Chapter 2: Efficiency and All That


Legal rules affect lots of people in lots of different ways. In a society as large and complicated as ours, one can be fairly certain that passing or repealing a law will make some people worse off, including some who have done nothing for which they deserve to be made worse off, and make some people better off, including some who have done nothing for which they deserve to be made better off. How, then, can one decide what the law ought to be?

One possible answer is that we ought to have whatever laws best serve our interests—result in people getting more nearly the outcomes they want. This raises an obvious problem: how to add people up. If a law benefits some and hurts others, as most do, how can one decide whether the net effect is loss or gain, cost or benefit? How do you put a pie containing everything that happens to every human being on earth, or even in the United States, on a scale, so as to get a single measure of its size?


I: A Very Large Pie with All of Us in It


A little over a hundred years ago, an economist named Alfred Marshall proposed a solution to that problem. It is not a very good solution. It is merely, for many although not all purposes, better than any alternative that anyone has come up with since. The result is that economists, in both law schools and economics departments, continue to use Marshall's solution, sometimes concealed behind later and (in my view) less satisfactory explanations and defenses.

Marshall's argument starts by considering some change—the imposition or abolition of a tariff, a revision of the tax code, a shift in tort law from strict liability to negligence. The result of the change is to make some people better off and some worse off. In principle, one could measure the magnitude of the effects by asking each person affected how much he would, if necessary, pay to get the benefit (if the change made him better off) or prevent the loss (if it made him worse off). If the sum was positive, if total gains were larger than total losses, we would describe the change as an economic improvement; if it was negative, an economic worsening.

Several things are worth noticing about this way of evaluating changes. One is that we are accepting each person's own judgement of the value to him of things that affect him. In measuring the effect of drug legalization on heroin addicts we ask not whether we think they are better off with legal access to heroin but whether they think they are—how much each addict would pay, if necessary, to have heroin made legal. A second is that we are comparing effects on different people using dollars as our common unit—not dollars actually paid out or received, but dollars as a common measure of value, a way of putting all costs and benefits on the same scale.


II. How to Add People Up


The experiment of asking people such questions is an imaginary one not only because we don't do it but because if we did there is no reason to expect them to tell us the truth. If someone asks you how much you want something, the rational response may be to greatly exaggerate its value to you in the hope that he will then give it to you.

We get the relevant information not by asking questions but by observing behavior, by seeing how much people are willing to give to get things and making deductions from such observations. The reason I believe heroin addicts would be willing to pay quite a lot to have heroin made legal is that I observe heroin addicts paying quite a lot to get illegal heroin. The economist's term for that approach is "revealed preference." Preferences are revealed by choices.

If you are still puzzled, as you probably should be, about how one can make any estimate at all of the net effect of some legal rule on a population of hundreds of millions of people, consider the following, deceptively simple, application of Marshall's approach:


  • Mary has an apple. John wants the apple. The apple is worth fifty cents to Mary, meaning that she is indifferent between having the apple and not having the apple but having an additional fifty cents instead. The apple is worth one dollar to John. John buys the apple for seventy-five cents.


  • Mary no longer has the apple but has seventy-five cents instead—making her, on net, twenty-five cents better off than before, since the apple was only worth fifty cents to her. John no longer has his seventy-five cents but has the apple, making him too twenty-five cents better off than before, since the apple is worth a dollar to him. Both are better off; their net gain is fifty cents. The transfer was an improvement.

    It would still be an improvement, and by the same amount, if John, a particularly skilled bargainer, managed to get the apple for fifty cents: he gains fifty cents, she gains nothing, net gain again fifty cents. Ditto if Mary was the better bargainer and sold her apple for a dollar, its full value to John.

    It would still be an improvement, and by the same amount, if John stole the apple—price zero—or if Mary lost it and John found it. Mary is fifty cents worse off, John is a dollar better off, net gain fifty cents. All of these represent the same efficient allocation of the apple: to John, who values it more than Mary. They differ in the associated distribution of income: how much money John and Mary each end up with.

    Since we are measuring value in dollars, it is easy to confuse "gaining value" with "getting money." But consider our example. The total amount of money never changes; we are simply shifting it from one person to another. The total quantity of goods never changes either, since we are cutting off our analysis after John gets the apple but before he eats it. Yet total value increases by fifty cents. It increases because the same apple is worth more to John than to Mary. Shifting money around does not change total value. One dollar is worth the same number of dollars to everyone: one.

    We now expand the analysis by applying Marshall's approach not to a transaction (John buys Mary's apple) but to a legal rule. The rule is freedom of exchange: Anyone who owns an apple is free to sell or not to sell it on any terms mutually acceptable.

    In our two-person world the result is efficient. If the apple is worth more to John than to Mary, John will buy it; if the apple is worth more to Mary, she will keep it. Similarly if John starts with the apple. In each case we end up with the outcome that gives the highest total value. That is the efficient outcome, hence freedom of exchange is the efficient rule.

    We now add a third party, Anne, an alternative customer for Mary's apple.

    First suppose that Anne really likes apples; she is willing to pay up to a dollar fifty for one. Anne outbids John and gets the apple. The apple goes from someone who valued it at fifty cents to someone who values it at a dollar fifty, for a net gain of a dollar, with the distribution of the gain between Mary and Anne depending on how good a bargainer each is. That is a better outcome than having the apple go to John, for a net gain of fifty cents, or stay with Mary, for a net gain of zero. So far, it looks as though freedom of exchange is the efficient rule.

    Next suppose that Anne does not like apples so much; she is willing to pay up to seventy-five cents, but no more. This time John outbids Anne and gets the apple. The net gain is fifty cents—superior to the result if the apple went to Anne (now only twenty-five cents) or Mary (again zero).

    Thinking through these examples, you should be able to satisfy yourself that freedom of exchange, in our little world of three people and one apple, is the efficient legal rule. Whatever you assume about how much each person values the apple, the rule results in the apple going to whoever values it most, thus maximizing net gain.

    This is a simple example in a very small world, but sufficient to illustrate the fundamentals of how Marshall's approach works in practice. The examples depended on particular assumptions about how much the apple was worth to whom, but the argument did not. The form of the argument was not "Anne values the apple more, therefore the rule is efficient" but rather "If Anne values the apple more, she will get it, which is efficient; if John values it more, he will get it, which is efficient."

    Arguments about the efficiency of legal rules rarely rest on real-world data about how much different people value things. Typically, we try to take into account all possible, or at least all plausible, valuations, and find a legal rule that works for all of them—freedom of exchange in our example. When that is impossible, we end up with weaker conclusions, typically of the form "if most people ... then rule X is more efficient, but if... ."

    Our simple example also illustrates another important point—that money, although convenient for both making transactions and talking about them, is not what economics is about. The same argument could have been worked through, at the cost of an extra page or two of explanation, in a world where money had never been invented. Mary starts with an apple, John a loaf of bread, Anne a pear. All three have knives for making change. No cash needed.


    III. Is Efficiency Always a Good Thing?


    Marshall's approach to defining economic efficiency has two major virtues:

    1. It sometimes makes it possible to answer questions of the form "When and why is strict liability in tort law efficient?" or "What is the efficient amount of punishment for a particular crime?"

    2. Although "efficient" is not quite identical to "desirable" or "should," it is close enough so that the answer to the question "What is efficient?" is at least relevant, although not necessarily identical, to the answer to the question "What should we do?"

    Put differently, Marshall's version of "more efficient" has at least a family resemblance to what people mean by "better" and is very much more precise and more readily applied. Family resemblance, however, is not the same thing as identity, as my fivesix year old son could easily demonstrate by going to a liquor store with my photo ID. Before accepting the usefulness of the concept of economic efficiency, it is worth pointing out its limitations.

    1. It assumes that all that matters is consequences. It thus assumes away the possibility of judging legal rules by nonconsequential criteria such as justice.

    Consider a sheriff who observes a mob about to lynch three innocent murder suspects and solves the problem by announcing (falsely) that he has proof one of them is guilty and shooting him. Judged consequentially, and assuming there was no better solution available, it seems an unambiguous improvement—by two lives. Yet many of us would have serious moral reservations about the sheriff.

    2. It assumes that when evaluating the consequence of a legal rule for a single person, the appropriate values are that person's values as expressed in his actions, that there is no relevant difference between the value of insulin and of heroin.

    3. It assumes that, in combining values across people, the appropriate measuring rod is willingness to pay, that a gain that one person is willing to pay ten dollars to get just balances a loss that another is willing to pay ten dollars to avoid. But most of us believe that, measured by some more fundamental standard such as happiness, a dollar is worth more to some people than to others—more to poor than to rich, more to materialist than to ascetic.

    If we were claiming that economic efficiency was a perfect criterion for judging legal rules, that whatever legal rule produced a better outcome by Marshall's criterion was always preferable, these would be serious, probably fatal, objections to the claim. They are less serious if our claim is only that it is the best criterion available. To see why, consider the alternatives.

    The statement that we should choose just rules, while emotionally satisfying, does not convey much information. Economic value may capture only part of what we want out of a legal system, but at least economic theory tells us how to get it. And consequences are an important part of what we want. The doctrine fiat justicia, ruat coelum (let justice be done though the skies fall) is, in my experience, uniformly proclaimed by people who are confident that doing justice will not, in fact, bring down the sky.

    As we develop the economic analysis of law we will observe a surprising correspondence between justice and efficiency.justice and efficiency. In many cases, principles we think of as just correspond fairly closely to rules that we discover are efficient. Examples range from "thou shalt not steal" to "the punishment should fit the crime" to the requirement that criminal penalties be imposed only after proof beyond a reasonable doubt. This suggests a radical conjecture—that what we call principles of justice may actually be rules of thumb for producing an efficient outcome, rules we have somehow internalized. Whether that is a sufficient account of justice you will have to decide for yourself.

    Defining value by what I act to get may not always give the right answer, but it is hard to see how one can do better. If value to me is not defined by my actions, it must be defined, for operational purposes, for controlling what actually ends up happening, by someone else's actions. As long as the statue of justice remains firmly attached to her pedestal instead of stepping down and taking charge, people's actions are the only tools available for moving the world. That leaves us with the problem of finding a "someone else" who both knows my interest better than I do and can be trusted to pursue it.

    The final criticism of efficiency, that it ignores the fact that a dollar is worth more to some people than to others, may be the most serious. Marshall's response was that most economic issues involve costs and benefits to large and heterogeneous groups of people, so that differences in individual value for money (in the language of economics, differences in the "marginal utility of income") were likely to average out.

    At first glance this argument seems inapplicable to law; it is widely believed that some legal rules favor rich people and some poor people, in which case judging rules by their effect on dollar value might give a different result than judging them by their effect on, say, total happiness. But first glances are often deceptive. One of the things we learn from economic analysis of law is that it is hard to use general legal rules to redistribute wealth, that "pro-rich" or "pro-poor" laws usually are neither.

    We saw one example of this in the previous chapter, in the context of the nonwaivable warranty of habitability, a doctrine viewed by many people, including many judges, as a way of benefiting poor tenants at the expense of their landlords. Changing one term of a contract in one case in favor of one tenant may benefit that tenant, but if legal rules consistently change one term in favor of one party, other terms will shift to compensate. Viewed from the backward-looking perspective of a single case, redistribution from one party to the other is obviously an option; viewed from the forward looking perspective of the effect of a legal rule on how parties affected by it will act, it may not be.

    Consider as an extreme example a law "favoring" poor tenants by providing that a landlord may never enforce any term in the lease against them. The result of such a law would be that few people would rent to poor tenants, since there is little point to renting an apartment to someone if you have no way of collecting the rent.

    This is not a wholly imaginary argument. It corresponds reasonably well to the eighteenth-century approach to protecting women. Married women were, in most contexts, not permitted to make binding contracts, with the result that they were unable to participate in a wide variety of economic activity. The abandonment of that doctrine in the course of the nineteenth century was an improvement both for women and for men who wanted to do business with women. If, as these examples suggest, most legal issues ultimately involve efficiency rather than the distribution of income, then designing law to maximize efficiency may well be a good, although not perfect, way to maximize happiness.

    An alternative argument for efficient law is that, even when legal rules can be used to redistribute, there are better tools available, such as taxation. If so, it may be sensible to use the legal system to maximize the size of the pie and leave to the legislature and the IRS the job of cutting it.

    My conclusion is that efficiency, defined in Marshall's sense, provides a useful, although imperfect, approach to judging legal rules and their outcomes. You may find it useful to adopt that conclusion as a working hypothesis in reading this book, while feeling free to drop it at the end.

    So far I have been discussing economic efficiency as a normative criterion, a way of deciding what the law should be—what I earlier described as the third and most controversial project of economic analysis of law. In the context of the first two projects, understanding the effect of legal rules and understanding why particular rules exist, the objections I have been discussing are largely irrelevant. The consequences of laws are determined not by what people should value but by what they do value, since that is what determines their actions. And in the machinery that makes law, value measured in dollars is more relevant than value measured in some abstract unit of happiness. A rich man's dollar has the same weight in hiring a lawyer or bribing a legislator as a poor man's dollar, so if outcomes are determined by some sort of net value, dollar value looks like the best candidate.


    III. Alternatives to Marshall


    Rugs to Sweep the Dust Under


    Modern economists often try to avoid some of the problems implicit in Marshall's approach by using a different definition of economic improvement, due to Vilfredo Pareto, an Italian economist. Pareto avoided the problem of trading off gains to some against losses to others by defining an improvement as a change that benefits someone and injures nobody.

    Unfortunately, this approach eliminates the solution as well as the problem. Consider again our little world. As long as we have two people, freedom of exchange is efficient whether we use Marshall's definition (net gains) or Pareto's (some gain, no loss). At any price between fifty cents and a dollar both Mary and John gain.

    But now put Anne back into the picture—with a value for the apple of only seventy-five cents. Anne proposes, on the principle of gender solidarity, a new legal rule: Women can trade only with other women. Going from gender solidarity to freedom of exchange produces a net gain by Marshall's criterion, since it means John instead of Anne getting the apple, and it is worth more to him than to her. But it makes Anne worse off, so it is not a Pareto improvement.

    The problem with Pareto's approach becomes still more serious when we add a few hundred million more people. In a complicated society it is very unlikely indeed that a change in legal rules will produce only benefits and no costs. Not even the most enthusiastic supporter of free trade—myself, for example—would deny that the abolition of tariffs makes some people worse off. If we want to make an overall evaluation of the effects of such changes, we are stuck with the problem of balancing gains to some against losses to others, a problem that Marshall solves, even if imperfectly, and Pareto only evades. It is therefore Marshall's approach to defining economic improvements and the efficiency of legal rules that I will be using—and that other economists routinely use, whether or not they say so.

    Readers interested in a more detailed discussion of these issues will find it in other books of mine, including one on my web site. Hopefully, what I have provided here is enough to show readers with a background in economics why I consider the Paretian approach that they encountered in their textbooks, along with the more elaborate version due to Hicks and KaldorHicks and Kaldor that they may have also encountered, evasions of, not solutions to, the problem of evaluating changes that affect many people in a variety of ways.


    The Simple Case for Laissez-Faire


    The discussion so far suggests a simple solution to the problem of creating efficient legal rules—private property plus freedom of exchange. Everything belongs to someone. Everyone is free to buy or sell on any terms mutually acceptable to buyer and seller.

    The generalization to include growing apples as well as trading them is straightforward. Any new good belongs to whoever produced it. So if the cost of producing a good, the summed cost of all the necessary inputs, is less than its value to whoever values it most, it will pay someone to buy the inputs, produce the good, and sell it to the highest bidder. Not only do all goods end up in their highest valued uses, but all goods are produced if and only if their value to whoever values them most is greater than their cost to whoever can produce them most easily.

    If this were a book about price theory, I would now spend the next seven chapters working through the logic of this argument in a more complicated world, with firms, capital goods, international trade, and a great variety of other complications; interested readers will find that discussion in chapters 3-9 of my Hidden Order. I will instead assume here that the basic logic of the argument in favor of freedom of exchange—more generally, of a policy of private property and legal laissez-faire—is clear, and go on to briefly sketch its limitations.


    What Is Wrong with the Simple Case for Laissez-Faire


    Implicit in the argument so far are a variety of simplifying assumptions. One of the most important is that all transactions are voluntary. That assumption was important for two reasons. First, a voluntary exchange must benefit the parties who make it, otherwise they wouldn't. Second, while it may make a third party worse off—Anne in the case where John outbid her for the apple—that loss must be less than the gain to the transacting parties, since otherwise Anne would have offered a higher price and gotten the apple.

    When I drive my car down the street, both the car and the gasoline were obtained by voluntary exchange. But the same is not true of the relation between me and pedestrians I might run down or the homeowners downwind who must breath my exhaust. Nor is there a voluntary relation between me and the thief who steals my hubcaps.

    A second assumption implicit in the argument is that transactions are costless, that if the apple is worth more to John than to Mary, he will end up buying it. But suppose Mary believes that the apple is worth a dollar fifty to John when it is actually worth only a dollar. She holds out for a price of a dollar twenty-five, he refuses to pay it, and the apple remains with Mary. The same thing might happen even if nobody misestimates anyone's value for the apple. Mary holds out for a price of ninety-nine cents, in the hope of getting most of the gain from the transaction, and John, with a similar hope, offers only fifty-one cents. And even if the apple does end up in the right hands, a full analysis ought to include the costs of getting it there.

    For these and other reasons, the simple argument for a legal regime of laissez-faire is only the beginning of the analysis. In the next few chapters we will see some of the ways in which economic theory—and the legal system—can deal with a more complicated and more realistic picture.


    Further Reading


    The general argument for the efficiency of market arrangements can be found in a variety of places, including the following:

    Friedman, David, Price Theory: An Intermediate Text, (Cincinnati:Southwestern, 1990). Available on the web page.

    Friedman, David, Hidden Order: The Economics of Everyday Life, HarperCollins, 1996.

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