The Legal-Economic Nexus from the Perspective of New Institutional Economists and Original Institutional Economists

Abstract:

There are two institutional economics approaches to law and economics. New institutional economists prescribe that arbitrators foster efficiency in setting economic disputes and original institutional economists focus on creating reasonable values – that is, balancing efficiency and justice. Disequilibrium between desired efficiency and perceived fairness triggers agency and is a source of coevolution of law and economics.

Keywords::

• collective decision-making
• institutional and evolutionary economics
• law and economics

JEL Classification Codes::

• B25
• D70
• K00
• L14

Herbert Liebhafsky (1987, 1811, 1819-1820, 1832) qualifies the evolutionary idea of law as a promising alternative to static conceptions of law. Scholars of the evolutionary approach in John Commons’s original-institutional-economics tradition argue that judges should create reasonable values, while scholars of static approaches argue that judges should employ wealth maximization as an ethical imperative, foster equality of concern and respect, or restrict themselves to deductive reasoning.

Liebhafsky (1987, 1829) mentions the Coase theorem as one of the static approaches to law and economics. I elaborate on Ronald Coase’s new institutional economics (NIE) approach in contrast to the original institutional economics (OIE) approach to law and economics.¹ I argue that collective decision-making may result in harming some and benefitting other stakeholders. All stakeholders have to conform to institutional changes, if they like it or not. Perceived unfairness by some and greed by others constitute a source of permanent coevolution of law and economics.

The NIE Approach

NIE economists are largely led by what Liebhafsky (1987, 1810-1811) qualifies as a “First Principle.” Namely, they restate the first principle of the divine order to pursue “true and substantial happiness” in the instruction to maximize wealth. They say that wealth is maximized if resources are efficiently allocated. The allocation of resources is most efficient if resources are allocated in the governance structure at the lowest transaction costs. Governance structures range from markets through firms to public governance. Transaction costs are costs that are involved in “addressing bounded rationality and potential opportunistic behavior, that is, ‘self-interest-seeking with guile’” (Spithoven 2012, 430). Public governance is assumed to be efficient in providing desired goods and services that are not provided by other governance structures (Spithoven 2012, 430, 434). Within governance structures, there are differences in efficiency that induce competition. NIE economists consider judges (and other arbitrators) to be subservient to the efficient allocation of resources in economic disputes.

The Coase Theorem

Coase argued that, if there are no transaction costs, the outcome of bargaining about reciprocal social costs is a maximization of total output. Reciprocal costs are costs that would accrue on damaging agents should they try to harm somebody else (Champeyrache 2013). If maximizing people freely exchange well-defined property rights, then bargaining about reciprocal social costs will not influence the allocation of resources. It will, however, redistribute income, regardless of the law or what judges rule (Cooter 1982, 15-16). In other words, the law is neutral. The neutrality of the law is an abstraction of Coase’s analysis of the allocation of reciprocal social cost and has been called the Coase theorem (Champeyrache 2013). As long as transaction costs are lower than the gains of bargaining about reciprocal social costs, people may bargain at a second-best efficient output. In either case, consumers’ willingness to buy and producers’ willingness to sell at given prices results in a Pareto optimal externality (Samuels 1991, 283).

Things change if transaction costs exceed the gains from bargaining (Coase 1960, 15-18). Then it is the decision of legislators, judges, or other arbitrators that determines if the outcome is efficient or not. According to some scholars, an inefficient ruling might be avoided by applying the Coase theorem which “suggests that the role of law is to assign entitlements to the party who values them the most so that the costly process of exchanging the entitlement is unnecessary” (Cooter 1982, 18). The willingness to pay represents the individual utility function and is a function of distributions of income (Liebhafsky 1987, 1815-1816).

Criticisms of the NIE Approach to Law and Economics

The judge and economist Richard Posner (2011, S33) criticizes the economist Coase for not being rigorous enough in his methodology. Coase relied on case studies rather more than on econometric analyses. Posner adopts Coase’s efficiency criterion, but he has a more demanding approach through his belief that efficiency – and hence wealth maximization – is an ethical imperative and scientific concept. Posner defines wealth maximization as the realized consumer and producer surplus at the bargained equilibrium price (Liebhafsky 1987, 1811, 1815-1816), while Coase (1960, 5, 29) equates wealth maximization with gross national product (GNP).

The Coase theorem is based on a rather optimistic view. Its supporters assume cooperative behavior and fully informed people. However, people might be badly informed about the truthfulness of provided information and consequently they may “miscalculate and fail to anticipate the moves that others will make” (Cooter 1982, 20). Thus, cooperative outcomes might be obstructed by lack of rules for dividing the surplus. People also may decide to defect. They may decide not to bargain about reciprocal social costs, but to stick to their claims instead. If people choose to defect, then a third party might foster efficiency by restricting “the threats which the [non-cooperating] parties can make to each other” (Cooter 1982, 18-19). Regulation, Pigovian taxation (i.e., taxation of negative externalities), punishment of violence against property and persons, or assigning “liability to the party whose lack of precaution is most destructive” might enhance efficiency (Cooter 1982, 19). Such a third party intervention is known as the Hobbes theorem. The Hobbes theorem ignores the possibility that bargainers may lower their demands in order to increase the probability of an agreement. Regardless of their errors, both the Coase theorem and the Hobbes theorem are “illuminating falsehoods because they offer a guide to structure law in the interest of efficiency” (Cooter 1982, 28).

In addition to Robert Cooter’s criticism that the Coase theorem ignores the possibility that rational people may defect, some of the deficiencies of Coase’s approach are the following:

1. Judges cannot determine which allocation of resources is efficient because of the lack of appropriate market prices. For determining the efficient allocation of resources, judges have to refer to “prices of ‘similar’ goods in ‘similar’ situations in other places or times” (Cachanosky 2011, 68).

2. The theorem is falsified by tests of endowment effects – that is, people’s valuations are related to ownership. Because of the loss of aversion, the willingness to pay does not equal the willingness to accept (Kahneman, Knetsch and Thaler 1990).

3. The theorem is at odds with the assumption of original institutional economists that the economy and the law “are jointly produced – not independently given, not merely interacting” (Samuels 1989, 1567, emphasis original).

The OIE Approach

OIE economists assume that individuals are socialized beings, whose cooperation is enabled by institutions. Institutions not only “act to direct and define the aims and end of conduct” (Commons 1990, xx, 6), but also influence individual preferences (Veblen 1909, 629). Furthermore, institutions determine who will receive social recognition, who will get which payment, and who will have which privileges, immunities, power, freedom, liberties, duties and exposures (Samuels 1971, 444; 1973, 536). As such, institutions (among which, laws, regulations and rules) influence cooperation, distribution of income and wealth, and economic outcomes. In turn, the latter influence institutions (Samuels 1971, 435). In other words, institutions evolve in response to a trait in economics (for example, the growth rate), and that trait evolves in response to the features of institutions that are “necessary to maintain justice and prevent infringements of the right of property” (Samuels, Johnson and Perry 2011, 196). The coevolution of institutions and economics interacts with technology and social and ethical changes (Commons 1990, 719).²

Economic behavior of private organizations and individuals is supposed to be a function of multiple causations which are woven together by “Scarcity, Efficiency, Futurity, the Working Rules of Collective Action, and Sovereignty” (Commons 1990, 71). Efficiency concerns rationing of production factors, while scarcity is “distinguishable as power over others” (Commons 1990, 302).³ Power includes “the right to exclude others and to withhold from them what they want but do not own” (Commons 1990, 302).⁴ An unequal distribution of power to withhold supply and to acquire the goods and services one wants, market manipulation, and leverage of market power might generate outcomes like monopolistic profits or wages that are perceived as unjust or unreasonable. Therefore, competition on efficiency may end in various distributive results (Cooter and Ulen 2012, 110; Samuels 1991, 283-284), not all of which necessarily generate sustainable economic growth, “full and steady employment” (Commons 1990, 805), healthcare for those who need it most, and a society without systemic fraud (Spithoven 2017, 690). Competition for efficiency may result in an allocation of resources that, next to life threatening pollution, puts the chronically poor “at risk of premature death” (Samuels, Johnson and Perry 2011, 250, 265).

Adjudicators are assumed, first, to assess the fairness of prices, salaries, interests, remunerations, and profits, and, second, to rule on their reasonableness. Unfair distributions that are generated in bargaining and managerial transactions might be addressed by public rationing. Rationing concerns judicial decisions, logrolling, dictatorship, and all that is associated with control of output, cooperation, collective bargaining, and taxation. All these factors affect income, wealth distribution, and purchasing power (Uni 2017a, ix; 2017b 3, 15, 19-20).

The Role of Governments

According to the OIE economists in the tradition of Commons, governments are entitled to make “fundamental decisions about the socioeconomic order” (Samuels 1973, 535) and to develop institutions accordingly. By contrast, Thorstein Veblen ([1904] 1978, 284-285) mistrusted governments to set public goals. Veblen qualified governments as vehicles of the ruling class. In other words, vested interests could influence lawmakers by lobbying legislators, financially supporting their campaigns, or by executing specific media campaigns (Brown 2013, 215, 217; Veblen [1904] 1978, 285-286). As such, they indirectly influence institutions. Veblen’s skepticism is a reminder to stay critical about the guiding role of governments.

Governments consist of formally separated legislative, executive, and judicial branches of power. Legislators and executives have the responsibility to govern as well as a duty to act, which implies a responsibility to find compromises between different wings of parties or between parties. They have a composite decision-making right that also involves accountability. Judges have an answerable authoritative decision-making power and, with their interpretation of laws and regulations, they establish what the laws and regulations are (Solo 1974, 37). Consequently, judges are – in a material sense – also involved in lawmaking.

Additionally, one might argue that the separation of the three branches of government in the United States – and in line with this democratic decision-making – are under pressure. This argument is based, among other things, on the idea that the judiciary cannot rely on the Constitution for interpreting highly ideologically contested economic issues in Congress. Namely, the Constitution lacks an economic theory (Brief of Constitutional Law January 12, 2012; Liebhafsky 1987, 1826-1827). Therefore, judges have to rely on their own reasoning for rulings regarding highly ideologically contested economic issues. Because their reasoning might be ideologically biased, the judiciary is at risk of politicizing an issue. In order to avoid an infringement on the rule of law, the judiciary should be reluctant to grant review to plaintiffs concerning ideologically contested issues, and legislators and executives should abstain from commenting on pending lawsuits or from filing briefs.

From the perspective of Veblen-Ayres-Foster’s instrumental value paradigm, social goals “cannot be found in the subjective mindset of individuals ...[,] but are instead to be [scientifically] investigated” (Ramstad 1989, 762, 766, emphasis original). However, this is not without problems. Social scientists are biased as well. The contesting briefs in Obamacare lawsuits indicate this. A group of economists – among whom the Nobel laureates Kenneth Arrow, George Akerlof, Eric Maskin, and Peter Diamond – filed briefs that supported the 2010 health care reform (Brief of Amici Curiae January 12, 2012), while other economists (among whom the Nobel laureates Vernon Smit and Edward Prescott) filed briefs that opposed the reform (Brief for Amici Curiae February 13, 2012). The variety of schools in economics “represents a social reality that ought to be taken into account when various interests and instrumental theories are constructed” (Brenner-Golomb 2011, personal communication).

Theory of Reasonable Values

Commons’s (1990, 4, 715-716) “participation in collective action, in drafting bills,” and the associated study of rulings of the U.S. Supreme Court resulted in a common-law notion of reasonable value. Courts approach precedents by a method of “exclusion or inclusion.” Courts and other arbitrators have to assess if bargaining, managerial or rationing transactions meet the criteria of reasonableness: that is, if they meet precedents or current working rules (custom, precedent, statute, by-law, constitution and habitual assumptions) (Commons 1990, 704). They must consider the power of transaction partners and establish whether the contracting partners are adequately informed. According to Commons (1990, 763), the creation of reasonable “value is not intellectual or rational – it is the valuations of stupidity, passion and ignorance, and the dominant collective action that controls individual action … In any case the dominant institutions decide by collective action what is reasonable, regardless what individuals think.”

Adjudicators built reasonable values on a due weighing of “future effects of present acts” (Commons 1990, 826) and of all interests. Reasonableness is a matter of justice and judgment (1990, 826): that is, weighing relevant facts, opinions and experiences of experts and representatives of commoners and the privileged (i.e., vested interests) (Commons and Andrews 1967, 443). Consequently, reasonable values do not constitute absolute entities, but historic data (Commons 1990, 682). They “are artificial, collective, transitory, [and] forfeitable” (Commons 1990, 703), and reflect the social and economic goals governments aims to realize – inter alia, what type of society one aspires to actualize (Vatn 2005, 160). In essence, they balance desired efficiency and fair distribution (Commons 1990, 682). If macroeconomic issues are involved, reasonableness of laws and regulations is subject to the authority of democratic institutions. In the United States, laws are also subject to constitutional review.

Legislators, executives, and judges might be ideologically biased. Nevertheless, the method of creating reasonable values might offer a reasonable path to go. People may balance efficiency and notions of the fair distribution of income through discourse and communication. People cannot achieve it individually (Heyes 2017, 8). A reasonable distribution might imply, inter alia, “equality of treatment in matters of taxation” (Commons 1990, 651-652). Governments also may differentiate between sources of income (labor, wealth, capital) and opt for progressive or regressive taxation, in which case reasonableness is influenced by the judgment of future effects (Commons 1990, 696).

Collective Decision-Making

Arbitrators create reasonable values through reasonable practices or working rules, inter alia, the custom of recognizing the authority of the courts and preceding judicial rulings or decisions (Commons 1990, 704, 742), as well as aggregation, position, boundary, payoff, and information rules (Ostrom 2005, 186-210). Working rules “govern the distribution of power, and the distribution and exercise of power govern the development of the working rules” (Samuels 1973, 536, emphasis original). The type of working rules influences the process of what/whom is given priority. For example, given that court rulings are decided by majority voting, a highly ideologically contested law filed in Congress by Democrats is more likely to be upheld in the Supreme Court of the United States with a 5-to-4 Republican majority than with a 6-to-3 Republican majority. At a 5-to-4 majority, only one (modest) Republican judge has to shift votes. Consequently, not only working rules, but also the personalities on the bench of decision boards like the Supreme Court determine the creation of reasonable values (Commons 1990, 684).⁵ Therefore, the direction of socio-economic development is not predetermined (Gellner 1988, 3), but may change its path with a change in the ideological color of Congress or the ideological background of the judges.

In order to settle a reasonable solution by a majority rule or otherwise, consulting all parties that are involved in a conflict may strengthen cooperation and trust. Eventually, everybody “must conform under similar circumstances” to decisions by adjudicators (Commons 1990, 683) regardless of whether they like it or not. It might be a source of a new conflict when a board makes a decision, even if it was unanimous, or a force of re-identification for members of society. Not all stakeholders, who are represented by contesting decision-makers, have to support the decision wholeheartedly.

Conclusion

According to NIE economists, bargaining about reciprocal social costs results in an efficient outcome so long as benefits are higher than transaction costs. However, if transaction costs are higher than benefits, then law matters, and lawmakers and judges should act to minimize transaction costs. Because the available reference prices are disequilibrium prices, intervention by judges resemble income distribution mechanisms.

Conversely, OIE economists approach the law and the economy as a function of each other. The price mechanism may foster efficiency, but does not necessarily result in a fair income distribution. Fairness may require the creation of reasonable values. The essence of reasonable values is to find a balance between efficiency and a fair distribution of income. It requires balancing interests – inter alia, through consulting all stakeholders – and an assessment and interpretation of laws and their application. However, collective decision-making might become ideologically biased and institutional changes could harm some, while benefitting other stakeholders. Absolutely or relatively deprived stakeholders would perceive the outcome as unfair and benefitting stakeholders may think that the change lags far behind what is desired to achieve efficiency. The persistence of disequilibrium between desired efficiency and fair distribution of income (and wealth) may result in a coevolution of the law and economics.

Additional information

Notes on contributors

Antoon Spithoven

Antoon Spithoven is a research fellow at the Tjalling C. Koopmans Institute of the Utrecht University School of Economics (Netherlands). The author wishes to thank Johan den Hertog, Fatme Myuhtar-May, and Timothy Wunder for their constructive comments. The usual disclaimer applies.

Notes

¹ The difference between the NIE and OIE approaches has some points of similarity with the division between the Chicago school and the Yale school of law and economics. The Chicago approach places neoclassically oriented economics at the center of the analysis of law, and the Yale approach proclaims that the law shapes social values, hence economics may benefit from the law (Calabresi 2016). However, each of these approaches is far richer and more nuanced than I can afford to discuss in the limited space I have in this article.

² Commons distinguished technology and institutions, while others have included technology in the definition of institutions (Waller 1982, 762). Commons placed “the technological function in managerial transactions” (Atkinson and Reed 1990, 1098).

³ Agents are legally considered equal in bargaining transactions. However, if they are economically unequal, then scarcity might be addressed by coercion. If they are economically equal, then scarcity is addressed by persuasion (Commons 1990, 64). This statement should be nuanced. In addition, countervailing powers engage in successful lobbying (Spithoven 2016).

⁴ The inverse of selling power is purchasing power (Commons 1990, 128), which is the power to acquire what one wants but does not have.

⁵ New cases, presenting old assumptions in new light, and changes in economic or political conditions also influence the opinions of supreme courts (Commons 1990, 699).