for himself whether the benefit of getting where he is going a little sooner is worth the cost.

What these examples suggest is that many legal issues can be analyzed in economic terms, and that existing legal rules often make economic sense. Of course, a full economic analysis of either negligence or traffic fines, or a full description of the relevant law, would be much more complicated than the sketch given here.

Economics has made a substantial contribution to our understanding of the law, but the law has also contributed to our understanding of economics. Courts routinely deal with the reality of such economic abstractions as property and contract. The study of law thus gives economists an opportunity to improve their understanding of some of the concepts underlying economic theory. The most notable example is the work of University of Chicago economist Ronald Coase. Coase received the 1991 Nobel Prize in economics, in part for using ideas based on his study of the law of nuisance to revolutionize the corresponding area of economics—the theory of externalities.

About the Author

David D. Friedman is a professor of law and economics at Santa Clara University.

Further Reading

Calabresi, Guido, and A. Douglas Melamed. "Property Rules, Liability Rules, and Inalienability: One View of the Cathedral." Harvard Law Review 85 (1972): 1089-1128.

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

Landes, William, and Richard Posner. The Economic Structure of Tort Law. 1987.

Posner, Richard. Economic Analysis of Law. 1986.

Shavell, Steven. Economic Analysis of Accident Law. 1987.

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