The Economics of Law The Economics of Law Second edition CENTO VELJANOVSKI The Institute of Economic Affairs Second edition published in Great Britain in 2006 by The Institute of Economic Affairs 2 Lord North Street CONTENTS Westminster London SW1P 3LB in association with Profi le Books Ltd First edition published in 1990 by The Institute of Economic Affairs The author 8 Foreword by Geoffrey E. Wood 10 The mission of the Institute of Economic Affairs is to improve public Summary 14 understanding of the fundamental institutions of a free society, by analysing and expounding the role of markets in solving economic and social problems. List of tables, fi gures and boxes 17 Copyright © The Institute of Economic Affairs 1990, 2006 1 Introduction 21 The moral right of the author has been asserted. ‘A harmful disciplinary divide’ 22 The economic approach to law 24 All rights reserved. Without limiting the rights under copyright reserved above, Outline of the book 25 no part of this publication may be reproduced, stored or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written 2 A short history 27 permission of both the copyright owner and the publisher of this book. Disciplinary divides 28 The development of the economic approach 30 A CIP catalogue record for this book is available from the British Library. ISBN-10: 0 255 36561 6 3 Law as an incentive system 44 ISBN-13: 978 0 255 36561 1 Ex post versus ex ante 44 Rent control and all that 47 Many IEA publications are translated into languages other than English or are reprinted. Permission to translate or to reprint should be sought from the Assumption of economic rationality 49 Director General at the address above. Economists do it with models 53 Positive versus normative economics 56 Typeset in Stone by Phoenix Photosetting, Chatham, Kent Empirical analysis 57 www.phoenixphotosetting.co.uk Law without ethics 58 Printed and bound in Great Britain by Hobbs the Printers Summing up 61 Use of cost–benefi t analysis 164 4 The economic approach 62 Market-based alternatives 169 A biblical parable 62 Economics – choice and scarcity 64 8 Concluding remarks 173 Costs and benefi ts 64 Coasian economics 72 Questions for discussion 175 Implications of opportunity cost analysis 74 Further reading 176 5 Some legal applications 78 About the IEA 178 The roles of the economist 78 Personal injury damages 80 The economics of crime 84 Defi ning legal terms 93 6 Competition law 106 The rise of the economic approach 107 Why do we need competition law? 113 Defi ning legal terms 120 Effi ciency: goal, defence or offence? 130 Antitrust and the new economy 133 The danger of ‘nip and tuck’ economics 140 Assessment 141 7 Regulation 143 Models of regulation 145 Regulation as a barrier to competition 151 Adaptive responses to regulation 152 Economics of legal rules 155 the author Journal of Network Industries and Journal des Economistes et des Etudes Humaines, and the advisory committees of the Erasmus THE AUTHOR Programme in Law and Economics, Centre for the Study of the New Institutional Economics (University of Saarland), and the Centre for Law and Economics (Australian National University). Dr Cento Veljanovski is Managing Partner of Case Associates, IEA Fellow in Law & Economics, and an Associate Research Fellow, Institute of Advanced Legal Studies, University of London. He was previously Research and Editorial Director at the Institute of Economic Affairs (1989–91), Lecturer in Law and Economics, University College London (1984–87), Research Fellow, Centre for Socio-Legal Studies, Oxford (1974–84), and has held academic positions at UK, North American and Australian universities. He holds several degrees in law and economics (BEc, MEc, DPhil), and is an Associate Member of the Chartered Institute of Arbitrators (ACIArb). Dr Veljanovski has been in private practice since 1990, providing economic analysis in regulatory and competition inves- tigations, and has appeared as an expert witness is many court cases on competition and damage claims. He was voted one of the most highly regarded competition economists globally in the 2006 Global Competition Review survey. Dr Veljanovski was the fi rst economist appointed to a lecture- ship in a law department at a British university. He has written many books and articles on industrial economics, economic reform and law and economics, including Selling the State: Privatisation in Britain (1988), The Economic Approach to Law (1982) and Economic Principles of Law (2007). He is a member of the editorial boards of United Kingdom Competition Law Reports, 8 9 foreword catch fi sh. Resources, in other words, are always scarce and deci- sions have to be made about how to allocate them among various FOREWORD activities. In that world there would be no need for law. But give Crusoe a helper – Friday – and immediately law is needed to deal with who can use what. How much is Friday to get for his labours if he is a helper? Or, if he is a neighbour who just happens to fi nd a fi sh Crusoe has caught, is he entitled to fi llet, cook and eat it? When the Editorial and Programme Director of the Institute The moment there is more than one person in the world, effi cient of Economic Affairs asked me to write the foreword to this new resource allocation requires the defi nition and enforcement, even edition of Cento Veljanovski’s The Economics of Law, I accepted his if only by custom, of property rights. To see why, consider again invitation immediately and with great pleasure. A book I had long Crusoe’s fi shing rod versus fi sh decision. If he cannot rely on wanted to see back in print, to benefi t both new generations of getting the share he expects of the fi sh he catches, why should he students and practising lawyers and economists as yet unfamiliar even consider spending effort to improve his fi shing technology? with the area, would soon once again be available. One role, then, of the discipline of law and economics is to Dr Veljanovski’s book was fi rst published in 1990, and a explore whether laws promote economically effi cient outcomes second impression appeared in 1996. Since then there has been and, if they do not, to suggest how they can be changed to do so, little in the area for the British reader. Introductory texts have always provided the cost of the change falls short of the benefi ts. been aimed primarily at the US market, a meaningful concept in To an extent economists view law as, to quote Dr Veljanovski, this context, although not when applied to many other kinds of ‘a giant pricing machine’. This view, he says, ‘leads [economists] textbook – while US and English law have common origins there to a fundamentally different view of law which, while not alien are many differences. Further, these texts have been longer and to lawyers, is not central’. In contrast to that, lawyers, he writes, more detailed than anyone wanting simply a guide to why the see law as ‘a set of rules and procedures’. They take a ‘retrospect- subject is so important, and so interesting, would actually need. ive view’, and begin with a dispute that needs to be resolved. It is This substantially revised edition of The Economics of Law is there- therefore ‘natural that [the lawyer] should focus on the question fore greatly welcome. of how [the dispute] is to be resolved and how the solution affects Why exactly is the subject so important and so interesting? the welfare of the parties directly involved’. Law and economics are almost inevitably intertwined. In a world In Chapter 4, ‘The economic approach’, it is shown very with only one person – Robinson Crusoe – economics would still clearly how this is an apparent rather than a real confl ict. Dr have a role. Crusoe has to decide how much of his time to spend Veljanovski’s demonstration draws on a famous article by Ronald making a better fi shing rod, an activity that delays his going to Coase, which showed that if two parties, each of whom is affected 10 11 the economics of law foreword by an action of the other, can negotiate with each other, then unknown when the rule or regulation was framed. Economics however a court decides in a dispute will not matter in terms of also has a role in comparatively simple matters, showing how, for what actually happens. Negotiation will lead the parties to the example, to calculate appropriate compensation resulting from a least-cost outcome. decision over liability for harm. Dr Veljanovski uses this to illustrate some important proposi- Strikingly, economically effi cient outcomes come not only tions – economics matters not only when fi nancial costs are from the conscious application of economic analysis to the involved: mutual incompatibility not ‘the physical causation of framing of laws; law has in many areas evolved towards producing harm’ is the basis of harmful interactions between activities; the effi cient outcomes. This conclusion, startling to some, was argued law has no allocative effect when transaction costs are trivial; and by Guido Calabrisi in 1967, and then by Richard Posner in a series that when such costs are not trivial the law can have signifi cant of papers and books. More details of these, and of the work of the effects on ‘economic activity and behaviour’. economists who also helped open up the joint study of law and Economic activity and behaviour, it must be emphasised, economics, can be found in Chapter 2 of Dr Veljanovski’s book.