Front Page Titles (by Subject) The Economic Approach to Law - Literature of Liberty, Autumn 1981, vol. 4, No. 3
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The Economic Approach to Law - Leonard P. Liggio, Literature of Liberty, Autumn 1981, vol. 4, No. 3 
Literature of Liberty: A Review of Contemporary Liberal Thought was published first by the Cato Institute (1978-1979) and later by the Institute for Humane Studies (1980-1982) under the editorial direction of Leonard P. Liggio.
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The Economic Approach to Law
“Efficiency, Exchange, and Auction: Philosophic Aspects of the Economic Approach to Law.” California Law Review 68(March 1980):221:249.
The approach termed “law and economics” is widely influential in American law schools today. “Law and economics” applies the techniques of modern welfare economics to legal problems. This approach can be either descriptive or normative: by using economic techniques, we can explain legal institutions, or we can assert that economic criteria ought to be used to reform existing practices.
Probably the most important proposition of law and economics now is “Coase's Theorem.” Suppose that a farmer and a rancher are neighbors. The rancher wants to add an additional cow to his stock. This will impose some cost on the farmer, since a roaming cow will damage his crops. One might at first think that whether a cow will be added to the rancher's stock will depend on what property rights the two parties have. Perhaps surprisingly, R.H. Coase has been able to show that, under certain assumptions, the maximum productive use of resources does not depend on the initial assignment of rights. The two parties will bargain until the one who values the disputed claim more obtains it. Initial assignment of rights can affect the relative wealth of the competing parties, however.
George Fletcher has argued that Coase's Theorem does not insure that a “Pareto Optimal” outcome will result from negotiations. (A Pareto Optimal outcome is one in which resources cannot be shifted from one person to another without making at least one person worse off. A Pareto superior position is one in which one can make at least one person better off without making anyone else worse off.) Fletcher argues that Coase's Theorem will insure position. Allocative efficiency is achieved because it is assumed by the theorum that the parties want to maximize wealth.
Coase's Theorem leads to a different approach to externalities from that advocated by A.C. Pigou, the founder of classical welfare economics. An externality is an effect of one's production on someone else that leads to a welfare loss. Suppose, for example, that smoke from a factory pollutes the air of the surrounding neighborhood. Pigou's solution was to tax the factory, thus making it absorb the cost of the pollution. Coase's solution is to let the affected parties bargain. Although Coase's Theorem uses a confused notion of causation, this does not affect the practical value of his results. In some cases, Pigou's approach leads to an inefficient outcome.
If the market cannot assign property rights, how should they be allocated? One of the most important proponents of the law and economics approach, Richard Posner, favors an auction rule. According to this rule, one assigns the property right to the party who would have obtained it if there had been a market transaction. In other words, we should mimic the market. It is argued that Posner's rule derives from the Kaldor-Hicks concept of efficiency. According to it, a distribution in which some gain at the expense of others is efficient if the winners could compensate the losers. Note that they are not required to actually do so; the Kaldor-Hicks requirements are satisfied if they could do so.
Why is Posner's auction rule desirable? In actual market transactions, the winners actually have to buy out the losers. Why should property be awarded to those who would have won out in a market, without requiring that they pay compensation? Posner's rule guarantees neither a Pareto optimal nor a Pareto superior result. On the other hand, it is not clear that one always should compensate the losers.
The complexities discussed above suggest that the law and economics approach does not have a simple solution to the intractable problems of legal theory. Considerations other than economics are important and must be taken into account. Nevertheless, the law and economics school should be taken seriously.