Economic Analysis Of Law

Economic Analysis of LawEconomic Analysis of Law

Sustainable poverty reduction and equitable economic

development depends upon the solid foundation of the rule of

law

Economic analysis of law is an inter-disciplinary subject

that brings together two fields of study

Areas as contract, tort and criminal law are all based upon

economic aims

Eg. The assumption that criminals are deterred by the threat

of punishment only if the likelihood of punishment multiplied by

the quantity of punishment exceeds the gain offered by the

specific criminal act.

Interactional Dimensions of Law Interactional Dimensions of Law & Economics& Economics

The success of inter-disciplinary subject of law and economics has been attributed to the strength of economics in providing a sound behavioral theory. Reasons:In March 1993, the Journal of Economic Literature introduced law and economics as a field in its classification index. This signaled a formal recognition of the field.There has been an increase in the number of papers in area of law and economics and in the number of journals devoted specifically to law and economics.Scholars in this area are not only publishing academic papers, but have become federal judges in the US and thus have a chance to influence first hand the workings of legal system.


Holmes: “for the rational study of the law the black-letter man maybe the man of the present, but the man of the future is the man of statistics and the master of economics”

-Effect of economic considerations on the costs and benefits

that prospective offenders may expect from crime,

- on decisions to litigate or to settle out of court

- on significance of legal costs,

- practical problems of legal administration and the provision of

legal services etc.


Prof. Barker: if economic factors and economic interests have partly determined the legal framework, it is even more true that law has furnished the whole general framework of rules within which and under which the factors and interests of economics have had to work”.

-Law is necessary to maintain the socio-economic equilibrium

in the society.

-To know the effects of law on social goals, law makers must

have a method of evaluating the impact of law on social values.

-Economics does not predict the impact of law, but merely

describes and explains it with an economic angle.


Economic development results in rapid industrialization leading

to increase in urbanization. People move to the urban areas and

there arises more need for the social goods rather than the private

goods. The social goods are costly and not profitable to private

enterprises, thus, the state has to provide these goods.

Rise of monopolies leads to faulty price system by manipulation

of the supply of goods and selling inferior quality products.

The scarce resources are diverted towards rising advertising

costs, leading to increase in prices along with an increase in the

consumption of unnecessary goods.


Private enterprises are concerned with private cost of

production and the existing laws are not enough to control the

social costs.

For example, Trust Law was originally designed to protect the

social position and property of the children of landed

aristocracies, but later on, the concept was enlarged and

developed into Trust Law. Nowadays, trusts are shaped into a

system which protects trade unions, religious organizations,

educational institutions etc.


Most important questions are:

1.How much it will cost?

2.Who pays for it?

3.Who will decide how much it will cost and

who will pay for it?


Thus, economics is concerned with efficiency, i.e., rational allocation of resources with least cost and maximum satisfaction. Law is concerned with justice only and not about its cost.

Hence, in case there is a conflict between efficiency and justice, economic analysis can be used to provide information on the costs of justice.

There is another angle to justice here, i.e., the resources if not utilized properly or are being misused or wasted, it is considered as immoral and good law can prevent this to achieve efficiency and justice.

Economics, in itself, may not be able to give precise answers, but it can draw attention to some important questions. In many countries, the cost-benefit analysis is been used by law reform bodies and Governments to help in the development of more cost.-effective laws. For instance, the economic approach to tax avoidance and tax evasion provides an insight into its side effects.


When a productive activity is undertaken, the total cost involved in

it is constituted of both private and social cost.

Private cost is that part of total cost which is borne by the

individuals.

Social cost is the cost which the society bears on account of the

productive activity being undertaken.

For example, the basic costs like cost of inputs, i.e. raw materials;

wages, rent etc. are met by the manufacturer and are a part of private

cost. But when productive activity is undertaken, the society will also

bear its cost in the form of pollution to the environment and this cost

is called social cost. All this creates an inefficient production pattern.


Generally, legal economists are concerned with social costs and transaction costs as these divert the resources to unproductive purposes. The unnecessary costs resulting thereof also imply denial of justice to certain sections of the society.

Thus, we can say that “justice is not independent of its cost”.

For instance, if civil law remedies are to be effective, it has to be cheap, otherwise transaction costs, i.e., the costs of retaining legal advisors, cost of bargaining etc. maybe very high.

Ronald Coase in his Paper in 1961 suggested that the institution of legal liability has better economic advantages than the earlier view of classical economists of imposing tax on each unit of output of the polluting firm equal in size to the damage generated.


The main thesis of Coase, known as Coase Theorem is, “A fundamental economic principle of liability is that where informed and costless bargaining is possible between the injurer and victim, the cost justified level of accidents will result without the need for judicial intervention. The gains from trade inherent in an inefficient level of safety will encourage the parties to voluntarily negotiate a mutually advantageous accident bargain that minimize their joint costs/losses…”

Generally, it is observed that people do not respond positively to the law, nor mindlessly obey it, but they adopt to the changed costs and benefits of it.

Depending on the costs incurred and the benefits to be obtained, the people decide to follow the formality of law or the informality of law.


Formality of Law:

When people evaluate their relationship with formal activity, there are two things that they consider, viz, “cost of access”, and the “cost of staying in it”.

The cost of access is the cost incurred at the time of entering into the economic activity, i.e. the requirements to start the enterprise. Due to the regulations of varying nature and importance, like compliance with bureaucratic procedures, obligations to administer personnel, payment of higher rates for public utilities etc., the person loses a lot of time and money in standing the enterprise.

Besides, these costs, there are other costs of staying in the business, like taxes, insurity of property rights, inefficiencies in settling disputes or collecting debts etc.


Informality of Law (Illegality):

Formality of law involves money, time and diversion of scarce resources to unproductive activities, people resort to informality, i.e., they do business illegally. This involves three types of costs, viz., “cost of avoiding penalties”, “cost of net transfers” and the “cost of evading certain taxes and labour laws”.

When people do not obey laws, they constantly run the risk of being penalized for not having obtained permits, licenses, paid taxes etc.

These save them from the legal costs of compliance but sometimes have to bear the penalties.

If the informal costs are cheaper than the formal costs, then informal gain more.


Another point worth noting here is that, the informal businesses are generally undercapitalized. They cannot use much of the capital goods as it makes them easily detectable. The amount generally used by them comes from the unorganized sector, for instance from the moneylenders, who charge them a higher rate of interest due to lack of tangible security.

Apart from this, they also incur costs of the inability to use the contract system.

These informal lack the facilitative legal instruments, which makes them incur more costs.


But, the informal are able to make use of certain norms which help in

regulating their activities. These are:

Informal generally have long term friendships among them,

Informal deal with their own relations or people from the same

region,

Informal may organize associations to force the parties to the

contract to comply with the terms of the contract.

Sometimes, informal may use coercive methods like threats,

violence etc. to get compliance of the contracts.


Sometimes, the activities of the informal may even spread to the formal and ultimately it becomes costly for the general public.

A good law helps to prevent the misuse of scarce resources in the society. It is not enough that good laws exist in the country, it is equally important that they are implemented fairly, promptly and flexibly.

In India, this situation is quite disappointing as it results in minimum of benefits and maximum of costs. Due to this, the IMF, the World Bank and Multi-National Companies (MNCs) wanted the simplification of legal rules and judicial decisions regarding disputes to be quick, cheap and flexible.

If the costs are reduced, it leads to increased profits which can be used for further growth of the business.


A point worth noting here is that one has to consider the estimated value and not actual value of the economic opportunity.

In doing so, one has to take into account the cost of red-tape, the degree to which it can be protected against third party appropriation and the ease with which it can be sold.

People would be able to identify and seize existing opportunities to increase the value of economic activity if the law dealing with these is efficient.

Specialization and independence of the individuals and resources is also encouraged

Economic Analysis of Tort LawEconomic Analysis of Tort LawTort Law is the name given to a body of law that creates and provides remedies for civil wrongs.Generally speaking, it defines what constitutes a legal injury and establishes the circumstances under which one person maybe held liable for another’s injury. Deliberate torts causing bodily harm, property harm etc. is ruled as crimes in the court system. For example, if X throws a ball and accidentally hits another person Y in the eye. Now Y may sue the ball thrower for losses occasioned by the accident like the cost of medical treatment or loss of income during the time he is off from work. In this case, whether Y will win or not will depend upon whether he can prove that X engaged in tortious conduct in injuring him. The main substance of tort law is determining the “standard of care”, i.e., distinguishing between when conduct is or is not tortious.

Economic Analysis of Tort LawEconomic Analysis of Tort LawTort law may also be used to compensate injuries that are intangible, such as an interest in freedom from emotional distress, privacy interests and reputation.

These are protected by a number of torts such as infliction, privary torts and defamation. For example, defamation and privacy torts may allow a celebrity to sue a newspaper for publishing an untrue and harmful statement about him.

Economic torts are torts that provide the common law rules on liability for the infliction of economic loss, such as interference with economic or business relationships. These protect people from interference with their trade or business.

The principal torts can be listed as passing off, injurious falsehood and trade libel, conspiracy, inducement of breach of contract, tortuous interference and watching and besetting.

Economic Analysis of Tort LawEconomic Analysis of Tort LawBasically, there are three elements in torts:

Breach of duty owned to the plaintiff by the defendant;

Harm suffered by the plaintiff; and

The breach being the immediate or proximate cause of the

harm.

We impose risks upon each other in our daily lives. Norms have been developed to prescribe the standards of behavior to limit these risks. When people do not follow these standards of behavior, they cause harm and the cost of harm must fall upon someone. Liability is assigned either to the party at fault or to the party which cause the harm.

Economic Analysis of Tort LawEconomic Analysis of Tort Law

In the modern world, tort liability has been expanded to include intangibles, probabilistic connections and liability without fault. Before developing our economic analysis of tort law we need to make some assumptions.

Firstly, in economic theory, we consider the “rational man”. It implies that a person, who takes reasonable care, is stable and tries to maximize his satisfaction. Here it also implies that he can calculate the cost and benefits of the alternatives available to him and can minimize his liability by taking precautionary actions.

Secondly, we assume that there are no regulations designed to reduce external costs. If we compare liability regulation sometimes one is more efficient than the other and sometimes both together are more efficient than either one by itself. Regulation is ex-ante enforcement by administrators and liability is ex-post enforcement by victims.

Economic Analysis of Tort LawEconomic Analysis of Tort LawFor instance, if a store is required to have a fire extinguisher, the inspectors will check it from time to time that the store complies with the regulation. But suppose, if the store complies with the regulation, and a fire injures a customer, then the store maybe held liable.

In this case, the store is subject to regulation and liability.

Thirdly, we assume that there is no insurance. Insurance transfers the risk from the insured party to the insurer, i.e., it externalizes. This gives the insured an incentive to reduce precaution, which is known as moral hazard.

For example, a person who insures his bike against theft may not be so careful about locking it every time. Lawyers do not agree that insurance interferers with the goals of tort law but rather they favour insurance for accidents and liability. But there maybe some cases where this is not so, such as in case of punitive damages. Insurance allocates the cost of accidents according to private contracts and it also regulates.

Economic Analysis of Tort LawEconomic Analysis of Tort LawFor instance, under fire regulations, the insured may be required to maintain sprinklers and submit to inspections. In this case, insurance privatizes liability and regulates precaution.

A change in tort law may increase or decrease the costs of insurance against accidents and liability.

Thus, tort law provides the restrictions within which the private insurers operate.

Fourthly, it is assumed that all the injurers are solvent and pay the damages in full.

Lastly, it is assumed that there are no litigation costs. But in real life, litigation is expensive and it has different effects on potential victims and potential injurers. For instance, it may induce the potential victims not to file actions or induce potential injurers to take more care.


Economic efficiency is not concerned with morality or social

purpose; rather it requires the minimization of the three costs:

Losses due to accidents;

Cost of preventing the accidents; and

Costs of administering a system of accident law.


Prof. Ronald Coase, Nobel Prize winning economist, 1991, popularized a theory that is called “Coase Theorem”. The main points of this theorem are:

If between the injurer and victim, costless bargaining is possible, then the cost justified level of accidents will result without the need for judicial intervention. The gains from trade inherent in an inefficient level of safety will encourage the parties to voluntarily negotiate a mutually advantageous accident bargain that minimizes their joint costs or losses.

Due to the existence of transaction costs like the costs of search, negotiation, contract specification, policing and enforcement, the tort liability arises. If these costs could be avoided, then the contractual bargains would provide market deterrence that would be adequate for economic efficiency.


Transaction costs can be divided into two categories:

Physical Transaction costs: These costs are associated with

actually locating, negotiating with and consummating bargains between

cost bearers. If these costs are imposed they would generally be

prohibitive in nature. For example, costs involved in environmental

pollution and road accidents.

Information Transaction costs: In these cases, the terms of the

accident bargains do not properly reflect the social cost savings because

one or both the parties are ill-informed.


The economic efficiency basis for tort liability is often referred

to as a market failure. Transaction costs are prohibitive or

bargaining is uninformed and due to this, accident bargains do

not take place. Thus, the market deterrence of accidents would

be inefficiently high.

Economic Analysis of Contract Economic Analysis of Contract LawLaw

Contract Law helps the people to cooperate with each other by enforcing, interpreting and regulating promises.

Contracts facilitate trade and economize the costs of making transactions.

It lays out guidelines for information that must be revealed and that maybe kept secret in a contractual relationship.


Prof. Stewart Macaulay, after empirical investigations of a number of companies and firms on this subject in Wisconsin described contract as involving two distinct elements:

Rational planning of the transaction with careful provision for as many future contingencies as can be foreseen; andThe existence or use of the actual or potential legal sanctions to induce performance or exchange or to compensate for non-performance.

He divided the types of issues which might be planned into four:Description of primary obligations;Contingencies;Defective performances; andLegal sanction


In real world people are not economically equal or equally knowledgeable. Thus, many times, contract between two unequal’s results in favour of economically stronger men. But in economics, we assume the people are economically equal and can trade with each other on equal footing.

Contract Law regulates the terms and conditions of the contracts between people of different economic backgrounds.

In Bombay Labour Union v. M/S. International Franchise (P) Ltd., the Supreme Court in India gave a blow to the so-called sanctity of contract. The Court observed, “It is too late in the day now to stress the absolute freedom of an employer to impose any condition, which he likes on labour. It is always open to industrial adjudication to consider the conditions of employment of labour and to vary them if it is found necessary, unless the employer can justify it by convincing reasons”.


Obeying the legal rules and trying to cover all the issues arising from a contract would be time-consuming and expensive. Hence, the contracting parties have found certain ways to reduce the costs involved in forming contracting parties. These are:

Normally, the contracting parties depend on the custom and trade practice to determine the profits and losses that may commonly result in their particular line of business; or

Well-known principles can be relied upon by the contracting parties to find out the results of certain contingencies that are not itself covered by the contract; or

Standard form of contracts maybe used by the contracting parties to help them to economize the costs, which can be used for many trading purposes, rather than having a custom-designed form for a single deal.


The empirical investigations by the economists and legal

economists came to the conclusion that resort to legal remedies by the parties to the contract is minimal due to heavy litigation costs or due to the reputation of a person in the trading community. For instance, if a person ‘X’ resorts to litigation with many of the contracting parties, he would be putting them to higher costs both in time and money. His own reputation that he is a litigant and a ‘court bird’, may isolate him from the trading community resulting in reduced contracts with others.Thus, if the contracting parties resolve their disputes by compromise, traditional business and morality points of view, then the mediation by the trading community will work efficiently and will also reduce the transaction costs to a large extent.


However, these might fail as the markets expand and become complex.

Sometimes, it may also be possible that a breach of contract is economically efficient. For example, ‘X’ contracts with ‘Y’, the seller, to buy a machine for Rs. 25000. Just before the delivery, the demand rises unexpectedly and the price of that machine increases. Another buyer ‘Z’ approaches ‘Y’ and offers to pay him Rs.35000 for the same machine. Due to the disequilibrium in the demand and supply, the market price of the machine is Rs.27000. Suppose, ‘X’ goes to the court for special performance or may compel “Y’ to pay him some profit that “Y’ would make from breaching the contract. ‘X’ may insist on receiving Rs.3000 from ‘Y’ as damages. If ‘Y’ agrees, ‘X’ can recover at Rs.27000 and be better off by Rs.2000, than he would have been under the damage remedy, which would have given him only the difference between the cover price and the contract price.


Thus, wherever, seller’s better offer is higher than the new market price, the seller has an incentive to breach and the first buyer has an incentive to threaten specific performance to capture some of the sellers’ gains from the breach.

Therefore, under economic analysis of contract law, we have to analyze the case laws from the economic efficiency point of view.

Economic Analysis of Consumer Economic Analysis of Consumer Protection LawProtection Law

Economic development of the countries over the period of time has resulted in the growth of monopolies, divergence between private and social goods, increase in advertisement expenditure resulting in imperfect competition etc.

All these factors have resulted in the defects in the price mechanism. State intervention thus, becomes necessary.

The government has to correct these imbalances in the economy by regulating the economic activities.


Consumer Protection Law developed essentially as a response

to the legal and political ideals. It is the outcome of the conflicts between manufacturers and retailers on one hand and the consumers on the other.

The bases for conflict between the manufacturers and retailers on one hand and the consumers on the other hand are:

Unequal knowledge among the parties; and

Unequal bargaining power between the parties.


The principle of caveat emptor, (let buyers’ beware), does not make much sense in the modern complex world where the information is not distributed freely.

The buyer ends up being a loser and needs to be protected. If the sellers are put in positions where they become more open to court actions for negligence, defective or unsafe goods etc., they would then take steps to improve the quality or even withdraw from the markets.

The spread of education, advertising media, rising prices, large variety of goods, the concept of social responsibilities of business etc. are responsible for growing consumer awareness. In some cases the consumers have formed associations to protect their rights against unfair trade practices.


According to David Cravens and Gerald Hills, “consumerism is a social force within the environment designed to aid and protect the consumer by exerting legal, moral and economic pressure on business”.

Businessmen exploit consumers by supplying poor quality of goods at higher prices or by adopting unfair trade practices such as adulteration, hoarding, black marketing etc.

The government of India has taken several measures to promote a strong and broad based consumer movement in the country. Consumers’ organizations are provided financial assistance and various National Awards are instituted for the protection of consumers. The Consumers’ Welfare Funds Scheme, 1992 is meant to provide financial assistance to protect and promote the welfare of the consumers. It prepares and distributes audiovisual material on consumer affairs.


The Consumer Protection Act, 1986, came into force on July 1, 1987.

It aims to promote some basic rights of consumers and to set up quasi-judicial bodies for redressal of consumer disputes at the District, State and National levels.

It provides enormous powers to consumers and consumer organizations against unscrupulous businessmen.


The Act recognizes the following rights of consumers:

1. The right to safety against the marketing of goods which are

hazardous to life and property.

2. The right to information regarding the quality, quantity,

potency, purity, standard and price of goods.

3. The right of choice to have access to a variety of goods at

competitive prices.

4. The right to be heard and be assured that consumer interests

will receive due consideration at appropriate forums.

5. The right to being educated regarding the use of the product.

6. The right to seek redressal against unfair trade practices or

unscrupulous exploitation of consumers.


The Consumer Protection Act applies to all goods and

services of any kind other than for commercial purposes

provided by private sector or public sector or by co-operatives.

It covers public utility services too.

Any consumer or registered association of consumers,

State and Central government can file a complaint under this

Act.

The complaint can be filed either in person or by post and

there is no fee for filing of such complaint.

The complaint may relate to any defect in the goods, any

deficiency in service, price variation and unfair trade

practice.


The Consumer Protection Act has proved very helpful to consumers but the authorities suffer from shortage of funds, legal complications, bureaucratic procedures, delay in deciding the complaints etc.

Sometimes false claims are lodged which waste a lot of time and energy. All these things result in economic inefficiencies, wastage of scarce resources, costly and time consuming litigation.

Economic Analysis Of Law

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