The law and economics merger

Satish Jain

For the last several decades economists have been analyzing laws by using methods normally applied in the analysis of economic phenomena. The sub-discipline that has emerged as a result of these contributions is known as ‘law and economics’.1 In order to understand why economists should be interested in studying laws and to get some idea as to the kind of propositions that have been arrived at in law and economics, we begin by considering a simple example. Suppose some activity by individual A gives him a benefit of Rs. 100 but causes harm of Rs. 50 to individual B.2 The quantum of harm, however, can be reduced if A and B undertake some precautionary measures. These measures of course will not be costless. Let us suppose that if A alone takes precautionary measures, the harm to B will be reduced to 30; if B alone takes precautionary measures then the harm to him will be reduced to 40; and if both A and B take precautionary measures then harm to B will be reduced to 10. For ease of viewing we can put this information regarding harm to B under alternative scenarios in a tabular form as follows.

Harm to B

B does not take precaution B takes precaution
A does not take precaution 50 40
A takes precaution 30 10

Let us further assume that the cost of precautionary measures that A can take is 5 and the cost of precautionary measures that B can take is 4. In order to obtain the net social gain from A’s activity we must subtract from his gain the harm to B and the costs of precautionary measures, if any. In other words, net gain to society from A’s activity is: A’s gain – harm to B – cost of precaution by A – cost of precaution by B. Thus, when only B is taking precaution the net social gain will be: 100-40-4=56. The following table gives the net social gain for all the four alternative scenarios.

Net Social Gain

B does not take precaution B takes precaution
A does not take precaution 50 56
A takes precaution 65 81

We see that the net social gain is at a maximum when both A and B take precautionary measures for abating harm. It would indeed be desirable if both the individuals could be induced to take precaution. Whether they would do so will depend on what the law is regarding liability for harm. Suppose the law is that whosoever causes harm to others is fully liable for the harm caused. The law which holds injurers fully liable for the harm is known as the law of ‘strict liability’. Let us analyze what kind of incentives the law of strict liability will provide in the context of our simple example. Given that B would not take precaution; if A does not take precaution he will have to pay B Rs. 50, and if he takes care then his total costs would be 35, Rs.5 being the cost of taking care and Rs. 30 being the liability to B. Thus given that B is not going to take care, the best course of action for A is to take care. Next suppose that B is going to take care. Then, if A does not take care he will have to pay 40 to B, and if he takes care then he will have to pay 10 to B and incur the cost of taking care which is Rs. 5. From this it follows that given that B is going to take care it would be best for A to take care. Thus we see that regardless of what B does, the best course of action for A is to take care. Now, under strict liability the only costs that B would incur are the costs of taking care as he would be fully compensated for the harm that results from A’s activity. Therefore, the best course of action for B is not to take care, regardless of what A does. Consequently, in the context of our example, under strict liability the net social gain will be only 65. Strict liability law does not succeed in inducing both the parties to take socially desirable precautionary measures.

In the contemporary times, most production activities, while being socially useful, also tend to harm large numbers of individuals on account of the pollution that they generate. In most instances the victims of pollution are not compensated for the harm that is inflicted on them. The law under which the injurers are not made liable for the harm that they cause, and thus making the victims bear the harm, is called the law of ‘no liability’. The law of no liability also, in general, does not result in maximization of social gain. If in the context of our example we do a similar analysis as in the case of strict liability then we can easily see that, under the law of no liability B will take care but A will not, and therefore the net social gain would be only 56.

money-balance

As neither strict liability law nor no liability law is able to induce both the parties to take care, a natural question that arises is whether it is at all possible to devise a law that will have the property of inducing both the parties to take appropriate care. The answer to this question is ‘yes’. In what follows we consider a law which can be shown to have the desirable property of always inducing both the parties to take appropriate care. Let us call a party negligent if his (her) care level is less than the appropriate level of care; and non-negligent if the care level is equal to or greater than the appropriate level of care. In our example A would be considered negligent if he does not take care; and non-negligent if he takes care. Let us consider the following slightly complex law: (i) If the injurer is negligent then he (she) is liable for the entire harm caused by his (her) activity. (ii) If the injurer is non-negligent then he (she) is not at all liable for the harm caused by his (her) activity. This particular law is known as the law of negligence. Let us now analyze our example in the context of this law. Let us first consider the best course of action for the injurer (A) when the victim (B) is not taking care. If A does not take care he would be adjudged negligent and will have to pay B Rs. 50. If he takes care then he would be adjudged non-negligent and will not have to pay for the harm to B, which would be 30 in this case. Thus if he takes care his costs would be only 5 and if he does not take care then they would be 50. Clearly given that B is not going to take care, it is best for A to take care. Next, we consider the case when B is taking care. If A takes care, being adjudged non-negligent, his costs would be only 5; and if he does not take care, being adjudged negligent, his costs would be 40. Thus, given that B is going to take care the best course of action for A is to take care. Thus we see that A will take care regardless of what B does. Given that A is going to take care B will have to bear the harm inflicted on him. Thus his costs would be 30 if he does not take care; and 14 if he takes care. It then follows that B would take care. Thus in the context of our example the negligence law is able to induce both the parties to take socially appropriate care and thereby maximize the net social gain. It has been shown in the law and economics literature that the negligence law has the property of invariably inducing both the parties to take levels of care that would maximize the net social gain.3

A law which has the property of invariably inducing parties involved in the harmful interaction to take levels of care that would maximize the net social gain is called an efficient law. Thus negligence law is an efficient legal rule. Negligence law is not the only rule apportioning liability between the injurer and the victim that is efficient; there are infinitely many legal rules for apportioning liability between the two parties that are efficient. In fact, any law with the following characteristic would have the net social gain maximizing property, i.e., would be efficient: If one party is negligent and the other non-negligent then the law must make the negligent party bear the entire harm. It is also the case that any law that does not have this characteristic would not be efficient.4

Here, the concerns of economic analysis of law have been illustrated with tort law. Economists have analyzed practically every branch of law from the perspective of wealth maximization and have obtained significant results in most cases.

It is important to bear in mind that law and economics literature analyzes laws from the perspective of wealth maximization only. A law which is satisfactory from the perspective of wealth maximization may not be so satisfactory from the perspective of fairness or justice. It is immediate that the law of strict liability is far more satisfactory from the perspective of fairness than is the negligence law. The goals of justice and wealth maximization are not congruent with each other.

Footnotes

  1. Robert D. Cooter and Thomas S. Ulen (2011), Law and Economics, 6th ed., provides an easy introduction to the subject of law and economics.
  2. The branch of law that deals with harmful interactions is known as tort law.
  3. This was first proved in John Prather Brown (1973), ‘Toward an Economic Theory of Liability’ Journal of Legal Studies 2, 323-350.
  4. This was first established in Satish K. Jain and Ram Singh (2002), ‘Efficient Liability Rules: Complete Characterization’, Journal of Economics, 75, 105-124.

Ideas for the classroom

Under the eminent domain power governments can acquire private property in general and land in particular, without the consent of the owners. Governments can use eminent domain power for acquiring private property for its own use as well as on behalf of private entities. Consider the following three rules for land acquisition:

Rule A: The amount of compensation that shall be paid to the landowner will be equal to half the market price.
Rule B: The amount of compensation that shall be paid to the landowner will be equal to the market price.
Rule C: The amount of compensation that shall be paid to the landowner will be equal to two times the market price.

  1. Can you think of some ways that these three rules could be misused and lead to a decrease in social wealth?
  2. In the light of answer to 1, is there a case for minimization of the use of the eminent domain power?

The author is Professor at the Centre for Economic Studies and Planning (CESP), Jawaharlal Nehru University (JNU). He was a member of the faculty at CESP during 1978-2013 and held the Reserve Bank of India Chair during 2011-13. He can be reached at satish.k.jain@gmail.com.