"The common law method is to allocate responsibilities between people engaged in interacting activities in such a way as to maximize the joint value, or, what amounts to the same thing, minimize the joint cost of the activities."(Posner 1972: 98)
Almost thirty years ago, Richard Posner, then a law school professor, now the chief judge of the Seventh Circuit, proposed a simple conjecture: that the common law could best be understood as a set of rules designed to maximize what we have been calling economic efficiency. Over the years since, he and others have offered a number of arguments for why we would expect that to be true—none of which I find entirely convincing. But Posner has also offered empirical evidence on a heroic scale. In a research project lasting decades and attracting the efforts of a large fraction of the law and economics community, he and his coworkers have scanned the common law, attempting to determine in each case what legal rules would be efficient and how they correspond to the legal rules that exist.
In past chapters, we have seen some of the results of that project—skewed, of course, toward my interests and contributions. In this chapter, I first sketch the arguments for why we might expect common law to be efficient and then offer a brief survey of the evidence.
"In searching for a reasonably objective and impartial standard, as the traditions of the bench require him to do, the judge can hardly fail to consider whether the loss was the product of wasteful, uneconomical resource use. In a culture of scarcity, this is an urgent, an inescapable question. And at least an approximation to the answer is in most cases reasonably accessible to intuition and common sense."
(Posner 1972: 99)
The quoted passage, from the first edition of Posner's Economic Analysis of Law, a treatise masquerading as a textbook, provides one half of his explanation of why judges can be expected to make efficient law: efficiency is a widely held value and judges, even without the apparatus of economic theory, can figure out more or less what rules are efficient. The other half is the claim that there is no other widely held value that judges are in a position to achieve.
One obvious alternative, income redistribution, is difficult to achieve through general legal rules, for reasons discussed back in chapter 1. If courts consistently interpret contracts in a way favorable to some class of litigants, tenants in disputes with landlords, say, or workers in disputes with employers, other features of the transactions will adjust; rents will rise or wages fall to take account of the changed terms. The end result is unlikely to benefit the favored class and may well injure both sides by forcing on them less efficient terms than they would have agreed to on their own. So it might be prudent for judges, even egalitarian judges, to concentrate on maximizing the size of the social pie, the objective that Posner calls wealth-maximization and I have been calling economic efficiency, and leave to legislatures the dispute over how it is to be divided.
Even if judges are unable to redistribute among groups, they can still redistribute among the parties to the particular case they are deciding, and it is those parties who are most obviously and directly affected by the judge's decision. If in some category of disputes, landlord tenant litigation for example, one party consistently appears more deserving than the other, the result may be a consistent bias in the resulting legal rules unrelated to economic efficiency. This problem is reduced but not eliminated by a legal system that distances the appeals courts making the rules from the parties whose cases they are deciding.
A more serious problem with Posner's argument is that it assumes that judges understand enough economics to realize that they cannot use general rules to benefit favored groups. As any economics teacher can testify, most of his students and acquaintances do believe that "pro-tenant" legal rules benefit tenants, "pro-labor" legal rules benefit workers, and "pro-business" legal rules benefit capitalists and executives. Why should we expect judges to be any better informed? Quite a lot of twentieth century law, including such economically unconvincing concepts as contracts of adhesion and unequal bargaining power, seems to bear the stamp of economic ignorance. As Posner himself put it in Economic Analysis of Law, criticizing the verdict in the Baby M case (holding the enforcement of surrogate motherhood contracts contrary to the public policy of the state of New Jersey), "The court gave a number of reasons for this conclusion that demonstrate a lack of economic sophistication and a need for a book like this."
A further problem is that judges may care about things other than either efficiency or redistribution, values summed up in vague but emotively powerful terms such as "justice" or "fairness." One possible reply is that those values can themselves be viewed as in large part reflecting social concerns with economic efficiency. Back in chapter 17 I argued that private norms among close knit groups, which may be one source of our intuitions of justice and fairness, have some tendency to be economically efficient.
Even if judges know enough economics to realize that they ought to be making efficient rules, it does not follow that they know enough to do it. Determining what legal rules are economically efficient can be a hard problem. Posner himself is one of the most intellectually able and economically sophisticated judges of this century. Yet in his academic work he has quite often proposed economically incorrect arguments for economically mistaken conclusions. We can hardly expect less qualified judges to do better, or even as well.
Economists routinely expect business firms to act efficiently, although there is little reason to expect that executives are any smarter than judges. But there is a crucial difference between the two cases. An executive who makes the wrong decision loses money. The market provides feedback, positive and negative reinforcement, to guide business firms toward efficient behavior. No comparable mechanism exists to push judges toward efficiency. A catastrophically bad decision might mean a reduction in national income of a tenth of a percent a decade later. That is an enormous amount of damage for one human being to do, billions of dollars down the drain, but it is not a signal that the judge making the decision is likely to pick up and respond to.
Another approach to arguing that legal rules should be efficient is to start with the incentives of the parties to litigation rather than the incentives of the judges. An inefficient rule makes the people it affects on net worse off, giving them an incentive to keep trying to contract or litigate around it. Eventually the water wears down the rock; after enough law cases, a court finally gets the right answer.
This argument cannot explain the efficiency of legal rules with widely dispersed effects, since no one affected person has the necessary incentive to try to litigate to change them. And even if effects are concentrated, there is no reason to expect benefits and costs of alternative legal rules to be equally concentrated. If a particular legal change produces benefits for a small and well organized group, well enough organized to fund repeated litigation aimed at establishing the necessary precedents, and spreads its costs widely enough, the argument implies that we can expect to get it even if it is, on net, inefficient. A cynical observer of the past century or so of legal change might argue that that is precisely what has been happening. The concentrated interest group consists of attorneys; the result of their efforts has been a body of law designed to maximize the demand for their services.
Ultimately, Posner and those supporting him have established no more than a possibility—that judges, especially 19th century judges in a culture favorable to the value of economic efficiency, might decide cases in ways that tend to produce efficient rules. The serious defense of his thesis depends not on the a priori argument but on the evidence.
Back in chapter 5 I introduced the distinction between property rules and liability rules: "steal my car, go to jail" Vs "dent my car, get sued." Under property rules, rights get allocated to their highest valued use through voluntary exchange; if the right to use your car is worth more to me than to you, I buy it. Under liability rules, they get allocated by appropriation followed by a court determined reimbursement of the victim by the appropriator.
As we saw, property rights are efficient in settings where private transaction costs are low and allocation via litigation costly and inaccurate; liability rights are efficient under the opposite circumstances. Roughly speaking, that corresponds to what we observe in the law. While there are some exceptions—I cannot sell you one of my kidneys, although that would be a straightforward private transaction—goods that should be allocated through property and trade are; goods that cannot be, at any reasonable cost, such as your right not to have me carelessly run my car into yours, are handled by liability rules instead.
This provides some evidence for the Posner thesis, but not much. The problem is that it is too easy a case. Consider the alternative: a system in which I was free to steal your car any time I wanted and your only recourse was to sue me for damage done, but in which driving down the street required me first to purchase permission from every other driver on the road. Such a system would be not merely inefficient but wholly unworkable. Economic analysis helps us understand why such a system would not work, but we do not need to assume that legal rules are efficient in order to predict that we will not get those ones. All we need is some mechanism to eliminate legal rules whose consequences are immediately catastrophic.
The background rules for property—in particular, the fact that if I own a right I can, under most circumstances, transfer my ownership to someone else—are again about what we would expect under an efficient legal system. As we saw in chapter 2, transferability provides a simple mechanism for moving goods to those who value them most. And at least some of the exceptions in our legal system—I cannot, for example, transfer my parental rights with regard to my child to someone else without first getting permission from the legal system, or openly sell my vote—can be defended as ways of dealing with potential third party effects.
The general pattern of the law of real property, the way in which property rights to land are bundled, also seems at least roughly consistent with economic efficiency. The person who owns the right to plant crops on the land also owns the right to decide who walks on it, which make sense, since the two rights are worth much more combined than separated. He does not own the right to decide whether airplanes fly a mile over his land or radio stations broadcast electromagnetic waves through it, which again makes sense for similar reasons. And, as I argued at some length in chapter 11, the broad pattern of intellectual property law, in particular the difference between the legal rules for patent and copyright, looks like a system of economically efficient rules.
In tort law, too, much of the general pattern seems consistent with economic efficiency. The requirement that the tortfeasor must make the victim whole gives us the Pigouvian solution to the externality problem—charge the person responsible an amount equal to the external cost—at least as long as we ignore both litigation costs and the risk that some tortfeasors may escape unscathed. Negligence rules offer a solution to Coase's problem of double causation: the tortfeasor takes optimal precautions in order not to be found negligent, the victim, knowing that the tortfeasor will not be found negligent, takes optimal precautions because he expects to bear the cost of the tort himself. Strict liability with contributory negligence achieves the same objective in a mirror image form: the potential victim takes precautions in order not to be contributorially negligent, so the tortfeasor knows he will be liable, so it is in his interest to take optimal precautions too. Both rules, along with a few other alternatives, are observed in common law settings.
A negligence rule generates inefficient incentives with regard to precautions that the court cannot readily monitor, such as activity level: was it efficient to take the trip during which I (non-negligently) ran my car into yours? The common law deals with that problem by imposing strict liability, which gives the correct activity level incentives for the tortfeasor but not the victim, on abnormally hazardous activities, activities where it is quite likely that reducing the activity level is an efficient way of reducing the problem. And (some) courts substitute negligence for strict liability where the activity is a normal and necessary part of the use of land, hence unlikely to be deterred. If strict liability produces additional litigation costs but little or no additional deterrence, we are better off with negligence, as the Texas Supreme Court concluded in Turner v. Big Lake Oil.
Some differences between tort and criminal law also make sense in terms of economic efficiency, as we saw in chapter 18. Torts are usually punished with money damages, crimes with imprisonment or execution. The former is a more efficient punishment, hence false convictions are less costly, which justifies the lower standard of proof in tort law.
Many other detailed rules in the legal system also seem to fit with economic efficiency. One example is the defense of necessity, under which Posner's starving hunter could successfully avoid criminal prosecution for breaking into an empty house and using the telephone to call for help. His crime is an efficient one, so we don't want to deter it and, since he has made no attempt to conceal his crime, he will be detected with certainty, making tort damages sufficient to deter him from breaking into houses when he is not starving. Another example is the rule of foreseeability. It is the Himalayan photographer, not the film developer, who bears most of the cost when the latter loses the former's film, since it is cheaper for the photographer, who knows the special value of the film, to take precautions than for the developer, who does not. A third example is the refusal of admiralty law to apply unlimited freedom of contract in salvage cases, thus discouraging ship captains from continuing to bargain as the water rises past their ankles.
If we look past the general pattern to the details, the Posner thesis becomes considerably less convincing. The fact that organ sales by the owner—you can survive with one kidney, although your odds of future medical problems are somewhat higher than if you have two—are illegal is one example. A completely free market in organs for transplant might raise problems, since it makes murder followed by medical dismemberment profitable, creating serious negative externalities for potential victims. But that problem would not apply to a market where individuals were free to accept payment now in exchange for selling the right to harvest their organs after death. A less exotic example is the failure of current law to support freedom of contract in the context of product liability and related issues—as I argued, back in chapter 14, would be efficient.
Posner has defended the efficiency of current product liability law, arguing that in a complicated modern society the costs to consumers of evaluating the mix of waivers and guarantees produced by free contract would be unreasonably high. The obvious response is that if general rules are superior to case by case decisions, rational consumers can adopt general rules. Instead of imposing mandatory terms for product liability, as they now do, the courts could require contracts that deviate from the court's default rules to provide clear notice—in bright red fourteen-point type on the first page. Consumers who agreed with Posner that the courts were more competent than they were to set the terms on which they purchased goods could follow a policy of never signing a contract with red print on the first page; consumers who believed the courts frequently got it wrong could follow a different policy. If Posner is right and consumers are rational, the result will be the same as without freedom of contract; if he is wrong, rational consumers can and will contract around inefficient default rules. Posner's argument requires him to assume not merely that consumers are ignorant about the details of optimal contracts but that they do not know that they are ignorant and would therefore choose to waive the superior liability regime offered by the courts.
The refusal of modern courts to enforce agreements to waive claims for product liability or medical malpractice is one example of a more general pattern, the retreat from freedom of contract over the past eighty years or so. Another is the reluctance of courts to recognize the enforceability of mass market form contracts, so-called "contracts of adhesion." A third example is their unwillingness to enforce penalty clauses, agreements for liquidated damages that the court considers excessive. As I pointed out back in chapter 12, a penalty clause in a contract is simply a privately negotiated property rule. It makes sense in the same contexts as other property rules: where the cost of moving resources to their highest valued use is lower through private transactions (one party buys permission from the other to void their contract) than through litigation.
There are many other examples of inefficient features in the common law. Perhaps the most striking is the refusal of the common law to include, in calculating damages for wrongful death, the value of the victim's life to himself. Insofar as that pattern is now changing, it is mostly through wrongful death statutes—and legislation is the part of the legal system that Posner does not claim is efficient.
Another example is the refusal of the common law to make tort claims, including inchoate tort claims, marketable. In chapter 9 I showed how doing so would help solve problems associated with tort damages for loss of life, in chapter 17 how it could be, and once was, used to solve the problem of victims too poor to prosecute, and in chapter 18 how it would make possible a superior alternative to the class action.
Earlier, I offered intellectual property law as evidence in favor of efficiency. But Posner's thesis is about common law, not legislated law—and both patent and copyright are the product of federal statutes. Of course, statutes must be interpreted, so even statutory law, by the time it get down to the litigants, has a substantial common law element. But if we look at that dimension of intellectual property law, the case for efficiency is not so clear.
Consider the issue of whether or not computer programs in machine code, the form of the program actually used by the computer, are copyrightable. In the early cases, some courts concluded that they were not, on the plausible enough grounds that something that was not intended to be read by a human being was not a writing. That argument was ended not by the courts but by Congress, which revised the copyright act to include software in both source code and object code forms. Insofar as that feature of intellectual property law is evidence for efficiency, it is evidence for the efficiency of statutory law.
For more evidence, consider the question of how long a patent lasts. The optimal term of patent protection depends on the technology of making and marketing inventions. The faster the rate of innovation, the more likely it is that what you invented today I would have invented tomorrow, hence the more likely that a long term of protection will over reward you for your invention. During the past century, the technology of making and marketing inventions has changed enormously. Throughout that time the term of protection provided by United States patent law has been somewhere in the range of 14 to 21 years.
So far I have been evaluating the thesis that the common law is efficient by listing features of the law that do or do not fit its predictions, that are or are not efficient. As you can see, there are quite a lot of both. A more serious problem with testing the thesis is that often we simply do not know what the efficient rule is. In many cases a clever theorist can come up with plausible economic arguments in favor of either of two alternative legal rules: negligence or strict liability, accepting or rejecting the defense of coming to the nuisance, including or not including probability multipliers in calculating tort damages.
I spent all of chapter 18 on one example of that sort of problem, the division in our legal system between crimes and torts. The existence of criminal law can be defended as a way of dealing with judgement-proof defendants. That defense can be answered by proposing that tort defendants be made less judgement-proof, by proposing a bounty system to combine private prosecution with some public funding, or by pointing out that deterrence can be made into a private good and even judgement-proof criminals are worth deterring.
A more sophisticated defense of current law, due to Landes and Posner, points out that in order to create a fully efficient system of privately enforced criminal law one must optimize two outcomes using a single control, which is, in the general case, mathematically impossible. There is no reason, short of blind luck, why the same fine would generate both the optimal probability of punishment (through the incentive that the opportunity to collect a fine gives the enforcers) and the optimal amount of punishment. I offered a solution to that problem by describing institutions for private enforcement under which profit maximization by the enforcement firm generates the optimal probability/punishment mix for any level of expected punishment, leaving one outcome to be optimized by one control. That solution can in turn be critiqued by pointing out that if the cost of apprehending and convicting an offender is greater than the fine he can be made to pay, offenses will sell at a negative price: victims must pay prosecution firms to prosecute crimes against them. That critique can be answered by again noting that deterrence can be a private good, with the real-world example of 18th century prosecution associations, a system of institutions where potential victims did pay to have offenses against them prosecuted. And that reply can be answered by raising the problem of anonymous victim offenses, for which deterrence can not be made a private good.
I have just run one argument—over whether we should abolish criminal law, a central feature of our legal system—through seven rounds, four or five more than you are likely to encounter if you take a law and economics course from anyone but me. At each step the conclusion reversed. I offer that as evidence of how risky it is to go from the existence of an argument for the efficiency of some particular rule to the conclusion that the rule is in fact efficient.
And we are not done; I omitted a second line of criticism of the Landes and Posner argument, itself one of the more sophisticated defenses of the tort/crime distinction in the literature. Their problem of optimizing two variables with one control is not limited to crimes; it applies to torts as well. Just as the fine in a private criminal system is both the disincentive to the criminal and the incentive to the prosecutor, so the damage payment in a civil system is both the punishment for committing a tort and the reward for successfully litigating one. There is no reason to expect the optimal incentives for the two purposes to be the same. Insofar as Landes and Posner have explained why private prosecution of crimes is a mistake, they have shown why private prosecution of torts is a mistake too, thus undercutting their argument for the efficiency of our current legal institutions.
The problem is not merely ambiguity but selection bias as well. Suppose you are a legal scholar who believes in the Posner thesis. You observe that the common law accepts the coming to the nuisance defense; the pig farm, sued by the neighboring development for creating an olfactory externality, can defend itself by pointing out that it was there first. After thinking about the problem for a little, you come up with an explanation. The problem is produced not by having a pig farm but by having a housing development next to a pig farm. It is easier to relocate a housing development, or a pig farm, before it is built than after, so whoever came second was the lower cost avoider of the problem.
Suppose, however, that you encounter the same issue a few decades later and find that the courts have become increasingly unwilling to accept that defense in nuisance suits. It occurs to you that while the developer can relocate his development, the owner of the land he was planning to build on cannot relocate his land. If urban expansion makes suburban housing the highest valued use for all of the land surrounding the pig farm, a legal rule of coming to the nuisance allows the pig farmer to impose large external costs on the owners of all the surrounding land. By rejecting that defense, we force him to take account of those costs—and move.
As this example shows, and as many others could show, a scholar looking for evidence that the common law is efficient can almost always find it—by figuring out what is efficient after he finds out what the law is. In most cases, the range of plausible arguments is wide enough so that an ingenious searcher can find at least one that justifies existing law. Sometimes, on sufficiently careful examination, it turns out that the argument, although plausible, is wrong. Sometimes it doesn't. And sometimes, when we are looking at a very large number of legal rules, the argument never gets a sufficiently careful examination.
My own conclusion is that the jury is still out on the Posner thesis. Some features of the common law make sense as what we would expect in an efficient legal system, some do not, and in many cases we simply do not know with any confidence what the efficient rule would be.
The case may be a little stronger for a modified version of the thesis, one that holds that common law used to be economically efficient, perhaps because it inherited its doctrines from efficient systems of private norms or from efficient legal rules generated by the competing court systems of medieval England, but has been gradually drifting away from efficiency for most of the past century. That would explain the retreat from freedom of contract, although not the tort law's longstanding refusal to award damages for the value of a victim's life to himself or to make tort claims marketable.
"Hence the economic analyst can move easily not only within common law fields but between them. Almost any tort problem can be solved as a contract problem, by asking what the people involved in an accident would have agreed on in advance with regard to safety measures if transaction costs had not been prohibitive. ...
Equally, almost any contract problem can be solved as a tort problem by asking what sanction is necessary to prevent the performing or paying party from engaging in socially wasteful conduct, such as taking advantage of the vulnerability of a party who performs his side of the bargain first. And both tort and contract problems can be framed as problems in the definition of property rights; ... . The definition of property rights can itself be viewed as a process of figuring out what measures parties would agree to, if transaction costs weren't prohibitive,..."
(Posner [1972] 1992: 252-3).
Whether or not Posner has correctly explained the common law as it now exists, he has done something else that may be just as important. In trying to demonstrate that the law is efficient, he (along with many others) has demonstrated the essential unity, not necessarily of the law as it exists, but of the problems the law exists to solve. We do not know whether the law is efficient. We do know that the question "What is the efficient legal rule?" converts the study of law from a body of disparate doctrines into a single unified problem, where the same arguments—moral hazard, holdouts, public good problems, adverse selection, ex ante vs ex postselection, ex ante vs ex post rules, and many others—help make sense of a wide variety of legal issues. The Posner thesis, whether true or false, has clearly been useful.
The best source for Judge Posner's work in the economic analysis of law is:
R. Posner, 1973. Economic Analysis of Law Boston, MA: Little, Brown; 2nd edn 1977, 3d edition 1986, 4th edition 1992.
His defense of the absence of freedom of contract in product liability law can be found in:
1987 (and Landes, W.). The Economic Structure of Tort Law. Cambridge, MA: Harvard University Press.
For a general review of his work, inside and outside of economics, see:
D. Friedman, "Richard Posner" in The New Palgrave Dictionary of Law and Economics.