A framework for studying law and economics

The market for transactions and the market for dispute resolution

[I am teaching line economics at The University of Chicago Law School this term. Usually law and economics is taught by applying economic analysis in each of the major common law subjects taught to first year law students: property law, contract law, tort law, criminal law, and civil procedure. When I began teaching the subject, over a decade ago, I felt that students on average needed an introduction to what economic analysis was before they could apply it to the common law subjects. So, I started out the course by teaching a two week crash course in microeconomics, specifically price theory. But I found the transition between economic analysis and the legal topics that we cover to be inadequate. This year, I am going to present the framework below to help students understand the relationship between economic activity and the legal system, and how that relationship explains the legal subjects that I teach in law and economics. If I ever get around to writing a law and economics textbook, I think I will use this framework as a superstructure to organize the book.]

People do not intrinsically value the legal system (legislature and courts combined) or lawyers. These two things are instrumental to producing things that are closer to what people ultimately value. People value things like food, housing, companionship and entertainment. They indirectly value inputs into producing those things. This includes things like seeds and fertilizer for food, bricks and insurance for housing, a community to find friends and mates, and wifi and laptops for entertainment. This should not come as a surprise. But producing consumer goods also requires contracts, legal rules, which require legislatures and courts, which in turn require lawyers. In other words, the legal system and lawyers are an input into the production of goods that our economy demands.

How should we organize our study of law and economics?

To understand in greater detail how the legal system and lawyers factor into production, it helps to consider two types of economic transactions (voluntary and involuntary) and two time periods (before the transaction and after it). This is illustrated in the table below. The legal sector plays different roles based on whether all parties to the transaction voluntarily entered it or whether some parties were forced to participate. It also plays different roles before the transaction (to help people plan for it) and after the transaction (to make up for poor planning or deter involuntary trades).¹

1. Before voluntary transactions

We start from the premise that individuals want to transact over goods, e.g., one person wants to trade money for a product that another person owns. This is basic economic activity. In order to conduct the trade, they need to know who owns what property (e.g., the money, the product), and how the legal system will enforce their trade. For instance, if I promise to pay you Tuesday for a hamburger today, what happens if I don’t pay? Without knowing the answer, it might not make sense for you to make me a burger today. In other words, in order to engage in trade, we need to know property law (which tells us who owns what) and contract law (which tells us how to consummate a contract and the consequences of contract breach). These things could be provided informally by your community, e.g., a handshake is your word. But it is more commonly provided by the legal system. To restate, the legal system sets forth property law and contract law to facilitate economic trade.

Whether a trade occurs depends on whether both parties gain from trade. For example, do I value the hamburger more than you charge for it? Can you produce the burger for less than the price you receive for it? But it also depends on the costs required to complete the trade. These are called transaction costs. They include the cost of my finding your diner, you and agreeing on a price, and the cost of consummating our contract so that it is enforceable by the legal system.

Transactional lawyers help write contracts and are a type of transaction costs. In an ideal world, they do not merely impose costs. Instead they write a legally enforced contract, for a price that is less than the value of the contract. Thus, transactional attorneys indirectly facilitate trade.

Trade occurs when the gains to both parties exceed the transaction costs, including those of formalizing the contract. In some cases, transaction costs may be so great as to prevent trade. In that case, the gains will be lost.²

There are situations where transaction costs (from lawyers) are not so high that a contract does not occur. However, the legal system can facilitate transactions at a lower cost than lawyers. For example, if parties to most contracts want a force majeure clause that absolves parties of their legal obligations if a force of nature prevents performance of contractual duties, then it might be less costly if courts interpret contracts without such clauses as having them. This saves the parties the cost of having a lawyer draft such clauses. This is called a default rule. In most cases, courts set default rules via contract law. But in certain contexts, it does so via tort law (e.g., medical malpractice and products liability law).³

2. Before involuntary transactions

In the last section, we said that, if transaction costs are too high, parties will not voluntarily transaction. However, there are a category of transactions that happen involuntarily, as when one car crashes into another. Because the transaction is involuntary, i.e., not desired by all parties, there is no contract to govern the interaction.⁴

In these cases, the legal system may step into the breach and impose an (unwritten) contract between the parties. One example is tort law, which governs legal responsibilities in the context of an accident. In some cases, the defendant in a tort suit is unable to meet her obligation to pay damages in tort. There the criminal law may enforce penalties that restrict the defendant’s freedom. The purpose of these rules is not merely to provide insurance or retribution for the victim, but to deter the involuntary transaction in the first place.

Lawyers play no role before involuntary transactions for an obvious reason: there is no contract. The involuntary party did not contract, so did not need to hire a lawyer to write a contract. In general, the tortfeasor or criminal, engaging in an involuntary transaction, did not need a contract and thus an attorney either. There are some cases where commercial tortfeasors, e.g., a factory, will engage a lawyer to minimize its tort damages. This is generally an exception to the rule that involuntary transactions do not involve transactional attorneys.

3. After transactions

The roles that the legal system and lawyers play above require action before a transaction. But these actors also play a critical role after a transaction. In a small percentage of voluntary transactions, and in a larger percentage of involuntary transactions, the parties have a dispute. It could be over non-performance of a known obligation or uncertainty over obligations. The primary provider of dispute resolution services are courts. In general, they step in the first time a question over uncertain obligations arises. And legal procedure is the engineering that courts use to resolve disputes. After that, however, courts face competitors. Arbitrators or settlements can follow precedent and resolve disputes without courts.⁵ In many places, courts will respect resolutions via these alternative providers.

Whether a dispute resolution is via courts or alternatives, lawyers play an important role representing the litigants’ interests. Interestingly, lawyers also play a role in deciding how to produce a resolution: via courts, arbitrators or settlement. In part this is via advice on how best to resolve the dispute. But, as we shall see, courts can also force people to settle if their fees to litigate in court or arbitration are sufficiently large.

Summary

To summarize, the legal system and lawyers are an important input into economic trade. The specific role depends on whether trade is voluntary or not and the role differs before and after transactions.

These roles map on the topics covered in a traditional law and economics course. Such a course would cover property law and contract law, then tort law and criminal law, and then civil procedure (i.e., how courts resolve disputes). It might even cover settlement.

My course modifies this a bit. I will talk about the market for transaction costs – i.e., the use of lawyers v. courts to write contracts. I will also discuss dispute resolution after transactions as a market. Here we discuss the competition between courts and alternatives such as settlement. I will talk about the incentive of prosecutors to bring criminal cases.

The framework above also makes an implicit assumption: that the legal system and courts perform their roles well. However, that is not always the case. The legal system may prosecute too few or too many crimes, even in developed countries. And in developing countries, where state capacity is more seriously limited, courts (and police) may be corruptible. In addition, low human capital in the labor force may mean there are not enough lawyers. In these countries, the legal system and lawyers may not facilitate as much trade, and may be a reason the countries are not more developed, a sort of catch-22. This course will also discuss the role of state capacity. However, my law and development course takes on that topic more directly.

1. This is not to say that only transaction costs matter to trade. Even if transaction costs were zero, people would not enter trades in which each party did not gain from the trade. However, there will be times when parties would gain from trade when transaction costs are zero, but do not trade when transactions costs are large. That is the sense in which I say that transaction costs matter to trade. Those costs can make trades infeasible.

2. The Coase Theorem indirectly addresses this problem.

3. In the US, contract default rules can be modified by express writing in a contract. For example, parties who do not want such a force majeure clause can opt out by writing that a force majeure is not an excuse for non-performance. But tort rules cannot in general be waived by parties. However, parties can often buy insurance for tort liability that cannot be waived.

4. Note, a transaction may be expected or intended by one party but not the other. E.g., a factory might knowingly pollute or a criminal may knowingly commit a theft. We classify it as voluntary because the victim did not ex ante consent to the transaction.

5. Settlement is just self-production of dispute resolution by the parties to a litigation.