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The Erroneous Foundations of Law and Economics† Mark Glick* and Gabriel A. Lozada

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The Erroneous Foundations of Law and Economics† Mark Glick* and Gabriel A. Lozada The Erroneous Foundations of Law and Economics† Mark Glick* and Gabriel A. Lozada** Working Paper No. 149 February 15th, 2021 ABSTRACT The fundamental originating principle of law and economics (L&E) is that legal decisions should be (and are) based on maximizing efficiency. But L&E proponents do not define “efficiency” in the way agreed to by most economists, as Pareto Efficiency. A Pareto optimal condition is obtained when no one can be made better off without making someone worse off. Pareto Improvements are win-win changes where no losers exist. In the judicial system, however, there are always winners and losers, because under Article III § 2 of the Constitution a legal case does not exist unless there is a justiciable “case or controversy” in need of resolution. Unable to use Pareto Efficiency, L&E scholars have been forced to adopt alternative definitions of efficiency. Most L&E scholars claim to define “efficiency” based on the work of Kaldor and Hicks, but (perhaps unwittingly) instead use a definition of “efficiency” derived from the 19th century idea of consumer surplus, which encompasses L&E notions such as “wealth maximization,” and “consumer welfare” in antitrust. Neither of these alternative definitions is viable, however. Outside of L&E, the Kaldor-Hicks approach has long been recognized to be riddled with logical inconsistencies and ethical failures, and the surplus approach is even more deficient. † The authors acknowledge support from the Institute for New Economic Thinking and would like to thank David Mangum and Thomas Ferguson for their helpful comments. * Professor of Economics, University of Utah. ** Associate Professor of Economics, University of Utah Remarkably, virtually none of the numerous L&E textbooks even hint at such problems. Critically, all definitions of efficiency improvements in economics are biased in favor of wealthy individuals or firms, either because they are dependent on the status quo ante distribution of assets, or because they bestow large advantages on parties with political influence or who can afford to bring lawsuits quickly. Many L&E practitioners treat efficiency improvements instead as being objectively good, an error revealing that L&E is primarily motivated by its neoliberal policy agenda. https://doi.org/10.36687/inetwp149 JEL codes: K1, D61, L4 Key words: law and economics, antitrust economics, efficiency, wealth maximization, legal realism, neoliberal theory, Kaldor Hicks, Pareto Optimality 2 Table of Contents I. INTRODUCTION ........................................................................................................................................ 5 II. NEOLIBERALISM AND THE ORIGINS OF LAW AND ECONOMICS ................................................................. 6 A. THE GREAT DEPRESSION BRINGS AN END TO LAISSEZ-FAIRE ECONOMIC POLICY ............................................................ 7 B. NEOLIBERALISM AND ITS “FREEDOM” NARRATIVE EMERGE AS A RESPONSE TO THE NEW DEAL CONSENSUS ....................... 8 C. LAW AND ECONOMICS FINDS A HOME AND FUNDING ............................................................................................ 13 D. LAW & ECONOMICS ADVANCES THE MODERN NEOLIBERAL AGENDA ........................................................................ 14 III. PARETO EFFICIENCY: THE REALM OF CONSENSUS ............................................................................... 16 A. THE BEGINNINGS OF UTILITY THEORY ................................................................................................................. 16 B. UTILITY: CARDINAL AND ORDINAL ...................................................................................................................... 17 C. ECONOMIC EFFICIENCY IS PARETO EFFICIENCY ...................................................................................................... 19 D. PARETO EFFICIENCY REQUIRES DISTRIBUTIVE EFFICIENCY ........................................................................................ 20 E. PARETO EFFICIENCY REQUIRES PRODUCTIVE EFFICIENCY ......................................................................................... 23 F. PARETO EFFICIENCY REQUIRES ALLOCATIVE EFFICIENCY .......................................................................................... 23 G. PARETO EFFICIENCY CANNOT BE USED TO ESTABLISH A THEORY OF THE COMMON LAW ............................................... 25 1. Positive Economic Limitations of Pareto Efficiency ............................................................................... 25 2. Normative Problems ............................................................................................................................. 33 IV. THE CRITERIA OF KALDOR AND HICKS: THE REALM OF COERCION ...................................................... 34 A. VALUE’S DUAL NATURE: WILLINGNESS TO PAY/ACCEPT; COMPENSATING/EQUIVALENT VARIATION ............................... 36 1. Settings: Describing Various Policy Changes and the Units in which they are Valued .......................... 36 2. Setting Qq Explained ............................................................................................................................. 38 3. Setting Pi Explained ............................................................................................................................... 40 4. The General Inequality of WATP and WTA ............................................................................................ 45 5. Compensating and Equivalent Variation ............................................................................................... 45 6. Nonexistent WATPs and Infeasible WTAs in Edgeworth Boxes ............................................................. 51 7. Consensual Uses of WATP/WTA/CV ...................................................................................................... 52 B. THE POTENTIAL-PARETO/KALDOR-HICKS/COST-BENEFIT-ANALYSIS CRITERION FOR MAKING COERCIVE SOCIAL DECISIONS 53 C. THE KALDOR TEST (CV MEASURED AS A QUANTITY) .............................................................................................. 56 D. THE HICKS TEST (EV MEASURED AS A QUANTITY) ................................................................................................. 56 E. POSITIVE PROBLEMS WITH CV & EV MEASURED AS QUANTITIES ............................................................................. 57 1. Potential Pareto Moves that Are Not, In Fact, Potentially Pareto Efficient ........................................... 57 2. Incompleteness Due to Inconsistencies and Reversals .......................................................................... 58 3. Incompleteness Due to Nonexistence of WATP or Infeasibility of WTA ................................................ 62 F. NORMATIVE PROBLEMS WITH CV & EV MEASURED AS QUANTITIES ......................................................................... 63 1. Potential Pareto Moves that Are not Potentially Pareto Efficient Moves ............................................. 63 2. Complete Inequality Can Be an Efficient Outcome Under the Kaldor Test ............................................ 64 3. Almost-Complete Inequality Can Be an Efficient Outcome Under the Hicks Test .................................. 65 4. Application of the Kaldor and Hicks Criteria Can Result in Arbitrary Outcomes ................................... 66 G. ECONOMETRICS AND POLITICAL POWER .............................................................................................................. 67 H. POSITIVE ECONOMIC AND NORMATIVE PROBLEMS WITH CV & EV MEASURED IN DOLLARS .......................................... 68 I. WATP JUSTIFIES RESULTS THAT FAVOR THE WEALTHY (POSITIVE THEORY) ................................................................ 71 J. WATP JUSTIFIES RESULTS THAT FAVOR THE WEALTHY (NORMATIVE THEORY) ........................................................... 72 K. THE COMPLETE FAILURE OF POTENTIAL PARETO IN A GENERAL PURE-EXCHANGE ECONOMY ......................................... 73 V. CONSUMER SURPLUS/CONSUMER WELFARE: COERCION, WITH LESS JUSTIFICATION ............................. 78 A. CONSUMER SURPLUS: AN ADVANCE OVER THE EXPENDITURE APPROACH .................................................................. 80 B. CONSUMER SURPLUS IS NOT PART OF WEALTH .................................................................................................... 82 C. CONSUMER SURPLUS IS NOT A CREDIBLE MEASURE OF WELFARE ............................................................................. 84 D. WILLIG’S CLAIM THAT CONSUMER SURPLUS APPROXIMATES EV AND CV DOES NOT SAVE CONSUMER SURPLUS .............. 86 3 E. ANOTHER PROBLEM WITH “WEALTH MAXIMIZATION” ........................................................................................... 88 F. NORMATIVE ISSUES IN USING CONSUMER SURPLUS ............................................................................................... 89 VI. CONCLUSION ..................................................................................................................................... 90 4 I. INTRODUCTION The primary aim of the Law and Economics movement (“L&E”) has been to elevate the notion of economic efficiency as the sole basis of jurisprudence. In economics, there are several definitions of efficiency, all of which are unfortunately biased in favor of currently wealthy individuals, though to different extents. Since the most widely accepted
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