Law and Economics
Law and Economic Development
Law and Economic Development
Economic Growth. Many Americans saw the stimulation of economic growth as one of the central responsibilities of government. This expectation accounted for the legislative preoccupation with economic regulation, most notably banking issues, and it equally influenced court dockets. Economic development was at the heart of cases that focused on a wide variety of legal issues. The impetus for the Cherokee litigation was the expansion of cotton cultivation through the Southwest; the landmark federalism cases of McCulloch v. Maryland and Gibbons v. Ogden affirmed congressional power to manage the national economy and sought to promote economic competition. A particularly crucial line of cases defined the property interests that courts would recognize. In the Supreme Court these cases centered on the Contract Clause, which barred states from passing any “Law impairing the Obligation of Contracts.” Equally important decisions in the state courts transformed the common law into an instrument for the promotion of economic expansion.
Corporations. Traditionally, people wishing to participate in joint economic enterprises formed partnerships, organizations in which each partner was entitled to a share of managerial authority and each was personally liable for the entire debt of the organization. The corporation, in contrast, was (and still is) a limited-liability organization; each investor risks only the capitol she puts into it. Corporations rapidly became more central to the American economy than to that of any other country. By 1817 there were more corporations chartered in Massachusetts than in all European countries combined. The early stages of industrialization promised the further growth of corporations as vehicles for pooling investments. The authority of state legislatures to alter corporate charters, considered by the Supreme Court in Dartmouth College v. Woodward (1819), therefore had vast economic implications. The Court invalidated the state statutes revising Dartmouth’s corporate charter (granted by King George III in 1769), holding that a private corporation’s charter was a contract and thus protected by the Constitution against impairment by the states. Previously, many courts had regarded all corporations as public institutions subject to direct government control; as one court opinion stated, “it seems difficult to conceive of a corporation established for merely private purposes.” When in Dartmouth College the Supreme Court recognized corporations funded by private capitol as private entities, entitled to the same legal protections as individuals, it was a crucial turning point in the development of American law and American industry. By protecting corporations the Court ensured the security of the legal structure on which the manufacturing firms of New England would soon build.
Bankruptcy. Debtor-creditor relations, an issue of immense practical significance in the aftermath of the Panics of 1819 and 1837, posed some of the most vexatious
constitutional problems of the era. In the capitalhungry and unpredictable American economy, moral condemnation no longer seemed an appropriate response to economic failure. States ceased to imprison debtors and began to pass bankruptcy laws. Bankruptcy allowed a person hopelessly in debt to make a fresh start, having all of his debts discharged by agreeing to a court-approved plan of partial repayment. Such laws pitted creditors’ expectations of full repayment against the public’s interest in encouraging investors to take risks and helping debtors to return to economic productivity. Although authorized by the Constitution to do so, Congress failed to pass bankruptcy legislation, leaving the states to act individually. Ogden v. Saunders (1827), the climax of a series of bankruptcy cases decided by the Supreme Court since 1819, dramatized the depth of disagreement over debtor-creditor relations. When the Court held that the application of state bankruptcy laws did not necessarily violate the Contract Clause, Chief Justice Marshall issued his first (and only) dissent from a Court opinion interpreting the Constitution.
Monopolies. In Dartmouth College the Supreme Court had encouraged investors by making corporations more secure; But by approving bankruptcy legislation in Ogden v. Saunders the Supreme Court encouraged entrepreneurs to take risks that might reduce the security of investors. These two principles, security and risktaking, collided head-on in the great Charles River Bridge v. Warren Bridge decision of 1837. The case involved a claim by stockholders in a toll bridge chartered by Massachusetts to connect Boston with Charlestown. In the forty years following construction of the Charles River Bridge in 1785, the population of Boston roughly tripled, to about 60, 000; the toll bridge, which had involved a total capitol investment of perhaps $70, 000, was annually collecting a tremendous profit of $30, 000 in tolls. These earnings were quickly destroyed, however, when the state chartered the rival Warren Bridge (which charged no tolls after it was paid for), a few hundred feet from the old bridge. The stockholders of the Charles River Bridge claimed that the new bridge violated the implied monopoly granted in their charter. Had the stockholders won, they would have set a precedent that would, in effect, have granted similar monopoly status to other existing bridges, turnpikes, and canals throughout the country and choked off the growth of railroads, new bridges, and other rival forms of transportation. The conflicting property interests deadlocked the Marshall Court, but over a vigorous dissent by Story, new Chief Justice Roger B. Taney forged a majority in favor of the new bridge. Taney emphasized that the charter of the original bridge had not expressly conferred monopoly privileges and maintained that “in grants by the public, nothing passes by implication.” The decision further defined the American conception of the corporate charter, not as a way for government to bestow special favors like monopolies, but as a simple license to conduct business.
Common Law. Less publicized than the Contract Clause decisions of the Supreme Court, but no less significant to economic development, were numerous state-court decisions that defined property rights under the common law. For example, the law of riparian rights (control over a river’s current by an owner of property on the banks) commanded extensive attention, because industrialization depended on the power generated by flowing water. Upon publishing the second volume of his treatise Watercourses in 1833, Joseph K. Angell observed that more riparian-rights cases had been decided since the appearance of the first edition in 1824 than in the entire previous history of Anglo-American common law. Consistent with the demand for economic growth, judges in riparian cases tended to move away from the traditional rule of finding people liable if they interfered with a stream’s “natural flow,” since that would have applied to every owner of a water-powered mill. One alternative approach was “prior appropriation,” under which courts protected the water flow of the first mill owner to build a dam. The triumphant doctrine, however, was the principle of “reasonable use,” under which courts decided whether dams built to aid manufacturing served “the needs and wants of the community.” The new standard, best articulated by Massachusetts chief justice Lemuel Shaw in Cary v. Daniels (1844), avoided the anti-development potential of “natural How” and the monopolistic tendencies of “prior appropriation,” The balancing test of “reasonable use” was a clear example of how judges assumed discretionary policy-making authority to contribute to economic growth.
Equity. In the Anglo-American tradition equity courts comprised a judicial system distinct from the law courts. Originating in England as a royal dispensation of mercy, equity had tempered the rigors of the law by enforcing a general rule of fairness; it would not come to the aid of a party with what were called “unclean hands,” or enforce an unfair bargain. American states had both law and equity courts; the great jurist James Kent was the chancellor of equity for New York, the chief judge of the state equity courts. But America’s rapidly fluctuating market economy had no place for the intrusion of informal and at times idiosyncratic moral judgments about fairness, and equity soon declined. Courts declined to consider whether the terms of contracts were just, and considered only the will of the parties to determine whether enforceable contracts had been formed. A leading example of this changing approach to contract was the New York case of Seymour v. Delancey (1824), in which Kent applied the principles of equity to refuse to enforce a land-sale contract because the price was grossly inadequate. The High Court of Errors reversed, leaving sellers of land to fend for themselves in the real estate market rather than relying on courts to redress bad bargains. Seymour was a harbinger of the disintegration of the idea of equity. Joseph Story’s Commentaries on Equity (1836) helped to recast equity as a set of procedures, rather than principles. The decline of equity culminated with the passage of the Field Code in New York in 1848, which merged the courts of law and equity.
ALLOCATING THE BURNEDS OF INDUSTRIALIZATION
One of the consequences of the growth of factories and railroads was an enormous increase in the number of industrial accidents. Lawsuits based on personal injuries from these accidents contributed to the emergence of the new subject of torts, which covered civil (as opposed to criminal) wrongdoing. One of the first important principles of tort law was the “fellow servant rules,” which barred workers from suing their employers for injuries that took place on the job as a result of a fellow worker’s negligence. The most influential decision in the American adoption of this rule (which shifted a significant cost of economic growth from entrepreneurs to employees) was Lemuel Shaw’s opinion in Farwell v. The Boston and Worcester Railroad Co., 4 Met. (45 Mass.) 49 (1842), in which the Massachusetts Supreme Court denied recovery to a railroad engineer who lost his right hand in a train derailment after a switchhman failed to move the track. Shaw wrote in part:
Where several persons are employed in the conduct of one common enterprise or undertaking, and the safety of each depends much on the care and skill with which each other shall perform his appropriate duty, each is an observer of the conduct of the others, can give notice of any misconduct, incapacity or neglect of duty, and leave the service, if the common employer will not take such precautions, and employ such agents as the safety of the whole party may require. By these means, the safety of each will be much more effectually secured, than could be done by a resort to the common employer for indemnity in case of loss by the negligence of each other.
Morton J. Horwitz, The Transformation of American Law, 1780–1860 (Cambridge, Mass.: Harvard University Press, 1977);
Leonard Levy, The Law of the Commonwealth and Chief Justice Shaw (Cambridge, Mass.: Harvard University Press, 1957);
G. Edward White, The Marshall Court and Cultural Change, 1815–1835 (New York: Macmillan, 1988).
Law and Economics
Law and Economics
Since the 1970s, a new approach to the analysis of law has developed. Known as law and economics, its focus is on identifying the effects of legal rules. Law and economics addresses questions like these: What is the effect on the number of automobile accidents of legal rules that hold negligent drivers responsible for harms that they cause? What is the influence on the amount of pollution of laws that penalize firms for releasing harmful wastes into the environment? Does the death penalty reduce the number of murders, and if so, by how much? In seeking to answer such questions, economic analysts generally assume that individuals and firms want to avoid legal sanctions, and the analysts often use data and statistics to verify their theoretical predictions.
Despite its name, the law and economics approach is not necessarily concerned with matters of money or markets. Determining the effects of the death penalty, for example, involves, among other things, consideration of whether an incensed individual would be deterred from shooting someone by fear of the punishment of execution. The economic aspect of law and economics lies in its emphasis on incentives in predicting behavior. In the field of economics proper, the incentives are to make profits or to find a good price; here the incentives are to avoid legal sanctions.
Because economic analysis of law allows the effects of legal rules to be ascertained, the approach is useful for evaluating and comparing rules with regard to their social desirability. If, for example, it is found that the death penalty fails to deter murders carried out by incensed individuals, then it might be concluded that the death penalty is undesirable as a punishment for such murders.
Economic analysis of law has been controversial, mainly because it is centered on identifying the effects of legal rules rather than on the fairness of the rules, the focal issue of traditional analysis. The economic approach to law can be traced in significant respects to the English philosopher Jeremy Bentham (1789), and its modern pioneers include Ronald Coase (1960), Guido Calabresi (1970), and Richard Posner (1972). Posner is also an exponent of the hypothesis that the legal rules that exist are approximately rational in the sense that the consequences of their use are socially desirable.
This entry will provide two illustrations of the economic approach to the analysis of law and will make comparisons with traditional analysis of law. The first illustration concerns legal liability for harm caused in accidents, such as automobile accidents, oil spills, and construction mishaps like the collapse of a crane. A major effect of legal liability is that it fosters the taking of precautions. For instance, in order to avoid being held liable for harm due to an oil spill, the owner of a supertanker might install better navigation devices or hire more experienced crews. Or consider a numerical example: Suppose that if a person does not take a precaution, it is certain that his activity will cause harm of $100,000, for which he would be held liable. If he takes the precaution, however, he would definitely prevent the harm. The precaution would cost $30,000. Then the person would be induced to spend the $30,000 because it would save him a liability expense of $100,000. Such logic underlies the conclusion that, under many forms of liability, parties will be led to take socially desirable risk-reducing steps, and empirical evidence suggests that the liability system has often substantially reduced harm from accidents.
A number of complications arise in assessing how the threat of liability for accidents affects behavior. One issue involves liability insurance, which covers insured parties if they are held liable for harm. If the owner of a supertanker has liability insurance protecting it against having to pay for harm caused by an oil spill, the owner’s reason to invest in navigation devices to prevent spills might be dulled. However, the liability insurer might insist that the owner install such devices. Another complication is that parties who cause harm might themselves suffer harm in accidents, as is true in automobile accidents. In this situation, parties have a strong reason to avoid causing accidents, regardless of the threat of being held liable. Taking such factors into account is necessary to obtain good estimates of the influence of liability on accidents.
Given analysis of the effects of liability in reducing accidents, questions about legal policy can be addressed. For example, would raising the amount that has to be paid for oil spills significantly reduce the number of oil spills? A radical question is whether, in some areas of activity, it is worthwhile using the liability system at all. This question is an important one in view of the high costs of the liability system. It is estimated that for every dollar that an accident victim receives through the liability system, approximately one additional dollar is spent on lawyers, making the liability system extremely expensive for society to employ. For that reason, economic analysis suggests that, unless the liability system substantially reduces the number of some type of accident, the system may not be worthwhile for that type of accident. Consider automobile accidents. Liability may not much reduce the number of automobile accidents, since the fear of being injured in an accident (or of being arrested for drunk driving) may already provide most drivers with a sufficient motive to drive with reasonable care. Hence, it might be advantageous for society to do away with the liability system for automobile accidents (something that has largely been done in a number of American states).
The foregoing economic analysis of legal liability for accidents may be contrasted with traditional legal analysis of the topic. Traditional analysis stresses the perceived fairness of liability, and notably, the view that an individual who wrongly injures another ought to compensate the victim for his losses. Under traditional analysis, liability is often seen as desirable without real regard to the degree to which it reduces the number of accidents or the costs of its use (or to the ability of accident victims to obtain compensation through their insurance policies). At the same time, economic analysts have generally not considered notions of the fairness of liability, although this issue is now beginning to receive some attention from them.
The second illustration of the economic approach to the analysis of law relates to a specific legal doctrine. When a person is making a contract, the law may impose on the person an obligation to disclose material information to the other party to the contract. For example, if a person is selling a home with a leaky basement, the person might be required to disclose this fact to the buyer. Or if an oil company is purchasing land and believes oil is likely to be found there, the company might have a duty to disclose this information to the seller.
Under the economic approach to law, emphasis is given to ascertaining the effects of a disclosure obligation. In the case of leaky basements, a principal effect of a disclosure obligation is that buyers will know about problems and will be able to take appropriate remedial steps, such as not storing valuables in the basement. Hence, a disclosure obligation for such problems as leaky basements may be socially desirable. However, the case of oil and land is different. If oil companies must reveal their knowledge about the high oil-bearing potential of land, they will have to pay significantly higher amounts to purchase land with promising potential. This will tend to reduce the willingness of oil companies to make investments, such as in geological surveys, to locate land with good oil-bearing potential. (Note that this issue of acquisition of information is not relevant in the case of leaky basements—homeowners will automatically learn about leaks, just because they live in their homes.) Therefore, it might not be desirable to obligate buyers to disclose what they know in situations like that of an oil company purchasing land (and, in fact, the law sometimes does not impose an obligation to disclose in these situations).
Under traditional analysis of law, the consideration of a disclosure obligation has mainly to do with whether it would be seen as unfair or immoral not to disclose information at the time of contracting. From this perspective, it might be thought that both a homeowner with knowledge of a leaky basement and an oil company with knowledge that there is probably valuable oil under a person’s land ought to reveal their information, for it would be underhanded, and perhaps akin to a lie, not to do so. Under traditional analysis, there would be no obvious reason to draw a distinction between the two types of cases, and the effects of the disclosure obligation on behavior and outcomes would not be the focus of attention.
These two illustrations show the importance of economic analysis of law, that is, of identifying the effects of legal rules, and the contrast between economic analysis and traditional analysis of law. Over time, economic analysis of law is likely to have a major, if not a revolutionary, influence on the understanding of law and on law-making activity.
SEE ALSO Information, Asymmetric; Insurance; Mechanism Design
Bentham, Jeremy.  1973. An Introduction to the Principles of Morals and Legislation. In The Utilitarians, 5–398. Garden City, NY: Anchor.
Coase, Ronald. 1960. The Problem of Social Cost. Journal of Law and Economics 3: 1–44.
Posner, Richard A.  2003. Economic Analysis of Law. Boston: Little, Brown. 6th ed. New York: Aspen.
Shavell, Steven. 2004. Foundations of Economic Analysis of Law. Cambridge, MA: Harvard University Press.