Business Law

Ali Siddique Sb
By:- Muhammad usman
Roll:- 54
Semester 3rd
BS Economics and Finance

Theory of Law and Economics

Law and Economics

The law and economics movement applies economic theory and method to the
practice of law. It asserts that the tools of economic reasoning offer the best possibility for
justified and consistent legal practice. It is arguably one of the dominant theories of
jurisprudence. The law and economics movement offers a general theory of law as well as
conceptual tools for the clarification and improvement of its practices. The general theory is that
law is best viewed as a social tool that promotes economic efficiency, that economic analysis
and efficiency as an ideal can guide legal practice. It also considers how legislation should be
used to improve market conditions in return. Law and economics offers a framework with which
to model legal outcomes, and common objectives with which to unify disparate areas of legal
activity. The bringing together of legal theory and economic reasoning has also created new
research agendas in the fields of behavioral economics: how rationality affects people's behavior
within legal scenarios; public choice theory and how collective behavior should have an effect on
legislation; and game theory : understanding strategic action in a legal context.

Table of Contents

1. Law as an Autonomous Practice

2. Law as a Tool to Encourage Economic Efficiency
1. Basic Concepts in Economic Reasoning
2. How Law Can Encourage Economic Efficiency
3. Can All Law be Explained as Economic in Nature?
 3. Economics and Normative Jurisprudence
4. Later Developments
1. Behavioral Economics and Law
2. Game Theory
3. Public Choice Theory
5. References and Further Reading

1. Law as an Autonomous Practice

Most traditional theories of jurisprudence look to uncover the essential or definitive aspects of
the institution of law. Two of the most influential are Legal Positivism and Dworkin’s Law as
Integrity. While these two differ as to their definition of law and legal reasoning, they agree upon
some basic central assumptions, determining the conclusions that two philosophical
investigations with largely the same aims, can reach. Because of this it is important to
acknowledge some of the assumptions that are held in common by these jurisprudential stances.

First, both theories agree upon the conceptual nature of jurisprudence. Both agree that it is
important for a philosophical theory of law to define the core aspects of proper legal practice in
order to fulfill the function of philosophical jurisprudence. In fact, much philosophical discussion
of law assumes that such a characterization is the essential aim of jurisprudence. Second in order
to arrive at a properly analyzed concept of law, both legal positivism and law as integrity are best
constructed from specific techniques of analytic and linguistic philosophy. These techniques
include the investigation and clarification of the way people commonly speak about law and
careful parsing of social practice that separate the legal from the non-legal. The third common
assumption is that the best way to understand legal practice is to understand the necessary and
sufficient qualities that make some rule or statement into a law. Once such a set of necessary and
sufficient conditions is identified (or approximated) it is thought that the essential aspects of
particularly legal practices have been understood.

2. Law as a Tool to Encourage Economic Efficiency

So, instead of looking for the unique and defining features of law, the practitioner of law and
economics looks at law as a social tool and tries to evaluate it functionally. What is emphasized
is not its uniqueness as an institution, but its place within the general and common economic
structure of society. The descriptive claim most often associated with law and economics is that
legal practices are best characterized as tools for encouraging economically efficient social
relations. To understand this claim it is important to examine some of the basic concepts used in
models of economic reasoning.

a. Basic Concepts in Economic Reasoning

Essential to an understanding of the law and economics movement is a set of fundamental

concepts. The most central assumption in economics is that human beings are rational
maximizers of their individual satisfactions, and, in turn, respond to incentives. A rational
maximizer of personal satisfaction adjusts means to ends in the most efficient way possible. It is
important to realize that economics, as understood here, is not restricted to analysis of monetary
issues; there are nonmonetary as well as monetary satisfactions. Every potential satisfaction is
implicated in the calculus of economic satisfactions and therefore can be investigated according
to economic or means-end rationality and the trade-off of costs and benefits. Normally what is
aimed at through economic reasoning is the improvement of efficiency.

b. How Law Can Encourage Economic Efficiency

The law and economics movement claims that law is best understood as a tool to promote
economic efficiency. But how can the institution of law help encourage efficient transactions?
One way is to help avoid situations that lead to market failure. One example of market failure is
the existence of monopolies: a situation where one party is able to extract more profit from a
good than a healthy market would allow. Law can be used as a tool to ensure that monopoly
situations are hard to bring about and maintain. Another way legal systems can be used to ensure
economically efficient transactions is through the enforcement of valid contracts. By ensuring
compliance with contractual terms courts can give parties to a contract confidence that the other
party will fulfill the agreed-to obligations. This becomes especially important in situations where
the parties must complete their obligations at different times.

c. Can All Law be Explained as Economic in Nature?

It may be no real surprise that law often is used to encourage efficient exchanges. But it seems a
stretch to claim that law as an institution is best completely described in economic terms. It
seems counterintuitive to view all law as based upon market principles. What the economic
analysis of law manages, though , is to see such disparate areas as contract, tort and criminal law
as all based upon economic aims, therefore giving law a more coherent basis than other theories
can offer. Richard Posner argues that tort cases - those involving private harm - can be seen as
contractual by looking for the hypothetical terms that the parties to an accident would have
agreed to in advance in order to bring about the accident voluntarily. Also that criminals are
deterred by the threat of punishment only if the likelihood of punishment multiplied by the
quantity of punishment exceeds the gain offered by the criminal act. Scholars have been quite
effective in extending the tools of economic analysis into areas that seem to be anything but
economic in nature. Even rules of evidence and legal ethics have proved amenable to economic
analysis. However, it may be argued that an economic explanation of law fails on two counts.
Firstly as a descriptive analysis it doesn’t do justice to everyday legal conceptions. Secondly as
an analytical analysis of the necessary conditions for the practice of law it may not be able to
account for the internal point of view which Hart thought so central to a proper understanding of
law. More analytical approaches to economic explanation of law have considered this a fatal
flaw in the project (see Coleman 2001). This may be mistakenly importing traditional
philosophical aims into a drastically different project, but the truth is that it is often hard to tell
what types of theoretical claims are being made within law and economics. If the claims are of
exhaustive descriptive accuracy or of the necessary and sufficient conceptual foundations of law
then it is more than likely a failure. But whether or not law and economics is an accurate or even
conceptually necessary description of law as a social institution, and whether or not it suffices as
a complete analysis of law, it could be argued that law should in any case adopt economic
efficiency as the central aim guiding judicial decision-making.
3. Economics and Normative Jurisprudence

Though analytically incomplete, economic analysis models the actual results of legal institutions
better than any other theory. This does not entail, however, that law ought to be consciously used
for such an aim. Might not law be better used to consider issues related to justice, duty and the
like? Advocates of law and economics have argued against such a conclusion. The arguments
usually are of two types. First, it is claimed that meanings of words such as justice or duty are so
vague and in dispute that the use of such concepts for a basis of judicial decisions offers no
guidance whatsoever. It is argued that while such concepts are unhelpfully complex, the tools of
economic analysis and the concept of economic efficiency are sufficiently clear to provide the
judge a solid and predictable basis of decision. Law is better able to decide according to
efficiency rather than justice or duty due to limitations of institutional competence. This might be
so if issues of justice are so complex as to involve information that courts are structurally unable
to process. Second, it has been argued that because the paradigm case of justice is the freely
entered in to contract, law is best seen as a tool to optimize contractual arrangements. If this is
so, then where law can help is in situations where transaction costs are so high as to prohibit
efficient contractual relationships. Here Posner argues that law can encourage economic
efficiency by assigning property rights to those parties who would have secured them through
market exchange if transaction costs were lower. In other words law should bring about
allocations that mimic the results of a properly functioning market. In addition, advocates of
economic analysis of law make a claim that other jurisprudential traditions seem to be unable to:
that the analytic tools offered by law and economics has encouraged the further creation of other
productive areas for analyzing law (see Posner 1998).

4. Later Developments

Another argument for the fertility of the economic analysis of law is that it has spawned a
number of further tools that seem helpful in understanding legal institutions. Three of the most
important of these are the results of behavioral economics, game theory and public choice theory.

a. Behavioral Economics and Law

Practitioners of behavioral law and economics examine human limits to means-end rationality.
One of the outcomes of behavioral economics is the concept of bounded rationality. Bounded
rationality means that information is not processed according to a model of perfect means-end
rationality but, to the contrary, is distorted due to limits of our cognitive abilities. For instance
the endowment effect is thought to be a behavioral limit that distorts the proper valuation of
property, an important aspect of bargaining to efficient outcomes. According to the effect, the
ownership of objects creates an irrational cognitive overvaluation of them. Another claim is that
our cognitive abilities are distorted by the availability heuristic. According to this the availability
of strong imagery may induce us to over or underestimate the actual probability of events
associated with the image. For instance, graphic representations of highly improbable harms
might be more influential on behavior and demand unjustified use of resources than statistical
analysis showing another equally undesirable harm to be more common and easier to avoid.
Jurisprudential practices could be significantly influenced by such results. For instance, judges
might be as irrationally influenced by the availability heuristic as other human beings. Therefore
victim impact statements might be important correctives to proceedings if a well-presented
defendant’s presence in the court skews judge or jury's decisions. An awareness of such a
cognitive failure could help adjust legal reasoning and its conclusions accordingly. Finally, an
awareness and exploitation of universal cognitive limits might help legislators to design more
effective laws (see Sunstein 2000).

b. Game Theory

Game theory adds to economic modeling the phenomenon of strategic action. Strategic actions
are those adopted because of the competitive nature of many social transactions. They are
adopted due to how one individual expects another to act in response. For example, a person who
wishes to buy an item cheap would act disinterested so as not to signal his or her actual desires to
the seller. Addition of analytic tools dealing with strategic action greatly strengthens the
economic analysis of law. For instance, the Coase theorem, to function properly, necessarily
excludes strategic action; cooperation is just assumed. But it seems apparent that legal actions
often are deeply implicated in and animated by strategic motives. Common sense tells us that full
open cooperation is not always the best path to bringing about one’s desired results. In fact much
of the bargaining invested in designing an effective contract seems to be done in the shadow of
potential strategic action on the part of the contracting parties. Designing legal rules with an eye
to the possibility of strategic action helps ensure that the rules will not create perverse outcomes.
For instance, if a defendant’s privilege against self-incrimination could also encourage an
inference of guilt from the silence the privilege would be all but useless. Therefore, courts have
not only barred comment on the refusal to testify but also have required that juries, on
defendant’s request, make no inference from such a choice (see Baird et al 1994). Further, the
understanding that legislators might have adopted specific wording for a law based upon
strategic motives may help direct the proper aims of judicial interpretation. This type of claim,
though, is often better analyzed by the tools offered in public choice theory.

c. Public Choice Theory

Public choice theory is centered upon how the nature of the legislative process and collective
decision making influence the nature of law. It is the application of economic models of
decision-making and their results to the issues that traditionally occupy political science, for
example Arrow's Theorem. One claim made within public choice theory is that a proper
understanding of collective decision processes will help judges understand their position within
the system. If all collective decisions are unavoidably influenced by those who get to frame the
questions debated and the order of voting - the agenda-setters - public legislation will need to be
interpreted differently than if it were a more neutral recording of collective wishes. Such a
theoretical result makes problematic a court’s reference to the intent of the legislature.

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