Removing the Rationality Assumption from Law and Economics
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California Law Review VOL. 88 JULY 2000 No. 4 Copyright © 2000 by California Law Review, Inc. Law and Behavioral Science: Removing the Rationality Assumption from Law and Economics Russell B. Korobkint Thomas S. Ulen$ Introduction ............................................................................................1053 I. The Uses and Shortcomings of Rational Choice Theory ................ 1060 A. Conceptions of Rational Choice Theory ................................... 1060 1. The Definitional Version .................................................... 1061 2. The Expected Utility Version ............................................ 1062 3. The Self-Interest Version ..................................... 1064 4. The Wealth Maximization Version .................................... 1066 Copyright © 2000 Russell B. Korobkin and Thomas S. Ulen t Associate Professor, University of Illinois College of Law and University of Illinois Institute of Government and Public Affairs. Visiting Professor, UCLA School of Law (2000-01). J.D., B.A., Stanford University. * Alumni Distinguished Professor, University of Illinois College of Law and Professor, University of Illinois Institute of Government and Public Affairs. Ph.D., Stanford University, M.A., Oxford University, B.A., Dartmouth College. We would like to thank the faculty and staff of the Max Planck Institute for Research into Economic Systems in Jena, Germany, for providing support and a stimulating environment in which to complete an early draft of this work. We also thank Robert Ashford, Stephen Bainbridge, Tom Cotter, Dan Farber, Christine Jolls, Owen Jones, Douglas Kysar, Richard Markovits, Eric Posner, and Jeff Rachlinski for their thoughtful comments on earlier drafts, along with participants at the Society for Socio-Economics Annual Meeting Vienna, Austria, and participants in faculty workshops at the Copenhagen Business School, Miami University, and the law schools at Case Western Reserve University, UCLA, the University of Hamburg, the University of Texas, Trinity College Dublin, Katholieke Universiteit Luven, the University of Ghent, the University of Ljubljana, and the University of Kentucky. We also thank Patrick Elder and Michael Hazy for their research and assistance. 1051 1052 CALIFORNIA LAW REVIEW [Vol. 88:1051 B. Limitations of Rational Choice Theory in Legal Analysis ..................................................................................... 1066 1. The Inadequacy of Thin Versions of Rational Choice Theory ..................................................................... 1067 2. The Implausibility of Thin and Thick Versions .................. 1069 C. The Responses of Rational Choice Theory to Criticisms ................................................................................... 1070 D. Modifying the Behavioral Predictions of Rational Choice Theory .......................................................................... 1074 II. Bounded Rationality and the Use of Heuristics ............................... 1075 A. Decision-making Strategies That Do Not Maximize Expected Utility ........................................................................ 1076 1. Complexity .......................................................................... 1077 2. Ambiguity ........................................................................... 1083 B. Decision-making Heuristics and Biases .................................... 1084 1. Availability and Representativeness ................................... 1085 2. Overconfidence and Self-Serving Biases ............................ 1091 3. Hindsight Bias ..................................................................... 1095 4. Anchoring and Adjustment ................................................ 1100 III. The Importance of Context .............................................................. 1102 A. Reference Points and the Framing Effect .................................. 1104 B. The Endowment Effect and the Status Quo Bias ....................... 1107 C. Habits, Traditions, Addictions, and Cravings ............................ 1113 D. Time Inconsistencies and the Multiple-Selves Problem ............ 1119 E. Sunk Costs ................................................................................. 1124 IV. Deviations from Self-Interest ........................................................... 1126 A. Social Norms ............................................................................. 1127 B. Fairness ...................................................................................... 1135 C. Collective Action ....................................................................... 1138 Conclusion .............................................................................................. 1143 2000] 0]LAW AND BEHAVIORAL SCIENCE 1053 Law and Behavioral Science: Removing the Rationality Assumption from Law and Economics Russell B. Korobkin Thomas S. Ulen As law and economics turnsforty years old, its continued vitality is threatened by its unrealistic core behavioral assumption: that people subject to the law act rationally. ProfessorsKorobkin and Ulen argue that law and economics can reinvigorate itself by replacing the rationality assumption with a more nuanced understandingof human behavior that draws on cognitive psychology, sociology, and other behavioral sciences, thus creating a new scholarly paradigm called "law and behavioral science." This article provides an early blueprintfor research in this paradigm. The authorsfirst explain the various ways the rationality assumption is used in legal scholarship and why it leads to unsatisfying policy pre- scriptions.They then systematically examine the empirical evidence incon- sistent with the rationality assumption and, drawing on a wide range of substantive areas of law, explain how normative policy conclusions of law and economics will change and improve under the law-and-behavioral- science approach. INTRODUCTION The law-and-economics movement has suffered from the truthfulness of one of its most important postulates: the law of diminishing marginal returns. Although law and economics was once viewed as a revolutionary approach to legal scholarship that applied the principles of microeconomic price theory to the analysis of legal rules, the value of its new insights is gradually diminishing. The movement's vast initial successes were so 1. This is a theme in recent stocktaking by the profession. See, e.g., Douglas G. Baird et al., The Future of Law and Economics: Looking Forward, 64 U. CHI. L. REv. 1129 (1997); Richard A. Epstein, LaIv and Economics: Its Glorious Past and Cloudy Future 64 U. C-m. L. REv. 1167 (1997). A decade ago, Robert Ellickson observed that "[The first generation of law and economics scholars has essentially accomplished the straightforward applications of the basic economic model in virtually every legal field. Current scholarship is more technical and interstitial." Robert C. Ellickson, Bringing Culture and Human Frailty to Rational Actors: A Critique of Classical Law and Economics, 65 CHI.-KErr L. REv. 23, 24 (1989). 1054 CALIFORNIA LAW REVIEW [Vol. 88:1051 sweeping that the current pliers of the trade have been forced to search for more narrow niches to fill. As a result, the discipline often seems to be de- volving into a subdiscipline of applied economics that happens to focus substantively on legal matters.2 What began as a form of legal analysis that employed economics as a tool is now too often economic analysis that uses law as a target. Mathematical elegance often becomes the primary goal,' with usefulness in the realm of law, that combines logic with human expe- rience, 4 a mere afterthought The seminal insight that economics provides to the analysis of law is that people respond to incentives-a generalized statement of price theory.6 From this insight, two important corollaries follow. First, the law can serve as a powerful tool to encourage socially desirable conduct and discourage undesirable conduct. In the hands of skillful policymakers, the law can be used to subsidize some behaviors and to tax others. Second, the law has efficiency consequences as well as distributive consequences. Intentionally or unintentionally, legal rules can encourage or discourage the production of social resources and the efficient allocation of those resources. Although efficiency need not be the sole or primary goal of legal policy,7 economic analysis of law teaches that policymakers ignore the efficiency implica- tions of their actions at society's peril. Legal rights that are unobjectionable in the abstract are not free but rather must be measured against their op- portunity costs.8 2. This is not to say that there are not some ongoing, exciting research projects in law and economics. One such project is the study of the legal and economic aspects of social norms, a literature that we investigate in Part IV.A. below. Another is the emerging body of literature on game theory, a branch of microeconomics largely neglected during the first two decades of the law-and-economics movement that has only recently been brought to bear on legal analysis. See, e.g., DOUGLAS G. BAIRD ET AL., GAME THEORY AND THE LAW xi (1994) (arguing that game theory explains how laws affect behavior); Ian Ayres, Three Approaches to Modeling Corporate Games: Some Observations, 60 U. CQN. L. REv. 419 (1991); Eric Talley, InterdisciplinaryGap Filling: Game Theory and the Law, 22L. & Soc. INQUIRY 1055 (1997). 3. This criticism is often